Section 1: Monetary Policy and the Economic Outlook

The U.S. economy posted significant further gains in the
first half of 1998. The unemployment rate dropped to its
lowest level in nearly thirty years, and inflation remained
subdued. Real output rose appreciably, on balance, although
much of the advance apparently occurred early in the year.
Household spending and business fixed investment, supported
by the ongoing rise in equity prices and the continued low
level of long-term interest rates, appear to have maintained
considerable momentum this year. The sizable advance
in capital spending and the resulting additions to the
capital stock should help bolster labor productivity--
the key to rising living standards.

Yet the news this year has not been uniformly good. The
turmoil
that erupted in some Asian countries last year has
generated major concerns about the outlook for those
economies and the repercussions for other nations,
including the United States. Several Asian countries
have had sharp contractions in economic activity, and
others have experienced distinctly sub-par growth.
Heightened uneasiness among international investors has
induced portfolio shifts away from Asia and, to some
extent, from other emerging market economies.

These difficulties have created considerable uncertainty
and risk for the U.S. economy, but they have also helped
to contain
potential inflationary pressures in the near term by
reducing import prices and restraining aggregate demand.
In particular, the substantial rise in the foreign
exchange value of the dollar has boosted our real
imports and--together with the slower growth in Asia--
depressed our real exports. At the same time, the run up
in the dollar and slack economic conditions in Asia have
helped
produce a sharp drop in the dollar prices of oil and
other commodities and have pushed down other import
prices. Shifts in preferences toward dollar-denominated
assets in combination with downward revisions to
forecasts of inflation and demand have helped to reduce
our interest rates; the lower interest rates have boosted
household and business spending, offsetting a portion of
the damping of demand from the foreign sector.

The Asian crisis is likely to continue to restrain U.S.
economic activity in coming quarters. The size of the
effect will depend in large part on how quickly the
authorities in the Asian nations can
put their troubled financial systems on a sounder footing
and carry out other essential economic reforms.
Deteriorating conditions in many countries during the
past few months created added pressures for reform, and
they underscored the depth and scope of the problems that
must be addressed.

Despite the pronounced weakening of our trade balance,
the
already tight U.S. labor market has come under further
strain this year owing to robust growth of domestic
demand. As a result, the outlook for inflation has taken
on a greater degree of risk.
Consumer prices actually rose a bit less rapidly in the
first half of 1998 than they did in 1997, but transitory
factors--the drop in oil prices, the run up in the
dollar, and weak economic activity in Asia--exerted
considerable downward pressure on domestic prices. These
factors will not persist indefinitely. Meanwhile, the
pool of individuals interested in working but who are not
already
employed has continued to shrink. The extraordinary
tightness in
labor markets has generated a rising trend of
increases in wages and related costs, although faster
productivity growth has damped the effect on business
costs so far.

In conducting monetary policy in the first half of 1998,
the Federal Open Market Committee (FOMC) closely
scrutinized incoming information for signs that the
strength of the economy and the taut labor market were
likely to boost inflation and threaten the durability of
the expansion. However, despite slightly larger
increases in the CPI in some months, inflation remained
moderate
on the whole. Moreover, the Committee expected that
aggregate demand would slow appreciably because of a
rising trade deficit and a considerable slackening in
domestic spending. Although the Committee was acutely
aware of the uncertainties in the economic outlook, it
believed that the deceleration in demand--and the
associated modest easing of pressures on resources--
could well be sufficient to limit any deterioration in
underlying price performance. On balance, the FOMC chose
to keep the intended federal funds rate at 5-1/2
percent.

Monetary Policy, Financial Markets, and the Economy over
the
First Half of 1998

Output grew rapidly in the first quarter, with real
gross domestic product estimated to have risen 5-1/2
percent at an annual rate. Business fixed investment
soared after a weak fourth quarter, and consumption and
housing expenditures expanded at a strong clip.
In addition, contrary to the expectations of many
forecasters, inventory investment rose substantially
from its already hefty fourth-quarter pace, with the
rise contributing more than 1-1/2 percentage points to
overall GDP growth. At the same time, the cumulative
effect of the appreciation of the dollar and faster
growth of demand here than abroad resulted in a sharp
drop in real net exports, with both rapid import growth
and the first quarterly drop in exports in four years.
Employment continued to advance briskly, and the
unemployment rate held steady at 4-3/4 percent. Hourly
compensation accelerated somewhat when measured on a
year-over-year basis, but impressive productivity growth
once again helped to restrain the increase in unit labor
costs. The consumer price index rose only 1/4 percent at
an annual rate over
the first three months of the year, as a sharp drop in
energy prices offset price increases elsewhere.

Falling long-term interest rates and rising equity
prices over the previous year provided substantial
impetus to household and
business spending in the first quarter. Interest rates
dropped sharply further in early January, and although
they moved up a little over the remainder of the quarter,
nominal yields on long-term Treasury securities were
among the lowest in decades. Interest rates continued to
benefit from the improvement in the federal budget and
the prospect of reduced federal borrowing in the future;
rates were also restrained to a significant extent by the
effects of the Asian crisis. Equity prices increased
sharply in the
first quarter, extending their remarkable gains of the
previous three years in spite of disappointing news on
corporate profits.
Households and firms borrowed at a vigorous pace in the
first quarter, and growth in the debt of domestic
nonfinancial sectors picked up from the fourth quarter
of 1997, as did the growth of the monetary aggregates.

At their March meeting, the members of the FOMC
confronted
unusual cross-currents in the economic outlook. On the
price side, the FOMC noted that, although the incoming
data were quite favorable, transitory factors were
possibly masking underlying tendencies toward higher
inflation. Moreover, the available data on household
and business spending confirmed the impressive
strength of domestic demand and highlighted the
possibility that developments in the external sector
might not provide sufficient offset in coming quarters to
avoid a build-up of inflation pressures. At the same
time, the FOMC noted the substantial uncertainty
surrounding the prospects for the Asian economies.
Balancing
these considerations, the FOMC kept its policy stance
unchanged but noted that recent information had altered
the inflation risks enough to make tightening more likely
than easing in the period ahead.

The second quarter brought both a marked further
deterioration in the outlook for Asia and some
indications that the U.S. economy might be cooling. In
Asia, evidence of steep output declines in several
countries was combined with mounting concern that
economic and financial problems in Japan were not likely
to be resolved as quickly as many observers had hoped or
expected. One
result was a further rise in the exchange value of the
dollar and a decline in long-term U.S. interest rates.
Increasing investor concern about emerging market
economies raised risk spreads on external
debts in Asia, Russia, and Latin America.

The higher value of the dollar and the depressed income
in many Asian countries continued to take their toll on
U.S. exports and to boost imports in the second quarter.
In addition, a marked slackening in the pace of
inventory accumulation, which was amplified by the
effects of a strike in the motor vehicle industry, was
reflected in a sharp slowing in domestic demand.
Nonetheless, the utilization of labor resources remained
very high: In the second quarter, the unemployment rate
averaged a bit less than 4-1/2 percent, its lowest
quarterly reading in nearly thirty years. The twelve-
month change in average hourly earnings indicated that
wages were rising somewhat more rapidly than they had a
year earlier. And the CPI rose faster in the second
quarter than in the first, mainly reflecting a smaller
drop in energy prices.

Financial conditions in the second quarter and into July
remained supportive of domestic spending. Yields on
private securities declined, although less than Treasury
yields, as quality spreads widened a bit. Equity prices
rose further in early April before falling back over the
next two months in response to renewed earnings
disappointments. Prices then rebounded substantially,
with most major indexes hitting record highs in July.
The growth of money and credit slowed a little on
balance from the first-quarter pace but remained
buoyant. Banks and other lenders continued to compete
vigorously, extending credit on generally favorable
terms as they responded in part to the sustained healthy
financial condition of most businesses and households.

The FOMC left the intended federal funds rate unchanged
at its
May and June-July meetings. At the May meeting, the FOMC
reiterated its earlier concern that the robust expansion
of domestic final demand, supported by very positive
financial conditions, had raised labor market pressures
to a point that might precipitate an upturn in inflation
over time. Yet the FOMC believed that the
growth of economic activity would slow. It also judged
that the
risk of significant further deterioration in Asia, which
could disrupt global financial markets and impair economic
activity in the
United States, was rising somewhat.

Economic Projections for 1998 and 1999

The members of the Board of Governors and the Federal
Reserve
Bank Presidents, all of whom participate in the
deliberations of the FOMC, expect economic activity to
expand moderately, on
average, over the next year and a half. For 1998 as a
whole, the central tendency of their forecasts for real
GDP growth spans a
range of 3 percent to 3-1/4 percent. For 1999, these
forecasts center on a range of 2 percent to 2-1/2
percent. The civilian
unemployment rate, which averaged a bit less than 4-1/2
percent in the second quarter of 1998, is expected to
stay near this level through the end of this year and to
edge higher in 1999. With labor markets remaining tight
and some of the special factors that helped restrain
inflation in the first half of 1998 unlikely to be
repeated, inflation is anticipated to run somewhat higher
in the second half
of 1998 and in 1999.

