Section 1  
          
          
          MONETARY POLICY AND THE ECONOMIC OUTLOOK   
           
          In 1998, the U.S. economy again performed impressively. Output
          expanded rapidly, the unemployment rate fell to the lowest level
          since 1970, and inflation remained subdued. Transitory factors,
          most recently falling prices for imports and commodities,
          especially oil, have helped to produce the favorable outcomes of
          recent years, but technological advances and increased efficiency,
          likely reflecting in part heightened global competition and changes
          in business practices, suggest that some of the improvement will be
          more lasting.   
           
          Sound fiscal and monetary policies have contributed importantly to
          the good economic results: Budgetary restraint at the federal level
          has bolstered national saving and permitted the Federal Reserve to
          maintain lower interest rates than would otherwise have been
          possible. This policy mix and sustained progress toward price
          stability have fostered clearer price signals, more efficient resource
          use, robust business investment, and sizable advances in the
          productivity of labor and in the real wages of workers. The more
          rapid expansion of productive potential has, in turn, helped to keep
          inflation low even as aggregate demand has been surging and as
          labor markets have tightened.   
           
          This past year, economic troubles abroad posed a significant threat
          to the performance of the economy. Foreign economic growth
          slowed markedly, on average, as conditions in many countries
          deteriorated. The recession in Japan deepened, and several
          emerging market economies in Asia, which had started to weaken
          in the wake of the financial crises of 1997, contracted sharply. A
          worsening economic situation in Russia last summer led to a
          devaluation of the ruble and a moratorium by that country on a
          substantial portion of its debt payments. As the year progressed,
          conditions in Latin America also weakened. Although some of the
          troubled foreign economies are showing signs of improvement,
          others either are not yet in recovery or are still contracting.   
           
          The Russian crisis in mid-August precipitated a period of unusual
          volatility in world financial markets. The losses incurred in Russia
          and in other emerging market economies heightened investors' and
          lenders' concerns about other potential problems and led them to
          become substantially more cautious about taking on risk. The
          resulting effects on U.S. financial markets included a substantial
          widening of risk spreads on debt instruments, a jump in measures
          of market uncertainty and volatility, a drop in equity prices, and a
          reduction in the liquidity of many markets. To cushion the U.S.
          economy from the effects of these financial strains, and potentially
          to help reduce the strains as well, the Federal Reserve eased
          monetary policy on three occasions in the fall. Global financial
          market stresses lessened somewhat after mid-autumn, reflecting, in
          part, these policy steps as well as interest rate cuts in other
          industrial countries and international efforts to provide support to
          troubled emerging market economies. Although some U.S.
          financial flows were disrupted for a time, most firms and
          households remained able to obtain sufficient credit, and the
          turbulence did not appear to constrain spending to a significant
          degree. More recently, some markets were unsettled by the
          devaluation and subsequent floating of the Brazilian real in
          mid-January, and the problems in Brazil continue to pose risks to
          global markets. Thus far, however, market reaction outside Brazil
          to that country's difficulties has been relatively muted.   
           
          The foreign exchange value of the dollar rose substantially against
          the currencies of the major foreign industrial countries over the
          first eight months of 1998, but subsequently it fell sharply, ending
          the year down a little on net. The appreciation of the dollar in the
          first half of the year carried it to an eight-year high against the
          Japanese yen. In June, this strength against the yen prompted the
          first U.S. foreign exchange intervention operation in nearly three
          years, an action that appeared to slow the dollar's rise against the
          yen over the following days and weeks. Later in the summer,
          concerns about the possible impact on the U.S. economy of
          increasing difficulties in Latin America began to weigh on the
          dollar's exchange value against major foreign currencies. After
          peaking in mid-August, it fell sharply over the course of several
          weeks, reversing by mid-October the appreciation that had
          occurred earlier in the year. The depreciation during this period
          was particularly sharp against the yen. The reasons for this decline
          against the yen are not clear, but repayment of yen-denominated
          loans by international investors and decisions by Japanese
          investors to repatriate their assets in light of increased volatility in
          global markets seem to have contributed. The exchange value of
          the dollar fluctuated moderately against the major currencies over
          the rest of the year, and after declining somewhat early in 1999, it
          has rebounded strongly in recent weeks, as incoming data have
          suggested continued strength of economic activity in the United
          States. Since the end of 1998, the dollar has appreciated about 7
          percent against the yen, partly reflecting further monetary easing in
          Japan. At the turn of the year, the launch of the third stage of
          European Economic and Monetary Union fixed the eleven
          participating countries' conversion rates and created a new
          common currency, the euro. The dollar has appreciated more than
          5 percent against the euro, in part because of signs that growth has
          slowed recently in some euro-area economies.   
           
          With the U.S. economy expanding rapidly, the economies of many
          U.S. trading partners struggling, and the foreign exchange value of
          the dollar having risen over 1997 and the first part of 1998, the
          U.S. trade deficit widened considerably last year. Some domestic
          industries were especially affected by reductions in foreign demand
          or by increased competition from imports. For example, a wide
          range of commodity producers, notably those in agriculture, oil,
          and metals, experienced sharp price declines. Parts of the
          manufacturing sector also suffered adverse consequences from the
          shocks from abroad. Overall, real net exports deteriorated sharply,
          as exports stagnated and imports continued to surge. The
          deterioration was particularly marked in the first half of the year;
          the second half brought a further, more modest, net widening of the
          external deficit.   
           
          Meanwhile, domestic spending continued to advance rapidly.
          Household expenditures were bolstered by gains in real income
          and a further rise in wealth, while a low cost of capital and
          optimism about future profitability spurred businesses to invest
          heavily in new capital equipment. Although securities markets
          were disrupted in late summer and early fall, credit generally
          remained available from alternative sources. Once the strains on
          securities markets had eased, businesses and households generally
          had ready access to credit and other sources of finance on relatively
          favorable terms, although spreads in some markets remained quite
          elevated, especially for lower-rated borrowers. All told, household
          and business outlays rose even more rapidly than in 1997, and that
          acceleration kept the growth of real GDP strong even as net
          exports were slumping.   
           
           Deteriorating economic conditions abroad, coupled with the
          strength of the dollar over the first eight months of the year, helped
          to hold down inflation in the United States by trimming the prices
          of oil and other imports. These declines reduced both the prices
          paid by consumers and the costs of production in many lines of
          business, and the competition from abroad kept businesses from
          raising prices as much as they might have otherwise. As the result
          of a reduced rate of price inflation, workers enjoyed a larger rise in
          real purchasing power even as increases in nominal hourly
          compensation picked up only slightly on average. Because of
          increased gains in productivity, corporations in the aggregate were
          able to absorb the larger real pay increases without suffering a
          serious diminution of profitability.    
          
           
          Monetary Policy, Financial Markets, and the Economy over 1998
          and Early 1999   
           
          Monetary policy in 1998 needed to balance two major risks to the
          economic expansion. On the one hand, with the domestic economy
          displaying considerable momentum and labor markets tight, the
          Federal Open Market Committee (FOMC) was concerned about
          the possible emergence of imbalances that would lead to higher
          inflation and thereby, eventually, put the sustainability of the
          expansion at risk. On the other hand, troubles in many foreign
          economies and resulting financial turmoil both abroad and at home
          seemed, at times, to raise the risk of an excessive weakening of
          aggregate demand.    
           
          Over the first seven months of the year, neither of these potential
          tendencies was sufficiently dominant to prompt a policy action by
          the FOMC. Although the incoming data gave no evidence of a
          sustained slowing of output growth, the Committee members
          believed that the pace of expansion likely would moderate as
          businesses began to slow the rapid rates at which they had been
          adding to their stocks of inventories and other investment goods,
          and as households trimmed the large advances in their spending on
          consumer durables and homes. Relatively firm real interest rates,
          buoyed by a high real federal funds rate resulting from the decline
          in the level of expected inflation, were thought likely to help
          restrain the growth of spending by businesses and households.
          Another check on growth was expected to come from the effects
          on imports and exports of the economic difficulties in emerging
          market economies in Asia and elsewhere. Indeed, production in the
          manufacturing sector slowed substantially in the first half of the
          year, and capacity utilization dropped noticeably. Moreover,
          inflation remained subdued, and a pickup was not expected in the
          near-to-intermediate term because of declining oil prices, and
          because of economic weakness abroad and the appreciation of the
          dollar, which were expected to trim the prices of imported goods
          and to increase price competition for many U.S. producers.
          Nonetheless, with labor markets already quite taut and aggregate
          demand growing rapidly--a combination that often has signaled the
          impending buildup of inflationary pressures--the Committee, at its
          meetings from March through July, judged conditions to be such
          that, if a policy action were to be taken in the period immediately
          ahead, it more likely would be a tightening than an easing; its
          directives to the Account Manager of the Domestic Trading Desk
          at the Federal Reserve Bank of New York noted that asymmetry.   
           
          By the time of the August FOMC meeting, however, the situation
          was changing. Although tight labor markets and rapid output
          growth continued to pose a risk of higher inflation, the damping
          influence of foreign economic developments on the U.S. economy
          seemed likely to increase. The contraction in the emerging market
          economies in Asia appeared to be deeper than had been
          anticipated, and the economic situation in Japan had deteriorated.
          Financial markets in some foreign economies also had experienced
          greater turmoil, and, the day before the Committee met, Russia was
          forced to devalue the ruble. These difficulties had been weighing
          on U.S. asset markets: Stock prices had fallen sharply in late July
          and into August as investors became concerned about the outlook
          for profits, and risk spreads in debt markets had widened, albeit
          from very low levels. Taking account of these circumstances, the
          Committee again left monetary policy unchanged at the August
          meeting, but it shifted to a symmetric directive, reflecting its
          perception that the risks to the economic outlook, at prevailing
          short-term rates, had become roughly balanced.   
           
          Over subsequent weeks, conditions in financial markets and the
          economic outlook in many foreign countries deteriorated further,
          increasing the dangers to the U.S. expansion. With investors
          around the world apparently reevaluating the risks associated with
          various credits and seemingly becoming less willing or able to bear
          such risks, asset demands shifted toward safer and more liquid
          instruments. These shifts caused a sharp fall in yields on Treasury
          securities. Spreads of yields on private debt securities over those
          on comparable Treasury instruments widened considerably further,
          and issuance slowed sharply. Measures of market volatility
          increased, and liquidity in many financial markets was curtailed.
          Equity prices continued to slide lower, with most broad indexes
          falling back by early September to near their levels at the start of
          the year. Reflecting the weaker and more uncertain economic
          outlook, some banks boosted interest rate spreads and fees on new
          loans to businesses and tightened their underwriting standards.   
           
          Against this backdrop, at its September meeting the FOMC looked
          beyond incoming data suggesting that the economy was continuing
          to expand at a robust pace, and it lowered the intended level of the
          federal funds rate 1/4 percentage point. The Committee noted that
          the rate cut would cushion the effects on prospective U.S.
          economic growth of increasing weakness in foreign economies and
          of less accommodative conditions in domestic financial markets.
          The directive adopted at the meeting suggested a bias toward
          further easing over the intermeeting period. In the days following
          the policy move, disturbances in financial markets worsened.
          Movements in the prices of securities were exacerbated by a
          deterioration in market liquidity, as some securities dealers cut
          back on their market-making activities, and by the expected
          unwinding of positions by hedge funds and other leveraged
          investors. In early October, Treasury yields briefly tumbled to their
          lowest levels in many years, reflecting efforts by investors to
          exchange other instruments for riskless and liquid Treasury
          securities.   
           
          Although some measures of market turbulence had begun to ease a
          bit by mid-October, financial markets remained extremely volatile
          and risk spreads were very wide. On October 15, consistent with
          the directive from the September meeting, the intended federal
          funds rate was trimmed another 1/4 percentage point, to 5 percent.
          This policy move, which occurred between FOMC meetings, came
          at the initiative of Chairman Greenspan and followed a conference
          call with Committee members. At the same time, the Board of
          Governors approved a 1/4 percentage point reduction in the
          discount rate. These actions were taken to buffer the domestic
          economy from the impact of the less accommodative conditions in
          domestic financial markets, in part by contributing to some
          stabilization of the global financial situation.   
           
