Board of Governors of the Federal Reserve System

Monetary Policy Report to the Congress
Submitted pursuant to section 2B of the Federal Reserve Act
February 11, 2003

Letter of Transmittal

BOARD OF GOVERNORS 
OF THE FEDERAL RESERVE SYSTEM
Washington, D.C., February 11, 2003

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

The Board of Governors is pleased to submit its Monetary Policy Report 
to the Congress pursuant to section 2B of the Federal Reserve Act.

Sincerely,
Alan Greenspan, Chairman

Monetary Policy Report to the Congress

SECTION 1

Monetary Policy Report to the Congress

Report submitted to the Congress on February 11, 2003, pursuant to 
section 2B of the Federal Reserve Act 

Monetary Policy 
and the Economic Outlook

The economy of the United States has suffered a series of blows in the 
past few years, including the fall in equity market values that began 
in 2000, cutbacks in capital spending in 2001, the horrific terrorist 
attacks of September 11, the emergence of disturbing evidence of 
corporate malfeasance, and an escalation of geopolitical risks. Despite 
these adversities, the nation's economy emerged from its downturn in 
2001 to post moderate economic growth last year. The recovery was 
supported by accommodative monetary and fiscal policies and undergirded 
by unusually rapid productivity growth that boosted household incomes 
and held down business costs. The productivity performance was also 
associated with a rapid expansion of the economy's potential, and 
economic slack increased over the year despite the growth in aggregate 
demand.

After turning up in late 2001, activity began to strengthen more 
noticeably early last year. Sharp inventory cutbacks in 2001 had 
brought stocks into better alignment with gradually rising final sales, 
and firms began to increase production in the first quarter of 2002 to 
curtail further inventory runoffs. Moreover, businesses slowed their 
contraction of investment spending and began to increase outlays for 
some types of capital equipment. Household spending on both personal 
consumption items and housing remained solid and was supported by 
another installment of tax reductions, widespread price discounting, 
and low mortgage interest rates. By midyear, the cutbacks in employment 
came to an end, and private payrolls started to edge higher. 

Although economic performance appeared to be gradually improving, the 
tentative nature of this improvement warranted the continuation of a 
highly accommodative stance of monetary policy. Accordingly, the 
Federal Open Market Committee (FOMC) held the federal funds rate at 1-
3/4  percent through the first part of the year. In March, however, the 
FOMC shifted from an assessment that the risks over the foreseeable 
future to its goals of maximum sustainable growth and price stability 
were tilted toward economic weakness to an assessment that the risks 
were balanced.

Around midyear, the economy began to struggle again. Concerns about 
corporate governance came to weigh heavily on investors' confidence, 
and geopolitical tensions, especially the situation in Iraq, elevated 
uncertainties about the future economic climate. Equity prices fell 
during the summer, liquidity eroded in corporate debt markets, and risk 
spreads widened. Businesses once again became hesitant to spend and to 
hire, and both manufacturing output and private payrolls began to 
decline. State and local governments struggled to cope with 
deteriorating fiscal positions, and the economies of some of our major 
trading partners remained weak. Although the already accommodative 
stance of monetary policy and strong upward trend of productivity were 
providing important support to spending, the Committee perceived a risk 
that the near-term weakening could become entrenched. In August, the 
FOMC adjusted its weighting of risks toward economic weakness, and in 
November, it reduced the targeted federal funds rate 50 basis points, 
to 1-1/4 percent. The policy easing allowed the Committee to return to 
an assessment that the risks to its goals were balanced. With inflation 
expectations well contained, this additional monetary stimulus seemed 
to offer worthwhile insurance against the threat of persistent economic 
weakness and substantial declines in inflation from already low levels.

On net, the economy remained sluggish at the end of 2002 and early this 
year. The household sector continued to be a solid source of demand. 
Motor vehicle sales surged at year-end on the tide of another round of 
aggressive discounting by the manufacturers, other consumer outlays 
trended higher, and activity in housing markets remained exceptionally 
strong. Concerns about corporate governance appeared to recede somewhat 
late last year, in part because no new revelations of major wrongdoing 
had emerged. However, the ongoing situation in Iraq, civil strife in 
Venezuela that has curtailed oil production, and tensions on the Korean 
peninsula have sustained investors' uncertainty about economic 
prospects and have pushed prices higher on world oil markets. Faced 
with this uncertainty, businesses have been cautious in spending and 
changed payrolls little, on net, over December and January.

Mindful of the especially high degree of uncertainty attending the 
economic outlook in the current geopolitical environment, the members 
of the FOMC believe the most likely outcome to be that fundamentals 
will support a strengthening of economic growth. Business caution is 
anticipated to give way over the course of the year to clearer signs of 
improving sales. Inventories are lean relative to sales at present, and 
restocking is likely to provide an additional impetus to production in 
the period ahead. The rapid expansion of productivity, the waning 
effects of earlier declines in household wealth, and the highly 
accommodative stance of monetary policy should also continue to boost 
activity. Although state and local governments face budgetary problems, 
their restraint is likely to offset only a part of the stimulus from 
past and prospective fiscal policy actions at the federal level. In 
addition, the strengthening economies of our major trading partners 
along with the improving competitiveness of U.S. products ought to 
support demand for our exports. Taken together, these factors are 
expected to lead to a faster pace of economic expansion, while 
inflation pressures are anticipated to remain well contained.

SECTION 2

Monetary Policy, Financial Markets, 
and the Economy over 2002 and Early 2003

As economic growth picked up during the early months of 2002, the FOMC 
maintained its target for the federal funds rate at 1-3/4 percent. A 
sharply reduced pace of inventory liquidation accounted for a 
significant portion of the step-up in real GDP growth, but other 
indicators also suggested that the economy was gaining momentum. 
Reductions in business outlays on equipment and software had moderated 
significantly after dropping precipitously in 2001, and consumer 
spending was well maintained by sizable gains in real disposable 
personal income. Residential construction activity was spurred by low 
home mortgage interest rates. The improvement in economic conditions 
sparked a rally in equity markets late in the first quarter and pushed 
up yields on longer-term Treasury instruments and investment-grade 
corporate bonds; yields on speculative-grade bonds declined in reaction 
to brighter economic prospects and the perceived reduction in credit 
risk. Meanwhile, surging energy prices exerted upward pressure on 
overall inflation, but still-appreciable slack in resource utilization 
and a strong upward trend in private-sector productivity were holding 
down core price inflation.

At both its March and May meetings, the FOMC noted that the apparent 
vigor of the economy was importantly attributable to a slowdown in the 
pace of inventory liquidation and that considerable uncertainty 
surrounded the outlook for final sales over the next several quarters. 
The Committee was especially concerned about prospects for a rebound in 
business fixed investment, which it viewed as key to ensuring 
sustainable economic expansion. Although the decline in investment 
spending during the first quarter of 2002 was the smallest in a year, 
gloomy business sentiment and large margins of excess capacity in 
numerous industries were likely to hamper capital expenditures. 
According to anecdotal reports, many firms were unwilling to expand 
capacity until they saw more conclusive evidence of growing sales and 
profits. At the same time, however, the FOMC noted that, with the 
federal funds rate unusually low on an inflation-adjusted basis and 
considerable fiscal stimulus in train, macroeconomic policies would 
provide strong support to further economic expansion. Against this 
backdrop, the Committee at the March 19 meeting judged the 
accommodative stance of monetary policy to be appropriate and announced 
that it considered the risks to achieving its long-run objectives as 
being balanced over the foreseeable future, judgments it retained at 
its meeting in early May.	

The information reviewed at the June 25-26 FOMC meeting confirmed that 
the economy was expanding but at a slower pace than earlier in the 
year. As expected, the degree of impetus to economic activity from 
decelerating inventory liquidation had moderated. Residential 
investment and consumer spending also had slowed appreciably after 
surging earlier in the year. The most recent data on orders and 
shipments suggested a small upturn in business spending on equipment 
and software, but the improvement in capital spending appeared to be 
limited, unevenly distributed across industries, and not yet firmly 
indicative of sustained advance. Industrial production continued to 
increase, and the unemployment rate declined somewhat. 

In financial markets, investors and lenders had apparently become more 
risk averse in reaction to the mixed tone of economic data releases, 
growing geopolitical tensions, further warnings about terrorist 
attacks, and additional revelations of dubious corporate accounting 
practices. In concert, these developments pushed down yields on longer-
term Treasury securities, while interest rates on lower-quality 
corporate bonds rose notably, and equity prices dropped sharply. 
Although the economy continued to expand and the prospects for 
accelerating aggregate demand remained favorable, downbeat business 
sentiment and skittish financial markets rendered the timing and extent 
of the expected strengthening of the expansion subject to considerable 
uncertainty. In these circumstances, the FOMC left the federal funds 
rate 
unchanged to keep monetary policy very accommodative and once again 
assessed the risks to the outlook as being balanced.		

By the time of the August 13 FOMC meeting, it had become apparent that 
economic activity had lost some of its earlier momentum. Turbulence in 
financial markets appeared to be holding back the pace of the economic 
expansion. Market participants focused their attention on the lack of 
convincing evidence that the recovery was gaining traction and the 
possibility that more news of corporate misdeeds would surface in the 
run-up to the Securities and Exchange Commission's August 14 deadline 
for the certification of financial statements by corporate executives. 
Although the cumulative losses in financial wealth since 2000 were 
restraining expenditures by households, very low mortgage interest 
rates were helping to sustain robust demand for housing. Moreover, the 
financial resources made available by a rapid pace of mortgage 
refinancing activity, in combination with attractive incentives offered 
by auto manufacturers, supported other consumer spending. The Committee 
continued to judge the prevailing degree of monetary accommodation as 
appropriate to foster a solid expansion that would bring the economy to 
fuller resource utilization. At the same time, the Committee recognized 
the considerable risks to that outlook and the potential adverse 
consequences for economic prospects from possible additional 
deterioration of financial conditions. The members noted, however, that 
a further easing of monetary policy, if it came to be viewed as 
appropriate, could be accomplished in a timely manner. In light of 
these considerations, the FOMC opted to retain a target rate of 1-3/4 
percent for the federal funds rate, but it viewed the risks to the 
economy as having shifted from balanced to being tilted toward economic 
weakness.

When the FOMC met on September 24, data indicated that economic growth 
had picked up in the third quarter, on average, buoyed in part by a 
surge in motor vehicle production. The uneventful passing of the mid-
August deadline for recertification of corporate financial statements 
briefly alleviated investors' skittishness in debt and equity markets. 
However, the most timely information suggested that some softening in 
economic activity had occurred late in the summer. Those economic 
reports, along with a darker outlook for corporate profits and 
escalating fears of a possible war against Iraq, led market 
participants to revise down their expectations for the economy. Equity 
prices and yields on both longer-term Treasury and private securities 
moved sharply lower in early autumn. In the Committee's view, 
heightened geopolitical tensions constituted a significant additional 
source of uncertainty clouding the economic outlook. Still, 
fundamentals suggested reasonable prospects for continued expansion. 
Accordingly, the FOMC left the federal funds rate unchanged at the 
close of the September meeting but also reiterated its view that the 
risks to the outlook were weighted toward economic weakness.

