July 2000 Monetary Policy Report to the Congress  
 
Report forwarded to the Congress on July 20, 2000  
 
 Section 1   
 

MONETARY POLICY AND THE ECONOMIC OUTLOOK

The impressive performance of the U.S. economy persisted in the
first half of 2000 with economic activity expanding at a rapid pace.
Overall rates of inflation were noticeably higher, largely as a result
of steep increases in energy prices. The remarkable wave of new
technologies and the associated surge in capital investment have
continued to boost potential supply and to help contain price
pressures at high levels of labor resource use. At the same time,
rising productivity growth--working through its effects on wealth
and consumption, as well as on investment spending--has been one
of the important factors contributing to rapid increases in aggregate
demand that have exceeded even the stepped-up increases in
potential supply. Under such circumstances, and with the pool of
available labor already at an unusually low level, the continued
expansion of aggregate demand in excess of the growth in potential
supply increasingly threatened to set off greater price pressures.
Because price stability is essential to achieving maximum
sustainable economic growth, heading off these pressures has been
critical to extending the extraordinary performance of the U.S.
economy.   
 
To promote balance between aggregate demand and potential
supply and to contain inflation pressures, the Federal Open Market
Committee (FOMC) took additional firming actions this year,
raising the benchmark federal funds rate 1 percentage point
between February and May. The tighter stance of monetary policy,
along with the ongoing strength of credit demands, has led to less
accommodative financial conditions: On balance, since the
beginning of the year, real interest rates have increased, equity
prices have changed little after a sizable run-up in 1999, and lenders
have become more cautious about extending credit, especially to
marginal borrowers. Still, households and businesses have
continued to borrow at a rapid pace, and the growth of M2
remained relatively robust, despite the rise in market interest rates.
The favorable outlook for the U.S. economy has contributed to a
further strengthening of the dollar, despite tighter monetary policy
and rising interest rates in most other industrial countries.   
 
Perhaps partly reflecting firmer financial conditions, the incoming
economic data since May have suggested some moderation in the
growth of aggregate demand. Nonetheless, labor markets remained
tight at the time of the FOMC meeting in June, and it was unclear
whether the slowdown represented a decisive shift to more
sustainable growth or just a pause. The Committee left the stance of
policy unchanged but saw the balance of risks to the economic
outlook as still weighted toward rising inflation.    
 
 
Monetary Policy, Financial Markets, and the Economy over the
First Half of 2000   
 
When the FOMC convened for its first two meetings of the year, in
February and March, economic conditions in the United States
were pointing toward an increasingly taut labor market as a
consequence of a persistent imbalance between the growth rates of
aggregate demand and potential aggregate supply. Reflecting the
underlying strength in spending and expectations of tighter
monetary policy, market interest rates were rising, especially after
the century date change passed without incident. But, at the same
time, equity prices were still posting appreciable gains on net.
Knowing that the two safety valves that had been keeping
underlying inflation from picking up until then--the economy's
ability to draw on the pool of available workers and to expand its
trade deficit on reasonable terms--could not be counted on
indefinitely, the FOMC voted for a further tightening in monetary
policy at both its February and its March meetings, raising the
target for the overnight federal funds rate 25 basis points on each
occasion. In related actions, the Board of Governors also approved
quarter-point increases in the discount rate in both February and
March.       
 
The FOMC considered larger policy moves at its first two meetings
of 2000 but concluded that significant uncertainty about the
outlook for the expansion of aggregate demand in relation to that of
aggregate supply, including the timing and strength of the
economy's response to earlier monetary policy tightenings,
warranted a more limited policy action. Still, noting that there had
been few signs that the rise in interest rates over recent quarters had
begun to bring demand in line with potential supply, the Committee
decided in both instances that the balance of risks going forward
was weighted mainly in the direction of rising inflation pressures. In
particular, it was becoming increasingly clear that the Committee
would need to move more aggressively at a later meeting if
imbalances continued to build and inflation and inflation
expectations, which had remained relatively subdued until then,
began to pick up. 1/    
 