          Following the October policy move, strains in domestic financial
          markets diminished considerably. As safe-haven demands for
          Treasury securities ebbed, Treasury yields generally trended
          higher, and measures of financial market volatility and illiquidity
          eased. Nonetheless, risk spreads remained very wide, and liquidity
          in many markets continued to be limited. Moreover, although
          pressures on some emerging market economies had receded a bit,
          partly reflecting concerted international efforts to provide
          assistance to Brazil, the foreign economic outlook remained
          uncertain. With downside risks still substantial, and in light of the
          cumulative effect since August of the tightening in many sectors of
          the credit markets and the weakening of economic activity abroad,
          the FOMC reduced the intended federal funds rate a further 1/4
          percentage point at its November meeting, bringing the total
          reduction during the autumn to 3/4 percentage point. The Board of
          Governors also approved a second 1/4 percentage point cut in the
          discount rate. The Committee believed that, with this policy action,
          financial conditions could reasonably be expected to be consistent
          with fostering sustained economic expansion while keeping
          inflationary pressures subdued. The action provided some
          insurance against an unexpectedly severe weakening of the
          expansion, and the Committee therefore established a symmetrical
          directive. By the time of the December meeting, the situation in
          financial markets had changed little, on balance, and the
          Committee decided that no further change in rates was desirable
          and that the directive should remain symmetrical.   
           
          Some measures of financial volatility eased further in the new year,
          although risk spreads on corporate bonds remained at quite high
          levels. Yields on Treasury securities were about flat, on balance, in
          January, as the effect of stronger-than-expected economic growth
          appeared to be about offset by data suggesting that inflation
          remained quiescent and perhaps also by the effects of some
          safe-haven flows prompted by the deteriorating situation in Brazil.
          Over the same period, stock prices surged higher, led by computer
          and other technology shares, and most stock price indexes posted
          new highs. By the time of the February 2-3 meeting, financial
          markets were easily accommodating robust demands for credit, and
          economic activity seemed to have more momentum than many had
          anticipated. However, the foreign sector continued to pose a threat
          to U.S. growth going forward, inflation showed no signs of picking
          up despite the rapid pace of growth and the very tight labor market,
          and some slowing of economic growth remained a likely prospect.
          In these circumstances, the FOMC concluded that it was prudent to
          wait for further information, and it left policy unchanged.    
           
          
          Economic Projections for 1999   
           
          By and large, the members of the Board of Governors and the
          Federal Reserve Bank presidents, all of whom participate in the
          deliberations of the FOMC, expect the economy to expand
          moderately, on average, in 1999. The central tendency of the
          FOMC participants' forecasts of real GDP growth from the fourth
          quarter of 1998 to the fourth quarter of 1999 is 2-1/2 percent to 3
          percent. The anticipated expansion is expected to create enough
          new jobs to keep the civilian unemployment rate near its recent
          average, in a range of 4-1/4 percent to 4-1/2 percent. With
          tightness of the labor market expected to persist and oil and import
          prices unlikely to be as weak in 1999 as they were in 1998,
          inflation is expected to move up somewhat from the rate of this
          past year but to remain low by the standards of the past three
          decades: The central tendency of the FOMC participants' CPI
          inflation forecasts for 1999 is 2 percent to 2-1/2 percent. The
          Federal Reserve officials' inflation forecasts are closely aligned
          with that of the Administration, and their forecasts of real GDP and
          unemployment depict a somewhat stronger real economy than the
          Administration is projecting.    
           
          Present circumstances suggest that domestic demand could
          continue to rise briskly for a while longer. Consumer spending
          continues to be driven by strong gains in employment, increases in
          real incomes, and rising levels of wealth. Those same factors,
          together with low mortgage interest rates, are keeping housing
          activity robust. Businesses are still investing heavily in new
          capital, especially computers and other high-tech equipment.
          Households and businesses appear willing to take on more debt in
          support of spending; although spreads on corporate debt remain
          elevated, rate levels are perceived to be attractive for most
          borrowers, and restraint on access to finance is not much in
          evidence.   
           
          As the year progresses, however, gains in domestic spending
          should begin to moderate. Spending increases for housing,
          consumer durables, and business equipment have been
          exceptionally large for a while now, substantially raising the rate of
          growth in the amounts of these goods owned by businesses and
          households; some moderation in outlays seems likely, lest these
          holdings become disproportionate to underlying trends in income
          and output. The outlook for spending continues to be obscured to
          some degree by uncertainties about the course of equity prices; a
          failure of these prices to match the outsized gains posted in recent
          years would contribute to some moderation in spending growth,
          especially by households. Government spending, which accounts
          for about one-sixth of domestic demand, seems likely to expand at
          a moderate pace overall. Along with the numerous other
          uncertainties that attend the outlook, an additional uncertainty is
          present this year because of the approach of the year 2000 and the
          associated Y2K problem.   
           
          Growth abroad is expected to remain sluggish, on balance, in 1999,
          limiting the prospects for exports. At the same time, growth of the
          U.S. economy probably will continue to generate fairly brisk
          increases in imports. In total, real net exports of goods and services
          seem likely to fall further in the coming year, although several
          factors--the decline in the dollar from its peak of last summer, the
          expected slowing of income growth in the United States, and the
          possibility of a slight pickup in economic growth abroad--provide a
          basis for thinking that this year's drop in net exports might not be
          as large as that of 1998.   
           
          The future course of inflation will depend in part on what happens
          to the prices of oil and other imports, and restraint from those
          sources seems unlikely to be as great as it was in 1998. The drop in
          the price of oil this past year left it toward the lower end of its
          range of the past couple of decades and has thereby reduced the
          incentives for exploration, drilling, and production. Futures
          markets have been showing a gradual rise in the price of oil going
          forward. Prices of nonoil imports changed little in the fourth
          quarter of last year after having fallen sharply in previous quarters.
          Indicators of the pressures on domestic resources provided mixed
          signals over the past year. In manufacturing, capacity utilization
          declined considerably, to a level below its long run average,
          reflecting slower production growth and sizable additions to the
          stock of capital. However, labor markets remained very taut, and
          with the economy apparently carrying substantial momentum into
          this year, data on costs and prices will need to be monitored
          carefully for signs that a rising inflation pattern might start to take
          hold. In that regard, the FOMC will continue to rely not only on
          the CPI but also on a variety of other price measures to gauge the
          economy's inflation performance in the period ahead.   
           
           
          Money and Debt Ranges for 1999  
           
          At its most recent meeting, the FOMC reaffirmed the 1999
          monetary growth ranges that were chosen on a provisional basis
          last July: 1 percent to 5 percent for M2, and 2 percent to 6 percent
          for M3. As has been the case for some time, the FOMC intends
          these money growth ranges to be benchmarks for growth under
          conditions of price stability, sustainable real economic growth, and
          historical velocity relationships rather than ranges that encompass
          the expected growth of money over the coming year or that serve
          as guides to policy.   
           
          Given continued uncertainty about movements in the velocities of
          M2 and M3 (the ratios of nominal GDP to the aggregates), the
          Committee would have little confidence that money growth within
          any particular range selected for the year would be associated with
          the economic performance it expected or desired. Nonetheless, the
          Committee believes that, despite the apparent large shift in velocity
          behavior in the early 1990s, money growth has some value as an
          economic indicator. Indeed, some FOMC members have expressed
          the concern that the unusually rapid growth in the money and debt
          aggregates in 1998 might have reflected monetary conditions that
          were too accommodative and would ultimately lead to an increase
          in inflation pressures. The Committee will continue to monitor the
          monetary aggregates as well as a wide variety of other economic
          and financial data to inform its policy deliberations.   
           
           Last year, M2 increased 8-1/2 percent, and with nominal GDP
          rising 5 percent, M2 velocity decreased 3 percent. This drop in
          velocity was considerably larger than would have been expected on
          the basis of historical relationships and the modest decline in the
          opportunity cost of M2 (measured as the difference between the
          interest rate on Treasury bills and the weighted average rate
          available on M2 assets). The fall in velocity in part reflected an
          increased demand for the safe and liquid assets in M2 as investors
          responded to the heightened volatility in financial markets in the
          second half of the year. Other factors that may have contributed
          include lower long-term interest rates and a very flat yield curve,
          which might have suggested to households that they would be
          giving up very little in earnings by parking savings in short-term
          assets in M2. In addition, M2 may have been boosted by a desire
          on the part of some investors to redirect savings flows away from
          equities after several years of outsized gains in stock market
          wealth. With equity wealth still elevated and the yield curve likely
          to remain flat, M2 velocity could continue to fall this year.
          However, the pace of decline should slow as some households
          respond to the easing of concerns about financial market volatility
          by reversing a portion of the shift toward M2 assets that occurred
          last fall. Indeed, this effect may already be visible, as M2 growth,
          while still robust, has slowed considerably early this year. If
          velocity does fall, given the Committee's expectations for nominal
          income growth, M2 could again exceed its price-stability
          benchmark range.   
           
          M3 expanded 11 percent last year, and its velocity fell 5-1/4
          percent, the largest drop in many years. The rapid growth in this
          aggregate owed in large part to a substantial rise in institutional
          money funds. These funds have been expanding rapidly in recent
          years as nonfinancial firms increasingly employ them to provide
          cash management services. Investments in these funds provide
          businesses with greater liquidity than direct holdings of money
          market instruments, and by substituting for such direct holdings,
          they boost M3. M3 was also buoyed last year by a large advance in
          the managed liabilities banks used to fund rapid growth in bank
          credit. In part, the growth in bank credit reflected demand by
          borrowers shifting from the securities markets, and with these
          markets again receptive to new issues, bank credit growth this year
          is expected to slow to a pace more in line with broader debt
          aggregates However, institutional money funds are likely to
          continue their robust gains, contributing to a further diminution in
          M3 velocity and, possibly, to growth of this aggregate above its
          price-stability range.   
           
          Domestic nonfinancial debt grew 6-1/4 percent in 1998, somewhat
          above the middle of the 3 percent to 7 percent growth range the
          Committee established last February. This robust growth reflected
          large rises in the debt of businesses and households owing to
          substantial advances in spending as well as debt-financed mergers
          and acquisitions. However, the increase in private-sector debt was
          partly offset by the first annual decline in federal debt in almost
          thirty years. As with the monetary aggregates, the Committee left
          the range for debt growth unchanged for 1999. After an aberrant
          period in the 1980s during which debt growth greatly exceeded
          growth of nominal GDP, debt growth over the past decade has
          returned to its historical pattern of about matching growth of
          nominal GDP, and the Committee members expect debt to fall
          within its range this year.  

          Section 2     
          
          ECONOMIC AND FINANCIAL DEVELOPMENTS IN 1998
          AND EARLY 1999        
          
          The U.S. economy continued to display great vigor in 1998,
          despite a sharp slowing of growth in foreign economies and an
          unsettled world financial environment. According to the
          Commerce Department's advance estimate, real GDP increased a
          little more than 4 percent over the four quarters of the year. The
          economic difficulties facing many of our trading partners and the
          strength of the dollar through much of the year led to sluggishness
          in real exports of goods and services. However, the drag on the
          economy from that source was more than offset by exceptional
          strength in the real expenditures of households and businesses,
          which were powered by strong real income growth, large gains in
          the value of household wealth, ready access to finance during most
          of the year, and widespread optimism regarding the future of the
          economy. Although turmoil in financial markets seemed to
          threaten the economy for a time in late summer and early autumn,
          that threat later receded, in part because of the steps taken by the
          Federal Reserve to prevent the tightening of credit markets from
          impairing the expansion of activity. The final quarter of the year
          brought brisk expansion of employment and income, and the
          limited indicators of activity in early 1999 have been strong, on
          balance.     
           
          The increase in the general price level this past year was smaller
          than that in the previous year, which had itself been among the
          smallest in decades. The chain-type price index for GDP rose
          slightly less than 1 percent. The further slowing of price increases
          was in large part a reflection of sluggish conditions in the world
          economy, which brought declines in the prices of a wide range of
          imported goods, including oil and other primary commodities. In
          the domestic economy, nominal hourly compensation of workers
          picked up only slightly despite the tightness of the labor market,
          and much of the compensation increase was offset by gains in
          labor productivity. As a result, unit labor costs, the most important
          item in total business costs, rose only modestly.    
           
          The Household Sector  
           
          Personal consumption expenditures increased more than 5 percent
          in real terms in 1998, the biggest gain in a decade and a half.
          Support for the large rise in spending came from a combination of
          circumstances that, on the whole, were exceptionally favorable to
          households. Strong gains in employment and real hourly pay gave
          another appreciable boost to the growth of real labor income. At
          the same time, the wealth of households recorded another year of
          substantial increase, bolstered in large part by the continued rise in
          equity prices. Although not all balance sheet data for the end of
          1998 are available, household net worth at that point appears to
          have been up about 10 percent from the level at the end of 1997.
          The cumulative gain in household wealth since 1994 has amounted
          to nearly 50 percent.     
           
