Board of Governors of the Federal Reserve System

Monetary Policy Report to the Congress Pursuant to the 
Full Employment and Balanced Growth Act of 1978

February 26, 1997

Letter of Transmittal
---------------------
Board of Governors of the
Federal Reserve System
Washington, D.C., February 26, 1997

THE PRESIDENT OF THE SENATE 
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES 

The Board of Governors is pleased to submit its Monetary Policy Report
to the Congress, pursuant to the Full Employment and Balanced Growth
Act of 1978. 
	
Sincerely, 
Alan Greenspan, Chairman
------------------------

Section 1: Monetary Policy and the Economic Outlook 
	
The economy performed impressively this past year, and members of the Board
of Governors and Reserve Bank presidents anticipate that 1997 will bring further
appreciable economic expansion with relatively low inflation. In 1996, solid
advances in the real expenditures of households and businesses led to sizable
gains in output. Employment rose briskly, and the unemployment rate edged
down to its lowest level of the current expansion. Consumer price inflation
increased owing to the likely temporary effects of firmness in food and energy
markets, but some broader price measures showed inflation holding steady or
even declining. With the economy strengthening, intermediate- and long-term
interest rates rose on net, but credit continued to be amply available to
businesses and most households, and equity prices soared.      
 
Several factors helped to restrain price increases this past year in the face of
high levels of resource utilization. With workers still concerned to some degree
about job security, acceleration in hourly compensation was not so pronounced
as in comparable periods in the past; wage increases picked up relatively
moderately, and further success in controlling health care costs helped to temper
the rise in benefits. Moreover, significant declines in the prices of U.S. imports,
owing to low inflation abroad and appreciation of the dollar on foreign exchange
markets, tended to hold down domestic prices. Damped inflation expectations
probably contributed as well to the favorable price performance: A lengthening
run of years during which inflation has been in a more moderate range, together
with an understanding of the Federal Reserve's commitment to maintaining
progress toward price stability, may have discouraged aggressive pricing
behavior. Business firms continued to rely on cost control and gains in
productivity, rather than on price increases, as the primary channels for
achieving profit growth.      
 
Still, the Federal Open Market Committee (FOMC) recognized the danger that
pressures emanating from the tight labor market might trigger an acceleration of
prices, which could eventually undermine the ongoing economic expansion.
Consequently, although conditions last year were not deemed to warrant
immediate policy action, the Committee's policy directives starting in mid-1996
reflected a perception that the most likely direction of any policy action would
be toward greater restraint in the provision of reserves to the banking system.
Forestalling a disruptive buildup of inflationary pressures in the near term and
moving toward price stability over time remain central to the System's mission
of promoting maximum sustainable growth of employment and production.      
 
 
Monetary Policy, Financial Markets, and the Economy in 1996      
 
The FOMC eased the stance of monetary policy twice around the beginning of
last year--in December 1995 and in January--lowering the federal funds rate 1/2
percentage point in total, to 5-1/4 percent. These actions were taken to offset
the effect on the level of the real federal funds rate of declines in inflation and
inflation expectations in the second half of 1995 and thereby to help ensure the
resumption of moderate economic growth after the marked slowdown and
inventory correction in late 1995. By the spring, economic growth had become
more vigorous than either the Committee or financial markets had foreseen. In
response, intermediate- and longer-term interest rates as of mid-May were up
around a full percentage point from the two-year lows reached early in the year.
In combination with some softening of economic activity abroad and declines in
interest rates in major foreign industrial countries, these developments
contributed to a further appreciation of the dollar, building on the rise that had
started in mid-1995. The Committee anticipated that the increase in the cost of
credit, along with the higher exchange value of the dollar, would be sufficient to
foster a downshift in economic expansion to a more sustainable pace and contain
price pressures; thus, it left its policy stance unchanged at its spring meetings.    
 
 
By early summer, however, the continued momentum in demand and pressures
on labor resources that were being reflected in faster growth in wages were seen
as posing a threat of increased inflation. Core inflation remained moderate, but
in light of the heightened risk that it would turn upward, the Committee in its
early July directive to the Manager of the Open Market Account indicated its
view that near-term economic developments were more likely to lead to a
tightening of policy than to an easing. Labor markets continued to be taut over
the balance of the year, and this bias toward restraint was included in directives
adopted at all of the Committee's remaining meetings in 1996.      
 
After peaking during mid-summer, interest rates moved down on balance
through the fall, as expansion of consumer spending and economic activity in
general appeared to be moderating and markets saw less likelihood of a need for
Federal Reserve firming action. Equity prices fell back for a time during the
summer, reversing some of the substantial increase registered over the first half
of the year, but by autumn they had reached new highs. Interest rates and dollar
exchange rates turned back up late in the year when signs of rapid growth and
more intense use of the economy's resources reemerged. Since year-end, interest
rates have changed little, on net. The foreign exchange value of the dollar has
posted further gains, in part reflecting greater-than-expected weakness in Europe
and renewed pessimism about economic and financial prospects in Japan. Equity
prices have registered new highs since the start of the year. As of
mid-February, intermediate- and long-term interest rates were up about 1/2 to
3/4 percentage point, on balance, since early 1996, and the value of the dollar
was up around 9 percent against an average of other G-10 currencies.      
 
For the nonfinancial business sector, the effect of the higher intermediate- and
long-term interest rates on the overall cost of funds last year was offset to some
degree by an easing of lending terms at banks and a narrowing of yield spreads
on corporate bonds over Treasuries, as well as by declines in the cost of capital
in the equity market. Encouraged, perhaps, by the prospects of sustained
economic expansion and low inflation, banks, market lenders, and equity
investors displayed a strong appetite for business obligations and seemed willing
to require less compensation for the possible risks entailed. Some households,
by contrast, faced a tightening of standards and terms with respect to credit card
debt and some other types of consumer debt last year, as banks reacted to a
rising volume of delinquencies and charge-offs on these instruments. However,
credit availability under home equity lines increased, particularly from finance
companies but also from banks. Overall debt growth slowed slightly but
remained near the midpoint of its 3 percent to 7 percent monitoring range. The
growth rates of M2 and M3 edged up last year and, as was anticipated in the
monetary policy reports to the Congress last February and July, both aggregates
ended 1996 near or above the upper end of their growth ranges. Again last year,
the growth of M2 relative to nominal income and interest rates was generally in
line with historical relationships, in contrast to its behavior during the early
years of the decade.      
 
 
Economic Projections for 1997      
 
With the economy free of serious imbalances, prospects appear favorable for
further growth of activity and expansion of job opportunities in the coming year,
although resource constraints seem likely to keep the pace of growth below that
of 1996. The central tendency of the GDP growth forecasts put forth by
members of the Board of Governors and the Reserve Bank presidents is from 2
percent to 2-1/4 percent, measured as the change in real output between the
final quarter of 1996 and the final quarter of 1997. Output growth of this
magnitude is expected to result in little change in the civilian unemployment
rate, which is projected to be between 5-1/4 percent and 5-1/2 percent in the
fourth quarter of this year. These forecasts of GDP growth and unemployment
are similar to those of the Administration. The central tendency of the
policymakers' CPI forecasts for 1997 spans the relatively narrow interval of
2-3/4 percent to 3 percent, with the lower bound near the inflation forecast of
the Administration.      
 
