Monetary Policy and Economic Developments 3 Monetary Policy and the Economic Outlook Last year was a difficult one for the in that rate to 3 percentage points by economy of the United States. The August. slowdown in the growth of economic The devastating events of Septem- activity that had become apparent in late ber 11 further set back an already fragile 2000 intensified in the first half of the economy. Heightened uncertainty and year. Businesses slashed investment badly shaken confidence caused a wide- spending—making especially deep spread pullback from economic activity cuts in outlays for high-technology and from risk-taking in financial mar- equipment—in response to weakening kets, where equity prices fell sharply for final demand, an oversupply of some several weeks and credit risk spreads types of capital, and declining profits. widened appreciably. The most pressing As actual and prospective sales deterio- concern of the Federal Reserve in the rated, many firms in the factory sector first few days following the attacks was struggled with uncomfortably high lev- to help shore up the infrastructure of els of inventories, and the accompany- financial markets and to provide mas- ing declines in manufacturing output sive quantities of liquidity to limit poten- steepened. At the same time, foreign tial disruptions to the functioning of economies also slowed, further reducing those markets. The economic fallout of the demand for U.S. production. The the events of September 11 led the Fed- aggressive actions by the Federal eral Open Market Committee (FOMC) Reserve to ease the stance of monetary to cut the target federal funds rate after a policy in the first half of the year pro- conference call early the following week vided support to consumer spending and and again at each meeting through the the housing sector. Nevertheless, the end of the year (see box ‘‘Monetary weakening in activity became more Policy after the Terrorist Attacks’’). widespread through the summer, job Displaying the same swift response to losses mounted further, and the unem- economic developments that appears ployment rate moved higher. With few to have characterized much business indications that economic conditions behavior in the current cyclical episode, were about to improve, with underlying firms moved quickly to reduce payrolls inflation moderate and edging lower, and cut production after mid-September. and with inflation expectations well Although these adjustments occurred contained, the Federal Reserve contin- across a broad swath of the economy, ued its efforts to counter the ongoing manufacturing and industries related to weakness by cutting the federal funds travel, hospitality, and entertainment rate, bringing the cumulative reduction bore the brunt of the downturn. Mea- sures of consumer confidence fell sharply in the first few weeks after the Note. The discussions here and in the next attacks, but the deterioration was not section (‘‘Economic and Financial Developments especially large by cyclical standards, in 2001 and Early 2002’’) consist of the text, tables, and selected charts from Monetary Policy and improvement in some of these Report to the Congress (Board of Governors, Feb- indexes was evident in October. Simi- ruary 2002). larly, equity prices started to rebound in 4 88th Annual Report, 2001 Monetary Policy after the Terrorist Attacks The terrorist attacks on September 11 Depository institutions took up the offer, destroyed a portion of the infrastructure of and borrowing surged to a record U.S. financial markets, disrupted communi- $451⁄2 billion by Wednesday. Discount cation networks, and forced some market loans outstanding dropped off sharply on participants to retreat to contingency sites Thursday and returned to very low levels in varying states of readiness. These devel- by Friday. Separately, overnight overdrafts opments, along with the tragic loss of life on Tuesday and Wednesday rose to several among the employees of a few major finan- billion dollars, as a handful of depository cial firms, greatly complicated trading, and other institutions with accounts at the clearing, and settlement of many different Federal Reserve were forced into overdraft classes of financial instruments. Direct dis- on their reserve accounts. Overnight over- locations elevated uncertainties about pay- drafts returned to negligible levels by the ment flows, making it difficult for the end of the week. reserve market to channel funds where they Like their U.S. counterparts, foreign were needed most. Depositories that held financial institutions operating in the more reserve balances than they preferred United States faced elevated dollar liquid- had considerable difficulty unloading the ity needs. In some cases, however, these excess in the market; by contrast, deposi- institutions encountered difficulties posi- tories awaiting funds had to scramble to tioning the collateral at their U.S. branches cover overdraft positions. As a result, the to secure Federal Reserve discount window effective demand for reserves ballooned. credit. To be in a position to help meet The Federal Reserve accommodated the those needs, three foreign central banks increase in the demand for reserves through established new or expanded arrangements a variety of means, the relative importance with the Federal Reserve to receive dollars of which shifted through the week. On in exchange for their respective currencies. Tuesday morning, shortly after the attacks, These swap lines, which lasted for the Federal Reserve issued a press release thirty days, consisted of $50 billion for the reassuring financial markets that the Fed- European Central Bank, $30 billion for the eral Reserve System was functioning nor- Bank of England, and an increase of $8 bil- mally and stating that ‘‘the discount win- lion (from $2 billion to $10 billion) for dow is available to meet liquidity needs.’’ the Bank of Canada. The European Central late September, and risk spreads began ately following September 11. Several to narrow somewhat by early Novem- factors were at work in support of ber, when it became apparent that the household spending during this period. economic effects of the attacks were Low and declining interest rates pro- proving less severe than many had vided a lift to outlays for durable goods feared. and to activity in housing markets. Consumer spending remained sur- Nowhere was the boost from low inter- prisingly solid over the final three est rates more apparent than in the sales months of the year in the face of of new motor vehicles, which soared in enormous economic uncertainty, wide- response to the financing incentives spread job losses, and further deteriora- offered by manufacturers. Low mort- tion of household balance sheets from gage interest rates not only sustained the sharp drop in equity prices immedi- high levels of new home construction Monetary Policy and the Economic Outlook 5 Bank drew on its line that week to channel level. As anticipated by the FOMC, federal the funds to institutions with a need for funds traded somewhat below their new dollars. target level for the rest of the week. By the By Thursday and Friday, the disruption end of the month, bid–asked spreads and in air traffic caused the Federal Reserve to trading volumes in the interbank and other extend record levels of credit to depository markets receded to more normal levels, institutions in the form of check float. Float and federal funds consistently began to increased dramatically because the Federal trade around the intended rate. Reserve continued to credit the accounts of The Federal Reserve took several steps banks for deposited checks even though the to facilitate market functioning in Septem- grounding of airplanes meant that checks ber in addition to accommodating the normally shipped by air could not be pre- heightened demand for reserves. The hours sented to the checkwriters’ banks on the of funds and securities transfer systems usual schedule. Float declined to normal operated by the Federal Reserve were levels the following week once air traffic extended significantly for a week after the was permitted to recommence. Lastly, over attacks. The Federal Reserve Bank of New the course of the week that included Sep- York liberalized the terms under which it tember 11, as the market for reserves began would lend the securities in the System to function more normally, the Federal portfolio, and the amount of securities lent Reserve resumed the use of open market rose to record levels in the second half operations to provide the bulk of reserves. of September. For the ten days following The open market Desk accommodated the attacks, the Federal Reserve reduced all propositions down to the target federal or eliminated the penalty charged on over- funds rate, operating exclusively through night overdrafts, largely because those overnight transactions for several days. The overdrafts were almost entirely the result injection of reserves through open market of extraordinary developments beyond the operations peaked at $81 billion on Friday. control of the account holders. In addition, The combined infusion of liquidity from the Federal Reserve helped restore commu- the various sources pushed the level of nication between market participants and reserve balances at Federal Reserve Banks in some cases processed bilateral loans of to more than $100 billion on Wednesday, reserves between account holders in lieu September 12, about ten times the normal of market intermediation. but also allowed households to refi- of demand, the surprising strength in nance mortgages and extract equity from household spending late in the year homes to