          The rise in net worth probably accounts for much of the decline in
          the personal saving rate over the past few years, to an annual
          average of  percent in 1998. Households tend to raise their saving
          from current income when they feel that wealth must be increased
          to meet longer-run objectives, but they are willing to reduce their
          saving from current income when they feel that wealth already is at
          satisfactory levels. The low level of the saving rate in 1998 is not
          so remarkable when gauged against a wealth-to-income ratio that
          has been running in a range well above its longer-run historical
          average.     
           
          All of the major categories of personal consumption
          expenditures--durables, nondurables, and services--recorded gains
          in 1998 that were the largest of the 1990s.  Spending on durable
          goods rose more than 12 percent over the year. Within that
          category, expenditures on home computers once again stood out,
          rising roughly 70 percent in real terms, a gain that reflected both
          increased nominal outlays and a further substantial decline in
          computer prices. Consumer outlays on motor vehicles also rose
          sharply, despite some temporary limitations on supply from a
          midyear auto strike. Spending on most other types of durable
          goods registered increases that were well above the averages of the
          past decade or so. Because goods such as these are not consumed
          all at once--but, rather, add to stocks of durable goods that will be
          yielding services to consumers for a number of years--they embody
          a form of economic saving that is not captured in the normal
          measure of the saving rate in the national income accounts.   
           
          The increases in income and net worth that led households to boost
          consumption expenditures also led them to invest heavily in
          additions to the stock of housing. Declines in mortgage interest
          rates weighed in as well, helping to maintain the affordability of
          housing even as house prices moved up somewhat faster than
          overall inflation. These developments brought the objective of
          owning a home within the reach of a greater number of households,
          and the home-ownership rate, which has been trending up this
          decade, rose to another new high in 1998.   
           
          In the single-family sector, sales of new and existing homes
          surged, the former rising more than 10 percent from the previous
          year's total and the latter more than 13 percent. Construction of
          single-family houses strengthened markedly. The number of these
          units started during the year was the largest since the late 1970s,
          and it exceeded the previous year's total by about 12 percent. In the
          fourth quarter, unusually mild weather permitted builders to
          maintain activity later into the season than they normally would
          have and gave an added kick to housing starts. Starts increased
          further in January of this year, despite harsher weather in some
          regions.   
           
          In contrast to the strength in the single-family sector, the number
          of multifamily units started in 1998 was up only a little from the
          total for 1997. After bottoming out at a very low level early in the
          1990s, construction of these units had been trending back up fairly
          briskly until this past year. But with vacancy rates on multifamily
          rental units running a touch higher this past year, builders and their
          creditors may have become concerned about adding too many new
          units to the stock. Financing appeared generally to be in ample
          supply for projects that looked promising; during the period of
          financial turmoil, the flow of credit was supported by substantial
          purchases of multifamily mortgages and mortgage-backed
          securities by Freddie Mac and Fannie Mae.   
           
          Total outlays for residential investment increased about 12-1/2
          percent in real terms during 1998, according to the Commerce
          Department's initial tally. The large increase reflected not only the
          construction work undertaken on new residential units during the
          year but also sizable advances in real outlays for home
          improvements and in the volume of sales activity being carried on
          by real estate brokers, which generated substantial gains in
          commissions.    
           
          The robust growth in household expenditures in 1998 was
          accompanied by an expansion of household debt that likely
          exceeded 8-1/2 percent, a somewhat larger rise than in other recent
          years. Nonmortgage debt increased about 6 percent, about 2
          percentage points above the previous year's pace but down
          considerably from the double-digit increases posted in 1994 and
          1995. Home mortgage debt is estimated to have jumped more than
          9 percent, its largest annual advance since 1990, boosted in part by
          the robust housing market. In addition, with mortgage rates
          reaching their lowest levels in many years, many households
          refinanced existing mortgages, and some households likely took
          the opportunity presented by refinancing to increase the size of
          their mortgages, using the extra funds raised to finance current
          expenditures or to pay down other debts.   
           
          The growth in household debt reflected both supply and demand
          influences. With wealth rising faster than income over the year and
          with consumer confidence remaining at historically high levels,
          households were willing to boost their indebtedness to finance
          increased spending. In addition, lenders generally remained
          accommodative toward all but the most marginal households, even
          after the turmoil in many financial markets in the fall. After a more
          general tightening of loan conditions in response to a rise in losses
          on such loans between mid-1995 and mid-1997, a smaller and
          declining fraction of banks tightened consumer lending standards
          and terms last year, according to Federal Reserve surveys.
          However, the availability of high loan-to-value and subprime home
          equity loans likely was reduced in the fall because of difficulties in
          the market for securities backed by such loans.   
           
          Despite the rapid increase in debt, measures of household financial
          stress were relatively stable last year, although some remained at
          high levels. The delinquency rate on home mortgages has stayed
          quite low in recent years, while the delinquency rate on auto loans
          at domestic auto finance companies has trended lower. The
          delinquency rate on credit card loans at banks fluctuated in a fairly
          narrow range in 1997 and 1998, but it remained elevated after
          having posted a substantial rise over the previous two years.
          Personal bankruptcy filings have followed a broadly similar
          pattern: Annual growth has run at about 3 percent over the past
          year and a half, down from annual increases of roughly 25 percent
          between mid-1995 and early 1997. The stability of these measures
          over the past couple of years likely owes in part to the earlier
          tightening of standards and terms on consumer loans. In addition,
          lower interest rates and longer loan maturities, which resulted from
          the shift toward mortgage finance, have helped to mitigate the
          effects of increased borrowing on household debt-service burdens.  
           
           
           
          The Business Sector  
           
          Business fixed investment increased about 12-1/2 percent during
          1998, with a 17-1/2 percent rise in equipment spending more than
          accounting for the overall advance. The strength of the economy
          and optimism about its longer-run prospects provided
          underpinnings for increased investment. Outlays were also
          bolstered by the efficiencies obtainable with new technologies, by
          the favorable prices at which many types of capital equipment
          could be purchased, and, except during the period of financial
          market turmoil, by the ready availability and low cost of finance,
          either through borrowing or through the issuance of equity shares.   
            
           
          Real expenditures on office and computing equipment, after having
          risen at an average rate of roughly 30 percent in real terms from
          1991 through 1997, shifted into even higher gear in 1998, climbing
          about 65 percent. The outsized increase likely owed in part to the
          efforts of some businesses to put new computer systems in place
          before the end of the millennium, in hopes of circumventing
          potential difficulties arising from the Y2K problem. But, beyond
          that, investment in computers is being driven by the same factors
          that have been at work throughout the expansion--namely, the
          introduction of machines that offer greater computing power at
          increasingly attractive prices and that provide businesses new and
          more efficient ways of organizing their operations. Price declines
          this past year were especially large, as the cost reductions
          associated with technical change were augmented by heightened
          international competition in the markets for semiconductors and
          other computer components and by price cutting to work down the
          stocks of some assembled products.   
           
          Investment in communications equipment--another high-tech
          category that is an increasingly important part of total equipment
          outlays--rose about 18-1/2 percent in 1998. After having traced out
          an erratic pattern of ups and downs through the latter part of the
          1980s and the early 1990s, real outlays on this type of equipment
          began to record sustained large annual increases in 1994, and the
          advance last year was one of the largest. Spending on other types
          of equipment displayed varying degrees of strength across different
          sectors but recorded a sizable gain overall. Investment in
          transportation equipment was strong across the board, spurred by
          the need to move greater volumes of goods or to carry more
          passengers in an expanding economy. Spending on industrial
          machinery advanced about 4-1/2 percent after larger gains in most
          previous years of the expansion, a pattern that mirrored a slowing
          of output growth in the industrial sector.   
           
          Business investment in nonresidential structures, which accounts
          for slightly more than 20 percent of total business fixed
          investment, was down slightly in 1998, according to the advance
          estimate. Sharply divergent trends were evident within the sector,
          ranging from considerable strength in the construction of office
          buildings to marked weakness in the construction of industrial
          buildings. The waxing and waning of industry-specific
          construction cycles appears to be the main explanation for the
          diverse outcomes of this past year. Although some of the more
          speculative construction plans may have been shelved because of a
          tightening of the terms and standards on loans, partly in reaction to
          the financial turmoil, most builders appear to have been able to
          eventually obtain financing. Despite the sluggishness of spending
          on structures this past year, the level of investment remained high
          enough to generate continued moderate growth in the real stock of
          structures.   
           
          Business inventories increased about 4-1/2 percent in real terms
          this past year after having risen more than 5 percent during 1997.
          Stocks grew at a 7 percent annual rate in the first quarter,
          appreciably faster than final sales, but inventory growth over the
          remainder of the year was considerably slower than in the first
          quarter. At year-end, stocks in most nonfarm industries were at
          levels that did not seem likely to cause firms to restrain production
          going forward. Inventories of vehicles may even have been a little
          on the lean side, as a result of both a strike that held down
          assemblies through the middle part of 1998 and exceptionally
          strong demand, which prevented the rebuilding of stocks later in
          the year. By contrast, inventories at year-end appear to have been
          excessive in a few nonfarm industries that have been hurt by the
          sluggish world economy. Stocks of farm commodities also
          appeared to be excessive, having been boosted further this past
          year by large harvests and sluggish export demand.     
           
          The economic profits of U.S. corporations--that is, book profits
          adjusted so that inventories and fixed capital are valued at their
          current replacement cost--rose further, on net, over the first three
          quarters of 1998 but at a much slower pace than in most other
          years of the current expansion. Companies' earnings from
          operations in the rest of the world fell back a bit, as did the profits
          of private financial corporations from domestic operations. The
          profits of nonfinancial corporations from domestic operations
          increased at an annual rate of about 1-3/4 percent. Although the
          volume of output of the nonfinancial companies continued to rise
          rapidly, profits per unit of output were squeezed a bit by
          companies' difficulties in raising prices in step with costs in a
          competitive market environment.    
           
          With profits expanding more slowly and investment spending still
          on the upswing, businesses' external funding needs increased
          substantially last year. Aggregate borrowing by the nonfinancial
          business sector is estimated to have expanded 9-1/2 percent from
          the end of 1997 to the end of 1998, the largest increase in ten years.
          The rise reflected growth in all major types of business debt.
          Business borrowing was also boosted by substantial merger and
          acquisition activity. Indeed, mergers and acquisitions, share
          repurchases, and foreign purchases of U.S. firms last year
          overwhelmed the high level of both initial and seasoned public
          equity issues, and net equity retirements likely exceeded $250
          billion.   
           
          The disruptions in the financial markets in late summer and early
          fall appear to have had little effect on total business borrowing but
          caused a substantial temporary shift in the sources of credit. With
          investors favoring high credit quality and liquidity, yields on
          lower-rated corporate bonds rose despite declining Treasury rates;
          the spread of yields on junk bonds over those on comparable
          Treasury securities roughly doubled between mid-summer and
          mid-autumn before falling back somewhat as conditions in
          financial markets eased. The spread of rates on lower-tier
          commercial paper over those on higher-quality paper rose
          substantially during the fall but had retraced the rise by the early
          part of this year.   
           
          Reflecting these adverse market conditions, nonfinancial corporate
          bond issuance fell sharply in August and remained low through
          mid-October, with issuance of junk bonds virtually halted for a
          time. Commercial paper issuance rose sharply in August and
          September, as some firms apparently decided to delay bond issues,
          turning temporarily to the commercial paper market instead. Bond
          issuance picked up again in late October, however, and issuance in
          November was robust. Reflecting this rebound, commercial paper
          outstanding fell back in the fourth quarter. More recently, bond
          issuance has remained healthy, while borrowing in the commercial
          paper market has picked up.    
           
          During the period when financial markets were strained, some
          borrowers substituted bank loans--in some cases under credit lines
          priced before the markets became volatile--for other sources of
          credit, and business loans at banks expanded very rapidly for a
          time before tailing off late in the year. Federal Reserve surveys
          indicate that banks responded to the turmoil in financial markets by
          tightening standards and terms on new loans and credit lines,
          especially loans to larger customers and those to finance
          commercial real estate ventures. The tightening reflected the less
          favorable or more uncertain economic outlook as well as a reduced
          tolerance for risk on the part of some banks. Bank lending
          standards and terms appear to have tightened only a little further
          since the fall, however, and business loans at banks have expanded
          a bit since the end of December.   
           
