|Monetary Policy Report forwarded to the Congress on July 20, 2000

Section 2
    
ECONOMIC 
AND 
FINANCIAL 
DEVELOPMENTS 
IN 2000

The expansion of U.S. economic activity maintained considerable
momentum through the early months of 2000 despite the firming in credit
markets that has occurred over the past year. Only recently has the
pace of real activity shown signs of having moderated from the
extremely rapid rate of increase that prevailed during the second half
of 1999 and the first quarter of 2000. Real GDP increased at an
annual rate of 5-1/2 percent in the first quarter of 2000.
Private domestic final sales, which had accelerated in the
second half of 1999, were particularly robust, rising at an annual
rate of almost 10 percent in the first quarter.
Underlying that surge in domestic spending were many
of the same factors that had contributed to the considerable
strength of outlays in the second half of 1999. The ongoing
influence of substantial increases in real income and wealth continued
to fuel consumer spending, and business investment, which continues to
be undergirded by the desire to take advantage of new, cost-saving
technologies, was further buoyed by an acceleration in sales and
profits late last year. Export demand posted a solid gain during the
first quarter while imports rose even more rapidly to meet booming
domestic demand. The available data, on balance, point to another solid
increase in real GDP in the second quarter, although they suggest that
private household and business fixed investment spending likely slowed
noticeably from the extraordinary first-quarter pace. Through June, the
expansion remained brisk enough to keep labor utilization near the very
high levels reached at the end of 1999 and to raise the factory
utilization rate to close to its long-run average by early spring. 


Chart of Change in real GDPInflation rates over the first half of 2000 were elevated by an
additional increase in the price of imported crude oil, which led to
sharp hikes in retail energy prices early in the year and again around
midyear. Apart from energy, consumer price inflation so far this
year has been somewhat higher than during 1999, and some of that
acceleration may be attributable to the indirect effects of higher
energy costs on the prices of core goods and services.
Sustained strong gains in worker productivity have kept
increases in unit labor costs minimal despite the persistence
of a historically low rate of unemployment.




Chart of Change in PCE chain-type price index
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|The Household Sector
Consumer Spending
 

Consumer spending was exceptionally vigorous during the first
quarter of 2000. Real personal consumption expenditures rose at an
annual rate of 7-3/4 percent, the sharpest increase since
early 1983. At that time, the economy was rebounding from a deep
recession during which households had deferred discretionary
purchases. In contrast, the first-quarter surge in consumption came on
the heels of two years of very robust spending during which real
outlays increased at an annual rate of more than 5 percent, and
the personal saving rate dropped sharply.


Chart of Change in real income and consumptionOutlays for durable goods, which rose at a very
fast pace in 1998 and 1999, accelerated during the first quarter to an
annual rate of more than 24 percent. Most notably, spending on
motor vehicles, which had climbed to a new high in 1999, jumped even
further in the first quarter of 2000 as unit sales of light motor
vehicles soared to a record rate of 18.1 million units. In
addition, households' spending on computing equipment and software
rebounded after the turn of the year; some consumers apparently had
postponed their purchases of these goods in late 1999 before the
century date change. Outlays for nondurable goods posted a solid
increase of 5-3/4 percent in the first quarter, marked by a
sharp upturn in spending on clothing and shoes. Spending for consumer
services also picked up in the first quarter, rising at an annual rate
of 5-1/2 percent. Spending was quite brisk for a number of
non-energy consumer services, ranging from recreation and telephone use
to brokerage fees. Also contributing to the acceleration was a rebound
in outlays for energy services, which had declined in late 1999, when
weather was unseasonably warm.

In recent months, the rise in consumer spending has moderated
considerably from the phenomenal pace of the first quarter, with much
of the slowdown in outlays for goods. At an annual rate of
17-1/4 million units in the second quarter, light motor
vehicles sold at a rate well below their first-quarter pace.
Nonetheless, that level of sales is still historically high, and with
prices remaining damped and automakers continuing to use incentives,
consumers' assessments of the motor vehicle market continue to be
positive. The information on retail sales for the April-to-June period
indicate that consumer expenditures for other goods rose markedly
slower in the second quarter than in the first quarter, at a pace well
below the average rate of increase during the preceding two years.
In contrast, personal consumption expenditures for consumer services
continued to rise relatively briskly in April and May.

Real disposable personal income increased at an
annual rate of about 3 percent between December and
May--slightly below the 1999 pace of 3-3/4 percent.
However, the impetus to spending from the rapid rise in household net
worth was still considerable, labor markets remained tight, and
confidence was still high. As a result, households continued to allow
their spending to outpace their flow of current income, and the
personal saving rate, as measured in the national income and product
accounts, dropped further, averaging less than 1 percent during
the first five months of the year.

After having boosted the ratio of household net worth to
disposable income to a record high in the first quarter, stock prices
have fallen back, suggesting less impetus to consumer spending going
forward. In addition, smaller employment gains and the pickup
in energy prices have moderated the rise in real income of
late. Although these developments left some imprint on consumer
attitudes in June, households remained relatively upbeat about their
prospective financial situation, according to the results of the
University of Michigan Survey Research Center (SRC) survey. However,
they became a bit less positive about the outlook for business
conditions and saw a somewhat greater likelihood of a rise in
unemployment over the coming year.


Chart of Wealth and saving
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|Residential Investment

Housing activity stayed at a high level during
the first half of this year. Homebuilders began the year with a
considerable backlog of projects that had developed as the
exceptionally strong demand of the previous year strained capacity. As
a result, they maintained starts of new single-family homes at an
annual rate of 1.33 million units, on average, through
April--matching 1999's robust pace. Households' demand for
single-family homes was supported early in the year by ongoing gains in
jobs and income and the earlier run-up in wealth; those forces
apparently were sufficient to offset the effects that higher mortgage
interest rates had on the affordability of new homes. Sales of new
homes were particularly robust, setting a new record by March; but
sales of existing units slipped below their 1999 high. As a result of
the continued strength in sales, the homeownership rate reached a new
high in the first quarter.



Chart of Private housing startsBy the spring, higher mortgage interest rates were leaving a
clearer mark on the attitudes of both consumers and builders. The
Michigan SRC survey reported that households' assessments of
homebuying conditions dropped between April and June to
the lowest level in more than nine years. Survey respondents
noted that, besides higher financing costs, higher prices of homes were
becoming a factor in their less positive assessment of market
conditions. Purchases of existing homes were little changed, on
balance, in April and May from the first-quarter average; however,
because these sales are recorded at the time of closing, they tend to
be a lagging indicator of demand. Sales of new homes--a more current
indicator--fell back in April and May, and homebuilders reported that
sales dropped further in June. Perhaps a sign that softer demand has
begun to affect construction, starts of new single-family homes slipped
to a rate of 1-1/4 million units in May. That level of new
homebuilding, although noticeably slower than the robust pace that
characterized the fall and winter period, is only a bit below the
elevated level that prevailed throughout much of 1998, when
single-family starts reached their highest level in twenty years.
Starts of multifamily housing units, which also had stepped up sharply
in the first quarter of the year, to an annual rate of 390,000 units,
settled back to a 340,000 unit rate in April and May.

 
Household Finance


Fueled by robust spending, especially early in the year, the
expansion of household debt remained brisk during the first half of
2000, although below the very strong 1999 growth rate. Apparently, a
favorable outlook for income and employment, along with rising wealth,
made households feel confident enough to continue to spend and take on
debt. Despite rising mortgage and consumer loan rates, household debt
increased at an annual rate of nearly 8 percent in the first
quarter, and preliminary data point to a similar increase in the second
quarter.

Mortgage debt expanded at an annual rate of 7 percent in
the first quarter, boosted by the high level of housing activity.
Household debt not secured by real estate--including credit card
balances and auto loans--posted an impressive 10 percent gain in
the first quarter to help finance a large expansion in outlays for
consumer durables, especially motor vehicles. The moderation in the
growth of household debt this year has been driven primarily by its
mortgage component: Preliminary data for the second quarter suggest
that, although consumer credit likely decelerated from the first
quarter, it still grew faster than in 1999.

Debt in margin accounts, which is largely a household liability
and is not included in reported measures of credit market debt, has
declined, on net, in recent months, following a surge from late in the
third quarter of 1999 through the end of March 2000. There has been no
evidence that recent downdrafts in share prices this year caused
serious repayment problems at the aggregate level that might pose
broader systemic concerns.