The economy is entering the second half of 1998 with
considerable strength in household spending and
business fixed investment. Consumers are enjoying
expanding job opportunities, rising real incomes, and
high levels of wealth, all of which are providing them
with the confidence and wherewithal to spend. These
factors, in conjunction with low mortgage interest
rates, are also bolstering housing demand. Business
fixed investment appears robust as well: Financial
conditions remain conducive to capital spending, and
firms no doubt are continuing to seek out opportunities
for productivity gains in an environment of rapid
technological
change, falling prices for high-tech equipment, and tight
labor markets.

Nonetheless, a number of factors are expected to exert
some restraint on the expansion of activity in the
quarters ahead. The demand for U.S. exports will continue
to be depressed for a while by weak activity abroad, on
average, and by the strong dollar, which will also likely
continue to boost imports. The effects of these external
sector developments on employment and income
growth have yet to materialize fully. In addition,
although financial conditions are generally expected to
be supportive, real outlays on housing and business
equipment have reached such high levels that gains from
here are expected to be more moderate.

With the plunge in energy prices in early 1998 unlikely
to be repeated, most FOMC participants expect the CPI for
all urban consumers to rise more rapidly in the second
half of 1998 than it
did in the first half, resulting in an increase in the CPI
of 1-3/4 percent to 2 percent for 1998 as a whole. The
pickup in the second half should be limited, however, by
further decreases in non-oil import prices, ample domestic
manufacturing capacity, and low expected inflation.
Looking ahead to next year, the central
tendency is for an increase in the CPI of 2 percent to 2-
1/2 percent. Absent a further rise in the dollar, the fall
in non-oil import prices should have run its course.
Moreover, even with the expected
edging higher of the unemployment rate next year, the
labor
market will remain tight, suggesting potential ongoing
pressures on available resources that would tend to
raise inflation a bit. The FOMC will remain alert to
the possibility of underlying
imbalances in the economy that could generate a
persisting pickup in inflation, which would threaten
the economic expansion.

As noted in past monetary policy reports, the Bureau of
Labor Statistics is in the process of implementing a
series of technical adjustments to make the CPI a more
accurate measure of price change. These adjustments and
the regular updating of the market basket are estimated
to have trimmed CPI inflation somewhat over 1995-98,
and a significant further adjustment is scheduled for
1999. All told, the published figures for CPI inflation
in 1999 are expected to be more than 1/2 percentage
point lower than they
would have been had the Bureau retained the methods and
formulas in place in 1994. In any event, the FOMC will
continue to monitor a variety of price measures besides
the CPI as it attempts to gauge progress toward the
long-run goal of price stability.

Federal Reserve officials project somewhat faster
growth in real
GDP and slightly higher inflation in 1998 than does the
Administration. The Administration's projections for
the growth in real GDP and inflation in 1999 are around
the lower end of the FOMC participants' central
tendencies.

Money and Debt Ranges for 1998 and 1999

At its most recent meeting, the FOMC reaffirmed the
ranges for 1998 growth of money and debt that it had
established in February:
1 percent to 5 percent for M2, 2 percent to 6 percent
for M3, and 3 percent to 7 percent for the debt of the
domestic nonfinancial sectors. The FOMC set these same
ranges for 1999 on a
provisional basis.

Once again, the FOMC chose the growth ranges for the
monetary aggregates as benchmarks for growth under
conditions of price stability and historical velocity
behavior. For several decades before 1990, the
velocities of M2 and M3 (defined as the ratios of
nominal GDP to the aggregates) behaved in a fairly
consistent way over periods of a year or more. M2
velocity showed little trend but varied positively from
year to year with changes in a traditional measure of
M2 opportunity cost, defined as the interest forgone by
holding M2 assets rather than short-term market
instruments such
as Treasury bills. M3 velocity moved down a bit over
time, as depository credit and the associated elements in
M3 tended to grow a shade faster than GDP. In the early
1990s, these patterns of M2 and M3 behavior were
disrupted, and the velocities of both aggregates climbed
well above the levels that were predicted by past
relationships. However, since 1994 the velocities of M2
and M3 have again moved roughly in accord with their pre-
1990 experience, although their levels remain elevated.

The recent return to historical patterns does not imply
that velocity will be fully predictable or even that all
movements in velocity can be completely explained in
retrospect. Some shifts in velocity arise from household
and business decisions to adjust their portfolios for
reasons that are not captured by simple measures of
opportunity
cost. Some shifts in velocity arise from decisions of
depository institutions to create more or less credit or
to fund credit creation in different ways. All these
decisions are shaped by the rapid pace of innovation in
financial institutions and instruments. Between 1994
and early 1997, M2 velocity drifted somewhat higher,
probably owing to some reallocation of household savings
into bond and equity markets. But M2 velocity has
declined over the past year
despite little change in its traditionally defined
opportunity cost. One explanation may be that the
flatter yield curve has reduced the return on longer-
term investments relative to the bank deposits and money
market mutual funds in M2. Another part of the story may
be the booming stock market, which has reduced the share
of households' financial assets represented by monetary
assets and may have encouraged households to rebalance
their portfolios by increasing their M2 holdings. M3
velocity has dropped more sharply over the past year,
with strong growth in large time
deposits and in institutional money funds that are
increasingly used by businesses for cash management.

If the velocities of M2 and M3 follow their average
historical patterns over the remainder of 1998 and the
growth of nominal
GDP matches the expectations of Federal Reserve
policymakers,
these aggregates will finish this year above the upper
ends of their respective ranges. Part of this relatively
rapid money growth reflects nominal GDP growth in excess
of that consistent with
price stability and sustainable growth of real output;
the rest represents a decline in velocity. Absent unusual
changes in velocity in 1999, policymakers' expectations
of nominal GDP growth imply that M2 and M3 will be in the
upper ends of their
price-stability growth ranges next year. The debt of the
domestic nonfinancial sectors is expected to remain near
the middle of its range this year and in 1999.

In light of the apparent return of velocity changes to
their pre-1990 behavior, some FOMC members have been
giving the aggregates
greater weight in assessing overall financial
conditions and the thrust of monetary policy. However,
velocity remains somewhat unpredictable, and all
Committee members monitor a wide variety of other
financial and economic indicators to inform their
policy deliberations. The FOMC decided that the money
and debt ranges are best used to emphasize the
Committee's commitment to
achieving price stability, so it again set the ranges
as benchmarks for growth under price stability and
historical velocity behavior.

Section 2: Economic and Financial Developments in 1998
The U.S. economy continued to perform well in the first
half of the year. The economic difficulties in Asia and
the strong dollar reduced the demand for our exports
and intensified the pressures
on domestic producers from foreign competition. But
these effects were outweighed by robust domestic final
demand, owing in part
to supportive financial conditions, including a higher
stock market, ample availability of credit, and long-
term interest rates that in nominal terms were among the
lowest in many years. Sharp swings
in inventory investment were mirrored in considerable
unevenness in the growth of real GDP, which appears to have
slowed markedly
in the second quarter after having soared to nearly 5-1/2
percent at
an annual rate in the first quarter. Nonetheless, over the
first half as a whole, the rise in real output was large
enough to support sizable gains in employment and to push
the unemployment rate down to
the range of 4-1/4 to 4-1/2 percent, the lowest in
decades.

The further tightening of labor markets in recent
quarters has been reflected in a more discernible
uptilt to the trend in hourly compensation. But price
inflation remained subdued in the first half of the
year, held down in part by a sharp decline in energy
prices and lower prices for non-oil imports. Intense
competition in product markets, ample plant capacity,
ongoing productivity gains, and damped inflation
expectations also helped to restrain inflation
pressures in the face of tight labor markets.

The Household Sector

Consumer Spending. The factors that fueled the sizable
increase in household expenditures in 1997 continued to
spur spending in the first half of 1998: Growth in
employment and real disposable
income remained very strong, and households in the
aggregate enjoyed significant further gains in net worth.
Reflecting these developments, sentiment indexes suggest
that consumers continued to feel extraordinarily upbeat
about the current and prospective condition of the economy
and their own financial situations.

In total, real consumer outlays rose at an annual rate of
6 percent in the first quarter, and the available data
point to another large increase in the second quarter.
Increases in spending were broad-based, but outlays for
durable goods were especially strong. Declining prices and
ongoing product innovation continued to
stimulate demand for personal computers and other home
electronic equipment. In addition, purchases of motor
vehicles were sustained by a combination of solid
fundamentals and
attractive pricing. Indeed, since 1994, sales of light
vehicles have been running at a brisk pace of 15 million
units (annual rate), and, in the second quarter, a round
of very attractive manufacturers' incentives helped lift
sales to a pace of 16 million units.

Spending on services also remained robust in the first
half of the year, with short-run variations reflecting
in part the effects of weather on household energy use;
outlays on personal business services, including those
related to financial transactions, and on recreation
services continued to exhibit remarkable strength. In
addition, real outlays for nondurable goods, which rose
only moderately last year, grew about 6-1/2 percent at
an annual rate in the first quarter, and they appear to
have posted another sizable increase in the second
quarter.