          Despite the rapid growth in debt and the relatively small gain in
          profits last year, the financial condition of nonfinancial businesses
          remained strong. Interest rates for many businesses fell, on
          balance, over the course of the year, and bond yields for
          investment-grade firms reached their lowest level in many years.
          Reflecting these low borrowing costs, the aggregate debt-service
          burden for nonfinancial corporations, measured as the ratio of net
          interest payments to cash flow, remained about 9-1/2 percent, near
          its low of 9 percent in 1997 and less than half the peak level
          reached in 1989. The delinquency rate for banks' commercial and
          industrial loans also remained near the trough reached in late 1997,
          while that for commercial real estate loans fell a bit further from
          the already very low level posted in 1997. Although Moody's
          Investors Service downgraded more nonfinancial firms than it
          upgraded over the second half of the year, the downgraded firms
          were smaller on average, and so the debt of those upgraded about
          equaled the debt of those downgraded. Through October, business
          failures remained at the low end of the range seen over the past
          decade.    
           
           
          The Government Sector  
           
          The federal government recorded a surplus in the unified budget
          this past fiscal year for the first time in nearly three decades. The
          surplus, amounting to $69 billion, was equal to about 3/4 percent
          of GDP, a huge turnabout from the deficits of the early 1990s,
          which in some years were more than 4-1/2 per cent of GDP. The
          swing from deficit to surplus over the past few years is partly the
          result of fiscal policies aimed at lowering the deficit and partly the
          result of the strength of the economy and the stock market.
          Excluding net interest payments--a charge stemming from past
          deficits--the government recorded a surplus of more than $300
          billion in fiscal 1998.    
           
          The improvement in the government's saving position has
          permitted national saving--the combined gross saving of
          households, businesses, and governments--to move up about 3
          percentage points from its low of a few years ago, even though
          personal saving has fallen sharply. In turn, that increase in national
          saving has helped facilitate the boom in investment spending--in
          contrast to the experience of the 1980s and early 1990s, when
          persistent large budget deficits tended to reduce national saving,
          boost interest rates higher than they otherwise would have been,
          and thereby crowd out private capital formation.    
           
          Federal receipts in the unified budget in fiscal year 1998 were up 9
          percent from the previous fiscal year, with much of the gain
          coming from personal income taxes, which rose more than 12
          percent for a second consecutive year. These receipts have been
          rising faster than personal income in recent years, for several
          reasons: Tax rates at the high end of the income scale were raised
          by legislation that was passed in 1993 to help reduce the deficit;
          more taxpayers have moved into higher tax brackets as income has
          increased; and large increases in asset values have raised tax
          receipts from capital gains. Social insurance tax receipts, the
          second most important source of federal revenue, increased 6
          percent in fiscal 1998, just a touch faster than the increase in fiscal
          1997 and roughly in step with the growth of wages and salaries.
          Receipts from the taxes on corporate profits, which account for just
          over 10 percent of federal revenues, rose less rapidly than in other
          recent years, restrained by the slower growth of corporate profits.
          In the first three months of fiscal 1999, net receipts from corporate
          taxes dipped below year-earlier levels, but gains in individual
          income taxes and payroll taxes kept total federal receipts on a
          rising trajectory.   
           
          Unified outlays increased 3-1/4 percent in fiscal 1998 after having
          risen 2-1/2 percent in the preceding fiscal year. Net interest
          payments and nominal expenditures for defense fell slightly in the
          latest fiscal year, and outlays for income security and Medicare
          rose only a little. Social security expenditures increased moderately
          but somewhat less than in other recent years. By contrast, the
          growth of Medicaid payments picked up to about 6 percent after
          having increased less than 4 percent in each of the preceding two
          years; however, even the 1998 rise was not large compared with
          those of many earlier years when both medical costs and Medicaid
          caseloads were increasing rapidly and rates of federal
          reimbursement to the states were being raised. Federal spending in
          fiscal 1999 will be boosted to some degree by new budget
          authority for a variety of functions, including defense, embassy
          security, disaster relief, preparation for Y2K, and aid to agriculture;
          this authority was created in emergency legislation that provided
          an exception to statutory spending restrictions.   
           
          Real federal outlays for consumption and investment, the part of
          federal spending that is counted in GDP, increased 1 percent, on
          net, from the final quarter of calendar year 1997 to the final quarter
          of 1998. A reduction in real defense outlays over that period was
          more than offset by a jump in the nondefense category.   
           
          With the budget balance shifting from deficit to surplus, the stock
          of publicly held federal debt declined last year for the first time
          since 1969 and fell further as a share of GDP. From the end of
          1997 to the end of 1998, U.S. government debt fell 1-1/2 percent,
          as the government reduced the outstanding stock of both bills and
          coupon securities. Despite the reduction in its debt, the federal
          government continued substantial gross borrowing to fund the
          retirement of maturing securities. However, with the need for funds
          trimmed substantially, the Treasury changed its auction schedules,
          discontinuing the three-year note auctions and moving to quarterly,
          rather than monthly, auctions of five-year notes. By reducing the
          number of coupon security issues, the Treasury is able to boost the
          size of each, thereby contributing to their liquidity. The decrease in
          the total volume of coupon securities is intended to boost the size
          of bill offerings over time, helping liquidity in that market and also
          allowing, as the Treasury prefers, for balanced issuance across the
          yield curve. The Treasury also announced in October that all future
          bill and coupon security auctions would employ the single-price
          format that had already been adopted for the two-year and
          five-year note auctions and for auctions of inflation-indexed
          securities. The Treasury judged that the single-price format had
          reduced servicing costs and resulted in broader market
          participation.    
           
          The Treasury continued to auction inflation-indexed securities in
          substantial volume last year in an effort to build up this part of the
          Treasury market. In April, the Treasury issued its first thirty-year
          indexed bond, and in September it announced a regular schedule of
          ten- and thirty-year indexed security auctions. The Treasury also
          began offering inflation-indexed savings bonds in September.   
           
          State and local governments recorded further increases in their
          budgetary surpluses in 1998, both in absolute terms and as a share
          of GDP. Revenue from the taxes on individuals' incomes has been
          growing very rapidly, keeping total receipts on a solid upward
          course. At the same time, the growth of transfer payments, which
          had threatened to overwhelm state and local budgets earlier in the
          decade, has slowed substantially in recent years. Growth of other
          types of spending has been trending up moderately, on balance.
          The 1998 rise in real expenditures for consumption and investment
          amounted to about 2-1/4 percent, according to the initial estimate;
          annual gains have been in the range of 2 percent to 2-3/4 percent in
          each of the past seven years.   
           
          Despite rising surpluses, state and local government debt increased
          an estimated 7 percent in 1998, a pickup of about 2 percentage
          points from growth in 1997. Somewhat more than half of the
          long-term borrowing by state and local governments last year
          reflected new borrowing to fund current and anticipated capital
          spending on utilities, transportation, education, and other capital
          projects. The combination of budget surpluses and relatively heavy
          borrowing likely reflected a number of factors. First, some of these
          governments may have spent the newly raised funds on capital
          projects while at the same time building up surpluses in "rainy day
          funds" for later use. Second, because state and local governments
          under some circumstances are allowed to hold funds raised in the
          markets for as long as five years before spending them, some of the
          money raised last year may not have been spent. Finally, there was
          a substantial volume of "advance refunding" last year. In an
          advance refunding, the borrower issues new bonds before existing
          higher-rate bonds can be called, in anticipation of calling the old
          bonds on the date that option becomes available. While this sort of
          refinancing temporarily boosts total debt, it allows the state or local
          government to lock in the lower rate even if municipal bond yields
          subsequently rise over the period before the call date. The high
          level of advance-refunding activity last year was the result of lower
          borrowing costs. Although yields on tax-exempt municipal
          securities did not decline nearly as much as those on comparable
          Treasury securities, they nonetheless reached their lowest levels in
          many years. In addition, rating agencies upgraded about five times
          as many state and local government issues last year as they
          downgraded, trimming borrowing costs further for the upgraded
          entities.    
           
           
          The External Sector   
           
           
          Trade and the Current Account   
           
          U.S. external balances deteriorated further in 1998, largely because
          of the disparity between the rapid growth of the U.S. economy and
          the sluggish growth of the economies of many of our trading
          partners. The nominal trade deficit for goods and services was
          $169 billion, considerably larger than the $110 billion deficit in
          1997. For the first three quarters of the year, the current account
          deficit averaged $220 billion at an annual rate, substantially larger
          than the 1997 deficit of $155 billion. The large current account
          deficits of recent years have been funded with increased net foreign
          saving in the United States. As a result, U.S. gross domestic
          investment has exceeded the level that could have been financed by
          gross national saving alone, but at the cost of a rise in net U.S.
          external indebtedness.    
           
          The increase in the current account deficit last year was due to a
          decline in net exports of goods and services as well as a further
          weakening of net investment income from abroad. Until 1997, net
          investment income had helped to offset persistent trade deficits.
          But as the U.S. net external debt has risen in recent years, net
          investment income has become increasingly negative, moving
          from a $14 billion surplus in 1996 to a $5 billion deficit in 1997
          and a deficit averaging $15 billion at an annual rate over the first
          three quarters of 1998. Net income from portfolio investment
          became increasingly negative during that period as the net portfolio
          liability position of the United States grew larger. In addition, net
          income from direct investment slowed last year because slower
          foreign economic growth lowered U.S. earnings on investment
          abroad, the appreciation of the dollar reduced the value of U.S.
          earnings, and buoyant U.S. growth boosted foreigners' earnings on
          direct investment in the United States.   
           
          The rise in the trade deficit reflected an increase of about 10
          percent in real imports of goods and services during 1998,
          according to the advance estimates from the Commerce
          Department. The expansion was fueled by robust growth of U.S.
          domestic demand and by continued declines in import prices,
          which stemmed in part from the strength of the dollar through
          mid-August and in part from the effects of recessions abroad. Of
          the major trade categories, increases in imports were sharpest for
          finished goods, especially capital equipment and automotive
          products. The quantity of imported oil rose appreciably as demand
          increased in response to the strength of U.S. economic activity and
          lower oil prices, while domestic production declined slightly. The
          price of imported oil fell about $6.50 per barrel over the four
          quarters of the year. World oil prices fell in response to reduced
          demand associated with the economic slowdown in many foreign
          nations and with unusually warm weather in the Northern
          Hemisphere as well as to an increase in supply from Iraq.    
           
          Real exports of goods and services grew about 1 percent, on net, in
          1998 after posting a 10 percent rise in 1997. Declines during the
          first three quarters (especially in machinery exports) were offset by
          a rebound in the fourth quarter, which was led by increases in
          exports of automotive products. The price competitiveness of U.S.
          products decreased, reflecting the appreciation of the dollar
          through mid-August. In addition, economic activity abroad
          weakened sharply; total average foreign growth (weighted by
          shares of U.S. exports) plunged from 4 percent in 1997 to an
          estimated 1/2 percent in 1998. Moderate expansion of exports to
          Europe, Canada, and Mexico was about offset by a decline in
          exports associated with deep recessions in Japan and the emerging
          Asian economies (particularly in the first half of the year) and in
          South America (in the second half of the year).   
           
           
          Capital Flows    
           
          The financial difficulties in a number of emerging market
          economies had several noticeable effects on U.S. international
          capital flows in 1998. Financial turmoil put strains on official
          reserves in many emerging market economies. Foreign official
          assets in the United States fell $43 billion in the first three quarters
          of the year. This decline, which began in the fourth quarter of
          1997, has been largest for developing countries, as many of them
          drew down their foreign exchange reserves in response to exchange
          rate pressures. OPEC nations' foreign official reserves also shrank
          in the first three quarters of 1998, as oil revenues dropped.
          Preliminary data indicate that foreign official assets in the United
          States, especially those of industrial countries, rebounded in the
          fourth quarter.   
           
          Private capital flows also were affected by the global turmoil. On a
          global basis, capital flows to emerging market economies fell
          substantially in the first half of 1998 and then dropped
          precipitously in late summer and early fall in the wake of the
          Russian crisis. During the first half of the year, U.S. residents
          acquired more than $40 billion of foreign securities. Net purchases
          virtually stopped in July, and in the August-October period U.S.
          residents, on net, sold about $40 billion worth of foreign securities.
          Preliminary data indicate a resumption of net U.S. purchases in the
          final two months of 1998. Foreign net purchases of U.S. securities,
          which were substantial in the first half of the year, fell off
          markedly in the July-October period, but preliminary data suggest
          a significant recovery in November and December. Thus, there is
          some evidence that the contraction in gross capital flows seen in
          late summer and early fall waned somewhat in the fourth quarter.   
           