Some readings between the March and May meetings of the FOMC
on labor costs and prices suggested a possible increase of inflation
pressures. Moreover, aggregate demand had continued to grow at a
fast clip, and markets for labor and other resources were showing
signs of further tightening. Financial market conditions had firmed
in response to these developments; the substantial rise in private
borrowing rates between March and May had been influenced by
the buildup in expectations of more policy tightening as market
participants recognized the need for higher short-term interest rates.
Given all these circumstances, the FOMC decided in May to raise
the target for the overnight federal funds rate 50 basis points, to
6-1/2 percent. The Committee saw little risk in the more forceful
action given the strong momentum of the economic expansion and
widespread market expectations of such an action. Even after
taking into account its latest action, however, the FOMC saw the
strength in spending and pressures in labor markets as indicating
that the balance of risks remained tilted toward rising inflation.    
 
By the June FOMC meeting, the incoming data were suggesting
that the expansion of aggregate demand might be moderating
toward a more sustainable pace: Consumers had increased their
outlays for goods modestly during the spring; home purchases and
starts appeared to have softened; and readings on the labor market
suggested that the pace of hiring might be cooling off. Moreover,
much of the effects on demand of previous policy firmings,
including the 50 basis point tightening in May, had not yet been
fully realized. Financial market participants interpreted signs of
economic slowing as suggesting that the Federal Reserve probably
would be able to hold inflation in check without much additional
policy firming. However, whether aggregate demand had moved
decisively onto a more moderate expansion track was not yet clear,
and labor resource utilization remained unusually elevated. Thus,
although the FOMC decided to defer any policy action in June, it
indicated that the balance of risks was still on the side of rising
inflation in the foreseeable future. 2/  
 
 
Economic Projections for 2000 and 2001  

The members of the Board of Governors and the Federal Reserve
Bank presidents expect the current economic expansion to continue
through next year, but at a more moderate pace than the average
over recent quarters. For 2000 as a whole, the central tendency of
their forecasts for the rate of increase in real gross domestic
product (GDP) is 4 percent to 4-1/2 percent, measured as the
change between the fourth quarter of 1999 and the fourth quarter
of 2000. Over the four quarters of 2001, the central tendency
forecasts of real GDP are in the 3-1/4 percent to 3-3/4 percent
range. With this pace of expansion, the civilian unemployment rate
should remain near its recent level of 4 percent. Even with the
moderation in the pace of economic activity, the Committee
members and nonvoting Bank presidents expect that inflation may
be higher in 2001 than in 1999, and the Committee will need to be
alert to the possibility that financial conditions may need to be
adjusted further to balance aggregate demand and potential supply
and to keep inflation low.       
 
Considerable uncertainties attend estimates of potential
supply--both the rate of growth and the level of the economy's
ability to produce on a sustained non-inflationary basis. Business
investment in new equipment and software has been exceptionally
high, and given the rapid pace of technological change, firms will
continue to exploit opportunities to implement more-efficient
processes and to speed the flow of information across markets. In
such an environment, a further pickup in productivity growth is a
distinct possibility. However, a portion of the very rapid rise in
measured productivity in recent quarters may be a result of the
cyclical characteristics of this expansion rather than an indication of
structural rates of increase consistent with holding the level of
resource utilization unchanged. Current levels of labor resource
utilization are already unusually high. To date, this has not led to
escalating unit labor costs, but whether such a favorable
performance in the labor market can be sustained is one of the
important uncertainties in the outlook.    
 
On the demand side, the adjustments in financial markets that have
accompanied expected and actual tighter monetary conditions may
be beginning to moderate the rise in domestic demand. As that
process evolves, the substantial impetus that household spending
has received in recent years from rapid gains in equity wealth
should subside. The higher cost of business borrowing and
more-restrictive credit supply conditions probably will not exert
substantial restraint on investment decisions, particularly as long as
the costs and potential productivity payoffs of new equipment and
software remain attractive. The slowing in domestic spending will
not be fully reflected in a more moderate expansion of domestic
production. Some of the slowing will be absorbed in smaller
increases in imports of goods and services, and given continued
recovery in economic activity abroad, domestic firms are expected
to continue seeing a boost to demand and to production from rising
exports.    
 