Consumer spending, which accounts for about two-thirds of total GDP, should
be supported in coming quarters by further gains in income and the substantial
increase in household net worth that has occurred over the past two years; debt
problems, although rising of late, do not seem to be so widespread as to
threaten the ongoing expansion of household expenditures in the aggregate. In
the business sector, balance sheets are strong, profits have been rising, and
efforts to bolster efficiency through the use of technologically advanced
equipment are continuing at an intense pace. In the commercial real estate
market, the supply-demand balance has shifted in many locales to a point at
which interest in office building projects has picked up noticeably. These
conditions, together with the ready access to a wide variety of sources of
finance that businesses currently are enjoying, should keep investment spending
on an upward trajectory. Foreign demand for U.S. products should continue to
rise with growth of the world economy, even in the wake of the significant
appreciation of the dollar since the first half of 1995; however, imports also
seem likely to remain on a clear upward trend, given the prospects for continued
expansion of the U.S. economy. Government expenditures for consumption and
investment probably will follow recent trends, with further cutbacks in real
outlays at the federal level and moderate increases in the combined purchases of
state and local governments.      
 
Although the risk of increased inflation pressures is significant, especially in
view of the tightness of the labor market and the strength in activity that has
been evident recently, Federal Reserve policymakers expect this year's rise in
the consumer price index to be somewhat smaller than that of 1996. The major
reason for expecting a smaller CPI increase this year is a more favorable
outlook for food and energy prices. Prices of farm products have dropped back
from the highs of last summer, and, barring further weather problems, this
year's rise in food prices at retail should be considerably smaller than that of
1996. Oil prices have recently declined and seem likely to ease further in
coming months as world production and consumption come back into better
balance; this price relief is important not only because of the direct effects on
the price of gasoline and other consumer energy items but also because
petroleum is a major element in the cost of producing and distributing many
other goods. By contrast to the favorable outlook for food and energy prices,
some risk exists that core inflation could turn up during the coming year. The
minimum wage will be moving up further in 1997, compounding whatever cost
pressures might be in train as a result of labor market tightness, and the degree
to which businesses can continue to absorb stepped-up increases in labor costs
without raising prices more rapidly is not certain.      
 
As noted in the July 1996 monetary policy report, the CPI forecasts of the
governors and Reserve Bank presidents incorporate allowances for the technical
improvements to this index that have been made by the Bureau of Labor
Statistics. These technical changes are estimated to have trimmed the reported
rate of CPI inflation slightly in each of the past two years, and additional
changes will be affecting the rise in the index in 1997. In view of the remaining
difficulties of accurately measuring price change in a highly complex and
rapidly changing economy, alternative price indexes will continue to be given
substantial weight, along with the CPI, in monitoring progress toward the
long-run goal of price stability. Some of the broad measures of inflation derived
from the GDP accounts slowed in 1996; the Committee is concerned that, even
if the CPI decelerates as expected in 1997, other indexes--with different scope
and weights--may pick up in reflection of the pressures on productive resources. 
   
 
 
Money and Debt Ranges for 1997      
 
Again in 1997, the Committee has set ranges for M2 and M3 that would
encompass monetary growth expected to be consistent with approximate price
stability and a sustainable rate of real economic growth, assuming that the
behavior of velocity is in line with historical norms. These ranges are
unchanged from those for 1996: 1 to 5 percent for M2 and 2 to 6 percent for
M3.      
 
As has been the case for several years, the 1997 ranges for M2 and M3 were
set against a backdrop of uncertainty about the stability and predictability of
their velocities. A long-run pattern of reasonably stable velocity behavior broke
down in the early 1990s when the public's holdings of monetary assets were
depressed by several factors: the contraction of the thrift industry; a tightening
of credit supplies and deleveraging by businesses and households; an extremely
wide spread between short- and intermediate-term interest rates that heightened
the attractiveness of capital market instruments relative to bank deposits; and the
expanding availability and growing acceptance of stock and bond mutual funds
as household investments.      
 
With the waning of all but the last of these influences, movements in velocity
have become more predictable over the past couple of years. This recent
evidence of stability, however, covers only a relatively brief period, and its
durability remains uncertain. In these circumstances, the Committee has opted to
continue treating the ranges as benchmarks for the trends of money growth
consistent with price stability rather than as short-run targets for policy.
Meanwhile, the actual behavior of the monetary measures will be monitored for
such information as it may convey about underlying economic developments.     

 
The central tendency of the Committee's expectations for nominal GDP growth
in 1997 is slightly below that registered in 1996. Thus, if velocity behaves as it
did last year, M2 and M3 might decelerate a bit but even so would again
expand around the upper ends of their growth ranges. Debt of the nonfinancial
sectors is anticipated to increase this year at around the pace of last year,
remaining near the midpoint of its unchanged 3 to 7 percent range. 

 
 
 Section 2: Economic and Financial Developments in 1996 and Early 1997      
 
 The economy turned in a remarkably favorable performance this past year.
Preliminary estimates indicate that real GDP rose more than 3 percent over the
four quarters of 1996, one of the larger gains of the past several years and
appreciably more than the FOMC was expecting a year ago. Although
intermediate- and long-term interest rates moved up, credit remained readily
available to most borrowers, and equity prices rose substantially. Expansion of
the debt of nonfinancial sectors continued at about the 5 percent rate it has
maintained over the past several years, and growth of the stock of money picked
up a little to its most rapid pace this decade. These financial developments
provided support for strong advances in the real expenditures of households and
businesses, and the growth of exports held up well in the face of an appreciating
dollar. Tightness of the labor market led to a moderate pickup in wage increases
in 1996. However, acceleration of prices was confined largely to the food and
energy sectors; prices for other consumer products decelerated, as did prices
paid by businesses for capital goods and materials. Economic data for early
1997 show the unemployment rate holding in a low range with the inflation
trend still subdued.      
 
 
 Economic Developments      
 
 
 The Household Sector      
 
 After rising less than 2 percent in 1995, real personal consumption expenditures
moved up 2-3/4 percent in 1996. Although debt problems arose with greater
frequency this past year, households benefited from healthy increases in real
income and another year of sizable gains in wealth. Consumers were relatively
optimistic about prospects for the economy at the start of 1996, and they became
more so as the year progressed.      
 