Real disposable income--that is, after-tax income
adjusted for inflation--remained on a strong uptrend in
early 1998: It rose about 4 percent at an annual rate
between the fourth quarter of 1997 and
May 1998. This increase in part reflected a sharp rise in
aggregate wages and salaries, which were boosted by
sizable gains in both employment and real wage rates;
dividends and nonfarm
proprietors' incomes also rose appreciably. However,
growth in after-tax income (as measured in the national
income and product accounts) was restrained by large
increases in personal income tax payments--likely owing
in part to taxes paid on realized capital gains; capital
gains--whether realized or not--are not included in
measured income. Reflecting the movements in spending and
measured income, the personal saving rate fell from an
already low level of about 4 percent in 1997 to 3-1/2
percent during the first five months of 1998.

Residential Investment. Housing activity continued to
strengthen in the first half of 1998, especially in the
single-family sector, where starts rose noticeably and
sales of both new and existing homes soared. Indeed, the
average level of single-family starts over the first five
months of the year--1-1/4 million units at an annual rate-
-was 9 percent above the pace for 1997 as a whole.
Moreover, surveys by the National Association of
Homebuilders suggested
that housing demand remained vigorous at midyear, and the
Mortgage Bankers Association reported that loan
applications for home purchases have been around all-time
highs of late.

The strong demand for homes has contributed to some
firming of house prices, which are now rising in the
neighborhood of 3 to 5
percent per year, according to measures that control for
shifts in the regional composition of sales and attempt to
minimize the effects
of changes in the mix of the structural features of
houses sold. In nominal terms, these increases are
well within the range of recent years; however, in
real terms, they are among the largest since the mid-
1980s--a development that should reinforce the
investment motive for homeownership. Of course,
rising house prices may
make purchasing homes more difficult for some
families. But, with income growth strong and mortgage
rates around 7 percent (thirty-year conventional
fixed-rate loans), homeownership is as affordable as
it has been at any time in the past thirty years.
Moreover, innovative programs that relax the
standards for mortgage qualification are helping low-
income families to finance home purchases. Also,
stock market gains have probably boosted demand among
higher-income groups, especially in the trade-up
and second-home segments of the market.

After having surged in the fourth quarter of 1997,
multifamily
starts settled back to about 325,000 units (annual rate)
over the first five months of 1998, a pace only slightly
below that recorded over
1997 as a whole. Support for multifamily construction
continued to come from the overall strength of the
economy, which undoubtedly has stimulated more
individuals to form households, as well as from low
interest rates and an ample supply of financing. In
addition, real rents picked up over the past year, and
the apartment vacancy rate appears to be edging down.

Household Finance. Household net worth rose sharply in
the first quarter, pushing the wealth-to-income ratio to
another record high. Although the flow of new personal
saving was quite small, the revaluation of existing
assets added considerably to wealth, with much of these
capital gains accumulated on equities held either
directly or indirectly through mutual funds and
retirement
accounts. Of course, these gains have been distributed
quite unevenly: The 1995 Survey of Consumer Finances
reported that 41 percent of U.S. families own equities in
some form, but that families with higher wealth own a
much larger share of total equities.

In the first quarter of this year, the runup in wealth,
together with
low interest rates and high levels of confidence about
future economic conditions, supported robust household
spending and borrowing. The expansion of household debt, at
an annual rate of 7-3/4 percent, was above last year's pace
and once again outstripped growth in disposable income. The
consumer credit component of household debt grew 4-1/2
percent at an annual rate
in the first quarter, a pace roughly double that for the
fourth quarter of last year but near the 1997 average.
Preliminary data for April
and May point to a somewhat smaller advance in the second
quarter.

Mortgage debt increased 8-1/4 percent at an annual rate in
the first quarter, the same as its fourth-quarter advance
and a little above its 1997 growth rate. Fixed-rate
mortgage interest rates were 15 basis points lower in the
first quarter than three months earlier and 75 basis points
lower than a year earlier, which encouraged both new
home purchases and a surge of refinancing of existing
mortgages. Within total gross mortgage borrowing, the
flattening of the yield curve made adjustable-rate
mortgages less attractive relative to fixed-rate
mortgages, and their share of originations reached the
lowest point in recent years. Net borrowing can be
boosted by refinancings if households "cash out" some
housing equity, but the magnitude of this effect is
unclear. In any event, continued expansion of bank real
estate lending and a high level of mortgage
applications for home purchases suggest a further solid
gain in mortgage debt in the second quarter. Home
equity credit at banks increased only 2 percent at an
annual rate from the fourth quarter of 1997 through
June 1998 after having posted a 15-1/2 percent
gain last year; this slowdown may reflect a diminished
substitution of mortgage debt for consumer debt or
simply the increase in mortgage refinancings, which
allowed households to pay down
more expensive home equity debt or to convert housing
equity into cash in a more advantageous manner.

Despite the further buildup of household indebtedness,
financial stress among households appears to have
stabilized after several years of deterioration. In the
aggregate, estimated required payments of loan principal
and interest have held about steady
relative to disposable personal income--albeit at a high
level--since 1996. Over this period, the effect on debt
burdens of faster growth of debt than income has been
roughly offset by declining interest rates and the
associated refinancing of higher interest-rate debt, as
well as by a shift toward mortgage debt (which has a
longer
repayment period). Various measures of delinquency
rates on consumer loans leveled off or declined in
1997, and delinquency rates on mortgages have been at
very low levels for several years. Personal bankruptcy
filings reached a new record high in the first quarter
of 1998, but this represented only 6 percent more
filings than four quarters earlier, which is the
smallest such change in three years.

These developments have apparently suggested to banks
that they have sufficiently tightened terms and
standards on consumer loans. In the Federal Reserve's
May Senior Loan Officer Opinion Survey
on Bank Lending Practices, relatively few banks, on net,
reported tightening standards on credit card or other
consumer loans. Little change was reported in the terms
of consumer loans.

The Business Sector

Fixed Investment. Real business fixed investment appears
to have posted another hefty gain over the first half of
1998 as spending continued to be boosted by positive
sales expectations in many industries; favorable
financial conditions; and a perceived opportunity, if
not a necessity, for firms to install new technology in
order to remain competitive. The exceptional growth of
investment since the early 1990s has been facilitated in
part by the increase in national saving associated with
the elimination of the federal budget deficit. It has
resulted in considerable modernization and expansion of
the nation's capital stock, which have been important in
the improved performance of labor productivity over
the past few years and which should continue to lift
productivity in the future. Moreover, rapid investment
in the manufacturing sector in recent years has resulted
in large additions to productive capacity, which have
helped keep factory operating rates from
rising much above average historical levels in the face
of appreciable increases in output.

Real outlays for producers' durable equipment, which
have been rising more than 10 percent per year, on
average, since the early 1990s, moved sharply higher in
the first half of 1998. All major categories of
equipment spending recorded sizable gains in the first
quarter; but as has been true throughout the expansion,
outlays for computers rose especially rapidly. Real
computer outlays received particular impetus in early
1998 from extensive price-cutting. Purchases of
communications equipment have also soared in recent
quarters; the rise reflects intense pressures to add
capacity to accommodate the growth of networking; the
rapid pace of technological advance, especially in
wireless communications; and regulatory changes. As for
the second quarter, data on shipments, coupled with
another steep decline in computer prices, point to a
further substantial increase in real computer outlays.
Spending on motor vehicles apparently continued to
advance as well while
demand for other types of capital equipment appears to have
remained brisk.

In total, real outlays on nonresidential construction
flattened out in 1997 after four years of gains, and they
remained sluggish in early 1998. Construction of office
buildings remained robust in the first half of this year,
after having risen at double-digit rates in 1996 and 1997,
and outlays for institutional buildings continued to trend
up. However, expenditures for other types of structures
were
lackluster. Nonetheless, the economic fundamentals for
the sector
as a whole remain quite favorable: Vacancy rates for
office and retail space have continued to fall; real
estate prices, though still well below the levels of the
mid-1980s in real terms, have risen appreciably in recent
quarters; and funding for new projects
remains abundant.

Inventory Investment. The pace of stockbuilding by
nonfarm businesses picked up markedly in 1997 and is
estimated to have approached $100 billion (annual rate)
in the first quarter of 1998--equal to an annual rate
increase of 8-1/2 percent in the level of inventories
and accounting for more than 1-1/2 percentage
points of that quarter's growth in real GDP. The first-
quarter accumulation was heavy almost across the board.
Among other things, it included a large increase in
stocks of petroleum as the unusually warm weather
reduced demand for refined products and
low prices provided an incentive for refiners and
distributors to accumulate stocks. However, overall
sales were also very strong, and with only a few
exceptions--notably, semiconductors,
chemicals, and textiles--stocks did not seem out of line
with sales. In any event, fragmentary data for the
second quarter point to a considerable slowing in
inventory investment that is especially evident in the
motor vehicle sector, where stocks were depleted by the
combination of strong sales and GM production
shortfalls. In addition, petroleum stocks appear to have
grown less rapidly than they did in the first quarter,
and stockbuilding elsewhere slowed sharply in April and
May.