The information reviewed at the November 6 meeting indicated a more 
persistent spell of below-par economic performance than the FOMC had 
anticipated earlier. With home mortgage rates at very low levels, 
residential construction activity remained high. But consumer spending 
had decelerated noticeably since midsummer under the combined weight of 
stagnant employment and declining household wealth resulting from 
further decreases in equity prices. Worries about the potential for war 
against Iraq, as well as persistent concerns about the course of 
economic activity and corporate earnings, were apparently engendering a 
high degree of risk aversion among business executives that was 
constraining capital spending and hiring. Despite a weakening in the 
exchange value of the dollar, sluggish economic growth among major 
trading partners spelled difficulties for U.S. exports, and a rebound 
in foreign output seemed more likely to follow than to lead a rebound 
at home. Moreover, economic slack that was larger and more persistent 
than previously anticipated ran the risk of reducing core inflation 
appreciably further from already low levels. Given these 
considerations, the Committee lowered its target for the federal funds 
rate 1/2 percentage point, to 1-1/4 percent. The relatively aggressive 
adjustment in the stance of monetary policy was deemed to offset the 
potential for greater economic weakness, and the Committee accordingly 
announced that it judged risks to the outlook as balanced with respect 
to its long-run goals of price stability and sustainable economic 
growth. 

When the FOMC met on December 10, overall conditions in financial 
markets had calmed considerably. Indicators of production and spending, 
however, remained mixed. The manufacturing sector registered large job 
losses in the autumn, and industrial production continued its slide, 
which had begun around midyear. A more vigorous rebound in business 
fixed investment was not evident, and indeed the recent data on orders 
and shipments and anecdotal reports from business contacts generally 
signaled continued softness in capital spending. Very low home mortgage 
interest rates were supporting residential construction activity, but 
consumption expenditures were sluggish. On balance, the Committee's 
view was that in the absence of major shocks to consumer and business 
confidence, a gradual strengthening of the economic expansion was 
likely over the coming quarters, especially given the very 
accommodative stance of monetary policy and probable further fiscal 
stimulus. The FOMC left the federal funds rate unchanged and indicated 
that it continued to view the risks to the outlook as balanced over the 
foreseeable future.

By the time of the FOMC meeting on January 28-29, 2003, it had become 
apparent that the economy had grown only slowly in the fourth quarter 
of last year, but little evidence of cumulating weakness appeared in 
the most recent data, and final demand had held up reasonably well. The 
escalation of global tensions weighed heavily on business and investor 
sentiment. Firms apparently were remaining very cautious in their 
hiring and capital spending, and equity prices had declined on balance 
since the December meeting. But yield spreads on corporate debt-
especially for riskier credits-narrowed further, and longer-term 
Treasury yields declined slightly. Although the fundamentals still 
pointed to favorable prospects for economic growth beyond the near 
term, geopolitical developments were making it especially difficult to 
gauge the underlying strength of the economy, and uncertainties about 
the economic outlook remained substantial. Against this background, the 
Committee decided to leave the federal funds rate unchanged and stated 
that it continued to judge the risks to the outlook as balanced.

Economic Projections for 2003

An unusual degree of uncertainty attends the economic outlook at 
present, in large measure, but not exclusively, because of potential 
geopolitical developments. But Federal Reserve policymakers believe the 
most probable outcome for this year to be a pickup in the pace of 
economic expansion. The central tendency of the real GDP forecasts made 
by the members of the Board of Governors and the Federal Reserve Bank 
presidents is 3-1/4 percent to 3-1/2 percent, measured as the change 
between the final quarter of  2002 and the final quarter of this year. 
The full range of these forecasts is 3 percent to 3-3/4 percent. Of 
course, neither the central tendency nor the range is intended to 
convey the uncertainties surrounding the 
individual forecasts of the members. The civilian unemployment rate is 
expected to end the year in the 5-3/4 percent to 6 percent range. 

Apart from the geopolitical and other uncertainties, the forces 
affecting demand this year appear, on balance, conducive to a 
strengthening of the economic expansion. Monetary policy remains highly 
accommodative, and federal fiscal policy is and likely will be 
stimulative. However, spending by many state and local governments will 
continue to be restrained by considerable budget difficulties. Activity 
abroad is expected to improve this year, even if at a less robust pace 
than in the United States; such growth together with the improving 
competitiveness of U.S. products should generate stronger demand for 
our exports. Furthermore, robust gains in productivity, though unlikely 
to be as large as in 2002, ought to continue to promote both household 
and business spending. Household purchasing power should be supported 
as well by a retreat in the price of imported energy products that is 
suggested by the oil futures market. And the adverse effects on 
household spending from past declines in equity wealth probably will 
begin to wane.

A reduction of businesses' hesitancy to expand investment and hiring is 
critical to the durability of the expansion, and such a reduction 
should occur gradually if geopolitical risks ease and profitability 
improves. Inventories are relatively lean, and some restocking ought to 
help boost production this year, albeit to a much smaller extent than 
did last year's cessation of sharp inventory liquidations. In addition, 
the continued growth of final sales, the tax law provision for partial 
expensing of equipment purchases, replacement demand, and a more 
hospitable financial environment should induce many firms to increase 
their capital spending. The growth of investment likely will be 
tempered, however, by the persistence of excess capital in some areas, 
notably the telecommunications sector, and reductions in business 
spending on many types of new structures may continue this year. 

Federal Reserve policymakers believe that consumer prices will increase 
less this year than in 2002, especially if energy prices partly reverse 
last year's sharp rise. In addition, resource utilization likely will 
remain sufficiently slack to exert further downward pressure on 
underlying inflation. The central tendency of FOMC members' projections 
for increases in the chain-type price index for personal consumption 
expenditures (PCE) is 1-1/4 percent to 1-1/2 percent this year, lower 
than the actual increase of about 2 percent in 2002.

Economic and Financial Developments 
in 2002 and Early 2003

In 2002, the United States economy extended the upturn in activity that 
began in late 2001. Real GDP increased 2-3/4 percent over the four 
quarters of last year, according to the advance estimate from the 
Commerce Department. However, the pace of activity was uneven over the 
course of the year, as concerns about emerging economic and political 
developments at times weighed heavily on an economy already adjusting 
to a succession of shocks from previous years.

Economic conditions improved through the first part of the year. 
Household spending on both personal consumption items and housing 
remained solid, businesses curtailed their inventory liquidation and 
began to increase their outlays for some types of capital equipment, 
and private employment started to edge higher. But the forward momentum 
diminished noticeably later in the year when concerns about corporate 
governance put a damper on financial markets and geopolitical 
developments boosted oil prices and added to the uncertainty already 
faced by businesses about the economic outlook. In the summer, equity 
prices fell, risk spreads widened, and liquidity eroded in corporate 
debt markets. Businesses' caution was reflected in their reluctance to 
substantially boost investment, restock inventories, or add to 
payrolls. Responding to these developments, as well as some weakening 
in demand from abroad, manufacturers trimmed production during the 
fall. Employment at private businesses declined again, and the 
unemployment rate rose to 6 percent in December. However, despite the 
modest pace of last year's overall recovery, output per hour in the 
nonfarm business sector grew 3-3/4 percent over the year-an 
extraordinary increase even by the standards of the past half decade or 
so. 

Signals on the trajectory of the economy as we enter 2003 remain mixed. 
Some of the factors that had noticeably restrained the growth of real 
GDP in the fourth quarter of last year-most especially a sharp decline 
in motor vehicle production-are not on track to be repeated. Moreover, 
employment leveled off on average in December and Janaury, and readings 
on industrial production have had a somewhat firmer tone of late. 
Nevertheless, the few data in hand suggest that the economy has not yet 
broken out of the pattern of subpar performance experienced over the 
past year.

Consumer price inflation moved up a bit last year, reflecting sharply 
higher energy prices. Excluding the prices of food and energy items, 
the price index for personal consumption expenditures increased 1-
3/4 percent, about 1/4 percentage point less than in 2001; this 
deceleration most likely resulted from continued slack in labor and 
product markets, robust gains in productivity, and somewhat lower 
expectations of future inflation.

The Household Sector 

Consumer Spending

Consumer spending grew at a moderate pace last year and, on the whole, 
continued to be an important source of support for overall demand. 
Personal consumption expenditures rose 2-1/2 percent in real terms, 
near the 2-3/4 percent increase in 2001 and down from the more than 
4 percent average growth over the preceding several years. Sales of new 
motor vehicles fell only a little from the extremely high levels of 
late 2001; outlays were especially strong during the summer and late in 
the year, when manufacturers were offering aggressive price and 
financing incentives. Growth of spending on other durable goods was 
well maintained last year as well, although the gains were smaller than 
is often seen early in an economic recovery; in contrast to the 
situation in many previous cycles, spending on durable goods did not 
decline sharply during the recession and so had less cause to rebound 
as the recovery got under way. Apart from outlays on durable goods, 
spending for most categories of consumer goods and services increased 
at a moderate rate last year. 

That moderate rate of aggregate consumption growth was the product of 
various crosscurrents. On the positive side, real disposable personal 
income rose nearly 6 percent last year, the fastest increase in many 
years. Strong productivity growth partially offset the effects of 
stagnant employment in restricting the growth of household income, and 
the phase-in of additional tax reductions from the Economic Growth and 
Tax Relief Reconciliation Act of 2001 boosted household purchasing 
power appreciably. In addition, high levels of mortgage refinancing 
allowed homeowners to reduce their monthly payments, pay down more 
costly consumer credit, and, in many cases, extract equity that could 
be used to support other spending. On the negative side, household 
wealth again moved lower last year, as continued reductions in equity 
values outweighed further appreciation of house prices. By the end of 
the third quarter, according to the Federal Reserve's flow-of-funds 
accounts, the ratio of household net worth to disposable income had 
reversed nearly all of its run-up since the mid-1990s.

Consumer confidence, which had declined during most of 2001 and 
especially after the September 11 attacks, picked up in the first half 
of last year, according to both the Michigan Survey Research Center 
(SRC) and Conference Board surveys. However, confidence retreated over 
the summer along with the drop in equity prices, and by early this 
year, consumer confidence again stood close to the levels of late 2001. 
These levels of consumer confidence, though at the bottom of readings 
of the past several years, are nevertheless above levels normally 
associated with recession.

The personal saving rate, which has trended notably lower since the 
early 1980s, moved above 4 percent by late last year after having 
averaged 2-1/4 percent in 2001. The saving rate has been buffeted 
during the past two years by surges in income induced by tax cuts and 
by spikes in spending associated with variations in motor vehicle 
incentives. But, on balance, the extent of the increase in the saving 
rate has been roughly consistent with a gradual response of consumption 
to the reduction in the ratio of household wealth to disposable income.