The combination of rapid debt growth and rising
interest rates has pushed the household debt-service burden to levels
not reached since the late 1980s. Nonetheless, with household income
and net worth both having grown rapidly, and employment prospects
favorable, very few signs of worsening credit problems in the household
sector have emerged, and commercial banks have reported in recent
Federal Reserve surveys that they remain favorably disposed to make
consumer installment and mortgage loans. Indeed, financial indicators
of the household sector have remained mostly positive: The rate of
personal bankruptcy filings fell in the first quarter to its lowest
level since 1996; delinquency rates on home mortgages and auto loans
remained low; and the delinquency rate on credit cards edged down
further, although it remained in the higher range that has prevailed
since the mid-1990s. However, delinquency rates may be held down, to
some extent, by the surge in new loan originations in recent quarters
because newly originated loans are less likely to be delinquent than
seasoned ones.



Chart of Delinquency rates on household loans
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|The Business Sector
Fixed Investment


The boom in capital spending extended into the first half of 2000
with few indications that businesses' desire to take
advantage of more-efficient technologies is diminishing. Real business
fixed investment surged at an annual rate of almost 24 percent in
the first quarter of the year, rebounding sharply from its lull at the
end of 1999, when firms apparently postponed some projects because of
the century date change. In recent months, the trends in new orders and
shipments of nondefense capital goods suggest that demand has remained
solid.


Chart of Change in real business fixed investmentSustained high rates of investment spending
have been a key feature shaping the current economic expansion.
Business spending on new equipment and software has been propelled
importantly by ongoing advances in computer and information
technologies that can be applied to a widening range of business
processes. The ability of firms to take advantage of these emerging
developments has been supported by the strength of domestic demand and
by generally favorable conditions in credit and equity markets. In
addition, because these high-technology goods can be produced
increasingly efficiently, their prices have continued to decline
steeply, providing additional incentive for rapid investment. The
result has been a significant rise in the stock of capital in use by
businesses and an acceleration in the flow of services from that
capital as more-advanced vintages of equipment replace older ones. The
payoff from the prolonged period during which firms have upgraded their
plant and equipment has increasingly shown through in the economy's
improved productivity performance.

Real outlays for business equipment and software shot up at an
annual rate of nearly 25 percent in the first quarter of this
year. That jump followed a modest increase in the final quarter of 1999
and put spending for business equipment and software back on the
double-digit uptrend that has prevailed throughout the
current economic recovery. Concerns about potential problems with
the century date change had the most noticeable effect on the patterns
of spending for computers and peripherals and for communications
equipment in the fourth and first quarters; expenditures for
software were also affected, although less so. For these categories
of goods overall, the impressive resurgence in business purchases early
this year left little doubt that the underlying strength in demand for
high-tech capital goods had been only temporarily interrupted by the
century date change. Indeed, nominal shipments of office and computing
equipment and of communication devices registered sizable increases
over the April-May period.

In the first quarter, business spending on computers and
peripheral equipment was up almost 40 percent from a year
earlier--a pace in line with the trend of the current expansion.
Outlays for communications equipment, however, accelerated; the
first-quarter surge brought the year-over-year increase in spending to
35 percent, twice the pace that prevailed a year earlier.
Expanding Internet usage has been driving the need for new network
architectures. In addition, cable companies have been investing heavily
in preparation for their planned entry into the markets for residential
and commercial telephony and broad-band Internet services.

Demand for business equipment outside of the high-tech area was
also strong at the beginning of the year. In the first quarter, outlays
for industrial equipment rose at a brisk pace for a third consecutive
quarter as the recovery of the manufacturing sector from the effects of
the Asian crisis gained momentum. In addition, investment in farm and
construction machinery, which had fallen steadily during most of 1999,
turned up, and shipments of civilian aircraft to domestic customers
increased. More recent data show a further rise in the backlog of
unfilled orders placed with domestic firms for equipment and machinery
(other than high-tech items and transportation equipment), suggesting
that demand for these items has been well maintained. However, business
purchases of motor vehicles are likely to drop back in the second
quarter from the very high level recorded at the beginning of the year.
In particular, demand for heavy trucks appears to have been adversely
affected by higher costs of fuel and shortages of drivers.

Real investment in private nonresidential structures jumped at an
annual rate of more than 20 percent in the first quarter of the
year after having declined in 1999. Both last year's weakness and this
year's sudden and widespread revival are difficult to explain fully.
Nonetheless, the higher levels of spending on office buildings, other
commercial facilities, and industrial buildings recorded early this
year would seem to accord well with the overall strength in aggregate
demand. However, the fundamentals in this sector of the economy are
mixed. Available information suggests that property values for offices,
retail space, and warehouses have been rising more slowly than they
were several years ago. However, office vacancy rates have come down,
which suggests that, at least at an aggregate level, the office sector
is not overbuilt. The vacancy rate for industrial buildings has also
fallen, but in only a few industries, such as semiconductors and other
electronic components, are capacity pressures sufficiently intense to
induce significant expansion of production facilities.
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|Inventory Investment


The ratio of inventories to sales in many
nonfarm industries moved lower early this year. Those firms that had
accumulated some additional stocks toward the end of 1999 as a
precaution against disruptions related to the century date change
seemed to have little difficulty working off those inventories after
the smooth transition to the new year. Moreover, the
first-quarter surge in final demand may have, to some extent, exceeded
businesses' expectations. In current-cost terms, non-auto manufacturing
and trade establishments built inventories in April and May at a
somewhat faster rate than in the first quarter but still roughly in
line with the rise in their sales. As a result, the ratio of
inventories to sales, at current cost, for these businesses was roughly
unchanged from the first quarter. Overall, the ongoing downtrend in the
ratios of inventories to sales during the past several years suggests
that businesses increasingly are taking advantage of new
technologies and software to implement better inventory management.


Chart of Change in real nonfarm business inventoriesThe swing in inventory investment in the motor vehicle industry
has been more pronounced recently. Dealer stocks of new cars and light
trucks were drawn down during the first quarter as sales climbed to
record levels. Accordingly, auto and truck makers kept assemblies at a
high level through June in order to maintain ready supplies of popular
models. Even though demand appears to have softened and inventories of
a few models have backed up, scheduled assemblies for the third quarter
are above the elevated level of the first half.

Business Finance

The economic profits of nonfinancial U.S. corporations posted
another solid increase in the first quarter. The profits that
nonfinancial corporations earned on their domestic operations were
10 percent above the level of a year earlier; the rise lifted the
share of profits in this sector's nominal output close to its 1997
peak. Nonetheless, with investment expanding rapidly, businesses'
external financing requirements, measured as the difference between
capital expenditures and internally generated funds, stayed at a high
level in the first half of this year. Businesses' credit demands were
also supported by cash-financed merger and acquisition activity. Total
debt of nonfinancial businesses increased at a 10-1/2
percent clip in the first quarter, close to the brisk pace of 1999, and
available information suggests that borrowing remained strong into the
second quarter.


Chart of Before-tax profits of nonfinancial corporations as a share of GDPOn balance, businesses have altered the composition of their
funding this year to rely more on shorter-term
sources of credit and less on the bond market, although the funding mix
has fluctuated widely in response to changing market conditions.
After the passing of year-end, corporate borrowers returned to the bond
market in volume in February and March, but subsequent volatility in
the capital market in April and May prompted a pullback. In addition,
corporate bond investors have been less receptive to smaller, less
liquid offerings, as has been true for some time.


Chart of Gross corporate bond issuanceIn the investment-grade market, bond issuers have responded to
investors' concerns about the interest rate and credit outlook by
shortening the maturities of their offerings and by issuing more
floating-rate securities. In the below-investment-grade market, many of
the borrowers who did tap the bond market in February and
March did so by issuing convertible bonds and other equity-related debt
instruments. Subsequently, amid increased equity market volatility and
growing investor uncertainty about the outlook for prospective
borrowers, credit spreads in the corporate bond market widened, and
issuance in the below-investment-grade market dropped sharply in April
and May. Conditions in the corporate bond market calmed in late May and
June, and issuance recovered to close to its first-quarter pace.


Chart of Spreads of corporate bond yields over the ten-year swap rate
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|As the bond market became
less hospitable in the spring, many businesses evidently turned to
banks and to the commercial paper market for financing. Partly as a
result, commercial and industrial loans at banks have
expanded briskly, even as a larger percentage of banks have reported in
Federal Reserve surveys that they have been tightening standards and
terms on such loans.