Regarding inflation, FOMC participants believe that the rise in
consumer prices will be noticeably larger this year than in 1999 and
that inflation will then drop back somewhat in 2001. The central
tendency of their forecasts for the increase in the chain-type index
for personal consumption expenditures is 2-1/2 percent to 
2-3/4 percent over the four quarters of 2000 and 2 percent to 
2-1/2 percent during 2001. Shaping the contour of this inflation forecast
is the expectation that the direct and indirect effects of the boost to
domestic inflation this year from the rise in the price of world crude
oil will be partly reversed next year if, as futures markets suggest,
crude oil prices retrace this year's run-up by next year. Nonetheless,
these forecasts show consumer price inflation in 2001 to have
moved above the rates that prevailed over the 1997-98 period.
Such a trend, were it not to show signs of quickly stabilizing or
reversing, would pose a considerable risk to the continuation of the
extraordinary economic performance of recent years.    
 
The economic forecasts of the FOMC are similar to those recently
released by the Administration in its Mid-Session Review of the
Budget. Compared with the forecasts available in February, the
Administration raised its projections for the increase in real GDP in
2000 and 2001 to rates that lie at the low end of the current range
of central tendencies of Federal Reserve policymakers. The
Administration also expects that the unemployment rate will remain
close to 4 percent. Like the FOMC, the Administration sees
consumer price inflation rising this year and falling back in 2001.
After accounting for the differences in the construction of the
alternative measures of consumer prices, the Administration's
projections of increases in the consumer price index (CPI) of 
3.2 percent in 2000 and 2.5 percent in 2001 are broadly consistent 
with the Committee's expectations for the chain-type price index for
personal consumption expenditures.      
 

 
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.   
 
Inflation 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.   
 
 
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.  
 
Outlays 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.   
 
 
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.   
 
By 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.  
 
 
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.   
 
Sustained 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.   
 
 
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.  
 
The 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.   
 
On 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.  
 
In 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.  
 
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.   
 
Commercial 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.  
 
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.   
 
Early 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.   
 
 
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.   
 
U.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.   
 
The 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.   
 
A 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.    
 
 
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.   
 
Monthly 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.   
 
This 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. 3/   
 
Part 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. 4/ 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.   
 
With 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.    
 
 
Prices  
 
Rates of increase in the broader measures of prices moved up
further in early 2000. After having accelerated from 1 percent
during 1998 to 1-1/2 percent last year, the chain-type price index
for GDP--prices of goods and services that are produced
domestically--increased at an annual rate of 3 percent in the first
quarter of this year. The upswing in inflation for goods and services
purchased by consumers, businesses, and governments has been
somewhat greater: The chain-type price index for gross domestic
purchases rose at an annual rate of 3-1/2 percent in the first quarter
after having increased about 2 percent during 1999 and just 
3/4 percent during 1998.  
 
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.   
 
Core 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.  
 
 
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.   
 
 
Interest 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.   
 
Forecasts 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. 5/ 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. 
 
 
The 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.   
 
Aware 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. 6/
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.   
 
 
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.   
 
Corporate 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.   
 
Depository 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.   
 
M2 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.  
 
M3 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.   
 
As 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.    
 
 
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.   
 
Concerns 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.   
 
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.  
 
In 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.      
 
 
 
FOOTNOTES 
---------   
 
1. At its March and May meetings, the FOMC took a number of
actions that were aimed at adjusting the implementation of
monetary policy to actual and prospective reductions in the stock of
Treasury debt securities. These actions are described in the
discussion of U.S. financial markets.  
 
2. At its June meeting, the FOMC did not establish ranges for
growth of money and debt in 2000 and 2001. The legal requirement
to establish and to announce such ranges had expired, and owing to
uncertainties about the behavior of the velocities of debt and
money, these ranges for many years have not provided useful
benchmarks for the conduct of monetary policy. Nevertheless, the
FOMC believes that the behavior of money and credit will continue
to have value for gauging economic and financial conditions, and
this report discusses recent developments in money and credit in
some detail.    

3. 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.  
 
4. 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.  
 
5. 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.  
 
6. 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.