Residential Investment

Real expenditures on residential investment increased 6 percent in 
2002-the largest gain in several years. 
Demand for housing was influenced by the same factors affecting 
household spending more generally, but it was especially supported by 
low interest rates on mortgages. Rates on thirty-year fixed-rate 
mortgages, which stood at around 7 percent in the first months of the 
year, fell to around 6 percent by the autumn and dipped below that 
level early this year-the lowest in thirty-five years. Not 
surprisingly, attitudes toward homebuying, as measured by the Michigan 
SRC, remained quite favorable.

Starts of new single-family homes were at 1.36 million units last year, 
7 percent above the already solid pace for 2001. Sales of both new and 
existing homes were brisk as well. Home prices continued to rise but at 
a slower rate than in 2001, at least according to some measures. The 
repeat-sales price index for existing homes rose 5-1/2 percent over the 
four quarters ended in 2002:Q3, a slowing from the 8-3/4 percent 
increase over the comparable year-earlier period. The constant-quality 
price index for new homes rose 4-1/2 percent last year, but this 
increase was close to the average pace over the past few years. At the 
same time, measures of house prices that do not control for the mix of 
homes sold rose considerably more last year than in 2001, a difference 
indicating that a larger share of transactions were in relatively 
expensive homes.

In the multifamily sector, starts averaged a solid 345,000 units last 
year, an amount in line with that of the preceding several years. 
However, the pace of building slowed a little in the fall. Apartment 
vacancy rates moved notably higher last year and rent and property 
values declined; these changes suggest that the strong demand for 
single-family homes may be eroding demand for apartment space. 

Household Finance

Households continued to borrow at a rapid pace last year; the 9-1/4 
percent increase in their debt outstanding was the largest since 1989. 
Low mortgage interest rates helped spur both very strong home purchases 
and refinancing of existing loans, which together increased home 
mortgage debt 11-1/2 percent. Refinancing activity was especially 
elevated in the fourth quarter, when fixed mortgage interest rates 
dipped to around 6 percent. Torrid refinancing activity helps explain 
last year's slowdown of consumer credit, which is household borrowing 
not secured by real estate: A significant number of households 
reportedly extracted some of the equity from their homes at the time of 
refinancing and used the proceeds to repay other debt as well as to 
finance home improvements and other expenditures. According to banks 
that participated in the Federal Reserve's Senior Loan Officer Opinion 
Survey on Bank Lending Practices in October, the frequency and size of 
cash-out refinancings were substantially greater than had been reported 
in the January 2002 survey. Although automakers' financing incentives 
and attractive cash rebates stimulated a substantial amount of consumer 
borrowing, the growth rate of consumer credit in 2002, at 4-1/4 
percent, was more than 2-1/2 percentage points below the pace in 2001.

Even though households took on a large amount of mortgage debt last 
year, extraordinarily low mortgage rates kept the servicing requirement 
for that debt (measured as a share of homeowners' disposable income) 
well below its previous peak levels. Moreover, reflecting large gains 
in residential real estate values, equity in homes has continued to 
increase despite sizable debt-financed extractions. The combined 
influence of low interest rates and the sizable gain in disposable 
personal income also kept the total servicing costs faced by 
households-which in addition to home mortgage payments include costs of 
other financial obligations such as rental payments of tenants, 
consumer installment credit, and auto leases-relative to their incomes 
below previous peaks. Against this backdrop, broad measures of 
household credit quality deteriorated very little last year, and signs 
of financial stress were confined mainly to the subprime segment of the 
market. Delinquency rates on home mortgages inched up, while those on 
auto loans at finance companies were flat. Delinquency rates on credit 
cards bundled into securitized asset pools remained close to those of 
recent experience.

The Business Sector

Overall business fixed investment moved lower last year, although the 
decline was not nearly so precipitous as in 2001. Outlays for equipment 
and software edged up, but spending on structures fell sharply. 
Financing conditions worsened over the summer, with equity prices 
declining, initial public offerings (IPOs) drying up, credit market 
spreads widening, and banks tightening up somewhat on credit standards 
in the wake of increased reports of corporate malfeasance. In addition, 
geopolitical concerns 
increased firms' already heightened uncertainty about the economic 
outlook. These factors contributed to an apparent deterioration in 
business confidence, and businesses still have not felt any great 
urgency to boost investment appreciably. For similar reasons, although 
firms slowed their rate of inventory liquidation last year, they have 
yet to undertake a sustained restocking.

Fixed Investment

After dropping sharply in 2001, real spending on equipment and software 
rose 3 percent last year. Spending on high-technology equipment, one of 
the hardest-hit sectors in 2001, showed signs of uneven improvement. 
The clearest rebound was in computing equipment, for which spending 
rose 25 percent in real terms; this gain fell short of the increases 
posted in the late 1990s but far more than reversed the previous year's 
decline. Software investment also turned positive, rising 6 percent 
after declining about 3 percent in 2001. By contrast, real outlays for 
communications equipment were reported to be up only slightly in 2002 
after plummeting 30 percent in 2001. 

Business spending on aircraft fell sharply last year. Airlines were hit 
especially hard by the economic downturn and by the reduction in air 
travel after the September 11 attacks; although expenditures for new 
aircraft held up through the end of 2001 because of the very long lags 
involved in producing planes, shipments of planes slowed greatly 
thereafter. Meanwhile, business outlays on motor vehicles edged up last 
year. Demand for autos and light trucks by rental companies weakened 
sharply along with the drop in air traffic that occurred after 
September 11 but recovered gradually over the course of last year. 
Purchases of medium and heavy trucks fell off overall, despite the fact 
that demand for heavy (class 8) trucks was boosted by spending in 
advance of the implementation of more-stringent environmental 
regulations.

Investment in equipment other than high-tech and transportation goods 
moved modestly higher through most of last year, as real outlays for 
industrial machinery and a wide range of other equipment gradually 
strengthened through the summer. Although spending edged lower again in 
the fourth quarter, investment in non-high-tech, nontransportation 
equipment increased 3-1/2 percent for the year as a whole. 

Spending on equipment and software was supported last year by low 
interest rates, which helped hold down the cost of capital, as did the 
tax provision enacted in March 2002 that allows partial expensing of 
new equipment and software purchased before September 11, 2004. 
Moreover, modest increases in final sales together with replacement 
demand no doubt spurred many firms to make new capital outlays. 
Nevertheless, some sectors, most notably telecommunications, probably 
still had excess holdings of some forms of capital. Concerns about 
corporate malfeasance, which had become more intense over the spring 
and summer, weighed heavily on financial markets and raised the cost of 
capital through reduced share prices and higher yields on the bonds of 
lower-rated firms. In addition, uncertainty about the geopolitical 
situation, including the possible consequences for oil prices of an 
outbreak of war with Iraq, likely made many firms reluctant to commit 
themselves to new expenditures. In all, businesses have been, and 
appear to remain, quite cautious about undertaking new capital spending 
projects.

Real business spending for nonresidential structures declined sharply 
for a second year in 2002. Outlays for the construction of office 
buildings and industrial buildings were especially weak. Vacancy rates 
for such buildings increased throughout the year, and property values 
and rents moved lower. Construction of new hotels and motels also fell 
considerably, reflecting the weakness in the travel industry. By 
contrast, spending on other commercial buildings, such as those for 
retail, wholesale, and warehouse space, moved only a little lower last 
year. 

A number of factors likely account for investment in structures having 
been much weaker than investment in equipment. Structures depreciate 
very slowly, so businesses can defer new outlays without incurring much 
additional deterioration of their capital stock. And unlike investment 
in equipment, spending on structures is not eligible for partial 
expensing. According to some analysts, concerns about additional acts 
of terrorism (and, until late in the year, the lack of insurance to 
cover such events) may also have had a damping effect on some types of 
construction, particularly large "trophy" projects. 

Inventory Investment

The sharp inventory runoffs that characterized the economic downturn, 
together with gradually rising final sales, implied that, by early last 
year, stocks were in much better alignment with sales than had been the 
case during 2001. Accordingly, businesses lessened the pace of 
inventory liquidation early in the year and by summer had turned to 
some modest restocking. However, firms appeared to have exerted tight 
control over production and inventories; with prospects for the 
strength of the recovery having diminished in the second half of the 
year, businesses quickly cut production, and inventories only edged up 
in the fourth quarter, according to incomplete and preliminary data. In 
all, total inventories were about unchanged last year compared with a 
liquidation of more than $60 billion in 2001, and this turnaround 
contributed 1 percentage point to the growth of real GDP over the year. 
At year-end, inventory-to-sales ratios in most sectors stood near the 
low end of their recent ranges. 

In the motor vehicle industry, last year's very strong sales were 
matched by high levels of production, and the stock of inventories, 
especially for light trucks, appeared at times to be higher than the 
industry's desired levels. Nevertheless, the surge in sales late in the 
year helped to pare stocks, and dealers ended the year with inventories 
of light vehicles at a comfortable level. 

Corporate Profits and Business Finance

The profitability of the U.S. nonfinancial corporate sector improved 
from its lows of 2001 but relative to sector output remained at the low 
end of the range experienced over the past thirty years. Economic 
profits of nonfinancial corporations-that is, book profits adjusted for 
inventory valuations and capital consumption allowances-rebounded in 
late 2001 and were little changed through the third quarter of last 
year. The sluggish expansion of aggregate demand and the lack of 
pricing power associated with intense competitive pressures were the 
main factors that held down profits in 2002. Also playing a role, 
especially in the manufacturing sector, were costs arising from 
underfunded defined-benefit pension plans. Reflecting the pause in 
economic growth, earnings reports for the fourth quarter indicate that 
profits may have dropped some late in the year.

A dearth of expenditures on fixed capital and moribund merger and 
acquisition activity were the chief culprits behind the sluggish pace 
of nonfinancial corporate borrowing last year. Also important was the 
propensity of some firms to draw on liquid assets-which began the year 
at high levels-rather than to seek external financing. Consequently, 
debt of the nonfinancial corporate sector expanded only 1-1/2 percent, 
a rate slower than the already subdued pace in 2001. The composition of 
business borrowing was dominated last year, as it was in 2001, by 
longer-term sources of funds. Robust demand for higher-quality 
corporate debt on the part of investors, combined with the desire of 
firms to lock in low interest rates, prompted investment-grade 
corporations to issue a large volume of bonds during the first half of 
2002. With funding needs limited, investment-grade issuers continued to 
use the proceeds to strengthen their balance sheets by refinancing 
higher-coupon bonds and by paying down short-term obligations such as 
bank loans and commercial paper. Buoyed by declining yields, gross 
issuance of below-investment-grade bonds for the most part also held up 
well during the first half, although this segment of the market was hit 
hard after revelations of corporate malfeasance, as investors shunned 
some of the riskiest issues; issuance was especially weak in the 
beleaguered telecom and energy sectors, which continue to be saddled 
with overcapacity and excessive leverage. Despite falling share prices, 
seasoned equity offerings were also well maintained over the first half 
of the year, in part because of the decision of some firms-especially 
in the telecom and energy sectors-to reduce leverage. IPOs, by 
contrast, were sparse. The evaporation of cash-financed mergers and 
acquisitions and desire by firms to conserve cash kept equity 
retirements at their slowest pace since 1994.