Underscoring lenders' concerns about the
creditworthiness of borrowers, the ratio of liabilities of failed
businesses to total liabilities has increased further so far this year,
and the default rate on outstanding junk bonds has risen further from
the relatively elevated level reached in 1999. Through midyear, Moody's
Investors Service has downgraded, on net, more debt in the nonfinancial
business sector than it has upgraded, although it has placed more debt
on watch for future upgrades than downgrades.




Chart of Ratio of liabilities of failed nonfinancial firms to liabilities of all nonfinancial firmsChart of Default rates on outstanding junk bondsCommercial mortgage borrowing has also expanded at a robust pace
over the first half of 2000, as investment in office and other
commercial building strengthened. Extending last year's trend,
borrowers have tapped banks and life insurance companies as the
financing sources of choice. Banks, in particular, have reported
stronger demand for commercial real estate loans this year even as they
have tightened standards a bit for approving such loans. In the market
for commercial mortgage-backed securities, yields have edged higher
since the beginning of the year.

The  Government Sector
Federal Government


The incoming information regarding the federal budget suggests
that the surplus in the current fiscal year will surpass last year's by
a considerable amount. Over the first eight months of fiscal year
2000--the period from October to May--the unified budget
recorded a surplus of about $120 billion, compared with
$41 billion during the comparable period of fiscal 1999. The
Office of Management and Budget and the Congressional Budget Office are
now forecasting that, when the fiscal year closes, the unified surplus
will be around $225 billion to $230 billion, $100
billion higher than in the preceding year. That outcome would likely
place the surplus at more than 2-1/4 percent of GDP, which
would exceed the most recent high of 1.9 percent, which occurred
in 1951.

The swing in the federal
budget from deficit to surplus has been an important factor in
maintaining national saving. The rise in federal saving as a percentage
of gross national product from -3.5 percent in 1992 to
3.1 percent in the first quarter of this year has been sufficient
to offset the drop in personal saving that occurred over the
same period. As a result, gross saving by households, businesses, and
governments has stayed above 18 percent of GNP since 1997,
compared with 16-1/2 percent over the preceding seven
years. The deeper pool of national saving, along with the continued
willingness of foreign investors to finance our current account
deficit, remains an important factor in containing increases in the
cost of capital and sustaining the rapid expansion of domestic
investment. With longer-run projections showing a rising federal
government surplus over the next decade, this source of national saving
could continue to expand.


Chart of National saving as a share of nominal GNPChart of Federal receipts and expenditures as a share of nominal GDP
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|The recent good news on the federal budget has been primarily on
the receipts side of the ledger. Nonwithheld tax receipts were very
robust this spring. Both final payments on personal income tax
liabilities for 1999 and final corporate tax payments for 1999 were up
substantially. So far this year, the withheld tax and social insurance
contributions on this year's earnings of individuals have also been
strong. As a result, federal receipts during the first eight months of
the fiscal year were almost 12 percent higher than they were
during the year-earlier period.

While receipts have accelerated, federal expenditures have been
rising only a little faster than during fiscal 1999 and continue to
decline as a share of nominal GDP. Nominal outlays for the first eight
months of the current fiscal year were 5-1/4 percent above
the year-earlier period. Increases in discretionary spending have
picked up a bit so far this year. In particular, defense spending has
been running higher in the wake of the increase in budget authority
enacted last year. The Congress has also boosted agricultural
subsidies in response to the weakness in farm income. While
nondiscretionary spending continues to be held down by declines in net
interest payments, categories such as Medicaid and other health
programs have been rising more rapidly of late.

As measured by the national income and product accounts, real
federal expenditures for consumption and gross investment dropped
sharply early this year after having surged in the fourth quarter of
1999. These wide quarter-to-quarter swings in federal spending appear
to have occurred because the Department of Defense speeded up its
payments to vendors before the century date change; actual
deliveries of defense goods and services were likely smoother. On
average, real defense spending in the fourth and first quarters was up
moderately from the average level in fiscal 1999. Real nondefense
outlays continued to rise slowly.

With current budget surpluses coming in above
expectations and large surpluses projected to continue for the
foreseeable future, the federal government has taken additional steps
aimed at preserving a high level of liquidity in the market for its
securities. Expanding on efforts to concentrate its declining debt
issuance in fewer highly liquid securities, the Treasury announced in
February its intention to issue only two new five- and ten-year notes
and only one new thirty-year bond each year. The auctions of five- and
ten-year notes will remain quarterly, alternating between new issues
and smaller reopenings, and the bond auctions will be semiannual,
also alternating between new and smaller reopened offerings. The
Treasury also announced that it was reducing the frequency of its
one-year bill auctions from monthly to quarterly and cutting the size
of the monthly two-year note auctions. In addition, the Treasury
eliminated the April auction of the thirty-year inflation-indexed bond
and indicated that the size of the ten-year inflation-indexed note
offerings would be modestly reduced. Meanwhile, anticipation of even
larger surpluses in the wake of the surprising strength of incoming tax
receipts so far in 2000 led the Treasury to announce, in May, that it
was again cutting the size of the monthly two-year note auctions. The
Treasury also noted that it is considering additional changes in its
auction schedule, including the possible elimination of the one-year
bill auctions and a reduction in the frequency of its two-year note
auctions.


Chart of Federal government debt held by the publicEarly in the year, the Treasury unveiled the details of its
previously announced reverse-auction, or debt buyback, program, whereby
it intends to retire seasoned, less liquid, debt securities
with surplus cash, enabling it to issue more "on-the-run"
securities. The Treasury noted that it would buy back as much as
$30 billion this year. The first operation took place in March,
and in May the Treasury announced a schedule of two operations per
month through the end of July of this year. Through midyear, the
Treasury has conducted eight buyback operations, redeeming a total
of $15 billion. Because an important goal of the buyback program
is to help forestall further increases in the average maturity of the
Treasury's publicly held debt, the entire amount redeemed so far has
corresponded to securities with remaining maturities at the long end of
the yield curve (at least fifteen years).


State and Local Governments

In the state and local sector, real consumption and investment
expenditures registered another strong quarter at the beginning of this
year. In part, the unseasonably good weather appears to have
accommodated more construction spending than usually occurs over the
winter. However, some of the recent rise is an extension of the step-up
in spending that emerged last year, when real outlays rose 5
percent after having averaged around 3 percent for the preceding
three years. Higher federal grants for highway construction have
contributed to the pickup in spending. In addition, many of these
jurisdictions have experienced solid improvements in their fiscal
conditions, which may be allowing them to undertake new spending
initiatives.

The improving fiscal outlook for state and local governments has
affected both the issuance and the quality of state and local debt.
Borrowing by states and municipalities expanded sluggishly in the first
half of this year. In addition to the favorable budgetary picture,
rising interest rates have reduced the demand for new capital
financing and substantially limited refunding issuance. Credit upgrades
have outnumbered downgrades by a substantial margin in the state and
local sector.
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|The External Sector
Trade and the Current Account

The deficits in U.S. external balances have continued to get even
larger this year. The current account deficit reached an annual rate of
$409 billion in the first quarter of 2000, or 4-1/4
percent of GDP, compared with $372 billion and 4 percent in
the second half of 1999. Net payments of investment income were a bit
less in the first quarter than in the second half of last year owing to
a sizable increase in income receipts from direct investment abroad.
Most of the expansion in the current account deficit occurred in trade
in goods and services. In the first quarter, the deficit in trade in
goods and services widened to an annual rate of $345 billion, a
considerable expansion from the deficit of $298 billion recorded
in the second half of 1999. Trade data for April suggest that the
deficit may have increased further in the second quarter.


Chart of U.S. current accountU.S. exports of real goods
and services rose at an annual rate of 6-1/4 percent in the
first quarter, following a strong increase in exports in the second
half of last year. The pickup in economic activity abroad that began in
1999 continued to support export demand and partly offset negative
effects on price competitiveness of U.S. products from the dollar's
past appreciation. By market destination, U.S. exports to
Canada, Mexico, and Europe increased the most. By product group, export
expansion was concentrated in capital equipment, industrial supplies,
and consumer goods. Preliminary data for April suggest that growth of
real exports remained strong.