 Real outlays for consumer durables rose more than 5 percent in 1996 after a
gain of only 1-1/4 percent during 1995. As has been true for many years, real
expenditures on computers and electronic equipment outpaced the growth of
other household outlays by a wide margin in 1996. Sizable increases were also
reported for most other types of consumer durables. However, real expenditures
on vehicles changed little on net over the year, as gains achieved during the first
half were reversed after mid-year. Late in 1996, sales of light vehicles may
have been constrained to some degree by supply shortages that arose during
strikes in the United States and Canada; early in 1997, vehicle sales
strengthened. Consumer purchases of nondurables rose 1-3/4 percent in 1996
after increasing 1 percent during 1995. Spending for services rose 2-1/2 percent
last year, about the same as the average gain in previous years of the expansion. 
    
 
 After-tax personal income increased 5 percent in nominal terms over the four
quarters of last year. Wages and salaries rose briskly, and the income of farm
proprietors surged. Other types of income generally exhibited moderate gains.
Given the low level of price inflation, the rise in nominal income translated into
another significant advance in real disposable income--about 2-3/4 percent over
the year.      
 
 As in 1995, strong cross-currents continued to shape individual households'
willingness--and ability--to spend from current income. Huge increases in stock
market wealth provided some households the wherewithal to boost spending at a
pace considerably faster than the growth of disposable income. But a number of
households were likely held back by the need to divert income to the servicing
of debt, and according to some survey evidence, households have become more
concerned about saving for retirement. Responding to these influences, the
annual average of the personal saving rate was up slightly from that of 1995;
however, it remained relatively low compared with its longer-run average.      
 
 Residential investment expenditures posted a gain of 4 percent in real terms
over the four quarters of 1996, more than reversing a small decline in the
previous year. Demand for single-family housing was especially strong.
Although interest rates on longer-term fixed-rate mortgage loans moved up
considerably in 1996, a substantial number of homebuyers side-stepped at least
the initial costs by using adjustable-rate loans that were available at lower rates.
The effects of the rate increases on the single-family market were cushioned by
other influences as well, most notably the growth of employment and income.
Even for fixed-rate loans, mortgage financing costs held at a level that, by
historical standards, was low relative to household incomes. All told, sales of
new homes surged to the highest annual total of the current expansion, and sales
of existing homes established a historical high. New construction of
single-family dwellings also rose but not so dramatically as sales, as builders
apparently chose to work off some of their inventories of unsold units, which
had climbed in 1995. Mild sluggishness in starts toward the end of 1996--which
was probably exacerbated by poor weather in December--was followed by more
upbeat indicators of new construction in January of this year.     
 
 Construction of multifamily units maintained a path of recovery from the
extreme lows of the early 1990s, moving up about 13 percent in terms of annual
totals. The number of multifamily units started--about 315,000--was double the
number started in 1993, when construction of these units was at a low.
However, compared with previous peaks, the 1996 total was less
impressive--starts were twice as high in some years of the 1970s and 1980s.
Although market conditions for multifamily properties varied considerably from
city to city in 1996, the national average vacancy rate for multifamily rental
units remained relatively high, and demographic influences were probably less
supportive of multifamily housing than they were a decade or so ago. Also,
manufactured houses have provided an increased number of families with an
alternative to rental apartments in recent years.     
 
 
 The Business Sector     
 
 Business fixed investment recorded a fifth consecutive year of strong expansion
in 1996, rising about 9 percent according to the initial estimate. As in other
recent years, investment was driven by rising profits, favorable trends in the
cost of capital, and the ongoing efforts of businesses to boost efficiency.
Although much of the investment spending was to replace depreciated
equipment, the net addition to the aggregate capital stock appears to have been
substantial. The rate of rise in the stock has picked up over the past two or three
years after subpar growth through the latter half of the 1980s and first few years
of the 1990s; the resulting rise in the level of capital per worker should enhance
labor productivity and potential output.     
 
 Equipment outlays moved up almost 9-1/2 percent in real terms in 1996.
Business purchases of office and computing equipment once again rose much
faster than the outlays for other types of equipment. Computer purchases were
propelled by many of the same forces that have been at work in other recent
years--most particularly, the expansion of networks and the availability of new
models of computers embodying substantially improved computing power at
highly attractive prices. Outlays for communications equipment also rose quite
rapidly in 1996. Gains for other types of equipment were generally more
modest.     
 
 Investment in nonresidential structures also rose substantially over the four
quarters of 1996, posting the largest advance in several years. Business spending
on structures went through an extended contraction in the latter part of the
1980s and early 1990s, and until recently, the subsequent recovery has been
relatively slow. That the 1996 gain in nonresidential investment would be so
large was not evident until late in the year, when incoming data began to trace
out sizable increases in new construction for many types of buildings.
Investment in office buildings scored an especially large gain over the year,
amid widespread reports of firming market conditions and reduced vacancy
rates, and real outlays for other commercial structures moved up for a fifth
consecutive year. Financing appears to be in ample supply for commercial
construction, and according to reports from the District Reserve Banks,
speculative office building projects--that is, those without pre-committed
tenants--are becoming more common.     
 
 Inventory investment was relatively subdued in 1996. The stock of nonfarm
business inventories rose less than 2 percent over the four quarters of the year,
the smallest increase since 1992. Businesses had been moving toward a reduced
rate of stockpiling over much of 1995, and the rate of accumulation came almost
to a halt in early 1996, when stocks of motor vehicles plummeted in conjunction
with a strike at two plants that manufacture auto parts. Thereafter, inventory
developments were relatively uneventful. Stocks of vehicles changed little on net
over the final three quarters of the year, and accumulation of inventories by
other nonfarm businesses was moderate on average. Stocks at year-end generally
appeared to be at comfortable levels relative to recent trends in sales.     
 
 Business profits turned in another strong performance in 1996. Economic
profits of all U.S. corporations rose at an annual rate of more than 10 percent
from the final quarter of 1995 to the third quarter of 1996. Profits earned by
foreign subsidiaries of U.S. corporations fluctuated from quarter to quarter but
remained at high levels, and returns from domestic operations rose substantially,
for both financial and nonfinancial firms. Domestic profits of nonfinancial
corporations amounted to 10.7 percent of the nominal value of these firms'
output in the third quarter, the highest reading of the current expansion.     
 
 
 The Government Sector     
 
 Real federal expenditures on consumption and gross investment--the part of
federal spending that is included in GDP--rose about 2-1/2 percent, on net, from
the fourth quarter of 1995 to the fourth quarter of 1996, but the rise was mostly
an artifact of late-1995 real purchases having been pushed to especially low
levels by government shutdowns. The underlying trend of federal consumption
and investment expenditures probably is better represented by the 2-1/2 percent
annual rate of decline from the fourth quarter of 1994 to the final quarter of
1996. Reductions have been apparent over the past two years both in real
defense purchases and in real nondefense purchases.     
 