Over the summer, investors grew more reluctant to buy corporate bonds 
because of concerns about the reliability of financial statements, 
deteriorating credit quality, and historically low recovery rates on 
defaulted speculative-grade debt. Macroeconomic data suggesting that 
the economic recovery was losing momentum and widespread company 
warnings about near-term profits pushed yields on speculative-grade 
debt sharply higher. Risk spreads on investment-grade bonds also 
widened appreciably in the third quarter, as yields in that segment of 
the corporate bond market declined less than those on Treasury 
securities of comparable maturity. Investors' aversion to risk was also 
heightened by mounting tensions with Iraq; by early autumn, risk 
spreads on junk-rated bonds reached their highest levels in more than a 
decade. Gross bond issuance both by investment-grade and below-
investment-grade firms fell off markedly, and the amount of redemptions 
was large. By the third quarter, net issuance of bonds by nonfinancial 
corporations had turned negative for the first time since the early 
1950s. Trading conditions in the corporate bond market deteriorated 
during this period, as bid-asked spreads  reportedly widened in all 
sectors. With share prices dropping and stock market volatility 
increasing, issuance of seasoned equity nearly stalled in the summer 
and early autumn. IPOs were virtually nonexistent amid widely 
publicized investigations into the IPO allocation process at large 
investment banks. 

A smattering of more upbeat news about the economy in mid-autumn and 
the absence of major revelations of corporate wrongdoing sparked a 
rally in equity prices and rekindled investors' appetite for corporate 
debt. Over the remainder of the year and during early 2003, risk 
spreads narrowed considerably on investment-grade corporate bonds-
especially for the lowest rated of these issues-and even more on 
speculative-grade bonds, although they remained high by historical 
standards. In the meantime, liquidity in the corporate bond market 
generally improved. A brightening of investor sentiment caused a 
rebound in gross bond issuance, with firms continuing to use bond 
proceeds to refinance long-term debt and to pay down short-term debt. 
Rising stock prices and reduced volatility also allowed seasoned equity 
issuance to regain some ground in the fourth quarter. The improved tone 
in corporate debt markets carried over into early 2003. Gross corporate 
bond issuance continued at a moderate pace, and despite the drop in 
stock prices in the latter half of January, seasoned equity issuance 
has been reasonably well maintained.  IPO activity and venture capital 
financing, however, remained depressed.

The heavy pace of bond issuance, sagging capital expenditures, and 
diminished merger and acquisition activity allowed firms to pay down 
large amounts of both business loans at banks and commercial paper last 
year. The runoff in business loans that started in early 2001 
intensified in the first half of 2002. At the same time, commercial 
paper issuers that were perceived as having questionable accounting 
practices encountered significant investor resistance, and most of 
these issuers discontinued their programs. Bond rating agencies stepped 
up the pressure on firms to substitute longer-term debt for shorter-
term debt and thereby reduce rollover risk. In addition, banks raised 
the total cost of issuing commercial paper by tightening underwriting 
standards and boosting fees and spreads on the associated backup lines 
of credit-especially for lower-rated issuers. In doing so, respondents 
to the April Senior Loan Officer Opinion Survey on Bank Lending 
Practices cited heightened concerns about the deterioration of issuers' 
credit quality and a higher probability of lines being drawn. Many 
commercial paper issuers either turned to longer-term financing or 
dropped out of the credit markets altogether, and the volume of 
nonfinancial commercial paper outstanding shrank about one-fourth 
during the first six months of the year after having dropped one-third 
in 2001. 

The volatility that gripped equity and bond markets around midyear, 
however, did not spill over to the commercial paper market. Quality 
spreads in the commercial paper market were largely unaffected, in part 
because many of the riskiest issuers had already exited the market, 
while others had strengthened their cash positions and significantly 
reduced rollover risk earlier in the year. Indeed, because of 
difficulties in the corporate bond market, some nonfinancial firms 
turned temporarily to the commercial paper market to obtain financing, 
and the volume of outstanding paper rose in July after a lengthy period 
of  declines. Over the remainder of the year, business loans at banks 
and commercial paper outstanding contracted rapidly, as inventory 
investment remained negligible, and firms continued to take advantage 
of relatively low longer-term interest rates by issuing bonds.

A decline in market interest rates and improved profitability helped 
reduce the ratio of net interest payments to cash flow in the 
nonfinancial corporate sector last year. Even so, many firms struggled 
to service their debt, and corporate credit quality deteriorated 
markedly. The trailing average default rate on corporate bonds, looking 
back over the preceding twelve months, was already elevated and 
climbing when WorldCom's $26 billion default in July propelled the 
average rate to a record level. The amount of nonfinancial corporate 
debt downgraded by Moody's Investors Service last year was more than 
fourteen times the amount upgraded. At less than 25 percent, the 
average recovery rate in 2002 on all defaulted bonds-as measured by the 
price of bonds at default-was at the low end of recovery rates over the 
past decade. Delinquency rates on business loans at commercial banks 
rose noticeably before stabilizing in the second half of the year, and 
charge-off rates remained quite high throughout 2002.

After expanding rapidly in 2001, commercial mortgage debt grew much 
more slowly during the first quarter of last year, as business spending 
on nonresidential structures fell. Despite the continued contraction in 
outlays on nonresidential structures, commercial mortgage debt 
accelerated over the remainder of the year, apparently because of 
refinancing to extract a significant portion of equity from existing 
properties. The issuance of commercial-mortgage-backed securities 
(CMBS), a key source of commercial real estate financing in recent 
years, was well maintained in 2002. Even as office vacancy rates rose, 
the quality of commercial real estate credit remained stable last year. 
Commercial banks firmed standards on commercial real estate loans in 
2002, on net, and delinquency rates on commercial real estate loans at 
banks stayed at historically low levels. Delinquency rates on CMBS 
leveled off after increasing appreciably in late 2001, and forward-
looking indicators also do not suggest elevated concerns about 
prospective defaults: Yield spreads on CMBS over swap rates remained in 
the fairly narrow range that has prevailed over the past several years.

The Government Sector 

Federal Government

Despite modest economic growth, the federal budget position 
deteriorated sharply in 2002. After running a unified budget surplus of 
$127 billion in fiscal 2001, the federal government posted a deficit of 
$158 billion in fiscal 2002-and that deficit would have been 
$23 billion larger if not for the shifting of some corporate tax 
payments from fiscal 2001 to fiscal 2002. After adjustment for that tax 
shifting, receipts declined 9 percent in fiscal 2002: A $50 billion 
drop in corporate payments stemmed largely from tax provisions enacted 
in the 2002 stimulus bill (especially the partial-expensing provision 
on investment), and a decline in individual tax payments of 
$136 billion was largely attributable to a drop in capital gains 
realizations and to lower tax rates that were enacted in the 2001 tax 
bill.
	
Meanwhile, federal outlays increased nearly 8 percent in fiscal 2002 
and 11 percent excluding a decline in net interest expenses. Spending 
increased notably in many categories, including defense, homeland 
security, Medicaid, and income security (which includes the temporary 
extended unemployment compensation program). Federal government 
consumption and investment-the part of spending that is counted in GDP-
rose more than 7 percent in real terms in 2002. (Government spending on 
items such as interest payments and transfers are not counted in GDP 
because they do not constitute a direct purchase of final production.)

The turn to deficit in the unified budget means that the federal 
government, which had been contributing to  national saving since 1997, 
began to reduce national saving last year. The reversal more than 
offset an increase in saving by households and businesses, and gross 
national saving declined to 15 percent of GDP by the third quarter of 
last year-the lowest national saving rate since the 1940s.

After it reentered the credit markets as a significant borrower of net 
new funds in the second half of 2001, the Treasury continued to tap 
markets in volume last year. Federal net borrowing was especially brisk 
over the first half of the year. With federal debt rapidly approaching 
its statutory borrowing limit, the Secretary of the Treasury declared a 
debt ceiling emergency on May 16 and identified about $80 billion worth 
of accounting measures that could be used to create financing room 
within the existing $5.95 trillion limit. The Secretary's announcement 
and subsequent employment of one of these devices-in which Treasury 
securities held in government trust funds were temporarily replaced by 
Treasury IOUs not subject to the debt ceiling-had little effect on 
Treasury yields, as market participants were apparently confident that 
the ceiling would be raised in time to avoid default. And indeed, the 
Congress approved legislation raising the statutory borrowing limit to 
$6.4 trillion on June 27. With its credit needs remaining substantial, 
the Treasury continued to borrow heavily over the second half of 2002. 
The increase in the Treasury's net borrowing last year caused the ratio 
of publicly held debt to nominal GDP to rise for the first time since 
1993.

State and Local Governments

State and local governments have continued to struggle in response to 
sluggish growth of receipts. In the current fiscal year (which ends 
June 30 for most states), most state governments are reported to be 
facing significant shortfalls. Although a variety of strategies may be 
available for the purpose of technically complying with balanced-budget 
requirements, including tapping nearly $20 billion in combined rainy-
day and general fund balances and turning to the capital markets, many 
states will be forced to boost revenues and hold the line on spending. 

Real expenditures for consumption and gross investment by state and 
local governments rose less than 
2 percent in 2002-the smallest increase in ten years. The slowdown in 
spending growth was widespread across expenditure categories and 
included notably smaller increases in outlays for construction. 
Employment in the state and local sector continued to rise in 2002, but 
at a slower rate than in recent years. 

Debt of the state and local government sector expanded last year at the 
fastest pace since 1987. Governments used the proceeds to finance 
capital spending and to refund existing debt in advance. Net issuance 
of short-term municipal bonds was also well maintained, as California 
and some other states facing fiscal difficulties turned to shorter-term 
borrowing while fashioning more permanent solutions to their budget 
problems. Worsening budget situations contributed to some deterioration 
in municipal credit quality last year. Credit-rating downgrades 
outpaced upgrades by a significant margin, and the yield spread of BBB-
rated over insured AAA-rated municipal bonds rose significantly over 
the second half of 2002.

The External Sector

The U.S. current account deficit widened again in 2002 after a brief 
respite during the cyclical slowdown in 2001. Two-thirds of the 
expansion of the deficit last year was attributable to a decline in the 
balance on goods and services, although net investment income also fell 
sharply as receipts from abroad declined more than payments to foreign 
investors in the United States. The broad exchange value of the dollar 
peaked around February 2002 after appreciating about 13 percent in real 
terms from January 2000; in early February 2003 it was down about 5 
percent from the February 2002 level.   

Trade and the Current Account

Both exports and imports rebounded in 2002 as the cyclical downturn of 
the previous year was reversed and spending on travel recovered from 
the post-September 11 slump. As is often the case, the amplitude of the 
recent cycle in trade has been greater than that of real GDP. In 2001, 
stagnant real GDP in the United States and abroad was coupled with 
declines of 11-1/2 percent in real exports and 8 percent in real 
imports. Last year, moderate growth of both foreign and domestic real 
GDP was exceeded by gains of 5 percent and 9 percent, respectively, in 
our real exports and imports. The faster growth of imports relative to 
exports over the past two years was consistent with the historical 
pattern in which the responsiveness of imports to income is greater in 
the United States than in the rest of the world. Although the dollar 
depreciated on balance last year, the lagged effects of its prior 
appreciation over the two previous years contributed to the faster 
growth in imports relative to exports in 2002. 

