For use at 10:00 a.m., EDT

Thursday

July 20, 2000

Board of Governors of the Federal Reserve System

Monetary Policy Report to the Congress

July 20, 2000
Letter of Transmittal

BOARD OF GOVERNORS OF THE

FEDERAL RESERVE SYSTEM

Washington, D.C., July 20, 2000

THE PRESIDENT OF THE SENATE

THE SPEAKER OF THE HOUSE OF REPRESENTATIVES

The Board of Governors is pleased to forward its Monetary Policy Report to the Congress.

Sincerely,

Alan Greenspan, Chairman
Table of Contents

Page

Monetary Policy and the Economic Outlook 1

Economic and Financial Developments in 2000 4
Monetary Policy Report to the Congress

Report forwarded to the Congress on July 20, 2000

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 tight-
enings, 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 61⁄2 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

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.

Selected interest rates

2/4 3/31 5/19 7/1 8/18 9/29 10/1511/17 12/22 2/3 3/30 5/18 6/30 8/24 10/5 11/16 12/21 2/3 3/21 5/16 6/28

1998 1999 2000

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

Percent

Thirty-year Treasury

Two-year Treasury

Intended federal funds rate

Discount

rate Three-month Treasury

Note. The data are daily. Vertical lines indicate the days on which the

Federal Reserve announced a change in the intended funds rate. The dates on the

horizontal axis are those on which either the FOMC held a scheduled meeting or

a policy action was announced. Last observations are for July 17, 2000.

2 Monetary Policy Report to the Congress July 2000
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

41⁄2 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 31⁄4 percent to

33⁄4 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 chaintype index for personal consumption expenditures

is 21⁄2 percent to 23⁄4 percent over the four quarters

of 2000 and 2 percent to 21⁄2 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

1. Economic projections for 2000 and 2001

Percent

Indicator

Federal Reserve governors

and Reserve Bank presidents

Administration

Range Central

tendency

2000

Change, fourth quarter

to fourth quarter1

Nominal GDP ........... 6–71⁄4 61⁄4–63⁄4 6.0

Real GDP 2 ............. 33⁄4–5 4–41⁄2 3.9

PCE prices . . . . . . . . . . . . . . 2–23⁄4 21⁄2–23⁄4 3.2 3

Average level,

fourth quarter

Civilian unemployment

rate . . . . . . . . . . . . . . . . 4–41⁄4 About 4 4.1

2001

Change, fourth quarter

to fourth quarter1

Nominal GDP ........... 5–61⁄4 51⁄2–6 5.3

Real GDP 2 ............. 21⁄2–4 31⁄4–33⁄4 3.2

PCE prices . . . . . . . . . . . . . . 13⁄4–3 2–21⁄2 2.5 3

Average level,

fourth quarter

Civilian unemployment

rate . . . . . . . . . . . . . . . . 4–41⁄2 4–41⁄4 4.2

1. Change from average for fourth quarter of previous year to average for

fourth quarter of year indicated.

2. Chain-weighted.

3. Projection for the consumer price index.

Board of Governors of the Federal Reserve System 3
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.

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 51⁄2 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.

Change in real GDP

1994 1995 1996 1997 1998 1999 2000

2

4

6

Percent, annual rate

Q1

Note. In this chart and in subsequent charts that show the components of

real GDP, changes are measured to the final quarter of the period indicated, from

the final quarter of the previous period.

Change in PCE chain-type price index

1994 1995 1996 1997 1998 1999 2000

0

–

+

1

2

3

4

Percent, annual rate

Q1

4 Monetary Policy Report to the Congress July 2000
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 73⁄4 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 53⁄4 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 51⁄2 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 171⁄4 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 33⁄4 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

Change in real income and consumption

1994 1995 1996 1997 1998 1999 2000

0

–

+

2

4

6

8

Percent, annual rate

Disposable personal income

Personal consumption expenditures Q1

Wealth and saving

4

5

6

Ratio

1978 1982 1986 1990 1994 1998

0

–

+

2

4

6

8

10

12

Percent

Wealth-to-income ratio Personal saving rate

Q1

Q1

Note. The wealth-to-income ratio is the ratio of net worth of households to

disposable personal income.

Board of Governors of the Federal Reserve System 5
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 home-ownership 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 11⁄4 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

Private housing starts

1988 1990 1992 1994 1996 1998 2000

.4

.8

1.2

Millions of units, annual rate

Single-family

Multifamily Q1

Q1

6 Monetary Policy Report to the Congress July 2000
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

Delinquency rates on household loans

1988 1990 1992 1994 1996 1998 2000

2

3

4

5

Percent

Credit card accounts

at banks

Auto loans at domestic

auto finance companies

Mortgages

Q1

Q1

Q1

Note. Data on credit card delinquencies are from bank Call Reports; data on

auto loan delinquencies are from the Big Three automakers; data on mortgage

delinquencies are from the Mortgage Bankers Association.