Chart of Change in real imports and exports of goods and servicesThe quantity of imported goods and services continued to expand
rapidly in the first quarter. The increase in imports, at an annual
rate of 11-3/4 percent, was the same in the first quarter
as in the second half of 1999 and reflected both the continuing
strength of U.S. domestic demand and the effects of past dollar
appreciation on price competitiveness. Imports of consumer goods,
automotive products, semiconductors, telecommunications equipment,
and other machinery were particularly robust. Data for April
suggest that the second quarter got off to a strong start. The price of
non-oil goods imports rose at an annual rate of 1-3/4
percent in the first quarter, the second consecutive quarter of sizable
price increases following four years of price declines; non-oil import
prices in the second quarter posted only moderate increases.


Chart of Prices for oil and other commoditiesA number of developments affecting world oil
demand and supply led to a further step-up in the spot price of West
Texas intermediate (WTI) crude this year, along with considerable
volatility. In the wake of the plunge of world oil prices during 1998,
the Organization of Petroleum Exporting Countries (OPEC) agreed in
early 1999 to production restraints that, by late in the year, restored
prices to their 1997 level of about $20 per barrel. Subsequently,
continued recovery of world demand, combined with some supply
disruptions, caused the WTI spot price to spike above $34 per
barrel during March of this year, the highest level since the Gulf War
more than nine years earlier. Oil prices dropped back temporarily in
April, but in May and June the price of crude oil moved back up again,
as demand was boosted further by strong global economic activity and by
rebuilding of oil stocks. In late June, despite an announcement by OPEC
that it would boost production, the WTI spot price reached a new high
of almost $35 per barrel, but by early July the price had settled
back to about $30 per barrel.


Financial Account


Capital flows in the first quarter of 2000 continued to reflect
the relatively strong performance of the U.S. economy and transactions
associated with global corporate mergers. Foreign private purchases
of U.S. securities remained brisk--well above the record pace set last
year. In addition, the mix of U.S. securities purchased by foreigners
in the first quarter showed a continuation of last year's trend toward
smaller holdings of U.S. Treasury securities and larger holdings of
U.S. agency and corporate securities. Private-sector foreigners sold
more than $9 billion in Treasury securities in the first quarter
while purchasing more than $26 billion in agency bonds. Despite a
mixed performance of U.S. stock prices, foreign portfolio purchases of
U.S. equities exceeded $60 billion in the first quarter, more than half
of the record annual total set last year. U.S. purchases of foreign
securities remained strong in the first quarter of 2000.

Foreign direct investment flows into the United States were
robust in the first quarter of this year as well. As in the past two
years, direct investment inflows have been elevated by the
extraordinary level of cross-border merger and acquisition activity.
Portfolio flows have also been affected by this activity. For example,
in recent years, many of the largest acquisitions have been financed by
swaps of equity in the foreign acquiring firm for equity in the
U.S. firm being acquired. The Bureau of Economic Analysis estimates
that U.S. residents acquired $123 billion of foreign equities in
this way last year. Separate data on market transactions indicate that
U.S. residents made net purchases of Japanese equities but sold
European equities. The latter sales likely reflect a rebalancing of
portfolios after stock swaps. U.S. direct investment in foreign
economies has also remained strong, exceeding $30 billion in the
first quarter of 2000. Again, a significant portion of this investment
was associated with cross-border merger activity.

Capital inflows from foreign official sources in the first
quarter of this year were sizable--$20 billion, compared with
$43 billion for all of 1999. As was the case last year, the
increase in foreign official reserves in the United States in the first
quarter was concentrated in a relatively few countries. Partial data
for the second quarter of 2000 show a small official outflow.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------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|The Labor Market
Employment and Labor Supply


The labor market in early 2000 continued to be
characterized by substantial job creation, a historically low level of
unemployment, and sizable advances in productivity that have held labor
costs in check. The rise in overall nonfarm payroll employment, which
totaled more than 1-1/2 million over the first half of the
year, was swelled by the federal government's hiring of intermittent
workers to conduct the decennial census. Apart from that temporary
boost, which accounted for about one-fourth of the net gain in jobs
between December and June, nonfarm payroll employment increased an
average of 190,000 per month, somewhat below the robust pace of the
preceding four years.


Chart of Net change in total nonfarm payroll employmentMonthly changes in private payrolls were uneven at times during
the first half the year, but, on balance, the pace of hiring, while
still solid, appears to have moderated between the first and second
quarters. In some industries, such as construction, the pattern appears
to have been exaggerated by unseasonably high levels of activity during
the winter that accelerated hiring that typically would have
occurred in the spring. After a robust first quarter,
construction employment declined between April and June; on
average, hiring in this industry over the first half of the year was
only a bit slower than the rapid pace that prevailed from 1996 to 1999.
However, employment gains in the services industry, particularly in
business and health services, were smaller in the second quarter than
in the first while job cutbacks occurred in finance, insurance,
and real estate after four and one-half years of steady expansion.
Nonetheless, strong domestic demand for consumer durables and business
equipment, along with support for exports from the pickup in economic
activity abroad, led to a leveling off in manufacturing employment over
the first half of 2000 after almost two years of decline. And, with
consumer spending brisk, employment at retail establishments,
although fluctuating widely from month to month, remained generally on
a solid uptrend over the first half.

The supply of labor increased slowly in recent
years relative to the demand for workers. The labor force participation
rate was unchanged, on average, at 67.1 percent from 1997 to
1999; that level was just 0.6 percentage point higher than at the
beginning of the expansion in 1990. The stability of the
participation rate over the 1997-99 period was somewhat surprising
because the incentives to enter the workforce seemed powerful: Hiring
was strong, real wages were rising more rapidly than earlier in the
expansion, and individuals perceived that jobs were plentiful. However,
the robust demand for new workers instead led to a substantial decline
in unemployment, and the civilian jobless rate fell from
5-1/4 percent at the beginning of 1997 to just over 4
percent at the end of 1999.


Chart of Measures of labor utilizationThis year, the labor force participation rate ratcheted up
sharply over the first four months of the year before dropping back in
recent months as employment slowed. The spike in participation early
this year may have been a response to ready availability of job
opportunities, but Census hiring may also have temporarily attracted
some individuals into the workforce. On net, growth of labor demand and
supply have been more balanced so far this year, and the unemployment
rate has held near its thirty-year low of 4 percent. At midyear,
very few signs of a significant easing in labor market pressures have
surfaced. Employers responding to various private surveys of
business conditions report that they have been unable to hire as many
workers as they would like because skilled workers are in short supply
and competition from other firms is keen. Those concerns about hiring
have persisted even as new claims for unemployment insurance have
drifted up from very low levels in the past several months, suggesting
that some employers may be making workforce adjustments in response to
slower economic activity.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Labor Costs and Productivity


Reports by businesses that workers are in short supply and that
they are under pressure to increase compensation to be competitive in
hiring and retaining employees became more intense early this year.
However, the available statistical indicators are providing somewhat
mixed and inconsistent signals of whether a broad acceleration in wage
and benefit costs is emerging. Hourly compensation, as measured by the
employment cost index (ECI) for private nonfarm businesses, increased
sharply during the first quarter to a level more than 4-1/2
percent above a year earlier. Before that jump, year-over-year changes
in the ECI compensation series had remained close to 3-1/2
percent for three years. However, an alternative measure of
compensation per hour, calculated as part of the productivity and cost
series, which has shown higher rates of increase than the ECI in recent
years, slowed in the first quarter of this year. For the nonfarm
business sector, compensation per hour in the first quarter was
4-1/4 percent higher than a year earlier; in the first
quarter of 1999, the four-quarter change was 5-1/4 percent. 1


Chart of Measures of the change in hourly compensationPart of the acceleration in the ECI in the
first quarter was the result of a sharp step-up in the wage and salary
component of compensation change. While higher rates of straight-time
pay were widespread across industry and occupational groups, the most
striking increase occurred in the finance, insurance, and real estate
industry where the year-over-year change in wages and salaries jumped
from about 4 percent for the period ending in December 1999 to
almost 8-1/2 percent for the period ending in March of this
year. The sudden spike in wages in that sector could be related to
commissions that are tied directly to activity levels in the industry
and, thus, would not represent a lasting influence on wage inflation.
For other industries, wages and salaries accelerated moderately, which
might appear plausible in light of reports that employers are
experiencing shortages of some types of skilled workers. However, the
uptrend in wage inflation that surfaced in the first-quarter ECI has
not been so readily apparent in the monthly data on average hourly
earnings of production or nonsupervisory workers, which are available
through June. Although average hourly earnings increased at an annual
rate of 4 percent between December and June, the June level of hourly
wages stood 3-3/4 percent higher than a year earlier, the
same as the increase between June 1998 and June 1999.