Real exports of goods posted a strong gain in the second quarter of 
2002 after six consecutive quarters of 
decline. However, as output growth slowed abroad, exports decelerated 
in the third quarter and then fell in the fourth quarter. On balance, 
exports of goods rose about 2 percent over the course of the year, 
reversing only a small portion of the previous year's decline. Not 
surprisingly, the increase in goods exports in 2002 was concentrated in 
the destinations where GDP growth was strongest-Canada, Mexico, and 
several developing Asian economies. A gain of 12 percent in real 
exports of services in 2002 more than reversed the previous year's 
decline and reflected both a pickup in tourism and an increase in other 
private services. Export prices turned up in the second quarter after a 
year of decline and continued to rise at a moderate pace in the second 
half.

The very rapid growth of real imports of goods in the first half of 
last year was a reaction to the revival of U.S. activity, and they 
gained about 9 percent over the year. The particularly large gains in 
imports of consumer goods and automotive products reflected the 
buoyancy of U.S. consumption expenditures. Imports of most major 
categories of capital goods also increased on balance over the year. 
However, as with exports, import growth was considerably stronger in 
the first half of the year than in the second. This pattern likely 
reflected the deceleration in U.S. GDP, along with the effects of some 
depreciation of the dollar. In addition, there may have been some 
shifting of import demand from later in the year to the earlier months 
as it began to appear more likely that labor contract negotiations at 
West Coast ports would not go smoothly.1 Imports of services more than 
reversed their 2001 decline over the course of the year, and gains were 
recorded for both travel and other private services. Prices of non-oil 
imports turned up in the second quarter after declining over the 
preceding four quarters, as a result of the weaker exchange rate and a 
turnaround in prices of internationally traded commodities.

The spot price of West Texas intermediate crude oil climbed above $35 
per barrel in early 2003, its highest level since the beginning of 
2000. Oil prices had fallen to around $20 per barrel during 2001 amid 
general economic weakness, but they began rising in February and March 
of last year in response to both improving global economic activity as 
well as a production-limiting agreement between OPEC and several major 
non-OPEC producers. Even though production in a number of OPEC and non-
OPEC countries in fact exceeded the agreed limits last year, heightened 
tensions in the Middle East along with severe political turmoil in 
Venezuela  continued to put upward pressure on prices. The pressure 
intensified late in the year as a strike in Venezuela that began on 
December 2 virtually shut down that country's oil industry, and 
Venezuelan oil production was still well below pre-strike levels in 
early 2003. Concern over a possible war with Iraq, along with a very 
low level of crude oil inventories in the United States, has helped to 
keep spot prices high. Also in response to the heightened tensions, the 
price of gold shot up about 30 percent over the past year.

The Financial Account

The increase in the current account deficit in 2002 was about equal on 
balance to the stepped-up foreign official purchases of U.S. assets, as 
changes in the components of private capital flows were offsetting. 
Private foreign purchases of U.S. securities were about $360 billion at 
an annual rate through November, a volume similar to last year's total. 
However, there was some shift in the composition of flows away from 
equities and toward Treasury securities. This shift may have reflected 
the damping of equity demand caused by slower economic growth and 
continued concern about corporate governance and accounting. Over the 
same period, purchases by private U.S. investors of foreign securities 
declined nearly $100 billion. Accordingly, the net balance of private 
securities trading recorded a sharp increase in net inflows. 

In contrast, net foreign direct investment inflows fell about $70 
billion between 2001 and 2002. Foreign 
investment in the United States and investment abroad by U.S. residents 
both declined, but the decline in flows into the United States was 
considerably larger, as merger activity slowed and corporate profits 
showed little vigor. U.S. direct investment abroad held up fairly well 
in 2002, a result largely reflecting retained earnings.

The Labor Market

Employment and Unemployment

Labor markets appeared to stabilize last spring after the sharp 
deterioration of 2001 and early 2002. Employment on private payrolls, 
which had declined an average of 160,000 per month in 2001, leveled off 
in the spring and moved slightly higher over the summer. But labor 
demand weakened again as the economy softened later in the summer, and 
private employment declined about 80,000 per month on average in the 
last four months of the year. Private payrolls rebounded nearly 150,000 
in January, though the magnitude of both the especially sharp decline 
in December and the rebound in January likely was exaggerated by 
difficulties in adjusting for the normal seasonal movements in 
employment during these months.

The manufacturing sector continued to be the weakest segment of the 
labor market; even during the spring and early summer, when the overall 
labor market seemed to be improving, factory payrolls contracted on 
average. Declines in factory employment were more pronounced-at about 
50,000 per month-toward the end of the year. Employment at help-supply 
firms and in wholesale trade-two sectors in which activity closely 
tracks that of manufacturing proper-rose over the summer but also 
turned down again later in the year. And employment in retail trade, 
though quite erratic, leveled off over the summer before declining 
further in the fall. However, employment in services other than help 
supply grew reasonably steadily throughout the year and rose nearly 
50,000 per month after March; health services and education services 
contributed more than half of those job gains. The finance and real 
estate sectors also added jobs last year, probably because of the surge 
in mortgage refinancings and high levels of activity in housing 
markets. Last year's job losses in the private sector were partially 
offset by an increase in government employment that averaged about 
20,000 per month; the increase resulted mostly from hiring by states 
and municipalities, but it also reflected hiring in the fall by the 
Transportation Security Administration.

Overall employment moved lower, on net, and the unemployment rate 
increased a little less than  percentage point over the year, to 
6 percent, before dropping back to 5.7 percent in January 2003. The 
unemployment rate probably has been boosted slightly by the federal 
temporary extended unemployment compensation program. By extending 
benefits for an additional three months, the program allows unemployed 
individuals whose regular benefits have expired to be more selective in 
accepting job offers and provides them with an incentive not to 
withdraw from the labor force. In addition, as would be 
expected in a still-weak labor market, the labor force participation 
rate moved lower last year. 

Productivity and Labor Costs

Labor productivity rose impressively in 2002. Output per hour in the 
nonfarm business sector increased an estimated 3-3/4 percent from the 
fourth quarter of 2001 to the fourth quarter of 2002. Labor 
productivity typically suffers in an economic downturn as businesses 
reduce hours worked by proportionally less than the decline in output; 
conversely, productivity typically rebounds early in an expansion as 
labor is brought back toward fuller utilization. During the most recent 
downturn, however, productivity held up comparatively well, a 
performance that makes last year's surge all the more impressive. 
Indeed, productivity rose at an average annual rate of nearly 3 percent 
over the past two years, faster than the average pace of increase 
during the late 1990s.

Very likely, the rapid pace of last year's productivity growth was due 
in part to the special circumstances that developed after the September 
11 attacks. Businesses cut labor substantially in late 2001 and early 
2002 amid widespread fear of a sharp decline in demand; when demand 
held up better than expected, businesses proved able to operate 
satisfactorily with their existing workforces. Moreover, the fact that 
this step-up in productivity was not reversed later in the year 
suggests that at least a portion of it is sustainable. The recent rapid 
growth in productivity may derive in part from ongoing improvements in 
the use of the vast amount of capital installed in earlier years, and 
it may also stem from organizational innovations induced by the weak 
profit environment.

Indicators of hourly compensation sent mixed signals last year. The 
rise in the employment cost index (ECI) for hourly compensation in 
private nonfarm businesses, 3-1/4 percent, was 1 percentage point lower 
than the increase in 2001. Compensation increases likely were damped 
last year by the soft labor market and expectations of lower consumer 
price inflation. The wages and salaries component and the benefits 
component of the ECI both posted smaller increases last year. The 
deceleration was less pronounced for the benefits component, however, 
which was boosted by further large increases in employers' health 
insurance costs. According to the ECI, health insurance costs, which 
constitute about 6 percent of overall compensation, rose 10 percent 
last year after having risen about 9 percent in each of the preceding 
two years.

An alternative measure of compensation costs is compensation per hour 
in the nonfarm business sector, which is derived from information in 
the national income and product accounts. According to this measure, 
hourly compensation rose 4-1/4 percent last year-a little more than the 
increase in the ECI and up from a much smaller increase in 2001. One 
important difference between these two measures of compensation is that 
the ECI omits stock options, while nonfarm compensation per hour 
captures the value of these options upon exercise. The very small 
increase in the latter measure in 2001 likely reflects, in part, a drop 
in option exercises in that year, and the larger increase in 2002 may 
point to a firming, or at least to a smaller rate of decline, of these 
exercises.

Prices

The chain-type price index for personal consumption expenditures (PCE) 
rose about 2 percent last year, compared with an increase of 1-1/2 
percent in 2001. This step-up in consumer price inflation resulted from 
a jump in energy prices. Outside of the energy sector, consumer price 
inflation was pushed lower last year by continued slack in labor and 
product markets as well as by expectations of future inflation that 
appeared to be lower in 2002 than in most of 2001. The increase in PCE 
prices excluding food and energy, which was just 1-3/4 percent, was 
about 1/4 percentage point less than in 2001. The price index for GDP 
was less affected by last year's rise in energy prices than was the PCE 
measure; much of the energy price increase was attributable to higher 
prices of imported oil, which are not included in GDP because they are 
not part of domestic production. On net, GDP prices rose only 1-
1/4 percent last year, a deceleration of 3/4 percentage point that 
reflected not just the deceleration in core consumer prices but also 
considerably smaller increases for prices of construction.

The upturn in consumer energy prices in 2002 was driven by a jump in 
crude oil prices. Gasoline prices 
increased some 25 percent from December 2001 to December 2002; prices 
of fuel oil increased considerably as well. By contrast, consumer 
prices of natural gas posted only a modest rise after declining sharply 
in 2001, and electricity prices moved lower. More recently, the rise in 
crude oil prices since mid-December, together with cold weather, has 
increased the demand for natural gas and has led to higher spot gas 
prices; the higher spot prices for both oil and gas are likely to be 
boosting consumer energy prices early this year. 

The PCE price index for food and beverages increased only 1-1/2 percent 
last year; the increase followed a 3 percent rise in 2001 that 
reflected supply-related price increases for many livestock products 
including beef, poultry, and dairy products. But livestock supplies had 
recovered by early last year, and a drought-induced selloff of cattle 
herds last summer pushed prices still lower.

The prices of goods other than food and energy items decelerated 
sharply last year. Prices for apparel, new and used motor vehicles, and 
a wide range of other durable goods all declined noticeably and, on 
average, at a faster pace than in 2001. Price increases for services 
were much larger than for goods and slowed less from the previous year. 
Both tenants' rent and the imputed rent of owner-occupied housing-
categories that account for a sizable share of services-rose 
significantly less last year than they did in 2001. But many other 
services prices posted increases in 2002 that were about the same as in 
2001. Information on medical prices was mixed. According to the CPI, 
the price of medical services continued to accelerate, rising 
51/2 percent last year. But the increase in the PCE measure of medical 
services prices was less than 3 percent, a smaller increase than in 
2001. One reason for this difference is that the prices of services 
paid for by Medicare and Medicaid are included in the PCE index but not 
in the CPI (because services provided by Medicare and Medicaid do not 
represent out-of-pocket costs to consumers and so are outside of the 
CPI's scope), and Medicare reimbursement rates for physicians were 
reduced last year. 