 Federal expenditures in the unified budget increased about 3 percent in nominal
terms in fiscal 1996 after having increased 3-3/4 percent in fiscal 1995. Slower
growth was recorded across many budgetary categories this past year, and
outright declines were reported in some. Combined expenditures on health,
social insurance, and income security--items that account for more than half of
all federal outlays--moved up 4-1/2 percent, the smallest increase this decade.
Defense spending was down about 2-1/4 percent in nominal terms, and net
interest outlays rose much less rapidly than in fiscal 1995. Measured relative to
the size of nominal GDP, total outlays in the most recent fiscal year were the
smallest since 1979. Legislative restraint has led to cuts in a number of
discretionary programs in recent years, and the expanding economy has relieved
pressure on those outlays that tend to vary inversely with the strength of
activity.     
 
 Federal receipts increased about 7-1/2 percent in fiscal 1996, the third year in
which growth of receipts outpaced growth of nominal GDP by a significant
margin. Receipts from individual income taxes climbed more than 11 percent in
the most recent fiscal year, in conjunction with healthy increases in households'
taxable earnings from capital and labor. Taxes on corporate profits also
continued to rise rapidly, more or less in step with the growth of business
earnings. The rapid growth of receipts, coupled with the restrained growth of
expenditures, brought the unified budget deficit down to $107 billion in fiscal
1996 from almost $165 billion in fiscal 1995. The deficit as a share of nominal
GDP was 1.4 percent, the smallest in more than twenty years.     
 
 The aggregate consumption and investment expenditures of state and local
governments rose 2-1/4 percent in real terms over 1996. This gain was about
the same as those of the two previous years. Outlays for services, which consist
mainly of employee compensation and account for more than two-thirds of all
state and local purchases, rose roughly 1-1/4 percent in real terms last year.
Investment expenditures, which make up the next biggest portion of state and
local purchases, rose about 4-1/2 percent in real terms. In the aggregate, the
budget picture for state and local governments was relatively stable in 1996, as
the surplus of nominal receipts over nominal current expenditures changed little
from the positive readings of other recent years.     
 
 
 The External Sector     
 
 The nominal trade deficit for goods and services widened to $115 billion in
1996 from $105 billion the previous year. For the first three quarters of the
year, the current account deficit totaled $165 billion at an annual rate, somewhat
greater than the $150 billion deficit recorded in 1995.    
 
 The quantity of imports of goods and services rose strongly over the four
quarters of 1996--about 8-1/2 percent according to the preliminary
estimate--after expanding only 4-1/4 percent the previous year. The pickup in
U.S. real output growth boosted the demand for imported goods, as did the
declines in the prices of non-oil imports. Sizable increases in import volume
were widespread among most major merchandise trade categories, with the
notable exceptions of oil and semiconductors.     
 
 Very strong export growth in the fourth quarter of 1996 raised the yearly gain
in the quantity of exports of goods and services to 7-1/2 percent. Growth in the
economies of our major trading partners was only moderate on average but was
somewhat faster than in 1995. As a consequence, growth of exports was similar
to the 1995 rate despite the appreciation of the dollar. Over the past year, most
of the rise in the value of merchandise exports went to Canada and Latin
America. Exports to Western Europe and Asia were only marginally higher than
they were a year earlier.     
 
 In most of the major industrial countries abroad, real economic activity
accelerated last year from a relatively weak performance in 1995. In the United
Kingdom, real output growth firmed through the year, as growth in consumption
spending rebounded from its low 1995 rate. In Germany and France, real GDP
growth strengthened but was still too low to prevent a further rise in the
unemployment rate in both countries. In Italy, output growth slowed as the
rebound in the lira from its previous depreciation sharply reduced the growth of
exports and depressed investment spending. For most continental European
countries, further fiscal restraint is planned this year as governments hoping to
participate in the third stage of European Monetary Union strive to meet the
Maastricht Treaty's 1997 reference standard of a budget deficit no larger than 3
percent of GDP. In Japan, fiscal stimulus spurred economic expansion early last
year; subsequently, slower private consumption, reduced inventory
accumulation, and decreased government investment spending reduced output
growth. In contrast, Canada's real output growth rose over 1996 as inventory
adjustment was completed during the first half of the year and as exports
strengthened.     
 
 Except in the United Kingdom, inflation pressures in the foreign industrial
countries continued to decline or remained subdued during 1996. Consumer
prices in Japan were flat. Consumer price inflation fell sharply in Italy and
remained below 2 percent in Germany and France. In the United Kingdom,
consumer prices excluding mortgage interest payments accelerated to an annual
rate of more than 3 percent.     
 
 The Mexican economy continued on a course of recovery that returned GDP to
its pre-crisis level in the fourth quarter of 1996. Increases in income and a
strengthening of the price-adjusted value of the peso contributed to a reduction
in the Mexican merchandise trade surplus over 1996. Argentina and Brazil also
continued to recover from recessions. In Chile, real GDP growth moderated
from the very high rate recorded in 1995 to about 6 percent in 1996. In
Venezuela, windfall oil revenues softened the decline in real GDP in 1996 and
improved the prospects for 1997.     
 
 In our major trading partners in Asia other than Japan, real output growth
generally slowed from its 1995 pace, despite a pickup in many countries toward
year-end in response to more accommodative monetary policies and a partial
recovery in export markets. In China, the slowdown of growth to about 10
percent last year from the 12 to 14 percent annual rates experienced during
1992-94 reflected a substantial deceleration in investment spending, owing to
China's efforts to reduce inflation by tightening central bank credit to
state-owned enterprises and by restricting investment.     
 
 Consumer price inflation in Mexico was around 28 percent in 1996,
significantly lower than the 1995 inflation rate of over 50 percent. Venezuela's
inflation rate in 1996 exceeded 100 percent, but inflation in most other Latin
American countries was at levels well under 10 percent. Inflation rates generally
remained low in Asia.  
 
 
 The Labor Market  
 
 The number of jobs on nonfarm payrolls rose more than 2-1/2 million from
December 1995 to December 1996, an increase of about 2-1/4 percent.
Employment gains were substantial in each quarter last year, and the labor
market report for January of this year showed a further sizable expansion of
payrolls.  
 
 Employment in the private service-producing sector, in which nearly two-thirds
of all nonfarm workers are employed, increased about 3 percent during 1996.
Moderate employment gains were posted in retail trade, transportation, and
finance, and sizable gains in hiring continued in some other service-producing
industries, such as data processing, computer services, and engineering and
management. Job growth at suppliers of personnel--a category that includes
temporary help agencies--was about 6-1/2 percent, a touch faster than in 1995
but much slower than it had been over 1992-94; with the tightening of labor
markets in the past couple of years, longer-lasting commitments in hiring may
have come back into greater favor among some employers.  
 
 Employment changes among producers of goods were mixed in 1996. In
construction, employment climbed about 5-1/2 percent, to a new high that was
almost 4 percent above the peak of the last business expansion. In
manufacturing, increases in factory jobs through the latter part of 1996 were not
sufficient to reverse declines that had taken place earlier in the year. On net,
last year's loss of factory jobs amounted to about 1/2 percent, a shade less than
the average rate of decline since 1979, the year in which manufacturing
employment peaked. Manufacturers of durable goods boosted employment
slightly last year, but many producers of nondurables implemented further job
cuts. As in many other recent years, reductions in factory employment were
accompanied by strong gains in worker productivity. Consequently, increases in
output were sizable--the rise in the Federal Reserve's index of manufacturing
production cumulated to 4-1/4 percent over the year.  
 