Corporate Profits and Business Finance. Businesses have
financed
a good part of their investment this year through
continued strong
cash flow, but they have also increased their reliance
on financial markets. Economic profits (book profits
after inventory valuation and capital consumption
adjustments) have run at 12 percent of national income
over the past year, well above the 1980s peak of
roughly 9 percent. However, the strength in profits has
resulted partly from the low level of net interest
payments, leaving total capital income at roughly the
same share of national income as at the 1980s peak.
Overall, a major portion of the increase in profits
between the 1980s and the 1990s represents a
realignment of
returns from debt-holders to equity-holders.

Although their level remains high, the growth of
profits has slowed: Economic profits rose 4-3/4 percent
at an annual rate in the first quarter compared with 9-
1/2 percent between the fourth quarter of 1996 and the
fourth quarter of 1997. This slowdown
may have resulted from various causes, including rising
employee compensation and the Asian financial crisis.
Quantifying the effect of the Asian turmoil is difficult:
Although only a small share of the profits of U.S.
companies is earned in the directly affected Asian
countries, the crisis has reduced the prices of U.S.
imports and thereby put downward pressure on domestic
prices.

Nonfinancial businesses realized annualized economic
profit
growth of only 1-1/4 percent in the first quarter.
Because capital expenditures (including inventory
investment) grew much faster,
the financing gap--the excess of capital expenditures
over retained earnings--widened. As a result, these
businesses used less of their cash flow to retire
outstanding equity and continued to borrow at the rapid
pace of the fourth quarter of 1997, with debt expanding
at
an annual rate of 9 percent in the first quarter of 1998.
Outstanding amounts of both bonds and commercial paper
rose especially
sharply. The decline in long-term interest rates around
year-end encouraged companies to lock in those yields,
and gross bond issuance reached a record high in the
first quarter of 1998. Borrowing by nonfinancial
businesses increased at a slightly
slower but still rapid clip in the second quarter, with
little change in outstanding commercial paper but very
strong net bond issuance
and some rebound in bank loans.

Despite persistent high borrowing, external funding
for businesses remained readily available on favorable
terms. The spreads
between yields on investment-grade bonds and yields on
Treasury bonds widened a little from low levels, with
investors favoring Treasury securities over corporate
securities as a haven from Asian turmoil and, perhaps,
with disappointing profits leading to some minor
reassessment of the underlying risk of private
obligations. The spreads on high-yield bonds also
increased, in part because of heavy issuance of these
bonds this spring, but they remain narrow by historical
standards. In the Federal Reserve's May survey on bank
lending practices, banks reported negligible change in
business loan standards; moreover, yield spreads on
bank loans remained low for both large and small firms.
Surveys by the National Federation of Independent
Business suggest that small firms have been facing
little difficulty in obtaining credit.

The ready availability of credit has stemmed
importantly from the healthy financial condition of
many businesses, which have
enjoyed an extended period of economic expansion and
robust
profits. The aggregate debt-service burden for
nonfinancial corporations, measured as the ratio of net
interest payments to cash flow, dropped substantially
between 1990 and 1996 and remains modest, despite edging
up in the first quarter of this year. In addition, most
measures of financial distress have shown favorable
readings. The delinquency rate on commercial and
industrial bank loans has stayed very low since 1995,
preserving the dramatic decline that occurred in the
first half of the decade. After moving
up a little in 1996 and 1997, business failures decreased
in the first five months of 1998; the liabilities of failed
businesses as a share
of total liabilities was less than one-quarter the value
reached in the early 1990s. At the same time, Moody's
upgraded significantly
more debt than it downgraded, and the rate of junk bond
defaults stayed close to its low 1997 level.

Net equity issuance was less negative in the first quarter
of this year than in the fourth quarter of last year, but
nonfinancial corporations still retired, on net, about
$100 billion of equity at an annual rate. The wave of
merger announcements this spring will
likely generate strong share retirements over the
remainder of the year. Gross equity issuance in the first
half of 1998 was close to its pace of the past several
years, although investors seemed
somewhat cautious about initial public offerings.

The Government Sector

Federal Government. The incoming news on the federal
budget
continues to be very positive. Over the twelve months
ending in May 1998, the unified budget registered a
surplus of $60 billion, compared with a deficit of
$65 billion during the twelve months ending in May
1997. Soaring receipts continued to be the main force
driving the improvement in the budget, but subdued
growth in outlays also played a key role. If the
latest projections from OMB and CBO are realized, the
unified budget for fiscal year 1998 as a whole will
show a surplus of roughly $40 billion to $65 billion.

With the federal budget having shifted into surplus,
the federal government is now augmenting, rather than
drawing on, the pool
of national saving. In fact, the improvement in the
government's budget position over the past several years
has been large enough to generate a considerable rise in
gross domestic saving despite a decline in the private
saving rate; all told, gross saving by households,
businesses, and governments increased from about 14-1/2
percent of gross national product in the early 1990s, when
federal saving was at a cyclical low, to more than 17
percent of GNP in recent quarters. This increase in
domestic saving, along with increased borrowing from
abroad, has financed the surge in domestic investment in
this expansion. Moreover, this year's budgetary surplus
will continue to pay benefits in future years because it
allows the government to reduce its outstanding debt,
which implies smaller future interest payments and, all
else equal, makes it easier to keep the budget in surplus.
If, in fact, the budget outcome over the next several
years is as favorable as OMB and
CBO now anticipate under current policies, the reduction
in the outstanding debt could be substantial.

Federal receipts in the twelve months ending in May 1998
were 10 percent higher than in the same period a year
earlier--roughly twice the percentage increase for
nominal GDP over the past year. Individual income tax
receipts, which have been rising at double-digit rates
since the mid-1990s, continued to do so over the past
year as the surge in capital gains realizations likely
persisted and sizable gains in real income raised the
average tax rates on
many households (the individual income tax structure
being
indexed for inflation but not for growth in real
incomes). In contrast to the ongoing strength in
individual taxes, corporate tax payments increased
only moderately over the past year, echoing
the deceleration in corporate profits.

Federal expenditures in the twelve months ending in
May 1998 were only 1-1/2 percent higher in nominal
terms than during the twelve months ending in May
1997, with restraint evident in most categories.
Outlays for defense were about unchanged, as were
those for income security programs. In the latter
category, outlays for low-income support fell as
economic activity remained robust, welfare reform capped
outlays for family assistance, and
enrollment rates in other programs dropped. In the
health area, spending on Medicaid picked up somewhat
after a period of extraordinarily small increases,
whereas growth in spending for Medicare slowed, in part
because of the programmatic changes that were legislated
in 1997. And, with interest rates little changed and the
stock of outstanding federal debt no longer rising, net
interest payments stabilized.

Real federal outlays for consumption and gross
investment, the
part of federal spending that is counted in GDP, fell
about 2 percent between the first quarters of 1997 and
1998. The decrease was concentrated in real defense
spending, which fell about 2-3/4 percent, roughly the
same as over the preceding four quarters; real nondefense
spending was unchanged, on balance. In the first quarter,
real federal outlays fell at a 10 percent annual rate;
the drop reflected a plunge in defense spending, which
appears to have been reversed in the second quarter.

With debt held by the public close to $4 trillion, the
government will continue to undertake substantial gross
borrowing in order to redeem maturing securities. The
government will also continue to adjust its issuance of
short-term debt to accommodate seasonal
swings in receipts and spending. The surplus during the
first half of calendar year 1998--boosted by the huge
inflow of individual
income tax receipts--enabled the Treasury to reduce its
outstanding debt $57 billion while augmenting its cash
balance $40 billion. The reduction in debt included net
paydowns of coupon securities and bills.

Looking ahead to projected surpluses for coming years,
the
Treasury announced that it will no longer issue three-
year notes and will auction five-year notes quarterly
rather than monthly. Over the past several years, the
Treasury has accommodated the surprising improvement in
federal finances by substantially reducing both bill and
coupon issuance. The Treasury hopes that concentrating
future coupon offerings in larger, less-frequent
auctions will maintain the liquidity of these securities
while still allowing for sufficient issuance of bills to
maintain their liquidity as well. These changes are also
intended to prevent further upcreep in the average
maturity of the outstanding debt held by private
investors, now standing at sixty-five months. The
Treasury
continues to work on encouraging the market for inflation-
indexed securities, issuing a thirty-year indexed bond in
April to complement the existing five-year and ten-year
indexed notes.

State and Local Governments. The fiscal position of state
and local governments in the aggregate has also remained
quite favorable. Strong growth of household income and
consumer spending has continued to lift revenues, despite
numerous small tax cuts, and governments have continued
to hold the line on expenditures. As a result, the
consolidated current account of the sector, as measured
by the surplus (net of social insurance funds) of
receipts over current expenditures in the national income
and product accounts,
held steady in the first quarter at around $35 billion
(annual rate), roughly where it has been since 1995.
State governments, which
have reaped the main benefits of rising income taxes,
have fared especially well: Indeed, all of the forty-
seven states whose fiscal years ended by June 30 appear
to have achieved balance or to have run surpluses in
their general funds budgets in fiscal year 1998.