pay down other debts or to resulted in a dramatic liquidation of increase spending. Fiscal policy pro- inventories. In the end, real gross vided additional support to consumer domestic product posted a much better spending. The cuts in taxes enacted last performance than had been anticipated year, including the rebates paid out over in the immediate aftermath of the the summer, cushioned the loss of attacks. income from the deterioration in labor More recently, there have been markets. And the purchasing power of encouraging signs that economic activ- household income was further enhanced ity is beginning to firm. Job losses by the sharp drop in energy prices dur- diminished considerably in December ing the autumn. With businesses having and January, and initial claims for unem- positioned themselves to absorb a falloff ployment insurance and the level of 6 88th Annual Report, 2001 insured unemployment have reversed provide some stimulus to activity this their earlier sharp increases. Although year. Perhaps the most significant poten- motor vehicle purchases have declined tial support to the economy could come appreciably from their blistering fourth- from further gains in private-sector pro- quarter pace, early readings suggest that ductivity. Despite the pronounced slow- consumer spending overall has remained down in real GDP growth last year, out- very strong early this year. In the put per hour in the nonfarm business business sector, new orders for capital sector increased impressively. Contin- equipment have provided some tentative ued robust gains in productivity, stem- indications that the deep retrenchment ming from likely advances in technol- in investment spending could be abat- ogy, should provide a considerable boost ing. Meanwhile, purchasing managers to household and business incomes and in the manufacturing sector report that spending and contribute to a sustained, orders have strengthened and that they noninflationary recovery. view the level of their customers’ inven- Still, the economy faces considerable tories as being in better balance. Indeed, risk of subpar economic performance the increasingly rapid pace of inventory in the period ahead. Because outlays for runoff over the course of the last year durable goods and for new homes have has left the level of production well been relatively well maintained in this below that of sales, suggesting scope for cycle, the scope for strong upward impe- a recovery in output given the current tus from household spending seems sales pace. Against this backdrop, the more limited than has often been the FOMC left its target for the federal case in past recoveries. Moreover, the funds rate unchanged in January. How- net decline in household net worth rela- ever, reflecting a concern that growth tive to income over the past two years is could be weaker than the economy’s likely to continue to restrain the growth potential for a time, the FOMC retained of spending in coming quarters. To be its assessment that the risks were sure, the contraction in business capital tilted unacceptably toward economic spending appears to be waning. But weakness. spending on some types of equipment, The extent and persistence of any most notably communications equip- recovery in production will, of course, ment, continues to decline, and there are depend critically on the trajectory of few signs yet of a broad-based upturn in final demand in the period ahead. Sev- capital outlays. Activity abroad remains eral factors are providing impetus to subdued, and a rebound of foreign out- such a recovery in the coming year. put is likely to follow, not lead, a With the real federal funds rate hovering rebound in the United States. Further- around zero, monetary policy should be more, lenders and equity investors positioned to support growth in spend- remain quite cautious. Banks have con- ing. Money and credit expanded fairly tinued to tighten terms and standards rapidly through the end of the year, and on loans, and risk spreads have many households and businesses have increased a little this year. Stock prices strengthened their finances by locking have retreated from recent highs as earn- in relatively low-cost long-term credit. ings continue to fall amid concerns The second installment of personal about the transparency of corporate income tax cuts and scheduled increases financial reports and uncertainty about in government spending on homeland the pace at which profitability will security and national defense also will improve. Monetary Policy and the Economic Outlook 7 Monetary Policy, Financial 21⁄2 percentage points—in 5 half-point Markets, and the Economy steps—by the middle of May. Moreover, over 2001 and Early 2002 the FOMC indicated throughout this period that it judged the balance of risks As economic weakness spread and to the outlook as weighted toward eco- intensified over the first half of 2001, nomic weakness. The Board of Gover- the FOMC aggressively lowered its tar- nors of the Federal Reserve System get for the federal funds rate. Because approved reductions in the discount rate firms reacted unusually swiftly to indi- that matched the Committee’s cuts in cators that inventories were uncom- the target federal funds rate. As a result, fortably high and capital was becoming the discount rate declined from 6 per- underutilized, the drop in production cent to 31⁄2 percent over the period. and business capital spending was espe- At its June and August meetings, cially steep. Moreover, sharp downward the FOMC noted information suggest- revisions in corporate profit expecta- ing continued softening in the economy tions caused equity prices to plunge, and a lack of convincing evidence that which, along with a decline in consumer the end of the slide in activity was in confidence, pointed to vulnerability in sight. Although consumer spending on household spending. Meanwhile, a sig- both housing and nonhousing items— nificant deceleration in energy prices, buoyed by the tax cuts and rebates, low after a surge early in the year, began to mortgage interest rates, declining energy hold down overall inflation; the restrain- prices, and realized capital gains from ing effect of energy prices, combined home sales—remained fairly resilient, with the moderation of resource utiliza- economic conditions in manufacturing tion, also promised to reduce core infla- deteriorated further. Firms continued to tion. Responding to the rapid deteriora- reduce payrolls, work off excess inven- tion in economic conditions, the FOMC tories, and cut back capital equipment cut its target for the federal funds rate expenditures amid sluggish growth in Selected Interest Rates Percent Intended federal funds rate 7 Ten-year Treasury 6 5 4 Two-year Treasury 3 2 Discount rate 1 2/2 3/21 5/16 6/28 8/22 10/3 11/15 12/19 1/3 1/31 3/20 4/18 5/15 6/27 8/21 9/17 10/2 11/6 12/11 1/30 2000 2001 2002 Note. The data are daily and extend through February 25, 2002. The dates on the horizontal axis are those of scheduled FOMC meetings and of any intermeeting policy actions. 8 88th Annual Report, 2001 business sales, significantly lower cor- to flock from private to Treasury and porate profits, and greater uncertainty federal agency debt, boosted risk about future sales and earnings. With spreads sharply, especially on lower- energy prices in retreat, price inflation rated corporate debt. Increased demand remained subdued. In reaching its policy for safe and liquid assets contributed to decisions at its June and August meet- selling pressure in the stock market. At ings, the FOMC took into account the its October 2 meeting, the FOMC had substantial monetary policy stimulus little hard information available on eco- already implemented since the start of nomic developments since the attacks. the year—but not yet fully absorbed by However, evidence gleaned from sur- the economy—and the oncoming effects veys, anecdotes, and market contacts of stimulative fiscal policy measures indicated that the events of Septem- recently enacted by the Congress. Con- ber 11 had considerable adverse reper- sequently, the Committee opted for cussions on an already weak economy: smaller interest rate cuts of 1⁄4 percent- Survey indicators of consumer confi- age point at both the June and August dence had fallen, and consumer spend- meetings, which brought the target fed- ing had apparently declined. At the same eral funds rate down to 31⁄2 percent; as time, anecdotal information pointed to earlier in the year, the FOMC continued additional deep cutbacks in capital to indicate that it judged the balance of spending by many firms after an risks to the outlook as weighted toward already-significant contraction in busi- economic weakness. After both meet- ness fixed investment over the summer ings, the Board of Governors of the months. Federal Reserve System also approved When the FOMC met on November similar reductions in the discount rate, 6, scattered early data tended to confirm which moved down to 3 percent. the information that the decline in pro- After the terrorist attacks on Septem- duction, employment, and final demand ber 11, the available Committee mem- had steepened after the terrorist attacks. bers held a telephone conference on Although an economic turnaround September 13, during which they agreed beginning in the first half of 2002 was that the financial markets were too dis- a reasonable expectation according to rupted to allow for an immediate alter- the Committee, concrete evidence that ation in the stance of monetary policy. the economy was stabilizing had yet However, the members were in agree- to emerge. Meanwhile, the marked ment that the attacks’ potential effects decrease