While employers in many industries appear to have kept wage
increases moderate, they may be facing greater pressures from rising
costs of employee benefits. The ECI measure of benefit costs rose close
to 3-1/2 percent during 1999, a percentage point faster
than during 1998; these costs accelerated sharply further in the first
quarter of this year to a level 5-1/2 percent above a year
earlier. Much of last year's pickup in benefit costs was
associated with faster rates of increase in employer contributions to
health insurance, and the first-quarter ECI figures indicated another
step-up in this component of costs. Private survey
information and available measures of prices in the health care
industry suggest that the upturn in the employer costs of health care
benefits is associated with both higher costs of health care and
employers' willingness to offer attractive benefit packages in order to
compete for workers in a tight labor market. Indeed, employers
have been reporting that they are enhancing compensation packages with
a variety of benefits in order to hire and retain employees. Some
of these offerings are included in the ECI; for instance, the ECI
report for the first quarter noted a pickup in supplemental forms of
pay, such as overtime and nonproduction bonuses, and in paid leave.
However, other benefits cited by employers, including stock options,
hiring and retention bonuses, and discounts on store purchases, are
not measured in the ECI. 2  The productivity and costs measure
of hourly compensation may capture more of the non-wage costs that
employers incur, but even for that series, the best estimates of
employer compensation costs are available only after business
reports for unemployment insurance and tax records are tabulated
and folded into the annual revisions of the national income and product
accounts.

Because businesses have realized sizable gains in worker
productivity, compensation increases have not generated
significant pressure on overall costs of production. Output per hour in
the nonfarm business sector posted another solid advance in the first
quarter, rising to a level 3-3/4 percent above a year
earlier and offsetting much of the rise in hourly compensation over the
period. For nonfinancial corporations, the subset of the nonfarm
business sector that excludes types of businesses for which output is
measured less directly, the 4 percent year-over-year increase
in productivity held unit labor costs unchanged.



Chart of Change in output per hour for the nonfarm business sectorChart of Change in unit labor costs for the nonfarm business sectorWith the further robust increases in labor
productivity recently, the average rise in output per hour in the
nonfarm business sector since early 1997 has stepped up further to
3 percent from the 2 percent pace of the 1995-97 period.
What has been particularly impressive is that the acceleration of
productivity in the past several years has exceeded the pickup in
output growth over the period and, thus, does not appear to be simply a
cyclical response to more rapidly rising demand. Rather, businesses are
likely realizing substantial and lasting payoffs from their investment
in equipment and processes that embody the technological advances of
the past several years.
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|Price
measure                                                                                                                                                                                                                                                                                                                                                     | 1997:Q4
  to
  1998:Q4                                  | 1998:Q4
  to
  1999:Q4 | 1999:Q4
  to
  2000:Q1
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | --------------------------------------------------------- | ------------------------ | ------------------------
|2.                                                                                                                                                                                                                                                                                                                                                                 | Alternative measures
of price changePercent, annual rate
|table rule                                                                                                                                                                                                                                                                                                                                                        
|Price
measure
1997:Q4
  to
  1998:Q4
1998:Q4
  to
  1999:Q4
1999:Q4
  to
  2000:Q1Chain-typeGross domestic
product1.01.6
    3.0Gross domestic
purchases0.71.9
    3.5Personal
consumption expenditures0.92.0
    3.5Excluding
food and energy1.31.5
    2.2Fixed-weightConsumer price index1.5
2.64.0Excluding
food and energy2.42.1
    2.3 | Chain-type                                                |                          |                         
|
|Chain-type                                                                                                                                                                                                                                                                                                                                                         |                                                           |                          |                         
|Gross domestic
product                                                                                                                                                                                                                                                                                                                                            | 1.0                                                       | 1.6                      | 3.0                     
|Gross domestic
purchases                                                                                                                                                                                                                                                                                                                                          | 0.7                                                       | 1.9                      | 3.5                     
|Personal
consumption expenditures                                                                                                                                                                                                                                                                                                                                 | 0.9                                                       | 2.0                      | 3.5                     
|Excluding
food and energy                                                                                                                                                                                                                                                                                                                                         | 1.3                                                       | 1.5                      | 2.2                     
|                                                                                                                                                                                                                                                                                                                                                                   |                                                           |                          |                         
|Fixed-weight                                                                                                                                                                                                                                                                                                                                                       |                                                           |                          |                         
|Consumer price index                                                                                                                                                                                                                                                                                                                                               | 1.5                                                       | 2.6                      | 4.0                     
|Excluding
food and energy                                                                                                                                                                                                                                                                                                                                         | 2.4                                                       | 2.1                      | 2.3                     
|table rule                                                                                                                                                                                                                                                                                                                                                        

|The pass-through of the steep
rise in the cost of imported crude oil that began in early 1999 and
continued into the first half of this year has been the principal
factor in the acceleration of the prices of goods and services
purchased. The effect of higher energy costs on domestic prices has
been most apparent in indexes of prices paid by consumers. After having
risen 12 percent during 1999, the chain-type price index for
energy items in the price index for personal consumption expenditures
(PCE) jumped at an annual rate of 35 percent in the first quarter
of 2000; the first-quarter rise in the energy component of the CPI was
similar.

Swings in energy prices continued to have a noticeable effect on
overall measures of consumer prices in the second
quarter. After world oil prices dropped back temporarily in the spring,
the domestic price of motor fuel dropped in April and May, and consumer
prices for energy, as measured by the CPI, retraced some of the
first-quarter increase. As a result, the overall CPI was little changed
over the two months. However, with prices of crude oil having climbed
again, the bounceback in prices of motor fuel led to a sharp
increase in the CPI for energy in June. In addition, with strong demand
pressing against available supplies, consumer prices of natural gas
continued to rise rapidly in the second quarter. In contrast to the
steep rise in energy prices, the CPI for food has risen slightly less
than other non-energy prices so far this year.

Higher petroleum costs also fed through into
higher producer costs for a number of intermediate materials.
Rising prices for inputs such as chemicals and paints contributed
importantly to the acceleration in the producer price index for
intermediate materials excluding food and energy from about
1-3/4 percent during 1999 to an annual rate of
3-1/2 percent over the first half of this year. Upward
pressure on input prices was also apparent for construction materials,
although these have eased more recently. Prices of imported industrial
supplies also picked up early this year owing to higher costs of
petroleum inputs.


Chart of Change in consumer pricesChart of Change in consumer prices excluding food and energyCore consumer price inflation has also been running a little
higher so far this year. The chain-type price index for personal
consumption expenditures other than food and energy increased at an
annual rate of 2-1/4 percent in the first quarter compared
with an increase of 1-1/2 percent during 1999. Based on the
monthly estimates of PCE prices in April and May, core PCE price
inflation looks to have been just a little below its
first-quarter rate. After having risen just over 2 percent
between the fourth quarter of 1998 and the fourth quarter of 1999, the
CPI excluding food and energy increased at an annual rate of
2-1/4 percent in the first quarter of 2000 and at a
2-3/4 percent rate in the second quarter. In part, the rise
in core inflation likely reflects the indirect effects of higher energy
costs on the prices of a variety of goods and services, although these
effects are difficult to quantify with precision. Moreover, prices of
non-oil imported goods, which had been declining from late 1995 through
the middle of last year, continued to trend up early this year.

The pickup in core inflation, as measured by the CPI, has
occurred for both consumer goods and services. Although price increases
for nondurable goods excluding food and energy moderated, prices of
consumer durables, which had fallen between 1996 and 1999, were little
changed, on balance, over the first half of this year. The CPI
continued to register steep declines for household electronic goods and
computers, but prices of other types of consumer durables have
increased, on net, so far this year. The rate of increase in the prices
of non-energy consumer services has also been somewhat faster; the CPI
for these items increased at an annual rate of 3-1/2
percent during the first two quarters of this year compared with a rise
of 2-3/4 percent in 1999. Larger increases in the CPI
measures of rent and of medical services have contributed importantly
to this acceleration. Another factor has been a steeper rise in
airfares, which have been boosted in part to cover the higher cost of
fuel.