 Growth of output per hour in the nonfarm business sector as a whole picked up
in 1996, rising about 1-1/4 percent over the year according to preliminary data.
However, coming after a three-year period in which output per hour changed
little, this rise left the average rate of productivity growth in the 1990s a bit
below that of the 1980s and well below the average gains achieved in the first
three decades after World War II. The sustained sluggishness in measured
productivity growth this decade is difficult to explain, as it has occurred during
a period when high levels of investment in new capital and extensive
restructuring of business operations should have been boosting the efficiency of
workers. Of course, measurement problems could be distorting the data. As a
summary measure that relates aggregate output to aggregate input of labor, the
nonfarm productivity index is affected by whatever deficiencies might be present
either in adding up the nominal expenditures for goods and services in the
economy or adjusting those expenditures for price change. A considerable
amount of recent research suggests that growth of output and productivity is in
fact understated, but whether the degree of understatement has been increasing
over time is less clear.  
 
 In contrast to the experience of most other recent years, this past year's rise in
employment was accompanied by a sustained pickup in the labor force
participation rate. The rise in participation boosted the labor supply and helped
to relieve pressures on the labor market. Nonetheless, hiring during 1996 was
sufficient to reduce the civilian unemployment rate from a December 1995 rate
of 5.6 percent to a December 1996 rate of 5.3 percent. In January of this year,
the rate remained low, at 5.4 percent.  
 
 Tightness of the labor market appears to have exerted some upward pressure on
the cost of labor in 1996, even as some workers continued to express anxiety
about job security. The employment cost index (ECI) for the private nonfarm
sector of the economy showed compensation per hour moving up 3.1 percent
over the year. The index had risen 2.6 percent in 1995. The step-up in hourly
pay increases was to some extent the result of a hike in the minimum wage that
took place at the start of October. More generally, however, businesses
probably had to boost hourly compensation either to attract workers or to retain
them at a time when alternative employment opportunities were perceived to be
more widely available.  
 
 As in 1995, increases in hourly compensation in 1996 came more as wage and
salary increases than as increases in fringe benefits. According to the ECI, the
rise in wage rates for workers in the nonfarm sector amounted to nearly 3-1/2
percent this past year after a rise of 2-3/4 percent in 1995. By contrast, the ECI
measure of the hourly cost of benefits rose only 2 percent, slightly less than it
did in 1995 and much less than it rose on average over the past decade.
Increases in the cost of benefits have been held down in recent years by reduced
inflation for medical services and by the actions that many firms have taken to
shift employees into managed care arrangements and to require them to assume
a greater portion of the cost of health insurance and other medical benefits.  
 
 
 Prices  
 
 The consumer price index rose more rapidly than in 1995, but the step-up was
concentrated in the food and energy sectors--areas in which prices were affected
by supply limitations that seemed likely to be of temporary duration. The CPI
excluding food and energy--often called the "core" CPI--rose just a touch more
than 2-1/2 percent after increasing 3 percent during 1995. Both the total CPI
and the core CPI have been affected in the past two years by technical
improvements implemented by the Bureau of Labor Statistics that are aimed at
obtaining more accurate readings of price change; the rise in the CPI in 1996
would have been somewhat greater if procedures used through 1994 had not
been altered.  
 
 Other price indexes generally rose less rapidly than the CPI. Like the overall
CPI, the chain type price index for personal consumption expenditures (PCE)
accelerated somewhat in 1996, but its rate of rise, shown in the accompanying
table, was significantly lower than that of the CPI. The two measures of
consumer prices differ to some degree in their weights and methods of
aggregation. They also differ somewhat in their selection of price data, with the
PCE measure relying on alternative data in some areas in which the accuracy of
the CPI has been questioned. The chain type price index for gross domestic
purchases, which takes account of the prices paid by businesses and
governments as well as those paid by consumers, moved up 2-1/4 percent
during 1996, about the same as the percentage rise during 1995. By contrast,
price measures associated with GDP decelerated in 1996 to thirty-year lows of
around 2 percent or less. Conceptually, the GDP measures are indicative of
price changes for goods and services that are produced domestically rather than
price changes for goods and services purchased domestically--foreign trade
accounting for the difference.  
 
 The 1996 outcomes for all these measures reflected an economy in which
inflation pressures were muted. Sharp declines in non-oil import prices during
the year lowered input costs for many domestic firms and likely caused other
firms to restrain their product prices for fear of losing market share to foreign
competitors. Also important, in all likelihood, were the favorable imprints that
several years of moderate and relatively stable rates of inflation have left on
inflation expectations. Despite the uptick in hourly compensation and adverse
developments in the food and energy sectors, survey data showed little change
in consumers' expectations of inflation, and private forecasters' views of the
prospects for prices held steady. Businesses commonly described the situation as
one in which competitive pressures were intense and the "leverage" for raising
prices simply was not present.  
 
 Food and energy prices were the exceptions. In the food sector, steep increases
in grain prices in 1995 and the first few months of 1996 caused production
adjustments among livestock farmers and substantial price increases for some
livestock products. Later in the year, grain prices fell back, but livestock
production could not recover in time to prevent significant price advances for
some retail foods. Consumer prices for pork, poultry, and dairy products
registered their largest increases in several years. Retail beef prices also rose but
only moderately: Expansion of the cattle herd in previous years had laid the
groundwork for a high flow of product to consumers, and herd reductions that
occurred in 1996 augmented that flow. Elsewhere in the food sector,
acceleration was reported in the price index for food away from home--a
category that has a weight of almost 40 percent in the CPI for food; the rise in
the minimum wage appears to have been an important factor in the acceleration.
All told, the 1996 rise in CPI food prices amounted to 4-1/4 percent, the largest
increase since 1990.  
 
 The energy sector was the other major part of the economy in which significant
inflation pressures were evident this past year. Crude oil prices, which had
started firming in the latter part of 1995, continued on an upward course
through much of 1996, rising more than 30 percent in total. Stocks of crude oil
and petroleum products were tight during the year, even after allowing for an
apparent downward trend in firms' desired inventories. Inventory building was
forestalled by production disruptions at refineries, a string of weather problems
here and abroad that boosted fuel requirements for heating or cooling, and a
reluctance of firms to take on inventories that seemed likely to fall in value once
renewed supplies from Iraq became available. Natural gas, too, was in tight
supply at times, and its price surged. With retail prices of gasoline, fuel oil, and
natural gas all moving up substantially, the CPI for energy rose about 7-1/2
percent over the four quarters of 1996, the largest increase since the Gulf War. 