Real expenditures for consumption and gross investment
by states and localities have been rising about 2
percent per year, on
average, since the early 1990s, and the increase in
spending for the
first half of 1998 appears to have been a bit below that
trend. These governments added jobs over the first half
of the year at about the same rate as they did over 1997
as a whole. However, real construction outlays, which
have been drifting down since early
1997, posted a sizable decline in the first quarter, and
monthly data suggest that spending dropped further in the
spring. The weakness
in construction spending over the past year has cut across
the major categories of construction and is puzzling in
light of the sector's ongoing infrastructure needs and the
good financial shape of most governments.

State and local governments responded to the low interest
rates
during the first half of the year by borrowing at a rapid
rate, both to refinance outstanding debt and to fund new
capital projects.
Because debt retirements eased in the first quarter
relative to the fourth quarter of 1997, net issuance
increased substantially. Meanwhile, credit quality of
state and local debt continued to improve, with much
more debt upgraded than downgraded in the
first half of the year.

External Sector

Trade and the Current Account. The nominal trade
deficit on goods and services widened to $140 billion
at an annual rate in the first quarter from $114
billion in the fourth quarter of last year. The current
account deficit for the first quarter reached $189
billion (annual rate), 2-1/4 percent of GDP, compared
with $155 billion
for the year 1997. A larger deficit on net investment
income as
well as the widening of the deficit on trade in goods
and services contributed to the deterioration in the
first quarter of the current account balance. In April
and May, the trade deficit increased further.

The quantity of imports of goods and services again grew
vigorously in the first quarter. The annual rate of
expansion at 17 percent exceeded that for 1997 and
reflected the continued strength of U.S. economic
activity and the effects of past dollar appreciation.
Imports of consumer goods, automotive products,
and machinery were particularly robust. Preliminary data
for April and May suggest that real import growth
remained strong. Non-oil import prices fell sharply
through the second quarter, reflecting the rise in the
exchange value of the dollar over the past year.

The quantity of exports of goods and services declined at
an annual rate of 1 percent in the first quarter, the
first such absolute drop since the first quarter of 1994.
The weakness of economic activity
in a number of our trading partners, with absolute
declines in several economies in Asia, and the strength
of the dollar, which
also partly resulted from the Asian financial crises,
largely account for the abrupt halt in the growth of real
exports after a 10 percent rise last year. Declines were
recorded for machinery, industrial supplies, and
agricultural products. Exports to the emerging market
economies in Asia, particularly Korea, as well as exports
to Japan were down sharply while exports to western
Europe and Canada
rose moderately. Preliminary data for April and May
suggest that real exports declined further.

The Capital Account. Foreign direct investment in the
United States and U.S. direct investment abroad
continued at near record levels in the first quarter of
1998, spurred by strong merger and acquisition activity
across national borders.

In the first quarter, the booming U.S. stock market
continued to
attract large foreign interest. Net purchases by
private foreigners were $29 billion, following record
net purchases of $66 billion in the year 1997. Foreign
net purchases of U.S. corporate bonds
remained substantial, and net purchases of U.S. government
agency bonds reached a record $21 billion. In contrast,
net sales of U.S. Treasury securities by private
foreigners, particularly large net sales booked at a
Caribbean financial center, were recorded in the first
quarter. U.S. net purchases of foreign stocks and bonds
were modest.

Foreign official assets in the United States increased $10
billion in the first quarter. However, the net increase in
the second quarter
was limited by large dollar sales by Japan.

The Labor Market

Employment and Labor Supply. Labor demand remained
robust during the first half of 1998. Growth in payroll
employment averaged 243,000 per month, only a little
less than in 1997 and
well above the rate consistent with the growth in the
working-age population. The unemployment rate held
steady in the first quarter at 4-3/4 percent but dropped
to the range of 4-1/4 percent to 4-1/2 percent in the
second quarter.

The services industry, which accounts for about 30
percent of nonfarm employment, continued to be the
mainstay of employment growth over the first half of
1998, posting increases of 115,000 per month, on
average. Within services, hiring remained brisk at
computer and data-processing firms and at firms
providing engineering and managerial services, but
payrolls at temporary
help agencies rose much less rapidly than they had over
the preceding few years--apparently in part reflecting
difficulties in finding workers, especially for highly
skilled and technical positions. Sizable increases were
also posted at wholesale and retail trade establishments
and in the finance, insurance, and real estate category.
Construction payrolls were bounced around by unusual
winter weather but, on average, rose a brisk 21,000 per
month--about the same as in 1997.

In contrast to the robust gains elsewhere, manufacturing
firms curbed their hiring in the first half of 1998 in
the face of slower growth in factory output. After having
risen a torrid 6-1/4 percent in 1997, factory output
increased at an annual rate of about 2-1/2 percent
between the fourth quarter of last year and May 1998; the
deceleration reflected the effects of the Asian crisis as
well as a downshift in motor vehicle assemblies and the
completion of the 1996-97 ramp-up in aircraft production.
In June, factory output is
estimated to have fallen 1/2 percent; the GM strike
accounted for the decline.

The labor force participation rate--which measures the
percentage
of the working-age population that is either employed or
looking
for work--trended up mildly over the past couple of years
and
stood at 67.1 percent, on average, in the first half of
1998, slightly above the previous cyclical highs achieved
in late 1989 and early 1990. Participation among adult
women has picked up noticeably
in recent years, after having risen only slowly in the
first half of the 1990s, and participation among adult
men, which had been on a
gradual downtrend through mid-decade, appears to have
leveled
out. In contrast, participation rates for teenagers, for
whom school enrollment rates have risen, have continued
to sag after having dropped sharply in the early 1990s.
Strong labor demand clearly contributed importantly to
the rise in overall participation over the past several
years, but the expansion of the earned income tax
credit and changes in the welfare system probably
provided added stimulus.

Labor Costs and Productivity. Firms no doubt are
continuing to rely heavily on targeted pay increases
and incentives like stock
options and bonuses to attract and retain workers. But
the tightness of the labor market also appears to be
exerting some upward
pressure on traditional measures of hourly compensation,
which have exhibited a somewhat more pronounced uptrend
of late. Indeed, the twelve-month change in the
employment cost index (ECI) for private industry workers
picked up to 3-1/2 percent in March, compared with 3
percent for the twelve months ending in March 1997 and 2-
3/4 percent for the twelve months ending in March 1996.
Hourly compensation accelerated especially rapidly
for employees of finance, insurance, and real estate
firms, some of whom received sizable bonuses and
commissions. However, the acceleration was fairly
widespread across industries and occupations and, given
the relatively small rise in consumer prices over the
past year, implies a solid increase in real pay for many
workers.

The acceleration in hourly compensation costs over the
past year resulted mainly from faster growth of wages
and salaries, which rose 4 percent over the twelve
months ending in March; this
increase was about 1/2 percentage point larger than the
one recorded over the preceding twelve months. Separate
data on average hourly earnings of production or
nonsupervisory workers also show an ongoing acceleration
of wages: The twelve-month change in this series was 4.1
percent in June, 1/2 percentage point above the reading
for the preceding twelve months.

Benefits costs have generally remained subdued, with the
increase over the year ending in March amounting to only
about 2-1/4
percent. According to the ECI, employer payments for
health insurance have picked up moderately in recent
quarters after
having been essentially flat over the previous couple of
years, and indications are that further increases may be
in the offing. Insurers whose profit margins had been
squeezed in recent years by pricing strategies designed
to gain market share reportedly are raising premiums, and
many managed care plans are adding innovations
that, while offering greater flexibility and protections to
consumers, may boost costs. Additional upward pressure on
premiums apparently has come from higher spending on
prescription drugs. Among other major components of
benefits, rising equity prices have reduced the need for
firms to pay into
defined benefit plans, and costs for state unemployment
insurance and workers' compensation have fallen sharply.

Labor productivity in the nonfarm business sector posted
another sizable advance in the first quarter of 1998,
bringing the increase over the year ending in the first
quarter to an impressive 2 percent.\1 Taking a slightly
longer perspective, productivity has risen a bit more than 1-
1/2 percent per year, on average, over the
past three years, after having risen less than 1 percent per
year, on average, over the first half of the decade. At
least in part, the recent strong productivity growth has
likely been a cyclical response to
the marked acceleration of output. But it is also possible
that the high levels of business investment over the past
several years--and the associated rise in the amount of
capital per worker--are translating into a stronger
underlying productivity trend. In addition, productivity
apparently is being buoyed by the assimilation of new
technologies into the workplace. In any event,
the faster productivity growth of late is helping to offset
the effects of higher hourly compensation on unit labor
costs and prices,
thereby allowing wages to rise in real terms.

Prices

Price inflation remained quiescent in the first half of
this year. After having increased 1-3/4 percent in 1997,
the consumer price
index (CPI) slowed to a crawl in early 1998 as energy
prices
plummeted, and it recorded a rise of only about 1-1/2
percent at an annual rate over the first six months of the
year. The increase in the CPI excluding food and energy--
the so-called "core CPI"--picked
up to 2-1/2 percent (annual rate) over the first half of
the year. However, this pickup follows some unusually
small increases in
the second half of 1997, and the twelve-month change has
held
fairly steady at about 2-1/4 percent since late last
summer. The chain price index for personal consumption
expenditures on items other than food and energy rose
only 1-1/2 percent over the year ending in the first
quarter of 1998--the most recent information available;
this measure typically rises less rapidly than does the
core CPI, in part because it is less affected by so-
called "substitution bias."