In addition to slightly higher core consumer price inflation, the
national income and product accounts measure of prices for private
fixed investment goods shows that the downtrend in prices for business
fixed investment items has been interrupted. Most notably,
declines in the prices of computing equipment became much smaller
in the final quarter of last year and the first quarter of this year. A
series of disruptions to the supply of component inputs to
computing equipment has combined with exceptionally strong demand to
cut the rate of price decline for computers, as measured by the
chain-type price index, to an annual rate of 12 percent late last
year and early this year--half the pace of the preceding three and
one-half years. At the same time, prices of other types of equipment
and software continued to be little changed, and the chain-type index
for nonresidential structures investment remained on a moderate
uptrend. In contrast, the further upward pressure on construction costs
at the beginning of the year continued to push the price index for
residential construction higher; after having accelerated from 3
percent to 3-1/2 percent between 1998 and 1999, this index
increased at an annual rate of 4-1/4 percent in the first
quarter of 2000.

Although actual inflation moved a bit higher over the first half
of 2000, inflation expectations have been little changed. Households
responding to the Michigan SRC survey in June were sensitive to the
adverse effect of higher energy prices on their real income but seemed
to believe that the inflationary shock would be short-lived. The median
of their expected change in CPI inflation over the coming twelve months
was 2.9 percent. Moreover, they remained optimistic that
inflation would remain at about that rate over the longer run,
reporting a 2.8 percent median of expected inflation during the
next five to ten years. In both instances, their expectations are
essentially the same as at the end of 1999, although the year-ahead
expectations are above the lower levels that had prevailed in 1997 and
early 1998.
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|U.S. Financial Markets

Conditions in markets for private credit firmed
on balance since the end of 1999. Against a backdrop of continued
economic vitality in the United States and a tighter monetary policy
stance, private borrowing rates are higher, on net, particularly those
charged to riskier borrowers. In addition, banks have tightened terms
and standards on most types of loans. Higher real interest rates--as
measured based on inflation expectations derived from surveys and
from yields on the Treasury's inflation-indexed
securities--account for the bulk of the increase in interest
rates this year, with short-term real rates having increased
the most. Rising market interest rates and heightened uncertainties
about corporate prospects, especially with regard to the high-tech
sector, have occasionally dampened flows in the corporate bond market
and have weighed on the equity market, which has, at times, experienced
considerable volatility. Through mid-July, the broad-based Wilshire
5000 equity index was up approximately 3 percent for the year.



Chart of Selected Treasury rates, daily dataInterest Rates


As the year began, with worries related to the
century date change out of the way, participants in the fixed-income
market turned their attention to the signs of continued strength in
domestic labor and product markets, and they quickly priced in the
possibility of a more aggressive tightening of monetary policy. Both
private and Treasury yields rose considerably. In the latter part of
January, however, Treasury yields plummeted, especially those on
longer-dated securities, as the announced details of the Treasury's
debt buyback program and upwardly revised forecasts of federal budget
surpluses led investors to focus increasingly on the prospects for
a diminishing supply of Treasury securities. A rise in both nominal and
inflation-indexed Treasury yields in response to strong economic data
and tighter monetary policy in April and May was partly offset by
supply factors and by occasional safe haven flows from the volatile
equity market. Since late May, market interest rates have declined as
market participants have interpreted the incoming economic data as
evidence that monetary policy might not have to be tightened
as much as had been previously expected. On balance, while Treasury
bill rates and yields on shorter-dated notes have risen 15 to
80 basis points since the beginning of the year, intermediate-
and long-term Treasury yields have declined 5 to 55 basis points.
In the corporate debt market, by contrast, bond yields have risen
10 to 70 basis points so far this year.


Chart of Selected Treasury rates, quarterly dataForecasts of steep declines in the supply of
longer-dated Treasuries have combined with tighter monetary policy
conditions to produce an inverted Treasury yield curve, starting with
the two-year maturity. In contrast, yield curves elsewhere in the U.S.
fixed-income market generally have not inverted. In the interest rate
swap market, for instance, the yield curve has remained flat to upward
sloping for maturities as long as ten years, and the same has been true
for yield curves for the most actively traded corporate
bonds. 3  Nonetheless, private yield curves are flatter than
usual, suggesting that, although supply considerations have played a
potentially important role in the inversion of the Treasury yield curve
this year, investors' forecasts of future economic conditions have also
been a contributing factor. In particular, private yield curves are
consistent with forecasts of a moderation in economic growth
and expectations that the economy will be on a sustainable,
non-inflationary track, with little further monetary policy tightening.


Chart of Selected yield curves, July 17, 2000The disconnect between longer-term Treasury and
private yields as a consequence of supply factors in the Treasury
market is distorting readings from yield spreads. For instance, taken
at face value, the spread of BBB corporate yields over the yield on the
ten-year Treasury note would suggest that conditions in the corporate
bond market so far in 2000 are worse than those during the financial
market turmoil of 1998. In contrast, the spread of the BBB yield over
the ten-year swap rate paints a very different picture, with spreads up
this year but below their peaks in 1998. Although the swap market is
still not as liquid as the Treasury securities market, and swap rates
are occasionally subject to supply-driven distortions, such distortions
have been less pronounced and more short-lived than those affecting the
Treasury securities market of late, making swap rates a better
benchmark for judging the behavior of other corporate yields.


Chart of Spread of BBB corporate yieldsAware that distortions to Treasury yields are likely to become
more pronounced as more federal debt is paid down, market participants
have had to look for alternatives to the pricing and hedging roles
traditionally played by Treasuries in U.S. financial markets. In
addition to interest rate swaps, which have featured prominently in the
list of alternatives to Treasuries, debt securities issued by the three
government-sponsored housing agencies--Fannie Mae, Freddie Mac, and
the Federal Home Loan Banks--have been used in both pricing and
hedging. The three housing agencies have continued to issue a
substantial volume of debt this year in an attempt to capture benchmark
status, and the introduction in March of futures and options
contracts based on five- and ten-year notes issued by Fannie Mae and
Freddie Mac may help enhance the liquidity of the agency securities
market. Nonetheless, the market for agency debt has been affected by
some uncertainty this year regarding the agencies' special relationship
with the government. Both the Treasury and the Federal Reserve have
suggested that it would be appropriate for the Congress to consider
whether the special standing of these institutions continues to
promote the public interest, and pending legislation would, among
other things, restructure the oversight of these agencies and
reexamine their lines of credit with the U.S. Treasury.

The implementation of monetary policy, too, has had to adapt to
the anticipated paydowns of marketable federal debt. Recognizing that
there may be limitations on its ability to rely as much as previously
on transactions in Treasury securities to meet the reserve needs of
depositories and to expand the supply of currency, the FOMC decided at
its March 2000 meeting to facilitate until its first meeting in 2001
the Trading Desk's ability to continue to accept a broader range of
collateral in its repurchase transactions. The initial approvals to
help expand the collateral pool were granted in August 1999 as part of
the Federal Reserve's efforts to better manage possible disruptions to
financial markets related to the century date change.

At the March 2000 meeting, the Committee also initiated a study
to consider alternative asset classes and selection criteria that
could be appropriate for the System Open Market Account (SOMA) should
the size of the Treasury securities market continue to decline. For the
period before the completion and review of such a study, the Committee
discussed, at its May meeting, some changes in the management of the
System's portfolio of Treasury securities in an environment of
decreasing Treasury debt. The changes aim to prevent the System from
coming to hold high and rising proportions of new Treasury debt issues.
They will also help the SOMA to limit any further lengthening of the
average maturity of its portfolio while continuing to meet long-run
reserve needs to the greatest extent possible through outright
purchases of Treasury securities. 4  The SOMA will cap the
rollover of its existing holdings at Treasury auctions and will engage
in secondary market purchases according to a schedule that
effectively will result in a greater percentage of
holdings of shorter-term security issues than of longer-dated ones. The
schedule ranges from 35 percent of an individual issue for Treasury
bills to 15 percent for longer-term bonds. These changes
were announced to the public on July 5, replacing a procedure in
which all maturing holdings were rolled over and in which coupon
purchases were spread evenly across the yield curve.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------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|Equity Prices

Major equity indexes have posted small gains so
far this year amid considerable volatility. Fluctuations in technology
stocks have been particularly pronounced: After having reached a record
high in March--24 percent above its 1999 year-end value--the
Nasdaq composite index, which is heavily weighted toward
technology shares, swung widely and by mid-July was up 5 percent
for the year. Given its surge in the second half of 1999, the mid-July
level of the Nasdaq was about 60 percent above its mid-1999
reading. The broader S&P 500 and Wilshire 5000 indexes have risen
close to 3 percent since the beginning of the year and are up
about 10 percent and 13 percent, respectively, from
mid-1999.