 
 The CPI for goods other than food and energy rose 1 percent during 1996, one
of the smallest increases of recent decades. As in 1995, price increases for new
vehicles were moderate last year, and prices of used cars turned down after
several years of sizable advances. Prices of apparel and house furnishings also
fell; these prices, as well as the prices of vehicles, may have been heavily
affected by the softness of import prices. Moderate increases were the rule
among most other categories of goods in the CPI. In the producer price index,
prices of capital equipment rose less than 1/2 percent over 1996; computer
prices continued to plunge, and the prices of other types of equipment rose
moderately, on balance. Materials prices were weak: Prices of intermediate
materials excluding food and energy declined about 1-1/4 percent from the
fourth quarter of 1995 to the final quarter of 1996, and the producer price index
for crude materials excluding food and energy dropped more than 6-1/2 percent
over that period. Productive capacity was adequate among domestic producers
of materials, and supplies of many materials were readily available at
competitive prices on the world market.  
 
 The CPI for non-energy services increased 3-1/4 percent in 1996. The rise was
somewhat smaller than the increases of most other recent years. Prices of
medical services decelerated for a sixth consecutive year, and increases in the
cost of shelter were held down by another year of moderate advances in
residential rent and owners' equivalent rent. Large increases were evident only
in scattered categories: Airfares posted a large increase, and educational costs,
maintaining a long-established trend, continued to rise quite rapidly relative to
prices in general.  
 
 
 Financial Developments  
 
 
 Debt  
 
 Growth of the debt of nonfinancial sectors slowed slightly last year, to 5-1/4
percent. The growth of household sector debt dropped from 8-1/4 percent to
7-1/2 percent, a deceleration accounted for entirely by a sharp slowing of
consumer credit. The expansion of business borrowing was held below its 1995
pace by an increase in internally generated funds, but at 5-1/4 percent, it was
faster than in any other year since 1989. Its strength reflected robust spending,
extremely favorable credit conditions, and financing needs associated with a
high level of mergers and acquisitions. Federal government debt grew 3-3/4
percent, the lowest rate in more than two decades. The debt outstanding of the
state and local sectors was unchanged.  
 
 The Household Sector. Consumer credit grew 8-1/4 percent last year, just a bit
over half the pace of the preceding two years. The sharp retrenchment likely
reflected the burdens associated with a substantial accumulation of outstanding
consumer debt over recent years as well as some tightening of lending terms and
standards by commercial banks, particularly with respect to credit cards.  
 
 The slowing in consumer credit growth also was associated with a shift toward
increased use of home equity loans. These loans were marketed vigorously,
particularly by finance companies, in part as a vehicle for consolidating credit
card and other outstanding consumer debt. Some of the growth in home equity
loans reflected moves by finance companies and banks into the sub-prime
market--lending either to higher-risk customers or on terms entailing unusually
high loan-to-value ratios, or both. The push to expand home equity lending last
year offset to some degree the effect of tighter lending standards and terms on
credit cards and other forms of consumer credit.  
 
 The shift toward home equity loans, along with a strong housing market, led to
a pickup in mortgage debt growth last year to a rate of 7-1/2 percent, the largest
advance since 1990. Mortgage borrowing for home purchases was restrained
surprisingly little by the increase in interest rates over the first half of the year.
As noted previously, many borrowers were able to put off, at least for a time,
much of the impact of the increase in rates by shifting to adjustable-rate
mortgages, the rates on which rose much less last year than those on fixed-rate
mortgages.  
 
 Although the growth of household sector debt fell off a bit from the pace of
recent years, it still exceeded that of disposable income. With loan rates up on
average for mortgages and down only a little on consumer loans, debt service
burdens continued to rise last year, and some households experienced difficulties
servicing certain kinds of debt. Delinquency rates on banks' consumer loans,
particularly credit card loans, posted a second year of considerable increase,
although they remained below levels in the early 1990s. At finance companies
that are subsidiaries of automakers, auto loan delinquency rates rose to very
high levels; but this rise apparently resulted in large part from a business
strategy to compete in the vehicle market by easing lending standards. Auto loan
delinquency rates at commercial banks also rose but remained well within
historical ranges. Delinquency rates on residential mortgages remained low.  
 
 In the segment of the finance company market that deals in "sub-prime" auto
loans, some problems emerged last month. A small firm in this market defaulted
on its commercial paper after it restated earlier earnings at lower levels, and
another firm filed for bankruptcy. Although the share prices of these and other
firms primarily engaged in sub-prime lending declined along with their earnings
outlook, this sector constitutes a very small part of the overall auto loan market,
and the implications for the availability of credit to the household sector overall
appear slight.  
 
 Charge-off rates on consumer loans rose at banks in 1996 to around the peak
levels of the last recession in 1990-91. According to Federal Reserve surveys of
senior loan officers, banks had anticipated some deterioration in the quality of
their consumer loan portfolios last year, but they were surprised by its extent.
These surveys also showed that banks considered the rate of charge-offs last
year to be high relative to the level of delinquencies and that the credit-scoring
models most banks use to evaluate consumer lending decisions have tended to be
too optimistic. An important reason for the high level of charge-offs and the
apparent shortcomings of the credit-scoring models was a 30 percent increase in
personal bankruptcies. This surge stemmed in part from changes in the
bankruptcy code that became effective at the beginning of last year against a
backdrop of an apparently reduced stigma associated with this method of dealing
with financial problems. Banks responded to the deterioration in their consumer
loan portfolios by tightening standards and terms, especially on credit cards. In
contrast, banks eased terms and conditions on home equity loans.  
 
 Despite the rise in delinquencies on consumer debt, household balance sheets
appear healthy overall, as growth of household assets over the past two years
has more than kept pace with the growth of debt. Although year-end balance
sheet figures are not yet complete, the net worth of households appears to have
risen approximately $5 trillion from the end of 1994 to the end of 1996, an
amount that is equal to almost a full year's personal disposable income. Roughly
two-thirds of that gain has been accounted for by the surge in the prices of
corporate shares, which has lifted the value of a wide range of household
investments, not only directly held stocks but also assets held in other forms
such as pension plans. The ratio of household net worth to personal disposable
income continued to climb this past year, moving to its highest level in recent
decades.  
 
 The Business Sector. Although many interest rates rose last year, businesses
continued to find credit readily available and at favorable terms. This
accommodation likely resulted in part from the strong financial condition of this
sector, reflected in minimal delinquency rates on bank loans to businesses and
very low default rates on corporate bonds, including those of low-rated issuers.
With securitization of household debt instruments proceeding apace and with
high levels of capital, banks appeared to have ample room on their balance
sheets for business loans. This situation encouraged the development of a highly
competitive lending environment in which banks further eased a variety of credit
terms, such as covenants and markups over base rates. In capital markets,
interest rate spreads of private debt instruments over Treasuries narrowed,
particularly in the case of high-yield bonds. Surveys by the National Federation
of Independent Business revealed a rising tendency of small businesses to
borrow over 1996, with credit availability reported to be in a range more
favorable than at any time in the current economic expansion.  
 