Despite the acceleration in medical prices in the CPI but not in the 
PCE price index, the CPI excluding food and energy decelerated notably 
more than did the core PCE price index between 2001 and 2002. The two 
price measures differ in a number of respects, but much of last year's 
greater deceleration in the CPI can be traced to the fact that the CPI 
suffers from a form of "substitution bias" that is not present in the 
PCE index. The CPI, being a fixed-weight price index, overstates 
increases in the cost of living because it does not adequately take 
into account the fact that consumers tend to substitute away from goods 
that are rising in relative price; by contrast, the PCE price index 
does a better job of taking this substitution into account. Last year, 
the Bureau of Labor Statistics began to publish a new index called the 
chained CPI; like the PCE price index, the chained CPI does a more 
complete job of taking consumer substitution into account, but it is 
otherwise identical to the official CPI. In 2001, an unusually large 
gap between increases in the official CPI and the chained CPI arose, 
pointing to very large substitution bias in the official CPI in that 
year. This gap narrowed in 2002, indicating that substitution bias 
declined between the two years. (Final estimates of the chained CPI are 
not yet available; the currently available data for both 2001 and 2002 
are preliminary and subject to revision.) 

Survey measures of expected inflation generally ran a little lower in 
2002 than in 2001. According to the Michigan SRC, median one-year 
inflation expectations plummeted after the September 11 attacks, but by 
early 2002, expectations returned to the 2-3/4 percent range that had 
prevailed during the previous summer. These expectations gradually 
moved lower over the course of last year and now stand around 2-
1/2 percent. Meanwhile, the Michigan SRC's measure of five- to ten-year 
inflation expectations remained steady at about 2-3/4 percent during 
2002, a rate a little lower than the 3 percent inflation expectations 
that had prevailed through most of 2001.

U.S. Financial Markets

Developments in financial markets last year were shaped importantly by 
sharp declines, on net, in equity prices and most long-term interest 
rates and by periods of heightened market volatility. In contrast to 
2001, when the Federal Reserve eased the stance of monetary policy 
eleven times, last year saw one reduction in the intended federal funds 
rate-in early November-and interest rates on short-term Treasury 
securities had moved little until then. Longer-term interest rates, by 
contrast, were more volatile. Investors' optimism about future economic 
prospects pressured longer-term Treasury bond yields higher early in 
2002. But as the year progressed, that optimism faded when the economy 
failed to gather much momentum, and longer-term Treasury yields ended 
the year appreciably lower. Softer-than-expected readings of the 
economic expansion, a marked deterioration in corporate credit quality, 
concerns about corporate governance, and heightened geopolitical 
tensions made investors especially wary about risk. Lower-rated firms 
found credit substantially more expensive, as risk spreads on 
speculative-grade debt soared for most of the year before narrowing 
somewhat over the last few months. Even for higher-quality firms, risk 
spreads widened temporarily during the tumultuous conditions that 
prevailed in financial markets over the summer. In addition, commercial 
banks tightened standards and terms for business borrowers, on net, in 
2002, and risk spreads on business loans remained in an elevated range 
throughout the year. Increased caution on the part of investors was 
particularly acute in the commercial paper market, where the riskiest 
issuers discontinued their programs.

Federal borrowing surged last year, while private borrowing was held 
down by the significantly reduced credit needs of business borrowers. 
Declines in longer-term interest rates during the first half of the 
year created incentives for both businesses and households to lock in 
lower debt-service obligations by heavily tapping corporate bond and 
home mortgage markets, respectively. While mortgage borrowing remained 
strong, businesses sharply curtailed their issuance of longer-term debt 
during the second half of 2002 amid the nervousness then prevailing in 
the financial markets.

Interest Rates

Reflecting an unchanged stance of monetary policy over most of last 
year, short-term market interest rates moved little until early 
November, when the FOMC lowered the target federal funds rate 1/2 
percentage point, and other short-term interest rates followed suit. 
Yields on intermediate- and long-term Treasury securities, by contrast, 
declined as much as 1-1/2 percentage points, on net, in 2002. Longer-
term interest rates began last year under upward pressure, as signs 
that the economy had bottomed out started to nudge rates higher in the 
final weeks of 2001. Positive economic news pushed interest rates up 
appreciably further during the first quarter of 2002. The increase in 
longer-term interest rates was consistent with the sharp upward tilt of 
money market futures rates, which suggested that market participants 
expected that the FOMC would almost double the intended level of the 
funds rate by year's end. However, as readings on the strength of the 
economic expansion came in on the soft side, investors substantially 
trimmed their expectations for policy tightening, and yields on longer-
term Treasury securities turned down in the spring. 

The slide in longer-term Treasury yields intensified over the summer 
amid weaker-than-expected economic data, heightened geopolitical 
tensions, fresh revelations of corporate malfeasance, and disappointing 
news about near-term corporate profits. In concert, these developments 
prompted investors to mark down their expectations for economic growth 
and, consequently, their anticipated path for monetary policy. A 
widespread retrenchment in risk-taking sent yields on speculative-grade 
corporate bonds sharply higher and kept those on the lower rungs of 
investment grade from declining, even as longer-term nominal Treasury 
yields fell to very low levels by the end of July.

The uneventful passing of the Securities and Exchange Commision's 
August 14 deadline for officers of large companies to certify corporate 
financial statements somewhat assuaged investors' anxieties about 
corporate governance problems. But subsequent news suggesting that the 
economy was losing momentum and a flare-up in tensions with Iraq 
further boosted demand for Treasury securities. The FOMC's decision at 
the August meeting-to leave the intended federal funds rate unchanged 
but to judge the balance of risks to the outlook as weighted toward 
economic weakness-pulled the expected path of the funds rate lower, and 
longer-term Treasury yields sank to forty-year lows in early autumn. A 
high degree of investor uncertainty about the future path of monetary 
policy was evidenced by implied volatilities of short-term interest 
rates derived from option prices, which soared to record levels in 
early autumn. The size of the FOMC's November cut in the target federal 
funds rate and the shift to balance in its assessment of risks 
surprised market participants, but the policy easing appeared to lead 
investors to raise the odds that the economy would pick up from its 
sluggish pace. Generally positive economic news and rising equity 
prices over the remainder of the year also bolstered confidence and 
prompted market participants to mark up the expected path for monetary 
policy and push up longer-term Treasury yields.

Yields on higher-quality investment-grade corporate bonds generally 
tracked those on Treasuries of comparable maturity last year, although 
risk spreads on these instruments widened moderately over the summer 
and early autumn before narrowing over the remainder of the year. 
Interest rates on below-investment-grade corporate debt, by contrast, 
increased for much of last year, as spreads over Treasuries ballooned 
in response to mounting concerns about corporate credit quality, 
historically low recovery rates on defaulted bonds, and revelations of 
improper corporate governance; credit risk spreads widened in all 
speculative sectors but especially in telecom and energy. By the 
summer, investors' retreat from risk-taking had widened bid-asked 
spreads in the corporate bond market enough to impair trading. Risk 
spreads on speculative-grade bonds narrowed considerably over the 
year's final quarter and in early 2003, though they remain elevated by 
historical standards; risk spreads for the weaker speculative-grade 
credits remain exceptionally wide, as investors evidently anticipate a 
continued high level of defaults and low recovery rates.

Equity Markets	

Equity prices were buffeted last year by considerable fluctuations in 
investors' assessments of the outlook for the economy and corporate 
earnings and by doubts about the quality and transparency of corporate 
balance sheets. Net declines in stock prices in 2002 exceeded those 
posted during either of the preceding two years. Worries about the 
pervasiveness of questionable corporate governance and a deterioration 
in the earnings outlook-especially in the technology sector-depressed 
equity prices in early 2002. The positive tenor of economic data, 
however, managed to outweigh those concerns, and stock prices staged a 
rally halfway through the first quarter, with the gains tilted toward 
"old economy" firms. But the rebound was short lived. Share prices 
started to tumble in early spring across all sectors as weaker-than-
expected economic data eroded investors' confidence in the strength of 
the economic expansion. These developments were reinforced by first-
quarter corporate earnings reports that, though mostly matching or 
exceeding investors' expectations, painted a bleak picture of 
prospective sales and profits. 

Over the spring and summer, accounting scandals, widespread warnings 
about near-term corporate profitability, and heightened geopolitical 
tensions intensified the slide in stock prices. Particularly large 
declines in share prices were posted for technology firms, whose 
prospects for sales and earnings were especially gloomy. Equity prices 
were boosted briefly by the uneventful passing of the August 14 
deadline to certify financial statements, but they quickly reversed 
course on continued concerns about the pace of economic growth and 
corporate earnings and the escalating possibility of military action 
against Iraq. By early October, equity indexes sank to their lowest 
levels since the spring of 1997, and implied stock price volatility on 
the S&P 100 surged to its highest reading since the stock market crash 
of 1987. The drop in stock prices widened the gap between the expected 
year-ahead earnings-price ratio for the S&P 500 and the real ten-year 
Treasury yield-one simple measure of the equity premium-to levels not 
seen since the mid-1990s.

Share prices turned around in late October, as the third-quarter 
corporate earnings reports were not as weak as investors had originally 
feared. Equity prices were also given a boost in early November by the 
larger-than-expected monetary policy easing, and the rally was 
sustained over the remainder of the year by the generally encouraging 
tone of economic data. Greater confidence among investors in the 
economic outlook also helped bring down the implied volatility on the 
S&P 100 significantly by year-end, although it remains at an elevated 
level by historical standards. Despite the fourth-quarter rebound, 
broad equity indexes were down, on net, about 20 percent in 2002, while 
the tech-heavy Nasdaq lost more than 30 percent. 

The decline in equity prices during the first three quarters of 2002 is 
estimated to have erased more than 
$3-1/2 trillion in household wealth, a loss of nearly 9 percent of 
total household net worth, although the fourth-quarter rise in stock 
prices restored about $600 billion. Still, the level of household net 
worth at the end of last year was more than 40 percent higher than it 
was at the start of the bull market in 1995. Equity prices maintained 
their upward momentum during the first half of January 2003 but then 
fell sharply amid the looming prospects of military action against Iraq 
and a still-gloomy outlook for corporate earnings. Broad stock price 
indexes have lost almost 5 percent this year; however, solid fourth-
quarter earnings from many prominent technology companies helped 
brighten investors' sentiment regarding that sector, and the Nasdaq is 
down about 3 percent this year.

Debt and Financial Intermediation

A deceleration of business borrowing slowed growth of the debt of 
nonfederal sectors about 1 percentage point in 2002, to 6-1/2 percent. 
By contrast, the decline in interest rates last year kept borrowing by 
households and state and local governments brisk. At the federal level, 
weak tax receipts and an acceleration in spending pushed debt growth to 
7-1/2 percent last year after a slight contraction in 2001.