The relatively favorable price performance in the first
half of 1998 reflected a number of factors that, taken
together, continued to exert enough restraint to offset
the upward pressures from strong aggregate demand and
high levels of labor utilization. One was the drop in oil
prices. In addition, non-oil import prices continued to
fall, thus further lowering input costs for many domestic
industries and limiting the ability of firms facing
foreign competition to raise prices for fear of losing
sales to producers abroad. Prices of manufactured goods
were also held in check by the sizable increase
in domestic industrial capacity in recent years and by
developments in Asia, which, among other things, led to
a considerable softening of commodity prices. Moreover,
the various surveys of consumers and forecasters suggest
that inflation expectations stayed low--even declined in
some measures. For example, according to the Michigan
survey, median one-year
inflation expectations dropped a bit further this year,
after having held fairly steady over 1996 and 1997, and
inflation expectations for the next five to ten years
edged down from about 3 percent, on average, in 1996 and
1997 to 2-3/4 percent in the second quarter of 1998.

The CPI for goods other than food and energy rose at an
annual
rate of 1 percent over the first six months of 1998, only
a bit above the meager 1/2 percent rise over 1997 as a
whole. In the main, the step-up reflected a turnaround in
prices of used cars and trucks, and prices of tobacco
products and prescription drugs also rose considerably
faster than they had in 1997. More generally, prices
continued to be restrained by the effect of the strong
dollar on prices of import-sensitive goods. For example,
prices of new
vehicles fell slightly over the first half of the year
while prices of other import-sensitive goods--such as
apparel and audio-video equipment--were flat or down. In
the producer price index, prices
of capital equipment were little changed, on balance, over
the first half of 1998; they, too, were damped by the
competitive effects of falling import prices.

The CPI for non-energy services increased 3 percent over
the first
six months of 1998, about the same as last year's pace.
After
having fallen somewhat last year, airfares picked up in the
first half of the year, and owner's equivalent rent seems
to be rising a bit faster than it did in 1997. In addition,
increases in prices of medical services, which had slowed
to about 3 percent per year in 1996-97,
have been running somewhat higher so far this year.
Price changes for most other major categories of
services were similar to or smaller than those
recorded in 1997.

Energy prices fell sharply in early 1998 as the price
of crude oil came under severe downward pressure from
weak demand in Asia,
a decision by key OPEC producers to increase output, and a
relatively warm winter in the Northern Hemisphere. After
averaging about $20 per barrel in the fourth quarter of
1997, the spot price of West Texas intermediate dropped to
a monthly
average of $15 per barrel in March, where it more or less
remained through the spring. Crude prices dropped sharply
in June following reports of high levels of inventories
and revised estimates of oil consumption in Asia but have
since firmed in response to an agreement by major oil
producers to restrict supply in the months ahead; they now
stand at $14-1/2 per barrel. Reflecting the decline in
crude prices, retail energy prices fell at an annual rate
of 12 percent over the first half of the year, led by a
steep drop in gasoline prices.

Developments in the agricultural sector also helped to
restrain
overall inflation in the first half of this year.
Excluding the prices of fruits and vegetables--which tend
to be bounced around by short-term swings in the weather--
food prices have been rising a
scant 0.1 percent per month, on average, since late
1997. Although farmers in some regions of the country
are experiencing more prolonged weather problems,
conditions in the major
crop-producing areas of the Midwest still look
relatively favorable, and it appears that aggregate farm
production will be sufficient to maintain ample supplies
over the coming year, especially in the context of
sluggish export demand.

Credit and the Monetary Aggregates

Credit and Depository Intermediation. The total debt of
U.S. households, governments, and nonfinancial
businesses increased at
an annual rate of 5-3/4 percent from the fourth quarter
of 1997 through May of this year. Domestic nonfinancial
debt now stands a little above the midpoint of the 3
percent to 7 percent range established by the FOMC for
1998. Debt growth has picked up
since 1997, as an acceleration of private credit
associated with strong domestic demand and readily
available supply has more than offset reduced federal
borrowing. Indeed, federal debt
declined 1-1/4 percent at an annual rate between the
fourth quarter of 1997 and May 1998, whereas nonfederal
debt increased 8-1/4 percent annualized over the same
period. The growth of nonfederal debt has slowed only
slightly over the past several months.

Credit on the books of depository institutions rose at
roughly the same pace as total credit in the first half
of the year. Commercial bank credit advanced rapidly in
the first quarter and at a more subdued rate in the
second. This slowdown was especially acute in
securities holdings, which had surged in both the
fourth quarter of 1997 and the first quarter of this
year. Responses to the Federal Reserve's May survey on
bank lending practices suggest that the earlier runup
in securities reflected the efforts of banks to boost
returns on equity by increasing leverage; much of the
rise in securities holdings was concentrated at banks
that were constrained by recent mergers from using
their profits to repurchase shares. Loan growth also
slowed in the second quarter, although the
various loan categories behaved quite differently: Real
estate lending expanded most slowly in May and June,
whereas business lending rebounded in those months
after stalling out in March and April. Outstanding
loans at branches and agencies of foreign banks
declined in the second quarter, and survey responses
identified an actual or expected weakening in the
capital position of the parent banks as the primary
impetus for a tightening of loan terms and standards.

The Report of Condition and Income (the Call Report)
showed that banks' return on equity was about unchanged
in the first quarter, staying in the elevated range it
has occupied since 1993. Call Report data also
indicated that delinquency and charge-off rates on
commercial and industrial loans and on real estate
loans remain quite low, while delinquency and charge-
off rates on consumer
loans have leveled off after their previous rise.
Indeed, bank profits
have benefited importantly in recent years from a low
level of provisioning for loan losses. Nevertheless,
bank supervisors have been concerned that intense
competition and favorable economic conditions might be
leading banks to ease standards excessively. They
reminded depositories that credit assessments should
take account of the possibility of less positive
economic circumstances in the future.

The trend toward consolidation in the banking industry
continued in the first half of the year. Some of the
announced mergers involve combinations of banks and
nonbank financial institutions, such as thrifts and
insurance companies. Many of the mergers were
designed to capitalize on the economies of scale and
diversification of risk in nationwide banking; other
mergers were undertaken to expand the range of services
offered to customers. Although some observers are
concerned that consolidation might raise banks'
market power, greater national concentration in
banking over the past several years has not increased
banking concentration in most local markets.

The Monetary Aggregates. The broad monetary aggregates
grew
more rapidly in the first half of 1998 than they did in
1997, although the pace of their expansion has slowed
noticeably in recent months. M2 grew 7-1/4 percent at an
annual rate between
the fourth quarter of last year and June of this year,
placing it well above the top of its 1 percent to 5
percent growth range. When the FOMC established this range
in February, it noted that annual
ranges represented benchmarks for money growth under
conditions
of stable prices and velocity behavior in accordance
with its pre-1990 historical experience. In fact,
nominal spending and income have grown more rapidly than
is consistent with price stability and sustainable real
growth, and the velocity of M2 (defined as the ratio of
nominal GDP to M2) has fallen relative to the behavior
predicted by the pre-1990 experience.

For several decades before 1990, M2 velocity showed
little overall trend but varied positively from year-to-
year with changes in M2
opportunity cost, which is generally defined as the
interest forgone by holding M2 assets rather than short-
term market instruments
such as Treasury bills. The relationship was disturbed in
the early 1990s by a sharp increase in velocity; however,
since mid-1994,
M2 velocity and opportunity cost have again been moving
roughly together, though not in lockstep. Indeed, velocity
has declined recently despite almost no change in the
standard measure of opportunity cost. The dip in velocity
may be partly attributable to the flatter yield curve,
which has reduced the return on longer-term investments
relative to M2 assets--bank deposits and money
market mutual funds. Money demand may also be bolstered by
the efforts of households to rebalance their portfolios in
the face of a booming stock market. By the end of 1997,
households' monetary
assets had ebbed to the smallest share of their total
financial assets in many years, and households may want to
reduce the
concentration of their assets in relatively risky
equities and increase their holdings of less volatile M2
assets. However, in spite of both the flatter yield curve
and the rebalancing motive, flows into both bond mutual
funds and stock mutual funds have been
quite heavy this year.

M2 increased 7-1/4 percent at an annual rate in the
second quarter, compared with 8 percent in the first
quarter. A buildup in
household liquid accounts in preparation for
individual income tax payments substantially boosted
money growth in April; the
clearing of these payments depressed May growth by a
roughly equal amount. At an annual rate, M2
increased about 6 percent on average over April and
May and about 5 percent in June, suggesting a larger
deceleration than is shown by the quarterly
average figures.