          Balance of payments data available through the first three quarters
          of 1998 show that total private foreign purchases of U.S. securities
          amounted to $194 billion, somewhat below the level in the first
          three quarters of 1997. Private foreign purchases of U.S. Treasury
          securities were only $22 billion in the first three quarters,
          compared with $147 billion for all of 1997. Private foreigners'
          purchases of other U.S. securities shifted away from equities and
          toward bonds, relative to 1997. U.S. purchases of foreign securities
          slowed markedly from their 1997 pace, totaling only $27 billion
          for the first three quarters of 1998 compared with $89 billion for
          all of the preceding year. The contraction in private portfolio
          capital flows, though large, was overshadowed by huge direct
          investment capital flows, which resulted in part from a number of
          very large cross-border mergers. The $72 billion in foreign direct
          investment into the United States in the first three quarters,
          together with several large mergers that occurred in the fourth
          quarter, are certain to bring the total for last year well above the
          record-high $93 billion posted in 1997. Merger activity also
          buoyed U.S. direct investment abroad: The pace of such
          investment in the first three quarters suggests that the annual total
          will be near the record-high $122 billion recorded in 1997.    
           
           
          The Labor Market  
           
          The rapid growth of output in 1998 was associated with both
          increased hiring and continued healthy growth in labor
          productivity. The number of jobs on nonfarm payrolls rose about
          2-1/4 percent from the end of 1997 to the end of 1998, a net
          increase of 2.8 million. Manufacturers reduced employment over
          the year, but in other parts of the economy the demand for labor
          continued to rise rapidly. The construction industry boosted
          employment about 6 percent over the year, and both the services
          industries and the finance, insurance, and real estate sector posted
          increases of more than 3-1/2 percent. Stores selling building
          materials and home furnishings expanded employment rapidly, as
          did firms involved in computer services, communications, and
          managerial services. In the first month of 1999, nonfarm payrolls
          increased an additional 245,000.   
           
          Output per hour in the nonfarm business sector rose 2-1/2 percent
          in 1998 after having increased about 1-3/4 percent, on average,
          over the two previous years. By comparison, the average rate of
          rise during the 1980s and the first half of the 1990s was just over 1
          percent per year. Because productivity often picks up to a pace
          above its long-run trend when economic growth accelerates, the
          results of the past three years might well be overstating the rate of
          efficiency gain that can be maintained in coming years. However,
          reasons for thinking that the trend might have picked up to some
          degree are becoming more compelling in view of the incoming
          data. The 1998 gain in output per hour was particularly impressive
          in this regard, in part because it came at a time when many
          businesses were diverting resources to correct the Y2K problem, a
          move that likely imposed a bit of drag on growth of output per
          hour. Higher rates of capital formation are raising the growth of
          capital per worker, and workers are likely becoming more skilled
          in employing the new technologies. Businesses not only are
          increasing their capital inputs but also are continuing to implement
          changes to their organizational structures and operating procedures
          that might enhance efficiency and bolster profit margins.    
           
          The rising demand for labor continued to strain supply in 1998.
          The civilian labor force rose just a touch more than 1 percent from
          the fourth quarter of 1997 to the fourth quarter of 1998, and with
          the number of persons holding jobs rising somewhat faster than the
          labor force, the civilian unemployment rate fell still further. The
          unemployment rate was 4.3 percent at the end of 1998; the average
          for the full year--4.5 percent--was the lowest of any year in almost
          three decades. In January of this year, the size of the labor force
          rose rapidly, but so did employment, and the unemployment rate
          remained at 4.3 percent. The percentage of the working age
          population that is outside the labor force and is interested in
          obtaining work but not actively seeking it edged down further this
          past year and has been in the lowest range since the collection of
          these data began in 1970. With the supply of labor as tight as it is,
          businesses are reaching further into the pool of individuals who do
          not have a history of strong attachment to the labor force; persons
          who are attempting to move from welfare to work are among the
          beneficiaries.     
           
          Workers have realized large increases in real wages and real hourly
          compensation over the past couple of years. The increases have
          come partly through faster gains in nominal pay than in the
          mid-1990s but also though reductions in the rate of price increase,
          which have been enhancing the real purchasing power of nominal
          earnings, perhaps to a greater degree than workers might have
          anticipated. According to the Labor Department's employment cost
          index, the hourly compensation of workers in private nonfarm
          industries rose 3-1/2 percent in nominal terms during 1998, a touch
          more than in 1997 and  percentage point more than in 1996.
          Taking the consumer price index as the measure of price change,
          this increase in nominal hourly compensation translated into a 2
          percent increase in real hourly pay, one of the largest on record in a
          series that goes back to the start of the 1980s; the gain was bigger
          still if the chain-type price index for personal consumption
          expenditures is used as the measure of consumer prices. Moreover,
          the employment cost index does not capture some of the forms of
          compensation that employers have been using to attract and retain
          workers--for example, stock options and signing bonuses.     
           
          Because of the rapid growth in labor productivity, unit labor costs
          have been rising much less rapidly than hourly compensation in
          recent years. The increase in unit labor costs in the nonfarm
          business sector was only 1-1/2 percent in 1998. Businesses were
          unable to raise prices sufficiently to recoup even this small increase
          in costs, however. Labor gained a greater share of the income
          generated from production, and the profit share, though still high,
          fell back a little from its 1997 peak.   
           
           
          Prices  
          
          The broader measures of aggregate price change showed inflation
          continuing to slow in 1998. The consumer price index moved up
          1-1/2 percent over the four quarters of the year after having
          increased nearly 2 percent in 1997. A steep decline in energy prices
          in the CPI more than offset a small acceleration in the prices of
          other goods and services. Only part of the deceleration in the total
          CPI was attributable to technical changes in data collection and
          aggregation./1     
           
          Measures of aggregate price change from the national income and
          product accounts, which draw heavily on data from the CPI but
          also use data from other sources, showed a somewhat more
          pronounced deceleration of prices in 1998. The chain-type price
          index for personal consumption expenditures, the measure of
          consumer prices in the national accounts, rose 3/4 percent after
          increasing 1-1/2 percent in 1997. The chain-type price index for
          gross domestic purchases--the broadest measure of prices paid by
          U.S. households, businesses, and governments--increased only 
          percent in 1998 after moving up 1-1/4 percent over the previous
          year. The rise in the chain-type price index for gross domestic
          product of slightly less than 1 percent was down from an increase
          of 1-3/4 percent in 1997.    
           
           Developments in the external sector helped to bring about the
          favorable inflation outcome of 1998. Consumers benefited directly
          from lower prices of finished goods purchased from abroad. Lower
          prices for imports probably also held down the prices charged by
          domestic producers, not only because businesses were concerned
          about losing market share to foreign competitors but also because
          declines in commodity prices in sluggish world markets helped
          reduce domestic production costs to some degree.   
           
          In manufacturing, one of the sectors most heavily affected by the
          softness in demand from abroad, the rate of plant capacity
          utilization fell noticeably over the year--even as the unemployment
          rate continued to decline. The divergence of these two key
          measures of resource use--the capacity utilization rate and the
          unemployment rate--is unusual: They typically have exhibited
          similar patterns of change over the course of the business cycle.
          Because the unemployment rate applies to the entire economy, it
          presumably should be a better indicator of the degree of pressure
          on resources in general. At present, however, slack in the
          goods-producing sector--a reflection of the sizable additions to
          capacity in this country and excess capacity abroad--seemingly has
          enforced a discipline of competitive price and cost control that has
          affected the economy more generally.   
           
          Prices this past year tended to be weakest in the sectors most
          closely linked to the external economy. The price of oil fell almost
          40 percent from December 1997 to December 1998. This drop
          triggered steep declines in the prices of petroleum products
          purchased directly by households. The retail price of motor fuel
          fell about 15 percent over the four quarters of the year, and the
          price of home heating fuel also plunged. With the prices of natural
          gas and electricity also falling, the CPI for energy was down about
          9 percent over the year after having slipped 1 percent in 1997.   
           
          Large declines in the prices of internationally traded commodities
          other than oil pulled down the prices of many domestically
          produced primary inputs. The producer price index for crude
          materials other than energy, which reflects the prices charged by
          domestic producers of these goods, fell more than 10 percent over
          the year. However, because these non-oil commodities account for
          a small share of total production costs, the effect of their decline on
          inflation was much less visible further down the chain of
          production. Intermediate materials prices excluding food and
          energy fell about 1-1/2 percent over the four quarters of the year,
          and the prices of finished goods excluding food and energy rose
          about 1-1/2 percent. The latter index was boosted, in part, by an
          unusually large hike in tobacco prices that followed the settlement
          last fall of states' litigation against the tobacco companies. In the
          food sector as well, the effects of declining commodity prices
          became less visible further down the production chain; the PPI for
          finished foods was about unchanged, on net, over the year, and
          price increases at the retail level, though small, were somewhat
          larger than those of the preceding year.   
           
          Consumer prices excluding those of food and energy--the core
          CPI--continued to rise in 1998, but not very rapidly. As measured
          by the CPI, these prices increased nearly 2-1/2 percent from the
          final quarter of 1997 to the final quarter of 1998, a shade more than
          in 1997. The chain-type price index for personal consumption
          expenditures excluding food and energy--the core PCE price
          index--decelerated a bit further, rising at roughly half the pace of
          the core CPI. Methodological differences between the two
          measures are numerous; some of the technical problems that have
          plagued the CPI are less pronounced in the PCE price measure, but
          the latter also depends partly on imputations of prices for which
          observations are not available. Both measures, however, seemed to
          suggest that the underlying trend of consumer price inflation
          remained low. A similar message came from surveys of
          consumers, which showed expectations of future price increases
          easing a bit further in 1998--although, as in other recent years, the
          expected increases remained somewhat higher than actual price
          increases.   
           
           
          U.S. Financial Markets  
           
          U.S. interest rates fluctuated in fairly narrow ranges over the first
          half of 1998, and most equity price indexes posted substantial
          gains. However, after the devaluation of the Russian ruble in
          August and subsequent difficulties in other emerging market
          economies, investors appeared to reassess the risks and
          uncertainties facing the U.S. economy and concluded that more
          cautious postures were in order. That sentiment was reinforced by
          the prospect of an unwinding of positions by some highly
          leveraged investors. The resulting shift toward safe, liquid
          investments led to a substantial widening of risk spreads on debt
          instruments and to volatile changes in the prices of many assets.
          Financial market volatility and many risk spreads returned to more
          normal levels later in the year and early this year, as lower interest
          rates and robust economic data seemed to reassure market
          participants that the economy would remain sound, even in the face
          of additional adverse shocks from abroad. However, lenders
          remained more cautious than they had been in the first part of last
          year, especially in the case of riskier credits.     
           
           Interest Rates   
           
          Over the first half of 1998, short-term Treasury rates moved in a
          narrow range, anchored by unchanged monetary policy, while
          yields on intermediate- and long-term Treasury securities varied in
          response to the market's shifting assessment of the likely impact of
          foreign economic difficulties on the U.S. economy. In late 1997
          and into 1998, spreading financial crises in Asia were associated
          with declines in U.S. interest rates, as investors anticipated that
          weakness abroad would constrain U.S. economic growth and
          cushion the impact of tight U.S. labor markets on inflation.
          However, interest rates moved back up later in the first quarter of
          1998, as the U.S. economy continued to expand at a healthy pace,
          fueled by hefty gains in domestic demand. After a couple of
          months of small changes, Treasury rates fell in May and June,
          when concerns about foreign economies, particularly in Asia, once
          again led some observers to expect weaker growth in the United
          States and may also have boosted the demand for safe Treasury
          securities relative to other instruments.    
           
          Treasury rates changed little, on net, in the early summer, but they
          slipped lower in August, reflecting increased concern about the
          Japanese economy and financial problems in Russia. The default
          by Russia on some government debt obligations and the
          devaluation of the ruble in mid-August not only resulted in sizable
          losses for some investors but also undermined confidence in other
          emerging market economies. The currencies of many of these
          economies came under substantial pressure, and the market value
          of the international debt obligations of some countries declined
          sharply. U.S. investors shared in the resulting losses, and U.S.
          economic growth and the profits of U.S. companies were perceived
          to be vulnerable. In these circumstances, many investors, both here
          and abroad, appeared to reassess the riskiness of various
          counterparties and investments and to become less willing to bear
          risk. The resulting shift of demand toward safety and liquidity led
          to declines of 40 to 75 basis points in Treasury coupon yields
          between mid-August and mid-September. In contrast, yields on
          higher-quality private securities fell much less, and those on issues
          of lower-rated firms increased sharply. As a result, spreads of
          private rates over Treasury rates rose substantially, reaching levels
          not seen for many years, and issuance of corporate securities
          dropped sharply.     
           