in energy prices since the on asset prices and on the performance spring had induced a decline in overall of the economy, and the resulting uncer- price inflation, and inflation expec- tainty, would likely warrant some policy tations had fallen. Accordingly, the easing in the very near future. Accord- FOMC voted to lower its target for the ingly, the FOMC, at a telephone confer- federal funds rate 1⁄2 percentage point ence on September 17, voted to reduce at both its October and November meet- its target for the federal funds rate ings and reiterated its view that the risks 1⁄2 percentage point, to 3 percent, and to the outlook were weighted toward stated that it continued to judge the risks economic weakness. The sizable adjust- to the outlook to be weighted toward ments in the stance of monetary policy economic weakness. in part reflected concerns that insuffi- Over subsequent weeks, heightened cient policy stimulus posed an unaccept- aversion to risk, which caused investors ably high risk of a more extended cycli- Monetary Policy and the Economic Outlook 9 cal retrenchment that could prove rate that matched the FOMC’s cuts in progressively more difficult to counter, the target federal funds rate, bringing given that the federal funds rate—at the discount rate to 11⁄4 percent, its low- 2 percent—was already at such a low est level since 1948. level. Subsequent news on economic activ- By the time of the December FOMC ity bolstered the view that the economy meeting, the most recent data were sug- was beginning to stabilize. The informa- gesting that the rate of economic decline tion reviewed at the January 29–30, might be moderating. After plunging 2002, FOMC meeting indicated that earlier in the year, orders and shipments consumer spending had held up remark- of nondefense capital goods had turned ably well, investment orders had firmed up early in the fourth quarter, and the further, and the rate of decline in manu- most recent survey evidence for manu- facturing production had lessened facturing also suggested that some toward the end of 2001. With weakness expansion in that sector’s activity might in business activity abating, and mone- be in the offing. In the household sec- tary policy already having been eased tor, personal consumption expenditures substantially, the FOMC left the federal appeared to have been quite well main- funds rate unchanged at the close of its tained, an outcome that reflected the meeting, but it continued to see the risks continuation of zero-rate financing to the outlook as weighted mainly packages offered by the automakers, toward economic weakness. widespread price discounting, and low interest rates. In an environment of very low mortgage interest rates, household Economic Projections for 2002 demand for housing remained at a rela- Federal Reserve policymakers are tively high level, and financial resources expecting the economy to begin to freed up by a rapid pace of mortgage recover this year from the mild down- refinancing activity also supported con- turn experienced in 2001, but the pace sumer spending. of expansion is not projected to be suffi- Nonetheless, the evidence of emerg- cient to cut into the margin of underuti- ing stabilization in the economy was lized resources. The central tendency of quite tentative and limited, and the the real GDP growth forecasts made by Committee saw subpar economic perfor- the members of the Board of Governors mance as likely to persist over the near and the Federal Reserve Bank presi- term. Moreover, in the probable absence dents is 21⁄2 percent to 3 percent, mea- of significant inflationary pressures for sured as the change between the final some time, a modest easing action could quarter of 2001 and the final quarter of be reversed in a timely manner if it this year. The pace of expansion is likely turned out not to be needed. In view of to increase only gradually over the these considerations, the FOMC low- course of the year, and the unemploy- ered its target for the federal funds rate ment rate is expected to move higher for 1⁄4 percentage point, to 13⁄4 percent, on a time. The FOMC members project the December 11, 2001, and stated that it civilian unemployment rate to stand at continued to judge the risks to the out- about 6 percent to 61⁄4 percent at the end look to be weighted mainly toward eco- of 2002. nomic weakness. As had been the case A diminution of the rate of inventory throughout the year, the Board of Gover- liquidation is likely to be an important nors approved reductions in the discount factor helping to buoy production this 10 88th Annual Report, 2001 Economic Projections for 2002 Percent Federal Reserve Governors and Reserve Bank presidents Memo: Indicator 2001 actual Central Range tendency Change, fourth quarter to fourth quarter 1 Nominal GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.9 31⁄2–51⁄2 4–41⁄2 Real GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 2–31⁄2 21⁄2–3 PCE chain-type price index . . . . . . . . . . . . . . . . . . 1.3 1–2 About 11⁄2 Average level, fourth quarter Civilian unemployment rate . . . . . . . . . . . . . . . . . 5.6 53⁄4–61⁄2 6–61⁄4 1. Change from average for fourth quarter of previous year to average for fourth quarter of year indicated. year. In 2001, businesses cut inventories through this period of economic weak- sharply so as to avoid carrying exces- ness suggests a lack of pent-up con- sive stocks relative to the weaker pace sumer demand going forward. In addi- of sales, and although this process of tion, consumers likely will not benefit liquidation probably is not yet complete from declining energy prices to the in many industries, the overall pace of extent they did last year, and the net reduction is likely to slow. Then, as decline in equity values since mid-2000 final demand strengthens, liquidation will probably continue to weigh on con- should give way to some restocking later sumption spending in the period ahead. in the year. Federal Reserve policymakers believe As noted above, the forces affecting that consumer prices will increase demand this year are mixed. On the slightly more rapidly in 2002 than in positive side are the stimulative effects 2001, as last year’s sharp decline in of both fiscal policy and the earlier energy prices is unlikely to be repeated. monetary policy actions. A gradual turn- The central tendency of the FOMC around in employment and a strengthen- members’ projections for increases in ing of the economies of our major trad- the chain-type price index for personal ing partners should provide some lift consumption expenditures (PCE) is to final demand, and spending by both about 11⁄2 percent; last year’s actual households and businesses ought to increase was about 11⁄4 percent. Never- be supported by robust productivity theless, diminished levels of resource growth. On the other hand, the problems utilization, the indirect effects of previ- facing the high-tech sector have not yet ous declines in energy prices on firms’ completely receded, and indications are costs, and continued competitive pres- that spending on other types of capital sures all ought to restrain the pace of equipment remains lackluster. The sur- price increases outside of the energy prising strength of household spending sector this year. 11 Economic and Financial Developments in 2001 and Early 2002 In 2001, the economy turned in its maintained, buoyed by lower interest weakest performance in a decade. Real rates and cuts in federal taxes. Firms GDP increased at an annual rate of trimmed payrolls through most of the 3⁄4 percent in the first half of the year year, and the unemployment rate moved and, according to the advance estimate up nearly 2 percentage points to around from the Commerce Department, 53⁄4 percent by year-end. Job losses were declined at a 1⁄2 percent annual rate in especially large following the terrorist the second half. Although the effects of attacks of September 11, which had the weakening economy were broadly extremely adverse effects on certain sec- felt, the factory sector was especially tors of the economy—most notably, air- hard hit. Faced with slumping demand line transportation and hospitality indus- both here and abroad, manufacturers tries. Nevertheless, by early this year cut production aggressively to limit some signs appeared that the economy excessive buildups of inventories. More- was beginning to mend. over, businesses sharply reduced their Inflation declined last year, pulled investment spending, with particularly down by a sharp drop in energy prices. dramatic cuts in outlays for high- Excluding food and energy items, con- technology equipment. By contrast, sumer price inflation leveled off and, by household spending was reasonably well some measures, moved lower last year. Weakening economic activity, the indi- Change in Real GDP rect effects of declining energy prices on Percent, annual rate Change in PCE Chain-Type Price Index Percent 4 Total Excluding food and energy 3 2 + 2 0 _ 1 1995 1997 1999 2001 Note. Here and in subsequent charts, except as noted, annual changes are measured from Q4 to Q4, 1995 1997 1999 2001 and change for a half-year is measured between its final quarter and the final quarter of the preceding Note. The data are for personal consumption period. expenditures (PCE). 