 On a gross basis, a pickup in bond issuance by nonfinancial firms last year was
accounted for mainly by speculative-grade offerings, likely in part a reaction to
the improved pricing. In the fourth quarter, however, investment-grade issuance
was substantial, responding to the decline in interest rates that began in late
summer. Commercial paper declined in the final months of the year, primarily
because of paydowns from bond proceeds, but bank lending to businesses was
strong, owing in some part to robust merger activity. Despite a marked increase
in gross stock issuance--with strong gains both for initial public offerings and
for seasoned offerings--equity continued to be retired on net last year, as merger
activity remained brisk and businesses used ample cash resources to repurchase
their outstanding shares.  
 
 The Government Sector. The growth of federal debt was held down in 1996 by
legislative constraints on spending and by the boost to tax receipts from both the
stronger economy and a booming stock market. Two years of contraction of
state and local government debt ended last year. The declines had occurred as
issues that were pre-refunded earlier in the decade, when interest rates were
unusually favorable, matured or became eligible to be called. Pre-refunded debt
continued to be called last year, albeit at a reduced pace, but this decline was
just offset by gross issuance, which picked up.  
 
 Depository Intermediation. The expansion of depository credit slowed last year,
entirely reflecting a slower advance in bank credit. Growth at thrift institutions
picked up, benefiting from strong demand for residential mortgages and
improved capital positions. Growth of commercial bank loans moderated, as
loans to businesses and, especially, consumers decelerated from elevated rates of
growth in 1995. Bank portfolio expansion also appears to have been damped
somewhat by a faster pace of asset securitization, likely spurred by receptive
capital markets. For example, real estate loan growth at banks was a subdued 4
percent last year, despite a robust housing market and a pickup in commercial
real estate. At the same time, outstanding securities backed by mortgage pools
expanded at a $179 billion annual rate in the first three quarters of last year,
well above the pace of 1995. Commercial banks are a major source of
securitized mortgages. The outstanding amount of consumer credit that had been
securitized by banks also rose at a brisk pace last year, although not so rapidly
as in 1995. As a result of the slowing of bank credit, the share of last year's
advance in nonfederal debt that ended up on the books of depositories fell to
about 38 percent, down from around 44 percent in the preceding two years.  
 
 The balance sheets and operating results of depositories remained strong in
1996. Bank profits through the third quarter were at historically high levels for
the fourth consecutive year, reflecting the maintenance of relatively wide
interest rate margins, further loan growth, and substantial fee income related to
sales of mutual funds as well as to securitization and other off-balance-sheet
activities. As of the third quarter, almost 99 percent of commercial bank assets
were held at banks classified as "well capitalized." Underlying thrift profits
were also stronger last year. However, profits at thrift institutions and at banks
with deposits insured by the Savings Association Insurance Fund (SAIF) were
held down temporarily by a special assessment on deposits to recapitalize SAIF.
(Some bank deposits are SAIF-insured because of mergers with thrifts or
acquisitions of them.)  
 
 
 The Monetary Aggregates  
 
 Despite the slowing of depository credit, growth of the broader monetary
aggregates strengthened last year: M3 expanded 7 percent, up 1 percentage
point from 1995 and also 1 percentage point above the upper end of its 2 to 6
percent annual range. M2 grew 4-1/2 percent, up 1/2 percentage point and in
the upper portion of its 1 to 5 percent range. As noted in Section 1, the ranges
for monetary growth last year had been chosen to be consistent with
approximate price stability and a sustainable rate of real economic growth,
rather than as indicators of the range of money growth rates likely to prevail
under expected economic conditions.  
 
 The acceleration of M3 was caused partly by a shift in the way banks financed
their credit--specifically, substituting issuance of large time deposits for
borrowings from offices abroad. Both foreign and domestically chartered banks
paid down net borrowing from foreign head offices and branches last year. For
domestic banks, this paydown may have been related to the reduction to zero of
insurance assessments on deposits, beginning with the last quarter of 1995. In
addition, the greater growth of M3 relative to that of M2 reflected the need to
fund particularly strong loan growth at U.S. branches and agencies of foreign
banks, which do not offer the retail accounts that dominate deposits in M2.  
 
 Growth of both M2 and M3 was supported again last year by continuing robust
advances in money market mutual funds (MMMFs). Because the yields on these
funds are based on the average return earned on their assets, they lag changes in
yields on new market instruments; thus, the funds tend to attract additional
inflows when market rates are falling. Accordingly, MMMFs advanced most
rapidly in the early part of last year, when the monetary easings of December
and January pulled down short-term rates, and also later in the year, when
short-term rates were again declining. However, these instruments expanded
briskly even in the third quarter, when short-term rates were rising, suggesting
that part of the attractiveness of MMMFs is the convenience they offer those
investors engaged in moving funds in and out of stock and bond mutual funds,
which expanded at a record pace last year. In addition, institution-only funds
seem to be having considerable success in marketing cash management programs
that capture excess cash of corporations and municipalities. Likely reflecting the
attractiveness of money market and capital market mutual funds last year,
deposits in M2 actually showed little growth in 1996. Retail deposit growth also
may have been damped by a lack of aggressive pricing of deposits on the part of
banks, as demand for their loans slipped and they apparently found it cheaper to
finance a larger share of loan originations through securitizations and large time
deposits.  
 
 The behavior of M2 relative to income last year, as summarized by its income
velocity, again bore a fairly systematic relationship to M2's opportunity
cost--the return on M2 assets relative to yields available on alternative
instruments. The relationship of velocity to opportunity costs was reasonably
stable historically, but it broke down in the early 1990s, a period characterized
by extensive restructuring of balance sheets by households, businesses, and
banks. In the process, M2 velocity rose substantially and, apparently,
permanently. Since 1993, velocity no longer appears to be shifting higher, and
M2 velocity and opportunity costs are moving together about as they did before
1990. However, the recent period of relative stability in this relationship has
been too short for the Federal Reserve to place increased reliance on M2 as a
guide to policy at this time.  
 
 M1 contracted 4-1/2 percent last year, as the pace at which new arrangements
were established to sweep reservable retail transactions deposits to nonreservable
nontransaction accounts accelerated. The initial amounts removed from
transaction accounts by sweep arrangements established last year amounted to
$116 billion, compared with $45 billion in 1995. M1 continued to be supported
by currency growth last year, when foreign demands, which were depressed
earlier in the year partly in anticipation of the new $100 bill, picked up in the
second half. Adjusted for the initial amounts removed from transaction accounts
by sweep arrangements, M1 grew 5-1/4 percent last year. The sweeping of
transaction deposits contributed to a contraction of almost 12 percent in required
reserves--twice the rate of decline of the previous year. The monetary base
decelerated only a little, however, as growth of its major component, currency,
was little changed between 1995 and 1996.  
 