Change in real business fixed investment

1994 1995 1996 1997 1998 1999 2000

0

–

+

10

20

Percent, annual rate

Structures

Equipment and software

Q1

Board of Governors of the Federal Reserve System 7
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 broadband 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 currentcost 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

Change in real nonfarm business inventories

1994 1995 1996 1997 1998 1999 2000

0

–

+

4

Percent, annual rate

Q1

8 Monetary Policy Report to the Congress July 2000
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 101⁄2 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 shorterterm 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

Before-tax profits of nonfinancial corporations

as a share of GDP

1977 1980 1983 1986 1989 1992 1995 1998 2000

6

8

10

12

14

Percent

Q1

Note. Profits from domestic operations, with inventory valuation and capital

consumption adjustments, divided by gross domestic product of nonfinancial

corporate sector.

Gross corporate bond issuance

J J A S OND J FMAM J J A S OND J FMAM J

1998 1999 2000

5

10

15

20

25

30

35

Billions of dollars

High yield

Investment grade

Note. Excludes unrated issues and issues sold abroad.

Board of Governors of the Federal Reserve System 9
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

Spreads of corporate bond yields

over the ten-year swap rate

J J A S OND J FMAM J J A S OND J FMAM J J

1998 1999 2000

0

–

+

1

2

3

4

5

6

Percentage points

High yield

BBB

AA

Note. The data are daily. The spreads compare the yields on the Merrill

Lynch AA, BBB, and 175 indexes with the ten-year swap rate from Bloomberg.

Last observations are for July 17, 2000.

Ratio of liabilities of failed nonfinancial firms

to liabilities of all nonfinancial firms

1989 1991 1993 1995 1997 1999

.3

.6

.9

1.2

Percent, annual rate

June1

1. Year-to-date.

Source. Dun & Bradstreet.

Default rates on outstanding junk bonds

1989 1991 1993 1995 1997 1999

2

4

6

8

10

Percent, annual rate

June1

1. Year-to-date.

Source. Moody’s Investors Service.

10 Monetary Policy Report to the Congress July 2000
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

21⁄4 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 161⁄2 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 51⁄4 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.

National saving as a share of nominal GNP

1982 1986 1990 1994 1998

16

20

Percent

Excluding federal saving

Total Q1

Q1

Note. National saving comprises the gross saving of households, businesses,

and governments.

Federal receipts and expenditures as a share of nominal GDP

1982 1986 1990 1994 1998

18

20

22

24

Percent

Total expenditures

Total receipts

Note. Data on receipts and expenditures are from the unified budget. Values

for 2000 are current services estimates from the Mid-Session Review of the

Budget by the Office of Management and Budget.

Board of Governors of the Federal Reserve System 11
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 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 41⁄4 percent of GDP, comFederal government debt held by the public

1959 1969 1979 1989 1999

30

40

50

60

Percent of nominal GDP

Note. The data are annual and extend through 2000. Federal debt held by

private investors is gross federal debt less debt held by federal government

accounts and the Federal Reserve System. The value for 2000 is an estimate

based on the Administration’s June 26 Mid-Session Review of the Budget.

12 Monetary Policy Report to the Congress July 2000
pared 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 61⁄4 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 113⁄4 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 13⁄4 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

U.S. current account

1994 1995 1996 1997 1998 1999 2000

350

280

210

140

70

0

–

+

Billions of dollars, annual rate

Q1

Change in real imports and exports of goods and services

1994 1995 1996 1997 1998 1999 2000

5

0

–

+

5

10

15

20

Percent, annual rate

Imports

Exports

Q1

Prices for oil and other commodities

100

150

Index, January 1999 = 100

Q1 Q2 Q3 Q4 Q1 Q2 Q3

1999 2000

10

20

30

Dollars per barrel

Oil

Non-oil commodities

Note. The oil price is the spot price of West Texas intermediate crude oil.

The price for non-oil commodities is a weighted average of thirty-nine non-fuel

primary-commodity prices from the International Monetary Fund. The data are

monthly. The last observation for non-oil commodities is May; for oil, July

average through July 12, 2000.

Board of Governors of the Federal Reserve System 13
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 11⁄2 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 accelerNet change in total nonfarm payroll employment

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

0

–

+

200

400

Thousands of jobs, monthly average

Hiring for

the Census

H1

14 Monetary Policy Report to the Congress July 2000
ated 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 51⁄4 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 41⁄2 percent above a year

earlier. Before that jump, year-over-year changes in

the ECI compensation series had remained close to

31⁄2 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 41⁄4 percent higher than a year earlier; in the first quarter of 1999, the four-quarter

change was 51⁄4 percent.3

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 51⁄2 percent for the year ending in the first quarter of 1999.