Chart of Major stock price indexesCorporate earnings reports have, for the most part, exceeded
expectations, and projections of future earnings continue to be revised
higher. However, the increase in interest rates since the beginning of
the year likely has restrained the rise in equity prices. In addition,
growing unease about the lofty valuations reached by technology shares
and rising default rates in the corporate sector may have given
some investors a better appreciation of the risks of
holding stocks in general. Reflecting the uncertainty about
the future course of the equity market, expected and actual
volatilities of stock returns rose substantially in the spring. At that
time, volatility implied by options on the Nasdaq 100 index
surpassed even the elevated levels reached during the financial market
turmoil of 1998.

Higher volatility and greater investor caution
had a marked effect on public equity offerings. The pace of
initial public offerings has fallen off considerably in recent months
from its brisk first-quarter rate, with some offerings being canceled
or postponed and others being priced well short of earlier
expectations. On the other hand, households' enthusiasm for equity
mutual funds, especially those funds that invest in the technology and
international sectors, remains relatively high, although it appears to
have faded some after the run-up in stock market volatility in the
spring. Following a first-quarter surge, net inflows to stock
funds moderated substantially in the second quarter but still were
above last year's average pace.Debt and the Monetary Aggregates
Debt and Depository Intermediation


The total debt of the U.S. household, government, and
nonfinancial business sectors is estimated to have increased at close
to a 5-1/2 percent annual rate in the first half of 2000.
Outside the federal government sector, debt expanded at an annual rate
of roughly 9-1/2 percent, buoyed by strength in household
and business borrowing. Continued declines in federal debt
have helped to ease the pressure on available savings and have
facilitated the rapid expansion of nonfederal debt outstanding: The
federal government paid down $218 billion of debt over the first
half of 2000, compared with paydowns of $56 billion and
$101 billion in the first six months of calendar years 1998 and
1999 respectively.


Chart of Growth of domestic nonfinancial debtDepository institutions have continued to play an important role
in meeting the strong demands for credit by businesses and households.
Adjusted for mark-to-market accounting rules, credit extended by
commercial banks rose 11-1/2 percent in the first half of
2000. This advance was paced by a brisk expansion of loans, which grew
at an annual rate of nearly 13 percent over this period. Bank
credit increased in part because some businesses sought bank loans as
an alternative to a less receptive corporate bond market. In addition,
the underlying strength of household spending helped boost the demand
for consumer and mortgage loans. Banks' holdings of consumer and
mortgage loans were also supported by a slower pace of securitizations
this year. In the housing sector, for instance, the rising interest
rate environment has kept the demand for adjustable-rate mortgages
relatively elevated, and banks tend to hold these securities on their
books rather than securitize them.

Banks have tightened terms and standards on loans further this
year, especially in the business sector, where some lenders have
expressed concerns about a more uncertain corporate outlook. Bank
regulators have noted that depository institutions need to take
particular care in evaluating lending risks to account for possible
changes in the overall macroeconomic environment and in conditions in
securities markets.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The Monetary Aggregates


Growth of the monetary aggregates over the first half of 2000 has been buffeted by several
special factors. The unwinding of the buildups in liquidity that
occurred in late 1999 before the century date change depressed
growth in the aggregates early this year. Subsequently, M2 rebounded
sharply in anticipation of outsized tax payments in the spring and then
ran off as those payments cleared. On net, despite the cumulative
firming of monetary policy since June 1999, M2 expanded at a relatively
robust, 6 percent, annual rate during the first half of 2000--the
same pace as in 1999--supported by the rapid expansion of
nominal spending and income.


Chart of M2 growth rateM2 velocity--the ratio of nominal income to
M2--has increased over the first half of this year, consistent with its
historical relationship with the interest forgone ("opportunity
cost") from holding M2. As usual, rates offered on many of the
components of M2 have not tracked the upward movement in market
interest rates, and the opportunity cost of holding M2 has risen. In
response, investors have reallocated some of their funds within M2
toward those components whose rates adjust more quickly--such as small
time deposits--and have restrained flows into M2 in favor of
longer-term mutual funds and direct holdings of market instruments.


Chart of M2 velocity and the opportunity cost of holding M2M3 expanded at an annual rate of 9 percent in the first half of
2000, up from 7-1/2 percent for all of 1999. The robust
expansion of bank credit underlies much of the acceleration in M3 this
year. Depository institutions have issued large time deposits and other
managed liabilities in volume to help fund the expansion of their loan
and securities portfolios. In contrast, flows to institutional money
funds slowed from the rapid pace of late 1999 after the heightened
preference for liquid assets ahead of the century date change ebbed.


Chart of M3 growth rateAs has been the case since 1994, depository institutions have
continued to implement new retail sweep programs over the first half of
2000 in order to avoid having to hold non-interest-bearing reserve
balances with the Federal Reserve System. As a result,
required reserve balances are still declining gradually, adding to
concerns that, under current procedures, low balances might adversely
affect the implementation of monetary policy by eventually
leading to increased volatility in the federal funds market. The
pending legislation that would allow the Federal Reserve to pay
interest on balances held at Reserve Banks would likely lead to a
partial unwinding over time of the ongoing trend in retail sweep
programs.
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|International Developments


In the first half of 2000, economic activity in
foreign economies continued the strong overall performance that was
registered last year. With a few exceptions, most emerging-market
countries continued to show signs of solid recoveries from earlier
recessions, supported by favorable financial market conditions. Average
real GDP in the foreign industrial countries accelerated noticeably in
the first half of this year after a mild slowdown in late 1999. The
pickup reflected in large part better performance of Japanese domestic
demand (although its sustainability has been questioned) and further
robust increases in Europe and Canada. In many countries, economic
slack diminished, heightening concern about inflation
risks. Higher oil prices bumped up broad measures of
inflation almost everywhere, but measures of core inflation edged up
only modestly, if at all.

Monetary conditions generally were tightened in foreign
industrial countries, as authorities removed stimulus by raising
official rates. Yield curves in several key industrial countries tended
to flatten, as interest rates on foreign long-term government
securities declined on balance after January, reversing an upward trend
seen since the second quarter of 1999. Yields on Japanese government
long-term bonds edged upward slightly, but at midyear still were only
about 1-3/4 percent.


Chart of Foreign interest ratesConcerns in financial markets at the end of last year about
potential disruptions during the century date change dissipated
quickly, and global markets in the early months of this year returned
to the comparatively placid conditions seen during most of 1999.
Starting in mid-March, however, global financial markets were jolted by
several episodes of increased volatility set off typically by sudden
downdrafts in U.S. Nasdaq prices. At that time, measures of market risk
for some emerging-market countries widened, but they later retraced
most of these increases. The performances of broad stock market indexes
in the industrial countries were mixed, but they generally tended to
reflect their respective cyclical positions. Stocks in Canada, France,
and Italy, for example, continued to make good gains, German stocks did
less well, and U.K. stocks slipped. Japanese shares also were down
substantially, even though the domestic economy showed some signs of
firmer activity. In general, price volatility of foreign high-tech
stocks or stock indexes weighted toward technology-intensive sectors
was quite high and exceeded that of corresponding broader indexes.


Chart of Nominal U.S. dollar exchange rates
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|The dollar continued to strengthen during most of the first half
of the year. It appeared to be supported mainly by continuing positive
news on the performance of the U.S. economy, higher U.S. short-term
interest rates, and for much of the first half, expectations of further
tightening of monetary policy. Early in the year, the attraction of
high rates of return on U.S. equities may have been an additional
supporting factor, but the dollar maintained its upward trend even
after U.S. stock prices leveled off near the end of the first quarter
and then declined for a while. In June, the dollar eased back a bit
against the currencies of some industrial countries amid signs that
U.S. growth was slowing. Nevertheless, for the year so far, the dollar
is up on balance about 5-3/4 percent against the major
currencies; against a broader index of trading-partner currencies, the
dollar has appreciated about 3-3/4 percent on balance.

The dollar has experienced a particularly large
swing against the euro. The euro started this year already down more
than 13 percent from its value against the dollar at the time
when the new European currency was introduced in January 1999, and it
continued to depreciate during most of the first half of 2000,
reaching a record low in May. During this period, the euro seemed to be
especially sensitive to news and public commentary by officials about
the strength of the expansion in the euro area, the pace of economic
reform, and the appropriate macroeconomic policy mix. Despite a modest
recovery in recent weeks, the euro still is down against the dollar
almost 7 percent on balance for the year so far and about
3-3/4 percent on a trade-weighted basis.