12 88th Annual Report, 2001 firms’ costs, and continued strong com- wealth position of many households; petitive pressures helped keep a lid on in the aggregate, however, household core consumer price inflation. wealth deteriorated further as equity prices moved lower, on net. The decline in wealth since mid-2000 likely exerted a notable restraining influence on house- The Household Sector hold spending last year. Both monetary and fiscal policy sup- Consumer Spending ported consumer spending over the past Growth in consumer spending slowed year. Low interest rates helped enable last year but remained sufficiently solid motor vehicle finance companies to to provide an important source of offer favorable financing on new vehi- support to overall final demand. Per- cles. In addition, low mortgage rates led sonal consumption expenditures (PCE) to a spate of mortgage refinancing that increased 3 percent in real terms in 2001 lasted most of the year, lowering pay- after having advanced 41⁄4 percent in ments and freeing cash to be used by 2000 and around 5 percent in both 1998 households for other spending needs. and 1999. The deceleration in consumer Indeed, many households apparently spending was widespread among dura- used these refinancings as an opportu- ble goods, nondurable goods, and ser- nity to extract equity from their homes, vices. However, motor vehicle expen- a move that further accommodated con- ditures remained strong through most sumer spending. Furthermore, the first of the year and surged in the fall as wave of tax reductions from the Eco- consumers responded enthusiastically to nomic Growth and Tax Relief Reconcili- automakers’ aggressive expansion of ation Act of 2001—including the $300 financing incentives. After Septem- and $600 rebate checks mailed last ber 11, spending declined in certain summer—likely helped to boost spend- travel- and tourism-related categories, ing in the latter part of the year. The including air transportation, hotels and continued phase-in of the tax reductions motels, and recreation services such as enacted last year should provide further amusement parks; spending in these categories has recovered only partially Change in Real Income and Consumption since then. Last year’s downshift in consumption Percent, annual rate growth reflected the weakening labor Disposable personal income market and associated deceleration of Personal consumption income as well as the erosion in house- expenditures 8 hold wealth since the middle of 2000. With employment declining over much 6 of last year, real personal income rose only about 13⁄4 percent after a gain of 41⁄2 percent in 2000. The slowing of 4 income growth was even sharper in nominal terms, but price declines for 2 gasoline and other energy items in the latter half of the year substantially cush- ioned the blow to real incomes. A con- 1995 1997 1999 2001 tinued rise in house prices supported the Economic and Financial Developments in 2001 and Early 2002 13 stimulus to income and consumption down sharply to very low levels in the this year. fourth quarter and into early 2002. The personal saving rate, which had According to the Michigan SRC survey, declined through 1999, leveled off in declining mortgage rates have helped 2000 and in the first half of 2001. The elevate consumers’ assessments of saving rate moved erratically in the sec- homebuying conditions substantially ond half of the year but rose on average. since mid-2000. It shot up in the summer as households In the single-family sector, 1.27 mil- received their tax rebates; it then lion new homes were started last year, declined later in the year as households 31⁄2 percent more than in 2000, when spent some of the rebates and as pur- activity had been held down by higher chases of new motor vehicles soared in mortgage rates. The pace of starts response to the incentives. moved up further in January 2002, in Consumer sentiment, as measured by part because of unusually favorable both the University of Michigan Survey weather. Furthermore, sizable backlogs Research Center (SRC) and the Con- of building permits early this year ference Board, had been running at suggest that construction activity will extremely high levels through most of remain solid. Sales of new homes were 2000 but fell considerably near the elevated throughout 2001—indeed, for beginning of last year as concerns about the year, they were the highest on the economy intensified. By the spring, record—and sales of existing homes measures of sentiment leveled off near remained strong as well. Meanwhile, the their historical averages and well above increase in home prices moderated last levels normally associated with reces- year. The constant-quality price index of sions. Sentiment dropped in September. new homes, which attempts to control The SRC measure recovered gradually for the mix of homes sold, rose only thereafter, while the Conference Board 11⁄2 percent last year, down from a 6 per- index fell further before turning up later cent gain in 2000. in the year; by early 2002, both senti- In the multifamily sector, starts aver- ment measures again stood near their aged 328,000 units last year, a rate close historical averages. to the solid pace of the past several years. Conditions are still relatively favorable for the construction of multi- Residential Investment family units. In particular, vacancy rates As with consumer spending, real expen- have remained low, although rents and ditures on housing were well maintained property values increased at a slower last year, buoyed by favorable mortgage rate last year than in 2000. interest rates. Interest rates on thirty- year fixed-rate mortgages, which had been as high as 81⁄2 percent in the spring Household Finance of 2000, hovered around the low level Households continued to borrow at a of 7 percent in the first half of 2001. brisk pace last year, increasing their debt They moved down further to 61⁄2 per- outstanding an estimated 83⁄4 percent, a cent by late October, before backing up rate about 1 percentage point faster than to 7 percent again by December as pros- the average growth over the previous pects for the economy improved. As two years. The cumulative declines in monetary policy eased, contract rates mortgage interest rates encouraged on adjustable-rate mortgages moved households to take on large amounts of 14 88th Annual Report, 2001 mortgage debt, both by fostering home- credit in that segment of the market buying and by making it attractive to moved sharply higher. refinance existing mortgages and extract some of the accumulated equity; indeed, the Mortgage Bankers Association The Business Sector (MBA) refinancing index in October Much of the weakness in activity last reached the highest level since its incep- year was concentrated in the business tion in January 1980. The frenzied pace sector. In late 2000, manufacturers had of refinancing activity tailed off some begun to cut back production in an effort later in the fourth quarter, when fixed to reduce an undesired build-up of mortgage interest rates backed up. All inventories, and sharp inventory liquida- told, mortgage debt grew an estimated tion continued throughout last year. 9 percent last year. Strength in durable Moreover, the boom in capital outlays goods outlays supported growth in con- that had helped drive the expansion sumer credit (debt not secured by real through the late 1990s gave way to a estate) in the first quarter of 2001, but as softening of spending in late 2000 and consumption spending decelerated over to sharp declines last year. Spending the next two quarters, the expansion of dropped for most types of capital equip- consumer credit slowed sharply. How- ment and structures; cutbacks were ever, consumer credit growth surged in especially severe for high-tech equip- the fourth quarter, in large part because ment, some types of which may have of the jump in motor vehicle sales. For been over-bought. A sharp reduction in the year as a whole, the rate of expan- corporate profits and cash flow contrib- sion of consumer credit, at 61⁄4 percent, uted to last year’s downturn in capital was well below the 101⁄4 percent rate spending, as did general uncertainty posted in 2000. about the economic outlook. Despite the Hefty household borrowing out- reduction in interest rates, which helped stripped the growth of disposable per- restrain businesses’ interest expenses, sonal income in 2001. As a result, financing conditions worsened some- despite lower interest rates, the house- what, on balance, given weaker equity hold debt-service burden—an estimate values, higher borrowing costs for risky of minimum scheduled payments on firms, and some tightening of banks’ mortgage and consumer debt as a share lending standards. of disposable income—finished the year near the peak recorded at the end of 1986. Measures of household credit Fixed Investment quality deteriorated noticeably last year. Real spending on equipment and soft- According to the MBA, delinquency ware (E&S) declined 81⁄2 percent in rates on home mortgages continued to 2001 after an increase of the same trend higher from their historic lows of amount in 2000 and double-digit rates the late 1990s, and auto loan delinquen- of increase for several preceding years. cies at finance companies edged up, Spending on high-tech equipment, although they too remained at a rela- which has accounted for about 40 per- tively subdued level. The economic cent of E&S spending in recent years, slowdown and the rise in unemployment dropped especially sharply last year. significantly eroded the quality of loans Outlays for computers and peripheral to subprime borrowers, and delinquency equipment, which had risen more than rates for both mortgages and consumer 30 percent in each of the preceding Economic and Financial Developments in 2001 and Early 2002 15 seven years, fell 9 percent in 2001. ditions and the absence of new appli- Spending on communications equip- cations requiring the most up-to-date ment swung even more severely, mov- machines. But in addition, the magni- ing from