Measures of labor utilization

1970 1975 1980 1985 1990 1995 2000

3

6

9

12

15

Percent

Augmented unemployment rate

Civilian unemployment rate

Note. The augmented unemployment rate is the number of unemployed plus

those who are not in the labor force and want a job, divided by the civilian labor

force plus those who are not in the labor force and want a job. The break in data

at January 1994 marks the introduction of a redesigned survey; data from that

point on are not directly comparable with those of earlier periods.

Board of Governors of the Federal Reserve System 15
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-overyear change in wages and salaries jumped from about

4 percent for the period ending in December 1999 to

almost 81⁄2 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 33⁄4 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

31⁄2 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

51⁄2 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

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.

Measures of the change in hourly compensation

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

2

4

6

Percent, Q4 to Q4

Employment cost index

Nonfarm compensation per hour

Q1

Note. The ECI is for private industry excluding farm and household workers. Nonfarm compensation per hour is for the nonfarm business sector.

Change in output per hour for the nonfarm business sector

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

0

–

+

2

4

6

Percent, Q4 to Q4

Q1

Note. The value for 2000:Q1 is the percent change from a year earlier.

16 Monetary Policy Report to the Congress July 2000
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 33⁄4 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-overyear 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 11⁄2 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 31⁄2 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 consumer 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

Change in unit labor costs for the nonfarm business sector

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

.5

1.0

1.5

2.0

2.5

3.0

Percent, Q4 to Q4

Q1

Note. The value for 2000:Q1 is the percent change from a year earlier.

2. Alternative measures of price change

Percent, annual rate

Price measure

1997:Q4

to

1998:Q4

1998:Q4

to

1999:Q4

1999:Q4

to

2000:Q1

Chain-type

Gross domestic product . . . . . . . . . . . . . . 1.0 1.6 3.0

Gross domestic purchases . . . . . . . . . . . . .7 1.9 3.5

Personal consumption expenditures . . . .9 2.0 3.5

Excluding food and energy . . . . . . . . . 1.3 1.5 2.2

Fixed-weight

Consumer price index . . . . . . . . . . . . . . . . 1.5 2.6 4.0

Excluding food and energy . . . . . . . . . 2.4 2.1 2.3

Note. A fixed-weight index uses quantity weights from the base year to

aggregate prices from each distinct item category. A chain-type index is the

geometric average of two fixed-weight indexes and allows the weights to change

each year. Changes are based on quarterly averages.

Change in consumer prices

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

1

2

3

4

5

Percent, Q4 to Q4

Consumer price index

Chain-type price index for PCE

Q1

Q2

Note. Consumer price index for all urban consumers. Values for 2000:Q1

and Q2 are percent changes from the previous quarter at an annual rate.

Board of Governors of the Federal Reserve System 17
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 13⁄4 percent

during 1999 to an annual rate of 31⁄2 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 21⁄4 percent in the first quarter compared with

an increase of 11⁄2 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

21⁄4 percent in the first quarter of 2000 and at a

23⁄4 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 31⁄2 percent

during the first two quarters of this year compared

with a rise of 23⁄4 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

Change in consumer prices excluding food and energy

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

1

2

3

4

5

6

Percent, Q4 to Q4

Consumer price index

Chain-type price index for PCE

Q1

Q2

Note. Consumer price index for all urban consumers. Values for 2000:Q1

and Q2 are percent changes from the previous quarter at an annual rate.

18 Monetary Policy Report to the Congress July 2000
construction higher; after having accelerated from

3 percent to 31⁄2 percent between 1998 and 1999, this

index increased at an annual rate of 41⁄4 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 fixedincome 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 moneSelected Treasury rates, daily data

J FMAM J J A S OND J FMAM J J A S OND J FMAM J J

1998 1999 2000

3.5

4.0

4.5

5.0

5.5

6.0

6.5

Percent

Thirty-year

Treasury

Three-month

Treasury

Five-year

Treasury

Note. Last observations are for July 17, 2000.

Selected Treasury rates, quarterly data

1964 1969 1974 1979 1984 1989 1994 1999

4

6

8

10

12

14

Percent

Thirty-year

Treasury

Three-month

Treasury

Five-year

Treasury

Q2

Note. The twenty-year Treasury bond rate is shown until the first issuance

of the thirty-year Treasury bond in February 1977. Last observations are for

2000:Q2.

Board of Governors of the Federal Reserve System 19
tary 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 longerdated 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. fixedincome 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 governmentsponsored 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

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.

Selected yield curves, July 17, 2000

2 5 10 20 30

Years to maturity

5.7

5.9

6.1

6.3

6.5

6.7

6.9

7.1

7.3

Percent

Interest rate swaps

Treasury securities

Source. Swap rates are from the International Swaps and Derivatives Association, as reported by Reuters.