The euro's persistent weakness posed a challenge for authorities
at the European Central Bank as they sought to implement a policy
stance consistent with their official inflation objective (2 percent or
less for harmonized consumer prices) without threatening the euro
area's economic expansion. Supported in part by euro depreciation,
economic growth in the euro area in the first half of 2000
was somewhat stronger than the brisk 3 percent pace recorded last
year. Investment was robust, and indexes of both business and
consumer sentiment registered record highs. The average unemployment
rate in the area continued to move down to nearly 9 percent,
almost a full percentage point lower than a year earlier. At the end of
the first half, the euro-area broad measure of inflation, partly
affected by higher oil prices, was above 2 percent, while core
inflation had edged up to 1-1/4 percent. Variations in the
pace of economic expansion and the intensity of inflation pressures
across the region added to the complexity of the situation confronting
ECB policymakers even though Germany and Italy, two countries that had
lagged the euro-area average expansion of activity in recent years,
showed signs that they were beginning to move ahead more rapidly. After
having raised its refinancing rate 50 basis points in November
1999, the ECB followed with three 25-point increases in the first
quarter and another 50-point increase in June. The ECB pointed to price
pressures and rapid expansion of monetary aggregates as important
considerations behind the moves.

Compared with its fluctuations against the euro, the dollar's
value was more stable against the Japanese yen during the first half of
2000. In late 1999, private domestic demand in Japan slumped badly,
even though the Bank of Japan continued to hold its key policy
rate at essentially zero. Several times during the first half of this
year, the yen experienced strong upward pressure, often associated with
market perceptions that activity was reviving and with speculation that
the Bank of Japan soon might abandon its zero-interest-rate policy.
This upward pressure was resisted vigorously by Japanese authorities on
several occasions with sales of yen in foreign exchange markets. The
Bank of Japan continued to hold overnight interest rates near zero
through the first half of 2000.

The Japanese economy, in fact, did show signs of stronger
performance in the first half. GDP rose at an annual rate of 10
percent in the first quarter, with particular strength in private
consumption and investment. Industrial production, which had made solid
gains last year, continued to expand at a healthy pace, and surveys
indicated that business confidence had picked up. Demand from the
household sector was less robust, however, as consumer confidence was
held back by historically high unemployment. A large and growing
outstanding stock of public debt (estimated at more than 110
percent of GDP) cast increasing doubt about the extent to which
authorities might be willing to use additional fiscal stimulus to boost
demand. Even though some additional government expenditure for coming
quarters was approved in late 1999, government spending did not supply
stimulus in the first quarter. With core consumer prices moving down at
an annual rate that reached almost 1 percent at midyear,
deflation also remained a concern.

Economic activity in Canada so far this year slowed a bit from
its very strong performance in the second half of 1999, but it still
was quite robust, generating strong gains in employment and reducing
the remaining slack in the economy. The expansion was supported by both
domestic demand and spillovers from the U.S. economy. Higher energy
prices pushed headline inflation to near the top of the Bank of
Canada's 1 percent to 3 percent target range; core
inflation remained just below 1-1/2 percent. The Canadian
dollar weakened somewhat against the U.S. dollar in the first half of
the year even though the Bank of Canada raised policy interest rates
100 basis points, matching increases in U.S. rates. In the United
Kingdom, the Bank of England continued a round of tightening that
started in mid-1999 by raising official rates 25 basis points
twice in the first quarter. After March, indications that the economy
was slowing and that inflationary pressures might be ebbing under the
effect of the tighter monetary stance and strength of
sterling--especially against the euro--allowed the Bank to hold rates
constant. In recent months, sterling has depreciated on balance as
official interest rates have been raised in other major industrial
countries.

In developing countries, the strong recovery of economic activity
last year in both developing Asia and Latin America generally continued
into the first half of 2000. However, after a fairly placid period that
extended into the first few months of this year, financial market
conditions in some developing countries became more unsettled in the
April-May period. In some countries, exchange rates and equity prices
weakened and risk spreads widened, as increased political uncertainty
interacted with heightened financial market volatility and rising
interest rates in the industrial countries. In general, financial
markets now appear to be identifying and distinguishing those
emerging-market countries with problems more effectively than they
did several years ago.



Chart of Emerging marketsIn emerging Asia, the strong bounceback of activity last year
from the crisis-related declines of 1998 continued into the first half
of this year. Korea, which recorded the strongest recovery in the
region last year with real GDP rising at double-digit rates in every
quarter, has seen some moderation so far in 2000. However, with
inventories still being rebuilt, unemployment declining rapidly, and
inflation showing no signs of accelerating, macroeconomic
conditions remained generally favorable, and the won came under upward
pressure periodically in the first half of this year. Nonetheless, the
acute financial difficulties of Hyundai, Korea's largest industrial
conglomerate, highlighted the lingering effect on the corporate
and financial sectors of the earlier crisis and the need
for further restructuring. Economic activity in other
Asian developing countries that experienced
difficulties in 1997 and 1998 (Thailand, Indonesia, Malaysia,
Singapore, and the Philippines) also continued to firm this year,
but at varying rates. Nonetheless, financial market conditions have
deteriorated in recent months for some countries in the region.
 In Indonesia and the Philippines, declines in equity prices and weakness
in exchange rates appear to have stemmed from heightened market
concerns over political instability and prospects for economic
reform. Output in China increased at near double-digit annual rates
in the second half of last year and remained strong in the first half
of this year, boosted mainly by surging exports. In Hong Kong, real GDP
rose at an annual rate of more than 20 percent in the
first quarter of this year after a strong second half in 1999. Higher
consumer confidence appears to have boosted private consumption, and
trade flows through Hong Kong, especially to and from China, have
increased.

The general recovery seen last year in Latin America from effects
of the emerging-market financial crisis extended into the first part of
this year. In Brazil, inflation was remarkably well contained,
and interest rates were lowered, but unemployment has remained high. An
improved financial situation allowed the Brazilian government to repay
most of the funds obtained under its December 1998 international
support package. However, Brazilian financial markets showed continued
volatility this year, especially at times of heightened market concerns
over the status of fiscal reforms, and risk premiums widened in the
first half of 2000 on balance. In Mexico, activity has been strong so
far this year. In the first quarter, real GDP surged at an annual
rate of 11 percent, boosted by strong exports to the United
States, soaring private investment, and increased consumer
spending. Mexican equity prices and the peso encountered some
downward pressure in the approach of the July 2 national
election, but once the election was perceived to be fair and the
transition of power was under way, both recovered substantially.
In Argentina, the pace of recovery appears to have slackened
in the early part of this year, as the government's fiscal position
and, in particular, its ability to meet the targets of its
International Monetary Fund program remained a focus of market concern.
Heightened political uncertainty in Venezuela, Peru, Colombia, and
Ecuador sparked financial market pressures in recent months in those
countries, too. In January, authorities in Ecuador announced a program
of "dollarization," in which the domestic currency would be
entirely replaced by U.S. dollars. The program, now in the process of
implementation, appears to have helped stabilize financial conditions
there.
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|Footnotes

1.  The figures for compensation per hour in the nonfinancial
corporate sector are similar: an increase of about 4 percent for
the year ending in the first quarter of this year compared with almost
5-1/2 percent for the year ending in the first quarter of
1999. Return to text2.  Beginning with publication of the ECI for June 2000, the
Bureau of Labor Statistics plans to expand the definition of
nonproduction bonuses in the ECI to include hiring and retention
bonuses. These payments are already included in the wage and salary
measure underlying the data on compensation per hour calculated for the
productivity and cost series.  Return to text3.  A typical interest rate swap is an agreement between two
parties to exchange fixed and variable interest rate payments on a
notional principal amount over a predetermined period ranging from one
to thirty years. The notional amount itself is never exchanged.
Typically, the variable interest rate is the London Interbank Offered
Rate (LIBOR), and the fixed interest rate--called the swap rate--is
determined in the swap market. The overall credit quality of market
participants is high, typically A or above; those entities with credit
ratings of BBB or lower are generally either rejected or required to
adopt credit-enhancing mechanisms, typically by posting collateral.  Return to text4.  The FOMC prefers a portfolio with a short average maturity
because the higher turnover rate of such a portfolio gives it greater
flexibility to redeem securities in times of financial market stress,
which may require substantial decreases in the securities portfolio
over a relatively short period, such as during an acute banking crisis
that involves heavy lending through the discount window. Return to textSection 1Home |
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July 2000 report
Accessibility | Contact UsLast update: July 20, 2000, 10:00 AM
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