increases of more than 20 per- tude by which these categories of expen- cent on average from 1998 to 2000 to a diture had increased in preceding years, decline of more than 30 percent last together with the abruptness of their year. Business spending on software downturn, suggests that firms may have held up comparatively well, falling only been too optimistic about the immediate 21⁄2 percent in 2001 after having risen profitability of some types of high-tech around 12 percent in 1999 and 2000. capital; as these expectations were A number of factors may have revised, businesses viewed their previ- weighed on outlays for high-tech equip- ous investment as more than sufficient ment, including businesses’ decisions to to meet anticipated demand. This possi- lengthen the replacement cycle for com- bility is especially likely in the case of puters in light of weak economic con- communications equipment, for which expectations about prospects for growth Change in Real Business Fixed Investment in demand appear to have been disap- pointed. Some of the cutbacks may have Percent, annual rate reflected a general pulling back in an Structures environment of greater uncertainty. The Equipment and software 20 sharp rise and subsequent decline of equity values in the high-tech sector mirrors the pattern of rising and slowing 10 investment and provides some support + for the notion that earnings expectations 0 _ may have been overly upbeat in the past. 10 Under the influence of ongoing weak- ness in the market for heavy trucks, 20 business spending on motor vehicles declined through most of the year. But Percent, annual rate spending stabilized in the fourth quarter, as the generous incentives on motor High-tech equipment vehicles may have helped boost spend- and software 50 ing by small businesses as well as con- Other equipment sumers. Domestic orders for new air- 40 craft declined last year, especially after 30 the terrorist attacks last fall, but these 20 lower orders had not yet affected spend- ing by year-end because of the very 10 long lags involved in producing planes. + 0 Apart from spending on transportation _ and high-tech equipment, real outlays 10 declined 71⁄2 percent last year after hav- ing increased 6 percent in 2000, with the 1995 1997 1999 2001 turnaround driven by a sharp swing in Note. High-tech equipment includes computers and spending on many types of industrial peripheral equipment and communications equipment. machinery and on office furniture. 16 88th Annual Report, 2001 Late last year, conditions in some seg- of fiber-optic networks. Investment in ments of the high-tech sector showed the energy sector was a pocket of signs of bottoming. Developments in the strength last year. Construction of drill- semiconductor industry have improved, ing structures surged in 2000 and much with production increasing during the of 2001, as the industry responded to fall. Some of the improvement is appar- elevated prices of oil and natural gas. ently coming from increased demand However, with oil and natural gas prices for computers. In the advance estimate reversing their earlier increases, drilling from the Commerce Department for the activity turned down in the latter part of fourth quarter, real spending on comput- the year. ers and peripheral equipment was reported to have surged at an annual rate of 40 percent. However, spending on Inventory Investment communications equipment, for which By late 2000, manufacturers were evidence of a capital overhang has been already cutting production to slow the most pronounced, continued to decline pace of inventory accumulation as sharply in the fourth quarter, and orders inventories moved up relative to sales. for communications equipment have Production cuts intensified in early yet to display any convincing signs of 2001, and producers and distributers turning around. As for other types of liquidated inventories at increasing rates capital equipment, spending continued throughout the year. The runoff of to decline in the fourth quarter, but inventories was a major factor holding a moderate rebound in new orders down GDP growth last year. Indeed, the for many types of capital goods arithmetic subtraction from real GDP from their autumn lows hinted that a growth attributable to the decline in non- broader firming of demand may be farm inventory investment was 11⁄2 per- under way. centage points over the four quarters Real business spending for nonresi- of 2001. However, because sales also dential structures also declined sharply were weakening, inventory-sales ratios in 2001. Construction of office buildings remained high in much of the manufac- dropped last year after having increased turing sector, and in some portions of notably for several years; industrial the wholesale sector as well, throughout building remained fairly steady through the year. the first half of last year but plummeted The motor vehicle sector accounted in the second half. Vacancy rates for for about one-quarter of last year’s over- these two types of properties rose con- all inventory drawdown. Late in 2000 siderably, and by year-end the indus- and early last year, automakers cut pro- trial vacancy rate had reached its high- duction in an attempt to clear out excess est level since mid-1993. Meanwhile, stocks held by dealers. By the spring, spending on non-office commercial vehicle assemblies had stabilized, and buildings (a category that includes retail, the automakers instead dealt with heavy wholesale, and some warehouse space) stocks by further sweetening incentives decreased moderately last year. Invest- to boost sales. By the end of the year, ment in public utilities moved down inventories of cars and light trucks stood as well, a decline reflecting, in part, a at a relatively lean 21⁄4 million units, cutback in spending for communi- nearly 1 million units fewer than were cations projects such as the installation held a year earlier. Economic and Financial Developments in 2001 and Early 2002 17 Corporate Profits and Business Business borrowing slowed markedly Finance last year because firms slashed invest- ment in fixed capital and inventories The profitability of the U.S. nonfinan- even more than the drop in profits and cial corporate sector suffered a severe other internally generated funds. Busi- blow in 2001. The profit slump had ness debt expanded at a 61⁄4 percent begun in the fourth quarter of the previ- annual rate in 2001, well below the ous year, when the economic profits of double-digit rates of the two previous nonfinancial corporations—that is, book years, and its composition shifted decid- profits from current production with edly toward longer-term sources of inventory and capital consumption funds. Early in the year, favorable condi- adjustments compiled by the Commerce tions in the corporate bond market, com- Department—plummeted almost 45 per- bined with firms’ desire to lock in low cent at an annual rate. The first three interest rates, prompted investment- quarters of 2001 brought little respite, grade firms to issue a high volume of and economic profits spiraled down- bonds. They used the proceeds to ward at an average annual rate of 25 per- strengthen their balance sheets by repay- cent. The ratio of the profits of nonfi- ing short-term debt obligations, refi- nancial corporations to the sector’s gross nancing other longer-term debt, and nominal output fell to 71⁄2 percent last building up liquid assets. Junk bond year, a level not seen since the early issuance was also strong early in 2001, 1980s. Earnings reports for the fourth as speculative-grade yields fell in quarter indicate that nonfinancial corpo- response to monetary policy easings, rate profits continued to fall late in the although investors shunned the riskiest year. issues amid increasing economic uncer- tainty and rising defaults among below- Before-Tax Profits of Nonfinancial investment-grade borrowers. Corporations as a Percent of Sector GDP The heavy pace of bond issuance, along with a reduced need to finance Percent capital investments, enabled firms to decrease their business loans at banks and their commercial paper outstanding. 12 The move out of commercial paper also reflected elevated credit spreads between high- and low-tier issuers 10 resulting from the defaults of California utilities and several debt downgrades among prominent firms early in the year. Announcements of new equity share 8 repurchase programs thinned consider- ably in the first half of the year, as firms sought to conserve their cash buffers 1981 1986 1991 1996 2001 in response to plummeting profits. A significant slowdown in cash-financed Note. The data are quarterly and extend through 2001:Q3. Profits are from domestic operations of merger activity further damped equity nonfinancial corporations, with inventory valuation retirements, although these retirements and capital consumption adjustments. still outpaced gross equity issuance, 18 88th Annual Report, 2001 which was restrained by falling share recovered, because of ongoing concerns prices. Over the summer, issuance of about credit quality and ratings down- investment-grade bonds dropped off grades among some high-profile issuers appreciably. Moreover, market senti- in the fall. ment toward speculative-grade issues By early October, the investment- cooled, as further erosion in that sector’s grade corporate bond market had largely credit quality took its toll. Business recovered from the disruptions associ- loans and outstanding commercial paper ated with the terrorist attacks, and bond continued to contract, and with share issuance in that segment of the market prices in the doldrums, nonfinancial picked up considerably. Firms