 Continued declines in the levels of required reserves have the potential to
impinge on the Federal Reserve's ability to exert close day-to-day control over
the federal funds rate--the overnight rate on reserves traded among depository
institutions. Depositories hold balances at Reserve Banks to meet daily clearing
needs in addition to satisfying statutory reserve requirements. At low enough
levels, reserve balances may provide inadequate protection against adverse
clearings, and banks' attempts to avoid overdrafts could generate highly variable
daily demands for balances at the Federal Reserve and a volatile federal funds
rate. To date, however, no serious problems have emerged, in part because the
substantial drop in depositories' required reserve balances attributable to sweeps
has been partially offset by increases in their holdings of required clearing
balances--an arrangement whereby depositories pay for services provided by the
Federal Reserve through the holding of specified amounts in reserve account
balances. In addition, advances in banks' techniques of monitoring balances at
the Federal Reserve and gauging their clearing needs have enabled them to
operate efficiently and smoothly at relatively low levels of balances. Sweeps
have had an effect on Federal Reserve earnings and the amounts it remits to the
Treasury. The decline in reserve balances of around $12 billion owing to sweeps
must be matched by an accompanying lower level of Treasury securities on the
books of Reserve Banks. The Federal Reserve continues to monitor sweep
activity closely.  
 
 
 Interest Rates, Equity Prices, and Exchange Rates  
 
 Interest Rates. Declines in interest rates during the second half of last year on
evidence that economic growth had moderated only partially reversed the
increases over the first half. Reflecting the surprising strength in economic
activity last year, longer-term Treasury rates rose on balance on the order of 1/2
percentage point over the year, and intermediate rates were up somewhat more.
Spreads between most private rates and Treasuries narrowed markedly last year,
reflecting the high quality of business balance sheets. Municipal rates moved up
comparatively little over the first half of 1996 as earlier relative increases in
these yields associated with discussions of fundamental tax reform were reversed
when the likelihood of such changes to the tax code diminished. Movements in
interest rates over the year appeared to be basically in their real component, as
inflation expectations were little changed, according to surveys.  
 
 Equity Prices. The substantial rise in equity prices last year was only a bit
below that registered in 1995. However, in contrast to 1995, when bond rates
declined substantially, the equity gains last year came despite the net rise in
bond rates. Corporate earnings were robust last year, but their advance fell
short of share price increases, and price-earnings ratios rose to unusually high
levels; dividend-price ratios were even more out of line with historical
experience. Market participants appear to be anticipating further robust earnings
growth, and they also seem to be requiring much less compensation for the
extra risk of holding equities compared to, say, Treasury bonds. Such
evaluations may be based on a perceived environment of persisting low inflation
and balanced economic growth that would lower the odds of disruptions to
economic activity. Other asset prices were generally subdued. Commodity prices
were flat to down. Commercial real estate prices, although no longer falling,
rose at little more than the rate of inflation. Residential real estate prices
increased moderately.  
 
 Exchange Rates. The foreign exchange value of the dollar in terms of the
currencies of the other G-10 countries rose about 4 percent during 1996. When
measured in terms of the currencies of a broader group of U.S. trading partners
and adjusted for differences in consumer price inflation, the appreciation of the
dollar last year was also about 4 percent. Much of the rise in the exchange value
of the dollar occurred during the first half of the year. Indications of
greater-than-expected underlying strength in the U.S. economy and signs of
weakness in some European economies in the first two quarters reinforced
market expectations that U.S. monetary policy was less likely to be eased than
was policy in the other industrial countries. These expectations boosted U.S.
long-term interest rates relative to those abroad and contributed to upward
pressure on the dollar. The dollar fluctuated somewhat from June through
December but on balance changed little. Over the course of 1996, the dollar
appreciated 12 percent in terms of the yen and 7-3/4 percent in terms of the
mark. During the first weeks of 1997, the dollar's average value against the
G-10 currencies has again moved up, appreciating about 7 percent since the end
of December, as economic data have suggested additional strength in the U.S.
economy and have raised questions about the vigor of economic expansions in
several foreign industrial countries.  
 
 On average, yields on ten-year government securities in the major foreign
industrial countries fell about 80 basis points last year, with most of the decline
coming in the second half. In Italy, long-term rates declined much more, about
375 basis points, in response to low growth in real output, substantial progress
in lowering inflation, and sizable, credible measures to reduce the government
deficit. In contrast, long-term rates in the United Kingdom rose slightly as the
economy strengthened. Rates in Japan rose early in the year as the economy
spurted, but subsequent indicators of a weakening expansion caused rates to turn
back down; over the year, they declined about 40 basis points on net.
Long-term rates abroad have moved down slightly further so far this year.
Short-term market rates in the foreign industrial countries on average declined
about 120 basis points during 1996. Except in Japan, official central bank
lending rates were lowered in the foreign G-10 countries last year, contributing
to the decline in market rates.  
 
 Equity prices in most industrial countries rose strongly last year. The major
exception was Japan, where prices on balance fell slightly. The general decline
in long-term interest rates abroad and moves toward monetary ease were among
the factors contributing to the upward movement in stock prices.  
 
 The dollar appreciated in nominal terms about 2-1/2 percent on balance against
the Mexican peso during 1996, with much of that appreciation coming over a
few weeks in October. After fluctuating in a narrow range for most of the year,
the Mexican peso depreciated in terms of the dollar when market participants
became concerned about the loss of competitiveness of Mexican exports during
the year and about the partial nature of the government's planned privatization
of the petrochemical industry. Peso interest rates rose in October and
November, but have since more than retraced that increase as the peso has
stabilized. In January, Mexican officials repaid all remaining outstanding
obligations to the Exchange Stabilization Fund of the U.S. Treasury, completing
repayment to the United States of all borrowings that were made following the
peso crisis in late 1994; a partial early repayment was made to the International
Monetary Fund as well.  
 
 In the first three quarters of 1996, large increases were reported in both foreign
ownership of assets in the United States and U.S. ownership of assets abroad.
Over the same period, foreign official assets in the United States increased
almost $90 billion. Part of this increase was associated with exchange market
intervention by the Japanese authorities to counter a brief strengthening of the
exchange value of the yen early in the year, but a larger part reflected the
repurchase of reserves by several European countries whose currencies
strengthened against the mark. About half reflected increases in reserves of
newly industrializing countries.  
 
 Private foreigners also added substantially to their assets in the United States in
the first three quarters of 1996. Net purchases of U.S. Treasury securities by
private foreigners amounted to $85 billion through September, and net purchases
of corporate and government agency bonds were equally large. Foreign direct
investment in the United States surged to a record $71 billion in the first three
quarters, reflecting numerous mergers and acquisitions of U.S. companies by
foreigners.  
 
 U.S. private investors also added rapidly to their holdings of foreign assets in
the first three quarters of 1996. In contrast to foreign investors in the United
States, U.S. portfolio investors favored foreign stocks over bonds. Net
purchases in Japan were particularly large in the first half of the year. In
addition, U.S. direct investment abroad remained strong, reflecting acquisitions
and continued privatizations of foreign firms.