          The desire of investors to limit risk-taking as markets became
          troubled in the late summer showed up clearly in mutual fund
          flows. High-yield bond funds, which had posted net inflows of
          more than $1 billion each month from May to July, saw a $3.4
          billion outflow in August and inflows of less than $400 million in
          September and October before rebounding sharply in November.
          By contrast, inflows to government bond funds jumped from less
          than $1 billion in July to more than $2 billion a month in August
          and September. Equity mutual funds posted net outflows totaling
          nearly $12 billion in August, the first monthly outflow since 1990,
          and inflows over the rest of the year were well below those earlier
          in the year.   
           
          In part, the foreign difficulties were transmitted to U.S. markets by
          losses incurred by leveraged investors--including banks, brokerage
          houses, and hedge funds--as the prospects for distress sales of
          riskier assets by such investors weighed on market sentiment,
          depressing prices. Many of these entities did reduce the scale of
          their operations and trim their risk exposures, responding to
          pressures from more cautious counterparties. As a result, liquidity
          in many markets declined sharply, with bid-asked spreads
          widening and large transactions becoming more difficult to
          complete. Even in the market for Treasury securities, investors
          showed an increased preference for the liquidity offered by the
          most recent issues at each maturity, and the yields on these more
          actively traded "on-the-run" securities fell noticeably relative to
          those available on "off-the-run" issues, the ones that had been
          outstanding longer.   
           
          Conditions in U.S. financial markets deteriorated further following
          revelations in mid-September of the magnitude of the positions and
          the extent of the losses of a major hedge fund, Long-Term Capital
          Management. LTCM indicated that it sought high rates of return
          primarily by identifying small discrepancies in the prices of
          different instruments relative to historical norms and then taking
          highly leveraged positions in those instruments in the expectation
          that market prices would revert to such norms over time. In
          pursuing its strategy, LTCM took very large positions, some of
          which were in relatively small and illiquid markets.   
           
          LTCM was quite successful between 1995 and 1997, but the
          shocks hitting world financial markets last August generated
          substantial losses for the firm. Losses mounted in September, and
          before new investors could be found, the firm encountered
          difficulties meeting liquidity demands arising from its collateral
          agreements with its creditors and counterparties. With world
          financial markets already suffering from heightened risk aversion
          and illiquidity, officials of the Federal Reserve Bank of New York
          judged that the precipitous unwinding of LTCM's portfolio that
          would follow the firm's default would significantly add to market
          problems, would distort market prices, and could impose large
          losses, not just on LTCM's creditors and counterparties, but also on
          other market participants not directly involved with LTCM.   
           
          In an effort to avoid these difficulties, the Federal Reserve Bank of
          New York contacted the major creditors and counterparties of
          LTCM to see if an alternative to forcing LTCM into bankruptcy
          could be found. At the same time, Reserve Bank officials informed
          some of their colleagues at the Federal Reserve Board, the
          Treasury, and other financial regulators of their activities.
          Subsequent discussions among LTCM's creditors and
          counterparties led to an agreement by the private-sector parties to
          provide an additional $3-1/2 billion of capital to LTCM in return
          for a 90 percent equity stake in the firm.   
           
          Because of the potential for firms such as LTCM to have a large
          influence on U.S. financial markets, Treasury Secretary Robert
          Rubin asked the President's Working Group on Financial Markets
          to study the economic and regulatory implications of the operations
          of firms like LTCM and their relationships with their creditors. In
          addition, the extraordinary degree of leverage with which LTCM
          was able to operate has led the federal agencies responsible for the
          prudential oversight of the fund's creditors and counterparties to
          undertake reviews of the practices those firms employed in
          managing their risks. These reviews have suggested significant
          weaknesses in the risk-management practices of many firms in
          their dealings with LTCM and--albeit to a lesser degree--in their
          dealings with other highly leveraged entities. Few counterparties
          seem to have had a complete understanding of LTCM's risk profile,
          and their credit decisions were heavily influenced by the firm's
          reputation and strong past performance. Moreover, LTCM's
          counterparties did not impose sufficiently tight limits on their
          exposures to LTCM, in part because they relied on collateral
          agreements requiring frequent marking to market to limit the risk
          of their exposures. While these agreements generally provided for
          collateral with a value sufficient to cover current credit exposures,
          they did not deal adequately with the potential for future increases
          in exposures from changes in market values. This shortcoming was
          especially important in dealings with a firm like LTCM, which had
          such large positions in illiquid markets that its liquidation would
          likely have moved prices sharply against its creditors. In such
          cases, creditors need to take further steps to limit their potential
          future exposures, which might include requiring additional
          collateral or simply scaling back their activity with such firms.   
           
          The private-sector agreement to recapitalize LTCM allowed its
          positions to be reduced in an orderly manner over time, rather than
          in an abrupt fire sale. Nonetheless, the actual and anticipated
          unwinding of LTCM's portfolio, as well as actual and anticipated
          sales by other similarly placed leveraged investors, likely
          contributed materially to the tremendous volatility of financial
          markets in early October. Market expectations of asset price
          volatility going forward, as reflected in options prices, rose
          sharply, as bid-asked spreads and the premium for on-the-run
          securities widened. Long-term Treasury yields briefly dipped to
          their lowest levels in more than thirty years, in part because of
          large demand shifts resulting from concerns about the safety and
          liquidity of private and emerging market securities. Spreads of
          rates on corporate bonds over those on comparable Treasury
          securities rose considerably, and issuance of corporate bonds,
          especially by lower-rated firms, remained very low.    
           
          By mid-October, however, market conditions had stopped
          deteriorating, and they began to improve somewhat in the days and
          weeks following the cut in the federal funds rate on October 15,
          between Federal Open Market Committee meetings.
          Internationally coordinated efforts to help Brazil cope with its
          financial difficulties, culminating in the announcement of an
          IMF-led support package in mid-November, contributed to the
          easing of market strains. In the Treasury market, bid-asked spreads
          narrowed a bit and the premium for on-the-run issues declined.
          With the earlier flight to quality and liquidity unwinding, Treasury
          rates backed up considerably. Corporate bond spreads reversed a
          part of their earlier rise, and investment-grade bond issuance
          rebounded sharply. In the high-yield bond market, investors
          appeared to be more hesitant, especially for all but the best-known
          issuers, and the volume of junk bond issuance picked up less. In
          the commercial paper market, yields on higher-quality paper
          declined; yields on lower-quality paper remained elevated,
          however, and some lower-tier firms reportedly drew on their bank
          lines for funding, giving a further boost to bank business lending,
          which had begun to pick up during the summer.   
           
          Market conditions improved a bit further immediately after the
          Federal Reserve's November rate cut, but some measures of market
          stress rose again in late November and in December. In part, this
          deterioration reflected widespread warnings of
          lower-than-expected corporate profits, a weakening economic
          outlook for Europe, and renewed concerns about the situation in
          Brazil. In addition, with risk a greater-than-usual concern, some
          market participants were likely less willing to hold lower-rated
          securities over year-end, when they would have to be reported in
          annual financial statements. As a result, liquidity in some markets
          appeared to be curtailed, and price movements were exaggerated.
          These effects were particularly noticeable in the commercial paper
          market: The spread between rates on top-tier and lower-tier
          thirty-day paper jumped almost 40 basis points on December 2,
          when that maturity crossed year-end, and then reversed the rise late
          in the month.   
           
          By shortly after year-end, some measures of market stress had
          eased considerably from their levels in the fall, although markets
          remained somewhat illiquid relative to historical norms, and risk
          spreads on corporate bonds stayed quite elevated. Nonetheless,
          with Treasury yields very low, corporate bond rates were
          apparently perceived as advantageous, and--following a lull around
          year-end--many corporate borrowers brought new issues to market.
          The devaluation and subsequent floating of the Brazilian real in
          mid-January had a relatively small effect on U.S. financial markets.
          More recently, intermediate- and long-term Treasury rates have
          increased, as incoming data have continued to show the economy
          expanding briskly, and investors have come to believe that no
          further easing of Federal Reserve policy is likely.    
           
           
          Equity Prices   
           
          Most equity indexes rose strongly, on balance, in 1998, with the
          Nasdaq Composite Index up nearly 40 percent, the S&P 500
          Composite Index rising more than 25 percent, and the Dow Jones
          Industrial Average and the NYSE Composite Index advancing
          more than 15 percent. Small capitalization stocks underperformed
          those of larger firms, with the Russell 2000 Index off 3 percent
          over the year. The variation in stock prices over the course of the
          year was extremely wide. Prices increased substantially over the
          first few months of 1998, as concerns eased that Asian economic
          problems could lead to a slowdown in the United States and to a
          consequent decline in profits. The major indexes declined, on
          balance, over the following couple of months before rising sharply,
          in some cases to new records, in late June and early July, on
          increasing confidence about the outlook for earnings. The main
          exception was the Russell 2000; small capitalization stocks fell
          more substantially in the spring, and their rise in July was
          relatively muted.    
           
          Rising concerns about the outlook for Japan and other Asian
          economies, as well as the deepening financial problems in Russia,
          caused stock prices to retrace their July gains by early August.
          After Russia devalued the ruble and defaulted on some debts in
          mid-August, prices fell further, reflecting the general turbulence in
          global financial markets. By the end of the month, most equity
          indexes had fallen back to roughly their levels at the start of the
          year. Commercial bank and investment bank stocks fell
          particularly sharply, as investors became concerned about the
          effect on these institutions' profits of emerging market difficulties
          and of substantial declines in the values of some assets. Equity
          prices rose for a time in September but then fell back by early
          October before rebounding as market dislocations eased and
          interest rates on many private obligations fell. By December, most
          major indexes were back near their July highs, although the Russell
          2000 remained below its earlier peak.   
           
          In late December, and into the new year, stock prices continued to
          advance, with several indexes reaching new highs in January. The
          devaluation of the Brazilian real caused some firms' shares to drop
          as investors reevaluated prospective earnings from Latin American
          operations, but all the major stock indexes posted gains in January;
          the Nasdaq advanced nearly 15 percent over the month, driven by
          large advances in the stock prices of high-technology firms,
          especially those related to the Internet. More recently, however,
          stock prices fell back, as interest rates rose and some investors
          apparently concluded that prices had risen too far, given the
          outlook for earnings.   
           
          The increase in equity prices last year and early this year, coupled
          with the slowing of earnings growth, left many valuation measures
          beyond their historical ranges. After ticking higher in the late
          summer and early autumn, the ratio of consensus estimates of
          earnings over the coming twelve months to prices in the S&P 500
          later fell back, dropping to a new low in January. In part, the
          decline in this measure over the past year likely reflected lower
          real long-term bond yields. For example, as measured by the
          difference between the ten-year nominal Treasury yield and
          inflation expectations reported in the Philadelphia Federal Reserve
          Bank's survey of professional forecasters, real yields fell
          appreciably between late 1997 and early 1999. (The yield on
          ten-year inflation-indexed Treasury securities actually rose
          somewhat last year. However, the increase may have reflected the
          securities' lack of liquidity and the substantial rise in the premium
          investors were willing to pay for liquidity.) Since mid-1998, the
          real interest rate has declined somewhat more than the forward
          earnings yield on stocks, and the spread between the two
          consequently increased a bit, perhaps reflecting the greater sense of
          risk in financial markets. Nonetheless, the spread has remained
          quite small relative to historical norms: Investors may be
          anticipating rapid long-term earnings growth--consistent with the
          expectations of securities analysts--and they may still be satisfied
          with a lower risk premium for holding stocks than they have
          demanded historically.    
           
           
          Debt and the Monetary Aggregates  
           
           
          Debt and Depository Intermediation   
           
          From the fourth quarter of 1997 to the fourth quarter of 1998, the
          total debt of the U.S. household, government, and nonfinancial
          business sectors increased about 6-1/4 percent, in the top half of its
          3 percent to 7 percent range and considerably faster than nominal
          GDP. Buoyed by strong spending on durable goods, housing, and
          business investment, as well as by merger and acquisition activity
          that substituted debt for equity, nonfederal debt expanded about 9
          percent last year, more than 2 percentage points faster than in
          1997. By contrast, federal debt declined 1-1/4 percent, following a
          rise of 3/4 percent the previous year.     
           
          Credit market instruments on the books of depository institutions
          rose at a somewhat slower pace than did the debt aggregate,
          posting a 5-3/4 percent rise in 1998, about half a percentage point
          less than in 1997. Growth in depository credit picked up in the
          second half of the year, as the turbulence in financial markets
          apparently led many firms to substitute bank loans for funds raised
          in the markets. Banks also added considerably to their holdings of
          securities in the third and fourth quarters, in part reflecting the
          attractive spreads available on non-Treasury debt instruments.   
           
          Financial firms also appeared to turn to banks for funding when the
          financial markets were volatile, and U.S. banks substantially
          expanded their lending to financial firms through repurchase
          agreements and loans to purchase and carry securities. As a result,
          growth of total bank credit, adjusted to remove the effects of
          mark-to-market accounting rules, accelerated to 10-1/2 percent on
          a fourth-quarter to fourth-quarter basis, the largest annual increase
          in more than a decade.    
           