capital- firms raised only a small amount of ized on relatively low longer-term funds in public equity markets in the interest rates to pay down short-term third quarter. obligations, to refinance existing higher- The terrorist attacks on September 11 coupon debt, and to boost their holdings constricted corporate financing flows for of liquid assets. With high-yield bond a time. The stock market closed for that risk spreads receding moderately, issu- week, and trading in corporate bonds ance in the speculative-grade segment came to a virtual halt. After the shut- of the corporate bond market stirred down of the stock market, the Securities somewhat from its moribund state, and Exchange Commission, in an effort although investors remained highly to ensure adequate liquidity, temporarily selective. Public equity issuance, after lifted some restrictions on firms’ repur- stalling in September, also regained chases of their own shares. According some ground in the fourth quarter, to reports from dealers, this change spurred by a rebound in stock prices. As triggered a spate of repurchases in the was the case for most of the year, initial first few days after the stock markets reopened on September 17. When full-scale trading in corporate bonds Spreads of Corporate Bond Yields over the resumed on September 17, credit Ten-Year Swap Rate spreads on corporate bonds widened Percentage points sharply: Risk spreads on speculative- grade private debt soared to levels not 9 seen since late 1991, and spreads on 8 investment-grade corporate bonds also 7 moved higher, although by a consider- ably smaller amount. Against this back- 6 High yield drop, junk bond issuance nearly dried up 5 for the rest of the month. Commercial 4 paper rates—even for top-tier issuers— 3 jumped immediately after the attacks, BBB 2 as risk of payment delays increased. In 1 AA + response to elevated rates, some issuers 0 _ tapped their backup lines at commercial banks, and business loans spiked in the 2000 2001 2002 weeks after the attacks. Risk spreads for low-tier borrowers in the commercial Note. The data are daily and extend through Feb- ruary 21, 2002. The spreads compare the yields on the paper market remained elevated, even Merrill Lynch AA, BBB, and 175 indexes with the after market operations had largely ten-year swap rate. Economic and Financial Developments in 2001 and Early 2002 19 public offerings and venture capital recent years, and most firms did not financing remained at depressed levels. experience significant difficulties servic- Commercial paper issuance recovered ing their debt. However, many firms somewhat early in the fourth quarter as were downgraded, and evidence of firms repaid bank loans made in the financial distress mounted over the immediate aftermath of the terrorist course of the year. The twelve-month attacks and as credit spreads for lower- trailing average of the default rate on rated issuers started to narrow. How- corporate bonds nearly tripled last year ever, the collapse of the Enron Corpora- and by December ran almost 1⁄2 percent- tion combined with typical year-end age point higher than its peak in 1991. pressures to widen quality spreads in Delinquency rates on business loans at early December. All told, the volume of banks also rose, although not nearly as domestic nonfinancial commercial paper dramatically. The amount of nonfinan- outstanding shrank by one-third over the cial debt downgraded by Moody’s year as a whole. Business loans at banks Investors Service last year was more fell further in the fourth quarter; for the than five times the amount upgraded; year, business loans contracted 41⁄4 per- downgrades were especially pronounced cent, their first annual decline since in the fourth quarter, when ratings agen- 1993. cies lowered debt ratings of firms in the The slowing of sales and the drop in telecommunication, energy, and auto profits caused corporate credit quality sectors. to deteriorate noticeably last year. In Commercial mortgage debt, sup- part because of the decline in market ported by still-strong construction interest rates, the ratio of net interest spending, expanded at a brisk 10 percent payments to cash flow in the nonfinan- pace over the first half of 2001. The cial corporate sector moved only mod- growth of commercial mortgage debt estly above the relatively low levels of edged down only 1⁄2 percentage point in the second half, despite a sharp slowdown in business spending on nonresidential structures. As a result, Default Rate on Outstanding Bonds the issuance of commercial-mortgage- Percent backed securities (CMBS) maintained a robust pace throughout the year. Avail- able data indicate some deterioration 3.0 in the quality of commercial real estate 2.5 credit. Delinquency rates on commercial real estate loans at banks rose steadily 2.0 in 2001 and have started to edge out of their recent record-low range. In 1.5 addition, CMBS delinquency rates increased, especially toward the end of 1.0 the year, amid the rise in office vacancy .5 rates. Despite the erosion in credit qual- ity in commercial real estate and heavy issuance of CMBS, yield spreads on 1991 1993 1995 1997 1999 2001 investment-grade CMBS over swap Note. The data are monthly; the series shown is a rates were about unchanged over the twelve-month moving average. year, suggesting that investors view 20 88th Annual Report, 2001 credit problems in this sector as being decline in net interest payments, outlays contained. Commercial banks, however, increased nearly 6 percent, a second stiffened their lending posture in year of increases larger than had pre- response to eroding prospects for the vailed for some time. Outlays have commercial real estate sector; signifi- increased across all major categories of cant net fractions of loan officers expenditure, including defense, Medi- surveyed over the course of the year care and Medicaid, and social security. reported that their institutions had As for the part of federal spending that firmed standards on commercial real is counted in GDP, real federal outlays estate loans. for consumption and gross investment increased somewhat more rapidly than in recent years through the first three The Government Sector quarters of 2001 as defense expendi- tures picked up. Spending rose faster Federal Government still in the fourth quarter because of Deteriorating economic conditions and increases for homeland security and the new fiscal initiatives have led to smaller additional costs associated with the war federal budget surpluses than had been in Afghanistan. anticipated earlier. The fiscal 2001 sur- The existence of surpluses through plus on a unified basis was $127 billion, fiscal 2001 meant that the federal gov- or about 11⁄4 percent of GDP—well ernment continued to contribute to the below both the record $236 billion sur- pool of national saving. Nevertheless, plus recorded in fiscal 2000 and the gross saving by households, businesses, $281 billion surplus that the Congres- and governments has been trending sional Budget Office had anticipated down over the past few years from the for fiscal 2001 at this time last year. recent high of around 19 percent of GDP Receipts, which had increased at least in 1998. 6 percent in each of the preceding seven The Treasury used federal budget fiscal years, declined around 2 percent surpluses over the first half of the year in fiscal 2001; the rise in individual tax to pay down its outstanding marketable receipts slowed dramatically and cor- debt. In the third quarter, however, the porate receipts plunged 27 percent. The cut in personal income taxes and a lower receipts reflected both the weak- weakening in receipts as the economy ening economy—specifically, slow contracted led the Treasury to reenter growth of personal income, the drop in the credit markets as a significant bor- corporate profits, and a pattern of rower of new funds. The Treasury’s declines in equity values that led to budget position swung back into surplus lower net capital gains realizations— late in the year owing to somewhat and changes associated with the Eco- stronger-than-expected tax receipts, nomic Growth and Tax Relief Reconcili- which helped push fourth-quarter net ation Act of 2001. Some provisions of borrowing below its third-quarter level. the act went into effect immediately, Despite the increase in the Treasury’s including the rebate checks that were net borrowing over the second half of mailed last summer. In addition, the act the year, publicly held debt remained at shifted some corporate tax payments only about one-third of nominal GDP into fiscal 2002. last year, its lowest level since the mid- Meanwhile, outlays were up 4 per- 1980s and well below the 1993 peak of cent in fiscal 2001; abstracting from a almost 50 percent. Economic and Financial Developments in 2001 and Early 2002 21 Federal Government Debt debt buybacks scheduled for late Sep- Held by the Public tember to conserve cash, it later announced that buyback operations Percent of nominal GDP would begin again in October. With its credit needs still limited, the Treasury announced on October 31 that 45 it was suspending issuance of nominal and inflation-indexed thirty-year securi- ties. Subsequently, the thirty-year Trea- 35 sury bond yield fell sharply, bid-asked spreads on outstanding bonds widened, and liquidity in the bond sector deterio- 25 rated. Although bid-asked spreads nar- rowed over the balance of the year, market participants reported that liquid- ity in the bond sector remained below its 1961 1971 1981 1991 2001 level before the Treasury’s announce- ment. The announcement on October 31 Note. The data are as of the end of the fiscal year. Excludes debt held in federal government accounts also indicated that after the January and by the Federal Reserve System. 