M3 grew 9-3/4 percent at an annual rate between the fourth
quarter
of last year and June, placing it far above the top of its
2 percent to 6 percent growth range. As with M2, the FOMC
chose the growth
range for M3 as a benchmark for growth under conditions
of price stability and historical velocity behavior. The
components of M3 not included in M2 increased 17-1/2
percent at an annual rate over the first half of the
year, following an even faster runup in 1997. Rapid
expansion of large time deposits in the first quarter
was driven importantly by strong credit growth at
depository institutions. More recently, gains in this
category have diminished as bank credit growth has
slowed. Holdings of institutional money market mutual
funds climbed more than 20 percent in each of the past
three years, and that strength has mounted in 1998 as
businesses' interest in outsourcing their cash
management
evidently has intensified. Because in-house management
often involves short-term assets that are not included
in M3, the shift to mutual funds boosts M3 growth.

M1 rose 1 percent at an annual rate between the fourth
quarter of 1997 and June of this year. Currency expanded
6-1/2 percent annualized over that period, a bit below
its increase last year. Foreign demand for U.S. currency
apparently weakened
substantially in the first five months of the year,
with an especially large decline in shipments to
Russia. Deposits in M1 declined in
the first half of the year owing to the continued
introduction of "sweep" programs. M1 growth has been
depressed for several
years by the spread of these programs, which sweep
balances out
of transactions accounts, which are subject to reserve
requirements, and into savings accounts, which are not.
Depositors are unaffected by this arrangement because
the funds are swept back when
needed; banks benefit because they can reduce their
holdings of reserves, which earn no interest. New sweeps
of other checkable deposits have slowed sharply, but
sweeps of demand deposits into savings deposits--an
activity that has become popular more recently--continue
to spread. Because many banks have already reduced their
required reserves to minimal levels, the total flow of
new sweep programs is tapering off, although it remains
considerable.

The drop in transactions accounts in the first half of
the year caused required reserves to fall 3-3/4 percent
at an annual rate, a much slower decline than in 1997.
The monetary base grew 5-1/2 percent over the same
period, as the runoff in required reserves was more than
offset by the increased demand for currency.

The substantial decline in required reserves over the
past several years has raised concern that the federal
funds rate might become more volatile. Required reserves
are fairly predictable and must be maintained on only a
two-week average basis. As a result, the Federal Reserve
has generally been able to supply a quantity of reserves
that is close to the quantity demanded at the federal
funds rate intended by the FOMC, and banks have
accommodated many unanticipated imbalances in reserve
supply by varying the quantity demanded across days.
Banks also hold reserve balances to avoid overdrafts
after making payments to other banks. But this
precautionary demand is more variable and difficult to
predict than requirement-related demand, and it cannot
be substituted across days. As required reserves drop,
more banks will hold deposits at the Federal Reserve
only to meet these day-to-day demands,
reducing the potential for rate-smoothing behavior.

So far, however, the federal funds rate has not become
noticeably more volatile on a maintenance-period average
basis. This outcome has occurred partly because the
Federal Reserve has responded to
the changing nature of reserve demand by conducting open
market operations on more days than had been customary
and by arranging more operations with overnight
maturity, thereby bringing the daily reserve supply more
closely in line with demand. At the same time, banks
have borrowed more reserves at the discount window
and have improved the management of their accounts at
Reserve
Banks. Between 1995 and 1997, banks also significantly
increased their required clearing balances, which they
precommit to hold and which earn credits that can be
applied to Federal Reserve priced services. Like
required reserve balances, required clearing balances
are predictable by the Federal Reserve and can be
substituted
across days within the two-week maintenance period. Going
forward, the Federal Reserve's recent decision to use
lagged reserve accounting rather than contemporaneous
reserve accounting will increase somewhat the
predictability of reserve demand by both banks and the
Federal Reserve. Still, further
declines in required reserves might increase funds-rate
volatility. Moreover, one-third of the banks responding
to the Federal
Reserve's recent Senior Financial Officer Survey report
that reserve management is more difficult today than in
the past. One way to diminish these problems would be to
pay interest on reserve balances, which would reduce
banks' incentives to minimize those balances.

Financial Markets

Interest Rates. Yields on intermediate- and long-term
Treasury securities moved in a fairly narrow band during
the first half of
1998, centered a little below the levels that prevailed
in the latter part of 1997. The thirty-year bond yield
touched its lowest value since the bond was introduced to
the regular auction calendar in 1977; it was also lower
than any sustained yield on the twenty-year bond (the
longest maturity Treasury security before the issuance of
the thirty-year bond) since 1968. Meanwhile, the average
yield on five-year notes in the first half of the year
was the lowest since early 1994.

Several factors have contributed to the decline in
intermediate- and long-term interest rates over the past
year. For one, developments
in the U.S. economy and overseas reduced expected
inflation and, perhaps, uncertainty about future
inflation. Between the second quarter of 1997 and the
second quarter of 1998, the median long-term inflation
expectation in the Michigan SRC survey of households
dropped 1/4 percentage point, and the average
expectation in the Philadelphia Federal Reserve's Survey
of Professional Forecasters fell almost 1/2 percentage
point. Over the
same period, the variance of long-term inflation
expectations in the Michigan survey was halved. This
greater consensus of
expectations suggests that people may now place less
weight on
the possibility of a sharp acceleration in prices; a
reduction in perceived inflation risk would tend to
reduce term premiums and thereby cut long-term interest
rates. A damping of expected growth in real demand here
and abroad, triggered importantly by the Asian financial
crisis, also has probably pulled rates lower, as has an
apparent shift in desired portfolios away from Asia and,
to some extent, from other emerging market economies.
Lastly, diminished borrowing by the federal government
has restrained interest rates by reducing the competition
for private domestic saving and for borrowed funds from
abroad.

Assessing the relative importance of some of these
factors might be aided, in principle, by comparing yields
on nominal and inflation-indexed Treasury notes. Between
the second quarters of 1997 and 1998, the nominal ten-
year yield fell more than 1 percentage point, whereas the
inflation-indexed ten-year yield
increased a bit. Unfortunately, the relatively recent
introduction of
inflation-indexed securities and the thinness of trading
makes interpreting their yield levels and movements
difficult. In particular, light trading may lead investors
to view these new securities as providing less liquidity
than traditional Treasury notes, and investors may value
liquidity especially highly now in the face of uncertainty
about developments in Asia.

The yield curve for Treasury securities has recently been
flatter than at any point since the beginning of the
decade. For example, the difference between the ten-year-
note yield and the three-month-bill yield was smaller in
the first half of 1998 than in
any other half-year period since early 1990. In that
earlier episode, the yield curve had been flattened by a
sharp runup in short-term interest rates as the Federal
Reserve tried to check an upcreep in inflation. In the
current episode, short rates have held fairly steady, while
long-term rates have declined significantly. Some of the
current flatness of the term structure probably stems
from the apparent reduction in term premiums noted above.
But the flat yield curve may also reflect the expectation
that short-term real
interest rates, which have been boosted by the decline in
inflation over the past year, will drop in the future.
Supporting that notion, the yield curve for inflation-
indexed debt has become inverted this year, as the return
on the five-year indexed note has risen above the return
on the ten-year indexed note, which exceeds the return on
the new thirty-year indexed bond.

Equity Prices. Equity markets have remained ebullient
this year. The S&P 500 composite index rose sharply in
the first several
months of 1998; it then fell back a little before moving
up to a new record in July. The NASDAQ composite, NYSE
composite, and
Dow Jones Industrial Average followed roughly similar
patterns,
and these indexes now stand about 17 to 28 percent
above their year-end marks. Small capitalization
stocks have not fared so well this year, with the
Russell 2000 index up about a third as much on net.

The increase in equity prices combined with the recent
slowdown
in earnings growth has kept many valuation measures
well above their historical ranges. The ratio of prices
in the S&P 500 to consensus estimates of earnings over
the coming twelve months reached a new high in April
and has retreated only slightly from that point. At the
same time, the real long-term bond yield--measured
either by the ten-year indexed yield or by the
difference between the ten-year nominal Treasury yield
and inflation expectations in the Philadelphia Federal
Reserve's survey--is little changed since year-end. As
a result, the forward-earnings yield on stocks exceeds
the real yield on bonds by one of the smallest amounts
in many years. Apparently,
investors share analysts' expectations of robust long-
term earnings growth, or they are content with a much
smaller equity premium
than the historical average.

International Developments

Events in Asia, including in Japan, have continued to
dominate developments in global asset markets so far
in 1998. During the first months of the year, many
financial markets in Asia appeared to stabilize, and
progress in implementing economic and financial
reform programs was made in most of the countries
seriously affected by the crises. In early April, the
agreement between Korean banks and their external
bank creditors to stretch out short-term obligations
was implemented, ending an interval of rollovers by
creditors that was endorsed by the authorities in
countries that had pledged to support the Korean
program. Indonesia reached a second revised agreement
with the International Monetary Fund (IMF) in April
on a reform program,
which was subsequently derailed by political strife
and the resignation of the president in late May; the
change in political regime was followed by calm, and
a new agreement was reached
with the IMF management in late June and approved by the
IMF Executive Board on July 15.