           
          The Monetary Aggregates   
           
          The broad monetary aggregates expanded very rapidly last year.
          From the fourth quarter of 1997 to the fourth quarter of 1998, M2
          increased 8-1/2 percent, placing it well above the upper bound of
          its 1 percent to 5 percent range. However, as the FOMC noted last
          February, this range was intended as a benchmark for money
          growth under conditions of stable prices, real economic growth
          near trend, and historical velocity relationships. Part of the excess
          of M2 above its range was the result of faster growth in nominal
          spending than would likely be consistent with sustained price
          stability. In addition, the velocity of M2 (defined as the ratio of
          nominal GDP to M2) fell 3 percent. Some of the decline resulted
          from the decrease in short-term market interest rates last year--as
          usual, rates on deposits fell more slowly than market rates,
          reducing the opportunity cost of holding M2 (defined as the
          difference between the rate on Treasury bills and the average return
          on M2 assets).      
           
          However, the bulk of the decline cannot be explained on the basis
          of the historical relationship between the velocity of M2 and this
          measure of its opportunity cost. Three factors not captured in that
          relationship likely contributed to the drop in velocity. First,
          households seem to have allocated an increased share of savings
          flows to monetary assets rather than equities following several
          years of outsized gains in stock market wealth. Second, some
          evidence suggests that in the 1990s the demand for M2 assets has
          become more sensitive to longer-term interest rates and to the
          slope of the yield curve, and so the decline in long-term Treasury
          yields last year, and the consequent flattening of the yield curve,
          may have increased the relative attractiveness of M2 assets.
          Finally, a critical source of the especially rapid M2 expansion in
          the fourth quarter likely was an increased demand for safe, liquid
          assets as investors responded to the heightened volatility in
          financial markets. With some of these safe-haven flows likely
          being reversed, growth in the broad monetary aggregates, while
          still brisk, has slowed appreciably early this year.     
           
          M3 expanded even faster than M2 in 1998, posting an 11 percent
          rise on a fourth-quarter to fourth-quarter basis. Last year's growth
          was the fastest since 1981 and left the aggregate well above the top
          end of its 2 percent to 6 percent growth range. As with M2,
          however, the FOMC established the M3 range as a benchmark for
          growth under conditions of stable prices, sustainable output
          growth, and the historical behavior of velocity. The rapid growth
          of M3 in part simply reflected the rise in M2. In addition, the
          non-M2 components of M3 increased 18-1/2 percent over the year,
          following an even larger advance in 1997. The substantial rise in
          these components last year was partly the result of the funding of
          the robust growth in bank credit with managed liabilities, many of
          which are in M3. However, M3 growth was boosted to an even
          greater extent by flows into institution-only money funds, which
          have been expanding rapidly in recent years as they have increased
          their share of the corporate cash management business. Because
          investments in these funds substitute for business holdings of
          short-term assets that are not in M3, their rise has generated an
          increase in M3 growth. In addition, institution-only funds pay rates
          that tend to lag movements in market rates, and so their relative
          attractiveness was temporarily enhanced--and their growth rate
          boosted--by declines in short-term market interest rates late last
          year.    
           
          M1 increased 1-3/4 percent over the four quarters of 1998, its first
          annual increase since 1994. Currency expanded at an 8-1/4 percent
          pace, its largest rise since 1994. The increase apparently reflected
          continued strong foreign shipments, though at a slower pace than
          in 1997, and a sharp acceleration in domestic demand. Deposits in
          M1 declined further in 1998, reflecting the continued introduction
          of retail "sweep" programs. Growth of M1 deposits has been
          depressed for a number of years by these programs, which shift--or
          "sweep"--balances from household transactions accounts, which
          are subject to reserve requirements, into savings accounts, which
          are not. Because the funds are shifted back to transactions accounts
          when needed, depositors' access to their funds is not affected by
          these programs. However, banks benefit from the reduction in
          holdings of required reserves, which do not pay interest. Over
          1998, sweep programs for demand deposit accounts became more
          popular, contributing to a 4-1/4 percent decline in such balances.
          By contrast, new sweep programs for other checkable deposits,
          which had driven double-digit declines in such deposits over the
          previous three years, were less important in 1998, and, with
          nominal spending strong and interest rates lower, other checkable
          deposits were about unchanged on the year.      
           
          As a result of the introduction of retail sweep accounts, the average
          level of required reserve balances (balances that must be held at
          Reserve Banks to meet reserve requirements) has trended lower
          over the past few years. The decline has been associated with an
          increase in banks' required clearing balances, which are balances
          that banks agree in advance to hold at their Federal Reserve Bank
          in order to facilitate the clearing of their payments. Unlike required
          reserve balances, banks earn credits on their required clearing
          balances that can be applied to the use of Federal Reserve priced
          services. Despite the increase in required clearing balances,
          required operating balances, which are the sum of required reserve
          balances and required clearing balances, have declined over the
          past few years and in late 1998 reached their lowest level in several
          decades.   
           
          The decline in required operating balances has generated concerns
          about a possible increase in the volatility of the federal funds rate.
          Because a bank's required level of operating balances must be met
          only on average over a two-week maintenance period, banks are
          free to allocate their reserve holdings across the days of a
          maintenance period in order to minimize their reserve costs.
          However, banks must also manage their reserves in order to avoid
          overdrafts, which the Federal Reserve discourages through
          administrative measures and financial penalties. Thus, as required
          operating balances decline toward the minimum level needed to
          clear banks' transactions, banks are less and less able to respond to
          fluctuations in the federal funds rate by lending funds when the
          rate is high and borrowing when the rate is low. As a result, when
          required operating balances are low, the federal funds rate is likely
          to rise further than it otherwise would when demands for reserves
          are unexpectedly strong or supplies weak; conversely, the federal
          funds rate is likely to fall more in the event of
          weaker-than-expected demand or stronger-than-expected supply.
          One way to ease this difficulty would be to pay interest on required
          reserve balances, which would reduce banks' incentives to expend
          resources on sweeps and other efforts to minimize these balances.   
           
          Despite the low level of required operating balances, the federal
          funds rate did not become noticeably more volatile over the spring
          and summer of 1998. In part, this result reflected more frequent
          overnight open market operations by the Federal Reserve to better
          match the daily demand for and supply of reserves. Also, banks
          likely improved the management of their accounts at the Federal
          Reserve Banks. Moreover, large banks apparently increased their
          willingness to borrow at the discount window. The Federal
          Reserve's decision to return to lagged reserve accounting at the end
          of July also likely contributed to reduced volatility in the federal
          funds market by enhancing somewhat the ability of both banks and
          the Federal Reserve to forecast reserve demand.     
           
          In the latter part of 1998 and into 1999, however, the federal funds
          rate was more volatile. The increase may have owed partly to
          further reductions in required operating balances resulting from
          new sweep programs, but other factors were probably more
          important, at least for a time. Market participants were scrutinizing
          borrowing banks more closely, and in some cases lenders pared or
          more tightly administered their counterparty credit limits, or
          shifted more of their placements from term to overnight maturities.
          The heightened attention to credit quality also made banks less
          willing to borrow at the discount window, because they were
          concerned that other market participants might detect their
          borrowing and interpret it as a sign of financial weakness. As a
          result, many banks that were net takers of funds in short-term
          markets attempted to lock in their funding earlier in the morning.
          On net, these forces boosted the demand for reserves and put
          upward pressure on the federal funds rate early in the day. To
          buffer the effect of these changes on volatility in the federal funds
          market, the Federal Reserve increased the supply of reserves and,
          at times, responded to the level of the federal funds rate early in the
          day when deciding on the need for market operations. Because
          demand had shifted to earlier in the day, however, the federal funds
          rate often fell appreciably below its target level by the end of the
          day.   
           
          At its November meeting, the FOMC amended the Authorization
          for Domestic Open Market Operations to extend the permitted
          maturity of System repurchase agreements from fifteen to sixty
          days. Over the remainder of 1998, the Domestic Trading Desk
          made use of this new authority on three occasions, arranging
          System repurchase agreements with maturities of thirty to
          forty-five days to meet anticipated seasonal reserve demands over
          year-end. While the Desk had in the past purchased
          inflation-indexed securities when rolling over holdings of maturing
          nominal securities, it undertook its first outright open market
          purchase devoted solely to inflation-indexed Treasury securities in
          1998, thereby according those securities the same status in open
          market operations as other Treasury securities.    
           
           
          International Developments  
           
          In 1998, developments in international financial markets continued
          to be dominated by the unfolding crises in emerging markets that
          had begun in Thailand in 1997. Financial market turbulence spread
          to other emerging markets around the globe, spilling over from
          Korea, Indonesia, Malaysia, Singapore, the Philippines, and Hong
          Kong in late 1997 and in the first part of 1998 to Russia in the
          summer, and to Latin America, particularly Brazil, shortly
          thereafter. The Asian crisis contributed to a deepening recession in
          Japan last year, and as the year progressed, growth in several other
          major foreign industrial economies slowed as well.   
           
          At the beginning of 1998, many Asian currencies were declining or
          were under pressure. The Indonesian rupiah dropped sharply in
          January, amid widespread rioting and talk of a coup, and fell again
          in May and June, as the deepening recession prompted more social
          unrest and ultimately the ouster of President Suharto. Some of the
          rupiah's losses were reversed in the second half of the year,
          following the relatively orderly transition of power to President
          Habibie. Tighter Indonesian monetary policy, which pushed
          short-term interest rates as high as 70 percent by July, contributed
          to the rupiah's recovery. On balance, between December 1997 and
          December 1998, the rupiah depreciated more than 35 percent
          against the dollar.   
           
          In contrast, the Thai baht and Korean won, which had declined
          sharply in 1997, gained more than 20 percent against the dollar
          over the course of 1998. Policy reforms and stable political
          environments helped boost these currencies. Between these
          extremes, the currencies of the Philippines, Malaysia, Singapore,
          and Taiwan fluctuated in a narrower range and ended the period
          little changed against the dollar. In September, Malaysia imposed
          capital and exchange controls, fixing the ringgit's exchange rate
          against the dollar. The Hong Kong dollar came under pressure at
          times during the year, but its peg to the U.S. dollar remained intact,
          although at the cost of interest rates that were at times considerably
          elevated. Short-term interest rates in Asian economies other than
          Indonesia declined in 1998, and as some stability returned to
          Indonesian markets near the end of the year, short-term rates in that
          nation began to retreat from their highs.   
           
          As the year progressed, the financial storm moved from Asia to
          Russia. At first the Russian central bank was able to defend the
          ruble's peg to the dollar with interest rate increases and sporadic
          intervention. By midyear, however, the government's failure to
          reach a new assistance agreement with the International Monetary
          Fund, reported shortfalls in tax revenues, and the disruption of rail
          travel by striking coal miners protesting late wage payments
          brought to the fore the deep structural and political problems faced
          by Russia. In addition, declining oil prices were lowering
          government revenues and worsening the current account. As a
          result of these difficulties, the ruble came under renewed pressure,
          forcing Russian interest rates sharply higher, and Russian equity
          prices fell abruptly. A disbursement of $4.8 billion from the IMF
          in July was quickly spent to keep the currency near its level of 6.2
          rubles per dollar, but the lack of progress on fiscal reform put the
          next IMF tranche in doubt.   
           
          On August 17, Russia announced a devaluation of the ruble and a
          moratorium on servicing official short-term debt. Subsequently, the
          ruble depreciated more than 70 percent against the dollar, the
          government imposed conditions on most of its foreign and
          domestic debt that implied substantial losses for creditors, and
          many Russian financial institutions became insolvent. The events
          in Russia precipitated a global increase in financial market
          turbulence, including a pullback of credit to highly leveraged
          investors and a widening of credit spreads in emerging market
          economies and in many industrial countries, which did not abate
          until after central banks in a number of industrial countries eased
          policy in the fall.   
           
          Latin American financial markets were only moderately disrupted
          by the Asian and Russian problems during the first half of 1998.
          The reaction to the Russian default, however, was swift and strong,
          and the prices of Latin American assets fell precipitously. The
          spreads between yields on Latin American Brady bonds and
          comparable U.S. Treasuries widened considerably (with increases
          ranging from 900 basis points in Argentina to 1500 basis points in
          Brazil) and peaked in early September before retracing part of the
          rise. Latin American equity prices plunged, ending the year down
          25 percent or more. Several currencies came under pressure,
          despite sharp increases in short-term interest rates. The Mexican
          peso, which was also weakened by the effects of falling oil prices,
          depreciated 18 percent against the dollar over the year. The
          Colombian peso and the Ecuadorian sucre were devalued, but
          Argentina's currency board arrangement survived.   
           