2002 buyback operations, the Treasury would determine the amount and timing of buybacks on a quarter-by-quarter The terrorist attacks on September 11 basis, thereby fueling speculation that and the associated disruptions to finan- future buybacks might be scaled back in cial markets had some spillover effects light of the changed budget outlook. on Treasury financing. On the day of the attacks, the Treasury cancelled its scheduled bill auction; over the next State and Local Governments several days, it drew down nearly all of its compensating balances with com- Real expenditures for consumption and mercial banks—about $121⁄2 billion in gross investment by states and localities total—to meet its obligations. On Thurs- rose 5 percent last year after an increase day of that week, the settlement of secu- of 21⁄2 percent in 2000. Much of the rities sold the day before the attacks acceleration reflected a burst of spend- eased the Treasury’s immediate cash ing on construction of schools and other squeeze, and the incoming stream of infrastructure needs. In addition, outlays estimated quarterly personal income tax at the end of last year were boosted payments provided additional funds. by the cleanup from the September 11 Infrastructure problems involving the attacks in New York. As for employ- trading and clearing of Treasury securi- ment, state and local governments added ties were largely resolved over the fol- jobs in 2001 at a more rapid pace than lowing week, and when the Treasury they did over the previous year and resumed its regular bill issuance on thereby helped to offset job losses in the September 17, exceptionally strong private sector. demand for bills pushed stop-out rates— The fiscal condition of state and local that is, the highest yield accepted during governments has been strained by the the auction—to their lowest level since deterioration in economic performance. 1961. Although the Treasury cancelled State governments are considering a 22 88th Annual Report, 2001 variety of actions to achieve budget The External Sector balance in the current fiscal year. Most states are intending to cut planned Trade and the Current Account expenditures, and many are considering The U.S. current account deficit nar- drawing down rainy-day funds, which rowed significantly during 2001, with governments had built up in earlier both imports and exports of goods and years. According to the National Con- services falling sharply in response to a ference of State Legislators, these rainy- global weakening of economic activity. day funds stood at the relatively high The deficit in goods and services nar- level of $23 billion at the end of fiscal rowed to $333 billion at an annual rate 2001 (June 30). Moreover, some states in the fourth quarter of 2001 from that had planned to fund capital expendi- $401 billion at the end of the previous tures with current receipts appear to be year. In addition, the deficit was tempo- shifting to debt financing. Finally, a few rarily reduced further in the third quarter states are considering actions such as because service import payments were postponing tax cuts that were enacted lowered by a large one-time estimated earlier. insurance payment from foreign insur- Debt of the state and local govern- ers (reported on an accrual basis) ment sector expanded rapidly last year related to the events of September 11.1 after slow growth in 2000. Gross issu- Excluding the estimated insurance ance of long-term municipal bonds figure, the current account deficit was accelerated over the first half of 2001 as $434 billion at an annual rate over state and local governments took advan- the first three quarters of the year, tage of lower yields to refund outstand- or 41⁄4 percent of GDP, compared with ing debt. Spurred by falling interest rates $445 billion and 41⁄2 percent for the and declining tax revenues, these gov- year 2000. Net investment income ernments continued to issue long-term payments were about the same during bonds to finance new capital projects at the first three quarters of 2001 as in a rapid clip over the second half of the the corresponding period a year ear- year. Despite a deterioration in tax lier; higher net payments on our grow- receipts, credit quality in the municipal ing net portfolio liability position were market remained high in 2001. Late in offset by higher net direct investment the year, however, signs of weakness receipts. had emerged, as the pace of net credit- U.S. real exports were hit by slower ratings upgrades slowed noticeably. growth abroad, continued appreciation Especially significant problems continue of the dollar, and plunging global to plague California and New York, both of which saw their debt ratings lowered in November. In California, the prob- lems were attributed to declining tax 1. The ‘‘insurance payment’’ component of revenues and difficulties related to the imported services is calculated as the value of premiums paid to foreign companies less the state’s electricity crisis earlier in the amount of losses recovered from foreign compa- year, while New York’s slip in credit nies. In the third quarter, the estimated size of quality resulted not only from deteriorat- losses recovered far exceeded the amount paid for ing tax receipts but also from fears of insurance premiums, resulting in a negative recorded insurance payment. According to NIPA higher-than-expected costs related to accounting, the entire amount of a recovery is clean up and rebuilding after the terror- recorded in the quarter in which the incident ist attacks. occurred. Economic and Financial Developments in 2001 and Early 2002 23 demand for high-tech products. Real during the year.2 Imported goods fell exports of goods and services fell 6 percent last year, with much of the 11 percent over the four quarters of decrease in capital goods (computers, 2001, with double-digit declines begin- semiconductors, and other machinery). ning in the second quarter. Service In contrast, real imports of automotive receipts decreased 7 percent; all of the products, consumer goods, oil, and other decline came after the events of Sep- industrial supplies were little changed, tember 11. Receipts from travel and and imports of foods rose. The pattern passenger fares, which plunged fol- of import growth appears to have shifted lowing the terrorist attacks, were about toward the end of the year. Imports of one-fourth lower in the fourth quarter real non-oil goods declined at about a than in the second quarter. Receipts 10 percent annual rate during the first from foreigners for other services three quarters of the year but fell less changed little over the year. Exports rapidly in the fourth quarter. The price declined in almost all major goods of imported non-oil goods, after rising categories, with the largest drops by in the first quarter, declined at an annual far in high-tech capital goods and rate of about 6 percent from the second other machinery. Two exceptions were quarter through the fourth quarter, led exports of automotive products, which by decreases in the price of imported rose during the second and third quar- industrial supplies. ters (largely parts to Canada and Mexico The value of imported oil fell more destined ultimately for use in U.S. than one-third over the four quarters of markets, and vehicles to Canada), and 2001, a drop resulting almost entirely agricultural goods. About 45 percent from a sharp decline in oil prices. The of U.S. exports of goods were capital spot price of West Texas intermediate equipment; 20 percent were industrial (WTI) crude decreased about $10 per supplies; and 5 percent to 10 percent barrel during the year, with much of the each were agricultural, automotive, con- decline occurring after September 11. sumer, and other goods. The value of During the first eight months of 2001, exported goods declined at double-digit the spot price of WTI averaged $28 per rates for almost all major market desti- barrel as weakened demand for oil nations. Even exports to Canada and and increased non-OPEC supply were Mexico declined sharply, despite sup- largely offset by OPEC production port from two-way trade with the United restraint. In the wake of the terrorist States in such sectors as automotive attacks, oil prices dropped sharply in products. response to a decline in jet fuel con- As growth of the U.S. economy sumption, weaker economic activity, slowed noticeably, real imports of goods and reassurance from Saudi Arabia that and services turned down and declined supply would be forthcoming. Oil prices 8 percent for 2001 as a whole. Service continued to drift lower during the payments dropped 15 percent last year. The plunge in outlays for travel and passenger fares after September 11 held 2. According to NIPA accounting, the value of down total real service payments, bring- the one-time insurance payments by foreign insur- ing their level in the fourth quarter ers is not reflected in NIPA real imports of services. The deflator for service imports was 15 percent below that in the second adjusted down for the third quarter to offset the quarter. Spending on services other than lower value of service imports; the deflator travel and passenger fares changed little returned to its usual value in the fourth quarter. 