For the year as a whole, corporate borrowing was quite weak, mainly 
because of sagging capital expenditures, a drying up of merger and 
acquisition activity, and a reliance on liquid assets. Although 
businesses tapped bond markets in volume over the first half of the 
year, subsequent concerns about the reliability of financial statements 
and the quality of corporate governance and deteriorating 
creditworthiness ruined investors' appetite for corporate debt in the 
summer and early autumn. Households, by contrast, flocked to the 
mortgage markets to take advantage of low mortgage rates throughout the 
year, and strong motor vehicle sales supported the expansion of 
consumer credit. For depository institutions, the net effect of these 
developments was an acceleration of credit to 6-1/2 percent last year, 
2 percentage points above the pace of 2001. The growth of credit at 
thrift institutions moderated, though the slowdown can be attributed 
for the most part to a large thrift institution's conversion to a bank 
charter. The growth of credit at commercial banks accelerated to 6-3/4 
percent-a significant increase from the anemic pace in 2001; the pickup 
was driven by large acquisitions of securities, especially mortgage-
backed securities, as well as a surge in home equity and residential 
real estate lending. 
	
By contrast, business lending at commercial banks dropped 7 percent 
last year after falling almost 4 percent in 2001; last year's decline 
kept overall loan growth for 2002 to about 5 percent. In the October 
Senior Loan Officer Opinion Survey on Bank Lending Practices, 
respondents noted that the decline in commercial and industrial (C&I) 
lending since the beginning of the year reflected not only the limited 
funding needs of creditworthy borrowers that found bond financing or a 
runoff of liquid assets more attractive, but also a reduction in the 
pool of creditworthy borrowers. Over the course of last year, banks 
reported some additional net tightening of standards and terms on C&I 
loans, mainly in response to greater uncertainty about the economic 
outlook and rising corporate bond defaults, although the proportions of 
banks that reported doing so declined noticeably. Direct measures of 
loan pricing conditions from the Federal Reserve's quarterly Survey of 
Terms of Business Lending also indicated that banks were cautious 
lenders last year, as the average spread of C&I loan rates over market 
interest rates on instruments of comparable maturity remained wide, and 
spreads on new higher-risk loans declined only slightly from the lofty 
levels that prevailed over the first half of the year. Although bank 
lenders were wary about business borrowers, especially toward lower-
rated credits, they did not significantly constrict the supply of 
loans: Most small firms surveyed by the National Federation of 
Independent Businesses in 2002 reported that they experienced little or 
no difficulty satisfying their borrowing needs.    

Loan quality at commercial banks improved overall last year. Loan 
delinquency rates edged down through the third quarter of 2002-the 
latest period for which Call Report data are available-in response to 
better performance of residential real estate and consumer loans and a  
stable delinquency rate on C&I loans. Despite the improvement in 
consumer loan quality, domestic banks imposed somewhat more stringent 
credit conditions when lending to households, according to the survey 
on bank lending practices. Moderate net proportions of surveyed 
institutions tightened credit standards and terms for credit card and 
other consumer loans throughout last year. The net fraction of banks 
that tightened standards on residential mortgage loans rose late in the 
year to the highest share in the past decade, but nonetheless remained 
quite low. Commercial banks generally registered strong profit gains 
last year, although steep losses on loans to energy and 
telecommunications firms significantly depressed profits at several 
large bank holding companies. Despite the increased rate of 
provisioning for loan losses, the banking sector's profitability stayed 
in the elevated range recorded for the past several years, as a result 
of the robust fee income from mortgage and credit card lending, 
effective cost controls, and the relatively inexpensive funding offered 
by inflows of core deposits. As of the third quarter of last year, 
virtually all assets in the banking sector were at well-capitalized 
institutions, and the substitution of securities for loans on banks' 
balance sheets helped edge up risk-based capital ratios. 

The financial condition of insurance companies, by contrast, worsened 
notably last year. Both property and casualty insurers and life and 
health insurers sustained significant investment losses from the 
decline in equity prices and the deterioration in corporate credit 
quality. However, these negative pressures were offset somewhat by the 
continued strong growth of insurance premiums, and both sectors of the 
insurance industry stayed fairly well capitalized in 2002.   

Monetary Aggregates

The broad monetary aggregates decelerated noticeably last year after 
surging in 2001. Short-term market interest rates, which had declined 
swiftly during 2001, were stable over the first half of the year; 
deposit rates, in a typical pattern of lagged adjustment, continued to 
fall. Consequently, the opportunity cost of holding M2 assets 
increased, especially for its liquid deposit (checking and savings 
accounts) and retail money fund components,  thereby restraining the 
demand for such assets. After decelerating in the first half of the 
year, M2 rebounded significantly in the second half, because of a surge 
in liquid deposits and retail money market mutual funds. The strength 
in both components partly reflected elevated volatility in equity 
markets against the backdrop of a still-low opportunity cost of holding 
such deposits. In addition, another wave of mortgage refinancing 
boosted M2 growth during this period. (Refinancings cause prepayments 
to accumulate temporarily in deposit accounts before being distributed 
to investors in mortgage-backed securities.) All told, over the four 
quarters of the year, M2 increased 7 percent, a pace that exceeded the 
expansion of nominal income. As a result, M2 velocity-the ratio of 
nominal GDP to M2-declined for the fifth year in a row, roughly in line 
with the drop in the opportunity cost of M2 over this period. 

Reflecting in part the slowing of its M2 component, M3-the broadest 
money aggregate-expanded 
6-1/2 percent in 2002, a pace well below the 12-3/4 percent advance 
posted in 2001. Growth in M3 was also held down by a sharp deceleration 
of institutional money funds, as their yields dropped to close 
alignment with short-term market interest rates. This effect was only 
partly offset by the pickup in needs to fund bank credit, which 
resulted in an acceleration in the issuance of managed liabilities, 
including large time deposits. M3 velocity continued to decline in 
2002.

New Discount Window Programs 

On October 31, 2002, following a three-month public comment period, the 
Board of Governors approved changes to its Regulation A that 
established two new types of loans to depository institutions-primary 
and secondary credit-and discontinued the adjustment and extended 
credit programs. The new programs were implemented on January 9, 2003. 
The seasonal credit program was not altered.

The primary reason for adopting the new programs was to eliminate the 
subsidy to borrowing institutions that was implicit in the basic 
discount rate, which since the late 1960s had usually been set below 
market interest rates. The subsidy required Federal Reserve Banks to 
administer credit extensions heavily in order to ensure that borrowing 
institutions used credit only in appropriate circumstances-
specifically, when they had exhausted other reasonably available 
funding sources. That administration was necessarily somewhat 
subjective and consequently difficult to apply consistently across 
Reserve Banks. In addition, the heavy administration was one factor 
that caused depository institutions to become reluctant to use the 
window even in appropriate conditions. Also, depository institutions 
were concerned at times about being marked with a "stigma" if market 
analysts and counterparties inferred that the institution was borrowing 
from the window and suspected that the borrowing signaled that the 
institution was having financial difficulties. The resulting reluctance 
to use the window reduced its usefulness in buffering shocks to the 
reserve market and in serving as a backup source of liquidity to 
depository institutions, and thus undermined its performance as a 
monetary policy tool.

To address these issues, the Board of Governors specified that primary 
credit may be made available at an above-market interest rate to 
depository institutions in generally sound financial condition. The 
above-market interest rate eliminates the implicit subsidy. Also, 
restricting eligibility for the program to generally sound institutions 
should reduce institutions' concerns that their borrowing could signal 
financial weakness.

The Federal Reserve set the initial primary credit rate at 2.25 
percent, 100 basis points above the FOMC's target federal funds rate as 
of January 9, 2003. The target federal funds rate remained unchanged, 
and thus the adoption of the new programs did not represent a change in 
the stance of monetary policy. In the future, the primary credit rate 
will be adjusted from time to time as appropriate, using the same 
discretionary procedure that was used in the past to set the adjustment 
credit rate. The Federal Reserve also established procedures to reduce 
the primary credit rate to the target federal funds rate in a national 
emergency, even if key policymakers are unavailable.

Institutions that do not qualify for primary credit may obtain 
secondary credit when the borrowing is consistent with a prompt return 
to market sources of funds or is necessary to resolve severe financial 
difficulties. The interest rate on secondary credit is set by formula 
50 basis points above the primary credit rate. The rate was set 
initially at 2.75 percent. Because secondary credit borrowers are not 
in sound financial condition, extensions of secondary credit usually 
involve some administration.

International Developments

The international economy rebounded in 2002 after a stagnant 
performance in 2001, but recovery was uneven in both timing and 
geographical distribution. Growth abroad picked up sharply in the first 
half of last year, as a strong rally in the high-tech exporting 
economies in developing Asia was joined by robust growth in Canada and, 
to a lesser extent, Mexico. Japan also posted respectable growth in the 
first half, largely as a result of a surge of exports. However, 
performance in the euro area remained sluggish, and several South 
American economies experienced difficulties, with full-fledged crises 
in Argentina and Venezuela and mounting concerns about prospects for 
Brazil. As the U.S. economy decelerated in the second half, the rapid 
pace of recovery slowed in developing Asia and in Canada, while 
performance remained lackluster in much of the rest of the world. 

Monetary policy actions abroad also diverged across countries in 2002 
as authorities reacted to differing economic conditions. In Canada, 
official interest rates were raised in three steps by July amid 
concerns that buoyant domestic demand and sharply rising employment 
would ignite inflationary pressures. Monetary authorities in Australia 
and Sweden also increased policy rates in the first half of the year. 
However, as economic conditions weakened around the world in the second 
half, official interest rates were held constant in Canada and 
Australia and were lowered in Sweden. Monetary policy was held steady 
throughout 2002 in the United Kingdom, where growth was moderate and 
inflation subdued, but official interest rates were lowered 25 basis 
points, to 3.75 percent, in early February 2003 in response to concerns 
about the prospects for global and domestic demand. The European 
Central Bank (ECB) held rates constant through most of the year, as 
inflation remained above the ECB's 2 percent target ceiling, but rates 
were lowered 50 basis points in December as the euro area's already 
weak recovery appeared to be stalling. Japanese short-term interest 
rates remained near zero, while authorities took some limited further 
steps to stimulate demand through nontraditional channels. Monetary 
policy was tightened in both Mexico and Brazil in response to concerns 
about the inflationary effects of past currency depreciation. 

Yield curves in the major foreign industrial countries steepened and 
shifted up in the first quarter of 2002 in response to generally 
favorable economic news, but later they flattened out and moved back 
down as the outlook deteriorated. Similarly, equity prices in the major 
foreign industrial economies held up well early in the year but then 
declined along with the U.S. stock market and ended the year down 
sharply from the previous year. The performance of the stock markets in 
the emerging-market economies was mixed. Share prices in Brazil and 
Mexico fell sharply in the second and third quarters but then showed 
some improvement toward the end of the year. In the Asian emerging-
market economies, equity prices rose in the first half of 2002 on a 
general wave of optimism, especially in the high-technology producing 
economies; equity prices began to decline around midyear as global 
demand softened but posted modest rebounds late in the year. 