After rising sharply during the final months of 1997
through mid-January of 1998, the exchange value of the
dollar in terms of the currencies of Korea, Indonesia,
Thailand, and other ASEAN countries partly retraced
those gains during February, March, and April. Since
then, however, market pressures have again led to
further sharp increases in the exchange value of the
dollar in terms of the Indonesian rupiah while the
dollar has changed little against most of the other
Asian emerging-market currencies. Since the end
of December, the dollar has declined, on balance, 24
percent
against the Korean won and nearly 14 percent against
the Thai baht and has risen moderately in terms of the
Taiwan dollar and increased about 130 percent in terms
of the Indonesian rupiah.

During the first weeks of the year, the dollar
depreciated in terms of the Japanese yen as improved
prospects elsewhere in Asia and market uncertainty
regarding potential intervention by the Japanese
monetary authorities lent support to the yen.
Indications that significant measures for economic
stimulus might be announced
also put upward pressure on the yen. In February, the
dollar resumed its appreciation with respect to the yen.
The rise in the dollar was only temporarily interrupted
by sizable intervention purchases of dollars by Japanese
authorities in April. Upward pressure on the dollar
relative to the yen intensified in late May and June.
Renewed signs of cyclical weakness in the Japanese
economy and lack of market confidence in the announced
programs for addressing the chronic problems within the
financial sector contributed to pessimism toward the
yen. Persistent weakness in the Japanese economy and the
yen, in turn, heightened concerns about prospects
elsewhere in Asia; the lower yen adversely affected the
competitiveness of goods produced in the Asian emerging-
market economies and raised questions about the
sustainability of current exchange rate policies in
China and Hong Kong.

On June 17, the monetary authorities in the United
States and Japan cooperated in foreign exchange
intervention purchases of
yen for dollars. This intervention operation was the
first by U.S. authorities since August 1995. In
announcing the market intervention, Treasury Secretary
Rubin cited Japanese government plans to restore the
health of their financial system and to strengthen
Japanese domestic demand. He pointed to the stake of
Asia and the international community as a whole in
Japan's success. The yen rose somewhat following the
exchange market intervention and has since partially
given back that gain. In the wake of the recent
election, which cost the LDP numerous seats in the upper
house of the Diet and precipitated the resignation of
Prime Minister Hashimoto, the yen changed little. On
balance, the
dollar has appreciated about 7 percent in terms of the
yen since the end of December.

Equity prices in the Asian emerging-market economies
have been volatile so far this year as well. These
prices recovered somewhat in the first weeks of the year
in response to the market perception that the crisis was
easing; after fluctuating narrowly, they began moving
back down in March and April, reaching new lows in June
in Korea, Thailand, and Hong Kong. On balance, these
equity
prices have moved down about 25 percent (Singapore and
Malaysia) to up about 20 percent (Indonesia) since the
end of last year. Equity prices in Japan also rose early
in the year on improved optimism but then gave back
those gains over time with the release
of indicators suggesting additional weakness in the
Japanese economy. Since the middle of June, Japanese
equity prices have rebounded on the perception that
significant fiscal stimulus is now more likely. On
balance, Japanese equity prices are up about 9 percent
from their level at the end of last year. Japanese long-
term interest rates continued through May on their
downward trend that began in mid-1997, declining an
additional 50 basis points during the first five months.
Since then, long-term interest rates have retraced more
than half of that decline, in part in response to the
announcement of the plan for financial restructuring and
in part in response to the outcome of the recent
election, which heightened expectations of additional
fiscal stimulus.

The Asian financial crises have resulted in a sharp drop
in the pace of economic activity in the region. Output
declined precipitously in the first quarter in those
countries most affected, such as Korea, Indonesia, and
Malaysia, and slowed in other Asian economies,
such as China and Taiwan, that have suffered a loss of
competitiveness and reduced external demand as a
consequence of the crises. Data for recent months
suggest that additional slowing has occurred and that
the risk of further spread and deepening of cyclical
weakness throughout the region cannot be ruled out.
Depreciation of their respective currencies has led to
acceleration of domestic prices in several of these
economies, particularly in Indonesia and Thailand.

Real GDP in Japan also fell sharply in the first
quarter, and output indicators suggest a further decline
in the second quarter.
Consumer price inflation remains very low. Japanese
authorities
have announced a series of fiscal measures that are
expected to boost domestic demand during the second half
of this year. In addition, officials have announced a
package of steps directed at restoring the soundness of
the financial sector, including (1) introduction of a
bridge bank mechanism to facilitate the resolution of
failed banks while permitting some of their borrowers to
continue to receive credit, (2) measures to improve the
disposal of bad bank loans, (3) enhanced transparency
and disclosure by
banks, and (4) strengthened bank supervision. These
actions are intended to restore confidence in Japanese
financial institutions and in the prospects for the
economy more broadly.

In the other major industrial countries, economic
developments so far this year have generally been
favorable. The exchange value of the dollar in terms of
the German mark has fluctuated narrowly and, on balance,
is little changed since the end of December.
Market perceptions that progress toward the start of the
final stage of European Monetary Union (EMU) is going
smoothly and signs
of momentum in the U.S. and German economies resulted in
little pressure in either direction on the exchange
rate. The dollar also fluctuated narrowly against the
U.K. pound with little net change
so far this year. Moves to tighten monetary conditions
in the United Kingdom lent support to the pound,
countering some tendency for weak external demand to
depress the currency. The Canadian dollar rebounded
following a tightening of monetary conditions by the
Bank of Canada on January 30. Since early March,
however, it has tended to move down as market
participants have come to believe that further upward
shifts of official interest rates are unlikely and as
weakness in global
commodity markets, partly the result of reduced
economic activity in Asia, have weighed on the
currency. The exchange value of the U.S. dollar in
terms of the Canadian dollar reached new highs in July
and, on balance so far this year, has risen about 4
percent.

Long-term interest rates have declined and equity
prices have generally risen strongly in European and
Canadian markets this year. Despite signs of
strengthening activity in Germany and other
continental European countries and continued healthy
expansion in the United Kingdom and Canada, long-term
rates have moved
down since December; long rates are about 60 basis
points lower in Germany and less than half that amount
lower in Canada. Shifts of international portfolios
away from Asian assets and toward those perceived to be
safer have probably contributed to rate declines in
Continental Europe and in the United States. Stock
prices have also continued to rise in Europe and
Canada. Since December, the gains have ranged from
about 40 percent in Germany and France to
about 10 percent in Canada.

The pace of real economic activity improved somewhat in
the first quarter in Germany and on average in the
eleven countries slated to proceed with currency union
on January 1, 1999.\2 Production and employment data
for more recent months suggest continued
expansion. Business confidence has firmed as progress
toward EMU has continued. Domestic demand is becoming
more buoyant
in several of these countries, offsetting weakening of
external demand arising from events in Asia. On average,
inflation remains subdued within the euro area. In the
United Kingdom and Canada, real output continues to
expand at a relatively rapid rate. U.K. inflation
threatens to exceed the government's target of 2-1/2
percent, and the Bank of England raised its official
lending rate 25 basis points in June in order to lessen
price pressures. Consumer price inflation in Canada
remains very low.

Events in Asia have spilled over to affect developments
in Latin American countries. Declines in global oil
prices have contributed to downward pressure on the
exchange value of the Mexican peso.
The peso declined sharply in terms of the dollar at the
start of the year but then stabilized in February
through May as Asian markets partially recovered. It
depreciated further in May and June, resulting in a net
decline of about 9 percent in terms of the dollar so far
this year. The Brazilian exchange rate regime of a
controlled crawl and the Argentine regime of pegging the
peso to the dollar remain in place, and Brazilian short-
term interest rates have been lowered from the very high
levels to which they were raised when
the Asian crisis intensified in late 1997. Equity
prices in these three Latin American countries have
been volatile, rising early in the
year and giving back those gains since April. On
balance this year, equity prices have declined about 10
percent in Mexico and Argentina and have risen about 8
percent in Brazil.

Real output growth remains strong in Mexico and
Argentina, but
the rate has slowed somewhat from last year's vigorous
pace. In Brazil, economic activity has weakened more
sharply, in part in response to the tightening of
monetary conditions that followed the outbreak of the
Asian crisis.

Lower global oil prices have combined with a poorly
functioning domestic tax system to trigger a financial
crisis in Russia. Russian officials have reached
agreement with IMF management on a
revised program that includes proposed increased funds
from the IMF and other sources. To help finance this
program, the General Arrangements to Borrow are being
activated in light of the inadequacy of IMF resources to
meet actual or expected requests
for financing and a need to forestall impairment of the
international monetary system. The General Arrangements
to Borrow provide
the IMF with supplementary lines of credit from the G-10
countries.

_________

  1. According to the published data, productivity rose
                       1.1 percent
at an annual rate in the first quarter. However, these
data are distorted by inconsistencies in the measurement
of hours
associated with varying lengths of pay periods across
months. Although the Bureau of Labor Statistics has
already revised the monthly hours and earnings data to
account for these
inconsistencies, it will not update the productivity
statistics until August. All else being equal, adjusting
the productivity data to reflect the Bureau's revisions
to hours would substantially raise productivity growth in
the first quarter, but it would have little effect on the
change over the four quarters ending in the first
quarter.

 _______

   2. Those countries are Austria, Belgium, Finland,
France,
Ireland, Italy, Germany, Luxembourg, the Netherlands,
Portugal, and Spain.