          Brazil's central bank defended the real's crawling peg until
          mid-January 1999 but is estimated to have used more than half of
          the $75 billion in foreign exchange reserves it had amassed as of
          last April. Anticipation of the IMF-led financial assistance package
          for Brazil helped spur a partial recovery in Latin American asset
          markets in late September and October. The details of the $41.5
          billion loan package were announced in November, but after the
          package was approved by the IMF in early December, Brazil's
          Congress rejected a part of the government's fiscal austerity plan,
          sparking renewed financial turmoil. In mid-December, $9.3 billion
          of the loan package was disbursed, but as the year ended, the
          continuing pressure from investors seeking to take funds out of
          Brazil put the long-run viability of the crawling exchange rate peg
          in doubt. The real came under pressure again in early January after
          the state of Minas Gerais threatened not to pay its debt to the
          federal government. On January 13, the real was devalued 8
          percent, and two days later it was allowed to float. Since the end of
          1998, the real has depreciated nearly 38 percent against the dollar,
          and capital flight from Brazil has likely persisted. The collapse of
          the real exerted some downward pressure on the currencies of other
          Latin American countries. Thus far, however, contagion has been
          more limited than it was after the Russian devaluation; unlike
          Russia, Brazil has continued to meet debt service obligations, and
          investors apparently had an opportunity to adjust positions in
          advance of the devaluation and have drawn a distinction between
          Brazil's problems and those of other economies.   
           
          The fallout from the financial crises that hit several Asian
          emerging market economies in late 1997 triggered a further decline
          in output in the region in early 1998. In the countries most heavily
          affected--Thailand, Korea, Malaysia, and Indonesia--output
          dropped at double-digit annual rates in the first half of the year, as
          credit disruptions, widespread failures in the financial and
          corporate sectors, and a resulting high degree of economic
          uncertainty depressed activity severely. Output in Hong Kong also
          dropped in early 1998, as interest rates rose sharply amid pressure
          on its currency peg. Later in the year, with financial conditions in
          most of the Asian crisis countries stabilizing somewhat, output
          started to bottom out.   
           
          The Asian crisis had a relatively moderate effect on China,
          although it may have encouraged authorities in that country to
          move ahead more quickly with various financial sector reforms.
          Financial tensions mounted early this year as foreign investors
          have reacted with concern to the failure of the Guangdong
          International Trust and Investment Corporation. Chinese growth
          remained fairly strong throughout 1998, despite a dramatic
          slowdown in the growth of exports.   
           
          Inflation in the Asian developing economies rose only moderately
          on average in 1998, as the inflationary effects of currency
          depreciations in the region were largely offset by the deflationary
          influence of very weak domestic activity. The current account
          balances of the Asian crisis countries swung into substantial
          surplus last year, reflecting a sharp drop in imports resulting from
          the falloff in domestic demand as well as improvement in the
          countries' competitive positions associated with the substantial
          depreciations of their currencies in late 1997 and early 1998.   
           
          In Russia, economic activity declined last year as interest rates
          were pushed up in an attempt to fend off pressure on the ruble.
          After the August debt moratorium and ruble devaluation, output
          dropped sharply, ending the year down about 10 percent from its
          year-earlier level. The ruble collapse triggered a surge in inflation
          to a triple-digit annual rate during the latter part of the year.   
          In Latin America, the pace of economic activity slowed only
          moderately in the first half of 1998, as the spillover from the Asian
          financial turbulence was limited. The Russian financial crisis in
          August, in contrast, had a strong impact on real activity in Latin
          America, particularly Brazil and Argentina, where interest rates
          moved sharply higher in response to exchange rate pressures.
          Output in both countries is estimated to have declined in the
          second half of the year at annual rates of about 5 percent. Activity
          in Mexico and Venezuela was also depressed by lower oil export
          revenues. Inflation rates in Latin American countries were little
          changed in 1998 and ranged from 1 percent in Argentina and 3
          percent in Brazil to 31 percent in Venezuela.   
           
          The dollar's value, measured on a trade-weighted basis against the
          currencies of a broad group of important U.S. trading partners, rose
          almost 7 percent during the first eight months of 1998, but it then
          fell, by December reaching a level about 2 percent above its
          year-earlier level. (When adjusted for changes in U.S. and foreign
          consumer price levels, the real value of the dollar in December
          1998 was about 1 percent below its level in December 1997.)
          Before the Russian default, the dollar was supported by the robust
          pace of U.S. economic activity, which at times generated
          expectations that monetary policy would be tightened and which
          contrasted with weakening economic activity abroad, especially in
          Japan. Occasionally, however, the positive influence of the strong
          economy was countered by worries about growing U.S. external
          deficits. From August through October, in the aftermath of the
          Russian financial meltdown, concerns that increased difficulties in
          Latin America might affect the U.S. economy disproportionately,
          as well as expectations of lower U.S. interest rates, weighed on the
          value of the dollar, and it fell sharply. The broad index of the
          dollar's exchange value eased a bit further during the fourth quarter
          of the year. So far in 1999, the dollar has gained nearly 3 percent in
          terms of the broad index.      
           
          Against the currencies of the major foreign industrial countries, the
          dollar declined 2 percent in nominal terms over 1998, on balance,
          reversing some of its 10 percent appreciation the preceding year.
          Among these currencies, the dollar's value fluctuated most widely
          against the Japanese yen. The dollar rose against the yen during the
          first half of the year as a result of concerns about the effects of the
          Asian crisis on the already-weak Japanese economy and further
          signs of deepening recession and persistent banking system
          problems in that country. It reached a level of almost 147 yen per
          dollar in mid-June, prompting coordinated intervention by U.S.
          and Japanese authorities in foreign exchange markets that helped to
          contain further downward pressure on the yen. The dollar resumed
          its appreciation against the yen, albeit at a slower pace, in July and
          early August.      
           
          The turning point in the dollar-yen rate came after the Russian
          collapse, amid the global flight from risk that caused liquidity to
          dry up in the markets for many assets. During the first week of
          October, the dollar dropped nearly 14 percent against the yen in
          extremely illiquid trading conditions. Although fundamental
          factors in Japan, such as progress on bank reform, fiscal stimulus,
          and the widening trade surplus may have helped boost the yen
          against the dollar, market commentary at the time focused on
          reports that some international investors were buying large
          amounts of yen. These large purchases reportedly were needed to
          unwind positions in which investors had used yen loans to finance
          a variety of speculative investments. On balance, the dollar
          depreciated almost 10 percent against the yen in 1998, reversing
          most of its net gain during 1997. It depreciated further against the
          yen in early 1999, hitting a two-year low on January 11, but it then
          rebounded somewhat amid reports of intervention purchases of
          dollars by the Bank of Japan. More recently, the Bank of Japan has
          eased monetary policy further, and the dollar has strengthened
          against the yen. So far this year, the dollar has gained about 7
          percent against the yen.   
           
          Japanese economic activity contracted in 1998, as the country
          remained in its most protracted recession of the postwar era.
          Business and residential investment plunged, and private
          consumption stagnated, more than offsetting positive contributions
          from government spending and net exports. Core consumer prices
          declined slightly, while wholesale prices fell almost 4-1/2 percent.
          In April, the Japanese government announced a large fiscal
          stimulus package. During the final two months of the year, the
          government announced another set of fiscal measures slated for
          implementation during 1999, which included permanent personal
          and corporate income tax cuts, various incentives for investment,
          and further increases in public expenditures.   
           
          Against the German mark, the dollar depreciated about 6 percent,
          on net, during 1998. Late in the year the dollar moved up against
          the mark, as evidence of a European growth slowdown raised
          expectations of easier monetary conditions in Europe. In the event,
          monetary policy was eased sooner than market participants had
          expected, with a coordinated European interest rate cut coming in
          early December.     
           
          A major event at the turn of the year was the birth of the euro,
          which marked the beginning of Stage Three of European Economic
          and Monetary Union (EMU). On December 31, the rates locking
          the euro with the eleven legacy currencies were determined; based
          on these rates, the value of the euro at the moment of its creation
          was $1.16675. Trading in the euro opened on January 4, with the
          first trades reflecting a significant premium for the euro over its
          initial value. As the first week of trading progressed, however, the
          initial euphoria wore off, and so far this year the dollar has
          strengthened more than 5 percent against the euro, partly reflecting
          better-than-expected economic data in the United States, contrasted
          with weaker-than-expected data in the euro area.   
           
          In the eleven European countries whose currencies are now fixed
          against the euro, output growth slowed moderately over the course
          of 1998, as net exports weakened and business sentiment
          worsened. Unemployment rates came down slightly, but the
          average of these rates remained in the double-digit range.
          Consumer price inflation continued to slow, helped by lower oil
          prices. In December, the harmonized CPI for the eleven countries
          stood 3/4 percent above its year-earlier level, meeting the European
          Central Bank's primary objective of inflation below 2 percent.   
           
          Between December 1997 and December 1998, the average value of
          the dollar changed little against the British pound but rose 8
          percent against the Canadian dollar. Weakness in primary
          commodity prices, including oil, likely depressed the value of the
          Canadian dollar. The Bank of Canada raised official rates in
          January 1998 and again in August, in response to currency market
          pressures. The Bank of England raised official rates in June 1998
          to counter inflation pressures. Tighter monetary conditions in both
          countries, as well as a decline in net exports associated with global
          difficulties, contributed to a slowing of output growth in the
          second half of the year. The deceleration was sharper in the United
          Kingdom than in Canada. U.K. inflation eased slightly to near its
          target rate, while Canadian inflation remained near the bottom of
          its target range. In response to weaker economic activity as well as
          to the expected effects of the global financial turmoil, both the
          Bank of Canada and the Bank of England have lowered official
          interest rates since September.   
           
          The general trend toward easier monetary conditions was reflected
          in declines in short-term interest rates in almost all the G-10
          countries during the year. Interest rates in the euro area converged
          to relatively low German levels in anticipation of the launch of the
          third stage of EMU. Yields on ten-year government bonds in the
          major foreign industrial countries declined significantly over the
          course of the year, as economic activity slowed, inflation continued
          to moderate, and investors sought safer assets. Between December
          1997 and December 1998, ten-year interest rates fell 180 basis
          points in the United Kingdom and 150 basis points in Germany.
          The ten-year rate fell only 30 basis points in Japan, on balance,
          declining about 90 basis points over the first ten months of the year
          but backing up in November and December. Market participants
          attributed the increase to concerns that the demand for bonds
          would be insufficient to meet the surge in debt issuance associated
          with the latest fiscal stimulus package.     
           
          Share prices on European stock exchanges posted another round of
          strong advances last year, with price indexes rising 8 percent in the
          United Kingdom, about 15 percent in Germany, nearly 29 percent
          in France, and 41 percent in Italy. In contrast, Japanese equity
          prices fell more than 9 percent in 1998, and Canadian share prices
          decreased 4 percent. After a considerable run-up earlier in the year,
          share prices around the globe fell sharply in August and
          September, but they rebounded in subsequent months as the
          Federal Reserve and central banks in many other industrial
          countries eased monetary policy.   
           
          On November 17, the FOMC voted unanimously to reauthorize
          Federal Reserve participation in the North American Framework
          Agreement (NAFA), established in 1994, and in the associated
          bilateral reciprocal currency swap arrangements with the Bank of
          Canada and the Bank of Mexico. On December 7, the Secretary of
          the Treasury authorized renewal of the Treasury's participation in
          the NAFA and of the associated Exchange Stabilization Agreement
          with Mexico. Other bilateral swap arrangements with the Federal
          Reserve--those with the Bank for International Settlements, the
          Bank of Japan, and many European central banks--were allowed to
          lapse in light of their disuse over the past fifteen years and in the
          presence of other well-established arrangements for international
          monetary cooperation. The swap arrangement between the
          Treasury's Exchange Stabilization Fund and the German
          Bundesbank was also allowed to lapse.          
           
           
           ------------ FOOTNOTE       
          1. Since the end of 1994, the Bureau of Labor Statistics has taken a
          number of steps to make the consumer price index a more accurate
          price measure. The agency also introduced new weights into the
          CPI at the start of 1998. In total, these changes probably reduced
          the 1998 rise in the CPI by slightly less than 1/2 percentage point,
          relative to the increase that would have been reported using the
          methodologies and weights in existence at the end of 1994.
          Without the changes that took effect in 1998, the deceleration in
          the CPI last year probably would have been about half as large as
          was reported.