The foreign exchange value of the dollar continued its mild upward 
trend into the early part of 2002, as it appeared that the United 
States was poised to lead a global economic recovery. However, the 
dollar weakened sharply in the late spring and early summer amid 
deepening concerns about U.S. corporate governance and profitability. 
Around that time market analysts also appeared to become more worried 
about the growing U.S. current account deficit and its potential 
negative influence on the future value of the dollar. The dollar 
rebounded somewhat around midyear as growth prospects for other major 
economies, particularly in the euro area, appeared to dim; the dollar 
dropped back again late in the year as geopolitical tensions 
intensified, and continued to depreciate in early 2003. In nominal 
terms the dollar has declined about 5 percent on balance over the past 
year, with depreciations against the currencies of the major 
industrial countries and several of the developing Asian economies 
partly offset by appreciation against the currencies of several Latin 
American countries. 

Industrial Economies

The Canadian economy recorded the strongest performance among the major 
foreign industrial countries last year despite some slowing in the 
second half. The strength, which was largely homegrown, reflected 
robust growth of consumption and residential construction as well as an 
end to inventory runoffs early in the year. The expansion was 
accompanied by very rapid increases in employment and utilization of 
capacity, and the core inflation rate breached the upper end of the 
government's 1 percent to 3 percent target range near the end of the 
year. The Canadian dollar appreciated against the U.S. dollar in the 
first half of the year, but it dropped back somewhat in the second half 
as the economy slowed; by the end of the year it was up only slightly 
on balance. The Canadian dollar has moved up somewhat more so far this 
year. 

The Japanese economy recorded positive growth during 2002, although it 
was not enough to fully reverse the decline in output that occurred in 
2001. Despite about 10 percent appreciation of the yen against the 
dollar in 2002, Japanese growth was driven largely by exports, with 
smaller contributions from both increased consumption and a slower pace 
of inventory reduction. In contrast, private investment continued to 
decline, although not as sharply as in 2001. Labor market conditions 
remained quite depressed, and consumer prices continued to fall. Little 
progress was made on the serious structural problems that have plagued 
the Japanese economy, including the massive and growing amount of bad 
loans on the books of Japanese banks. A new set of official measures 
that aims at halving the value of bad loans within two and a half years 
was announced in the fall, but the details of this plan are still not 
fully specified. In September, 
the Bank of Japan announced a plan to buy shares from banks with 
excessive holdings of equity, which would help to reduce bank exposure 
to stock market fluctuations. Because the transactions are to occur at 
market prices, there would be no net financial transfer to the banks. 
Near the end of last year the Bank of Japan (BOJ) raised its target 
range for bank reserves at the BOJ from 10-15 trillion to 15-20 
trillion, increased the monthly amount of its outright purchases of 
long-term government bonds, and broadened the range of collateral that 
can be used for market operations. In December the monetary base was up 
about 20 percent from a year earlier, a rise partially reflecting the 
increased level of bank reserves at the BOJ. However, the twelve-month 
rate of base money growth was considerably below the 36 percent pace 
registered in April. Broad money growth remains subdued.

Economic performance in the euro area was quite sluggish last year. 
Although exports were up sharply, growth in consumption was modest, and 
private investment declined. The area's lackluster economic performance 
pushed the unemployment rate up by several tenths of a percentage point 
by the end of the year. Economic weakness was particularly pronounced 
in some of the larger countries-Germany, Italy, the Netherlands, and, 
to a lesser extent, France. In contrast, growth in Spain and some of 
the smaller euro-area countries-Ireland, Portugal, Finland, and Greece-
was much more robust. Headline inflation jumped to a bit above 2-1/2 
percent early in the year, owing to higher food and energy prices and 
in small part to the introduction of euro notes and coins. Increased 
slack in the economy, however, together with the 15 percent 
appreciation of the euro by the end of the year, helped to mitigate 
inflation concerns, and the ECB lowered its policy interest rate in 
December. The euro continued to appreciate in early 2003.

Economic growth in the United Kingdom held up better than in the other 
major European countries last year, and sterling strengthened about 10 
percent versus the dollar. However, the expansion remained uneven, with 
the services sector continuing to grow more rapidly than the smaller 
manufacturing sector. Despite tight labor markets, inflation remained a 
bit below the Bank of England's target of 21/2 percent for most of the 
past year. A sharp rise in housing prices has, however, raised some 
concern about the possibility of a real estate price bubble. The 
British government announced its intention to complete a rigorous 
assessment of its criteria for joining the European Monetary Union 
(EMU) by the middle of this year and, if they are met, to hold a 
referendum on entry.

Emerging-Market Economies 

The Brazilian economy posted a surprisingly strong rebound in 2002 
despite a major political transition and accompanying turbulence in 
financial markets. The Brazilian real depreciated sharply between May 
and October, and sovereign bond spreads climbed to 2,400 basis points 
as it became increasingly likely that Luiz Inacio Lula da Silva (Lula), 
the Workers' Party candidate, would win the presidential election. 
Given some of the past stances of the party, this possibility fueled 
concerns among foreign investors about a potential erosion of fiscal 
and monetary discipline. In response to the sharp deterioration in 
financial conditions facing Brazil, a $30 billion IMF program was 
approved in September 2002, $6 billion of which was disbursed by the 
end of the year. However, financial conditions improved markedly after 
Lula won the election in late October and appointed a cabinet perceived 
to be supportive of orthodox fiscal and monetary policies, including 
greater central bank independence. By January 2003 the real had 
reversed about one-fourth of its previous decline against the dollar, 
and bond spreads had fallen sharply. However, the new administration 
still faces some major challenges. In particular, serious concerns 
remain over the very large quantity and relatively short maturity of 
the outstanding government debt. In addition, last year's currency 
depreciation fueled a rise in inflation that has prompted several 
increases in the monetary policy interest rate. In January the 
government raised the upper bound of its inflation target range for 
this year to 8.5 percent from 6.5 percent, although the target for next 
year was lowered at the same time to 5.5 percent from 6.25 percent. 

Argentine GDP contracted further in 2002 after declining 10 percent in 
2001. The currency board arrangement that had pegged the peso at a one-
to-one rate with the dollar collapsed early last year; the peso lost 
nearly three-fourths of its value by late June, and sovereign bond 
spreads spiked to more than 7,000 basis points. By early 2002, the 
banking system had become effectively insolvent as a result of the 
plunging peso, the weak economy, and the government's default on debt 
that the banks held mostly involuntarily. Confronted with this 
situation, the government forced the conversion of the banks' dollar-
denominated assets and liabilities to pesos and also mandated the 
rescheduling of a large share of deposits. As a result of these and 
other measures, confidence in the banking system, already shaken, was 
further impaired. Financial and economic conditions eventually 
stabilized in the second half of the year, but there are no signs yet 
of a sustained recovery. The government also defaulted on obligations 
to multilateral creditors in late 2002 and early 2003. In January, 
Argentina and the International Monetary Fund reached agreement on a 
$6.6 billion short-term program that will go to meeting Argentina's 
payments to the IMF at least through the elections expected in the 
spring and also to clearing its overdue obligations to the multilateral 
development banks.

Venezuela experienced extreme economic and political turmoil over the 
past year. In February 2002 the central bank abandoned the bolivar's 
crawling peg to the dollar, and the bolivar depreciated sharply. 
Opponents of President Hugo Chavez mounted a short-lived coup in April 
and declared a national strike in early December. The strike brought 
the already-weak economy to a standstill, and output in the key oil 
industry plummeted. The strike abated in early February in all sectors 
but oil. In response to the strike, Chavez increased his control of the 
state-owned oil company and oil production began rising in early 2003, 
but it was still well below pre-strike levels. With the exchange rate 
plunging in late January, the government suspended currency trading for 
two weeks before establishing a fixed exchange rate regime and some 
restrictions on foreign currency transactions.

One of the few bright spots in Latin America last year was the Mexican 
economy. Boosted by the U.S. recovery, growth was moderate for the year 
as a whole despite some late slowing. However, financial conditions 
deteriorated somewhat after midyear as market participants reevaluated 
the strength of the North American recovery. Mexican stock prices slid 
about 25 percent between April and September, and sovereign bond 
spreads widened nearly 200 basis points to around 430 basis points over 
the same period. Nevertheless, the Mexican economy did not appear to be 
much affected by spillovers from the problems elsewhere in Latin 
America; bond spreads dropped sharply between October and the end of 
the year to around 300 basis points, a level considerably lower than 
elsewhere in the region. The peso depreciated about 12 percent against 
the dollar over the course of last year. The decline fueled an increase 
in twelve-month inflation to more than 5-1/2 percent by year-end. The 
acceleration put inflation above the government target rate of 4-1/2 
percent and well above the ambitious 3 percent target set for 2003. In 
response to increasing inflation, the Bank of Mexico has tightened 
monetary policy four times since September 2002. The peso has continued 
to depreciate in early 2003, and bond spreads have moved back up a bit.

The Asian emerging-market economies generally performed well in 2002, 
although there were significant differences within the region. Outside 
of China, the strongest growth was recorded in South Korea, which 
benefited in the first half of the year from both an upturn in global 
demand for high-tech products and a surge in domestic demand, 
particularly consumption. However, consumer confidence deteriorated at 
the end of the year as tensions over North Korea intensified; the 
uneasy situation, as well as the substantial existing consumer debt 
burden, pose significant risks to growth in consumption this year. The 
Korean won appreciated sharply against the dollar between April and 
midyear in response to improving economic conditions; it then dropped 
back in late summer and early fall as perceptions about the strength of 
the global recovery were adjusted downward. However, the won turned 
back up against the dollar late last year.	

The performance of the ASEAN-5 economies-Indonesia, Malaysia, the 
Philippines, Singapore, and Thailand-also was generally robust in 2002, 
although the overall softening in global demand in the second half of 
the year was evident there as well. The second-half slowing in 
production was particularly pronounced in Singapore, which is heavily 
dependent on exports of high-technology products. Taiwan, another high-
technology producer, also showed a significant deceleration in output 
between the first and second halves of the year. Both of these 
economies experienced some mild deflation in 2002, although prices 
turned up toward the end of the year.

Although the Hong Kong economy did not show as much improvement as most 
other emerging Asian economies in the first half of last year, it 
recorded very strong growth in the third quarter. Nevertheless, prices 
continued to fall for the fourth consecutive year. The mainland Chinese 
economy, which again outperformed the rest of the region in 2002, 
enjoyed surging investment by the government and by foreign investors 
as well as robust export growth. The Chinese economy continued to 
experience mild deflation last year.

(FOOTNOTES)
1.  The dispute between the Pacific Maritime Association and the 
International Longshore and Warehouse Union eventually led to an 
eleven-day port closure in late September and early October that ended 
when President Bush invoked the Taft-Hartley Act. Although the monthly 
pattern of trade was influenced by the closure, the overall level of 
imports for the year does not appear to have been much 
affected.