Spread of BBB corporate yields

1998 1999 2000

.5

1.0

1.5

2.0

2.5

Percentage points

Over ten-year Treasury yield

Over ten-year swap rate

Note. Last observations are for July 17, 2000. The data are daily.

20 Monetary Policy Report to the Congress July 2000
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 shorterterm 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 midJuly 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

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.

Major stock price indexes

J J A S OND J FMAM J J A S OND J FMAM J J

1998 1999 2000

60

80

100

120

140

160

180

200

220

Index, June 30, 1999 = 100

Nasdaq

S&P 500

Wilshire 5000

Note. The data are daily. Last observations are for July 17, 2000.

Board of Governors of the Federal Reserve System 21
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 51⁄2 percent annual rate in the

first half of 2000. Outside the federal government

sector, debt expanded at an annual rate of roughly

91⁄2 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 111⁄2 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.

Growth of domestic nonfinancial debt

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

6

4

2

0

–

+

2

4

6

8

10

Percent, annual rate

Total

Federal

Nonfederal

H1

Note. Total debt consists of the outstanding credit market debt of the U.S.

government, state and local governments, households and nonprofit organizations, nonfinancial businesses, and farms. Annual growth rates are computed

from average for fourth quarter of preceding year to average for fourth quarter

of year indicated. Growth in the first half of 2000 is computed from average for

fourth quarter of 1999 to average for the second quarter of 2000 and expressed

at an annual rate. The growth rate for 2000:H1 is currently based on partially

estimated data.

22 Monetary Policy Report to the Congress July 2000
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 71⁄2 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 impleM2 growth rate

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

2

4

6

8

Percent, annual rate

H1

Note. M2 consists of currency, travelers checks, demand deposits, other

checkable deposits, savings deposits (including money market deposit accounts),

small-denomination time deposits, and balances in retail money market funds.

See footnote under the domestic nonfinancial debt chart for details on the computation of growth rates.

M2 velocity and the opportunity cost of holding M2

1.7

1.8

1.9

2.0

2.1

Ratio scale

1978 1983 1988 1993 1998

1

2

3

4

10

25

Percentage points, ratio scale

M2 velocity

M2

opportunity

cost

Note. The data are quarterly and are through 2000:Q1. The velocity of M2 is

the ratio of nominal gross domestic product to the stock of M2. The opportunity

cost of M2 is a two-quarter moving average of the difference between the

three-month Treasury bill rate and the weighted average return on assets

included in M2.

M3 growth rate

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

2

4

6

8

10

Percent, annual rate

H1

Note. M3 consists of M2 plus large-denomination time deposits, balances

on institutional money market funds, RP liabilities (overnight and term), and

eurodollars (overnight and term). See footnote under the domestic nonfinancial

debt chart for details on the computation of growth rates.

Board of Governors of the Federal Reserve System 23
mentation 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 13⁄4 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 53⁄4 percent against

the major currencies; against a broader index of

trading-partner currencies, the dollar has appreciated

about 33⁄4 percent on balance.

Foreign interest rates

0

–

+

2

4

6

Percent

Q1 Q2 Q3 Q4 Q1 Q2 Q3

1999 2000

2

4

6

Short-term (three-month)

U.K. interbank

Canadian finance paper

Euro-area interbank

Japanese CD

Long-term (ten-year government bonds)

Canada

United Kingdom

Germany

Japan

Note. The data are weekly. Last observations are for the week ending

July 12, 2000.

24 Monetary Policy Report to the Congress July 2000
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 33⁄4 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 11⁄4 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

Nominal U.S. dollar exchange rates

100

105

First week 1999 = 100

Q1 Q2 Q3 Q4 Q1 Q2 Q3

1999 2000

100

115

130

Exchange rate indexes

Broad

Major

Selected bilateral rates

Euro

U.K. pound

Canadian dollar Japanese yen

Note. The data are weekly. Indexes in the upper panel are trade-weighted

averages of the exchange value of the dollar against major currencies and

against the currencies of a broad group of important U.S. trading partners. Last

observations are for the week ending July 12, 2000.

Board of Governors of the Federal Reserve System 25
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 11⁄2 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 doubledigit 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

Emerging markets

100

120

140

160

First week 1999 = 100

Q1 Q2 Q3 Q4 Q1 Q2 Q3

1999 2000

4

8

12

16

Percentage points

Dollar exchange rates

Brazil

Korea

Mexico

EMBI+ spreads

Brazil

Mexico

Korea

Note. The data are weekly. EMBI+ (J.P. Morgan emerging market bond

index) spreads are stripped Brady-bond yield spreads over U.S. Treasuries. Last

observations are for the week ending July 12, 2000.

26 Monetary Policy Report to the Congress July 2000
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.

Board of Governors of the Federal Reserve System 27