24 88th Annual Report, 2001 fourth quarter, reflecting OPEC’s appar- eigners, who had sold a significant ent unwillingness to continue to sacri- quantity of Treasury securities during fice market share in order to defend 2000, roughly halted their sales in the higher oil prices. In late December, how- first half of 2001. The increased capi- ever, OPEC worked out an arrangement tal inflows arising from larger foreign in which it agreed to reduce its produc- purchases of U.S. securities in the tion targets an additional 1.5 million first half was only partly offset by an barrels per day, contingent on the increase in the pace at which U.S. resi- pledges from several non-OPEC produc- dents acquired foreign securities, espe- ers (Angola, Mexico, Norway, Oman, cially equities. and Russia) to reduce oil exports a total The pattern of private securities trans- of 462,500 barrels per day. Given the actions changed significantly in the third uncertainty over the extent to which quarter: Foreign purchases of U.S. equi- these reductions will actually be imple- ties slowed markedly, and U.S. investors mented and the comfortable level of oil shifted from net purchases of foreign inventories, the spot price of WTI securities to net sales. However, the remained near $20 per barrel in early reduced flows in the third quarter 2002. seem to have reflected short-lived reactions to events in the quarter. Pre- liminary data for the fourth quarter show a significant bounceback in foreign pur- Financial Account chases of U.S. securities and a return to The slowing of U.S. and foreign eco- purchases of foreign securities by U.S. nomic growth over the course of last residents. year had noticeable effects on the com- The changing economic climate also position of U.S. capital flows, especially affected direct investment capital flows. when the slowing became more pro- During 2000, foreign direct invest- nounced in the second half. On bal- ment in the United States averaged ance, net private capital flowed in at more than $70 billion per quarter. a pace only slightly below the record These flows slowed to less than set in 2000, including unprecedented $60 billion per quarter in the first net inflows through private securities half and then dropped to only $26 bil- transactions. lion in the third quarter (the last avail- During the first half of 2001, sagging able data). The drop resulted in part stock prices and signs of slower growth from a decline in the outlook for cor- brought a shift in the types of U.S. secu- porate profits and a significant reduc- rities demanded by private foreigners tion in general merger and acquisition but did not reduce the overall demand activity. By contrast, U.S. direct invest- for them. Indeed, during the first half, ment abroad picked up over the course foreign private purchases of U.S. securi- of 2001. The third quarter outflow of ties averaged $137 billion per quarter, a $52 billion—a record—reflected both a rate well above the record $109 billion large merger and robust retained earn- pace set in 2000. A slowing of foreign ings by the foreign affiliates of U.S. purchases of U.S. equities, relative to firms. Capital inflows from official 2000, was more than offset by a pickup sources were relatively modest in 2001, in foreign purchases of corporate and totaling only $15 billion, compared with agency bonds. In addition, private for- $36 billion in 2000. Economic and Financial Developments in 2001 and Early 2002 25 The Labor Market Early last year, employment in manufacturing, which had been trend- Employment and Unemployment ing down for several years, began to decline more rapidly. Job losses were Last year’s weakening in economic widespread within the manufacturing activity took its toll on the labor market. sector but were most pronounced in Payroll employment edged up early last durable-goods industries, such as those year and then dropped nearly 11⁄2 mil- producing electrical and industrial lion by January 2002. Declines were machinery and metals. Employment at particularly large in manufacturing, help supply firms and in wholesale which has shed one in twelve jobs since trade—industries that are directly mid-2000. Job cuts accelerated in the related to manufacturing—also began to months following the terrorist attacks of decline. Outside of manufacturing and September 11, with declines occurring its related industries, private payrolls in a wide variety of industries. The continued to increase robustly in the first unemployment rate moved up from quarter of last year, but hiring then 4 percent in late 2000 to 5.8 percent by slowed, although it remained positive, December 2001. In January 2002, the on net, in the second and third quarters. unemployment rate edged down to Construction payrolls increased into 5.6 percent. the spring but flattened out thereafter. Employment at retail trade establish- ments also continued to increase moder- Measures of Labor Utilization ately through the spring but began to Percent decline in the late summer. In services industries other than help supply firms—a broad group that accounted for 15 nearly half of the private payroll Augmented unemployment increases over the preceding several rate 12 years—job gains slowed but remained positive in the second and third quarters 9 of last year. In all, private payroll employment declined about 115,000 per 6 month in the second and third quarters, Civilian and the unemployment rate moved up unemployment 3 steadily to 41⁄2 percent by the spring and rate to nearly 5 percent by August. The labor market was especially hard 1972 1982 1992 2002 hit by the terrorist attacks. Although Note. The data extend through January 2002. The labor demand was weak prior to the augmented umemployment rate is the number of attacks, the situation turned far worse unemployed plus those who are not in the labor force following the events of September 11, and want a job, divided by the civilian labor force plus those who are not in the labor force and want a and private payrolls plunged more than job. In January 1994, a redesigned survey was intro- 400,000 per month on average in Octo- duced; data for the augmented rate from that point ber and November. Employment fell on are not directly comparable with those of earlier periods. For the augmented rate, the data are quarterly substantially not only in manufacturing through December 1993 and monthly thereafter; for and in industries directly affected by the civilian labor force rate, the data are monthly. the attacks, such as air transportation, 26 88th Annual Report, 2001 hotels, and restaurants, but also in a magnitude of that deceleration. The wide variety of other industries such as slowing likely reflected the influence of construction and much of the retail the soft labor market, energy-driven sector. declines in price inflation toward the Employment continued to decline in latter part of the year, and subdued infla- December and January but much less tion expectations. Compensation prob- than in the preceding two months. ably was also held down by a reduction Manufacturing and its related industries in variable pay, such as bonuses that are lost jobs at a slower pace, and employ- tied to company performance and stock- ment leveled off in other private indus- option activity. tries. The unemployment rate moved up According to the employment cost to 5.8 percent in December but then index, hourly compensation costs ticked down to 5.6 percent in January. increased 41⁄4 percent during 2001, The recent reversal of the October and down from a 41⁄2 percent increase in November spikes in new claims for 2000; both the wages and salaries and unemployment insurance and in the benefits components recorded slightly level of insured unemployment also smaller increases. The deceleration in point to some improvement in labor the index for wages and salaries was market conditions early this year. concentrated among sales workers, whose wages often include a substantial commission component and so are espe- Productivity and Labor Costs cially sensitive to cyclical develop- Given economic conditions, growth of ments. Although the increase in employ- labor productivity was impressive in ers’ cost of benefits slowed overall, 2001. Productivity growth typically the cost of providing health insurance drops when the economy softens, partly increased more than 9 percent last year; because businesses tend not to shed the rise continued this component’s workers in proportion to reduced accelerating contribution to labor costs demand. Last year, however, output per over the past few years after a period hour in the nonfarm business sector increased a relatively solid 11⁄2 percent, Change in Output per Hour according to the advance estimate, after having risen 21⁄2 percent in 2000—a Percent, annual rate mild deceleration by past cyclical stan- dards. Indeed, productivity is estimated 4 to have increased at an annual rate of more than 2 percent in the second half 3 of the year, an impressive performance during a period when real GDP was, on 2 net, contracting. The buoyancy of pro- ductivity during 2001 provides further support to the view that the underlying 1 trend of productivity growth has stepped + up notably in recent years. 0 _ Hourly labor compensation costs increased more slowly last year than in 1991 1993 1995 1997 1999 2001 2000, although different compensation measures paint different pictures of the Note. Nonfarm business sector. Economic and Financial Developments in 2001 and Early 2002 27 of restrained cost increases in the mid- The chain-type price index for personal 1990s. consumption expenditures (PCE) An alternative measure of hourly increased 1.3 percent last year after hav- compensation is the BLS’s measure of ing increased 2.6 percent in 2000; the compensation per hour in the non- turnaround in consumer energy prices farm business sector, which is derived accounted for almost all of that decelera- from compensation information in tion. Increases in PCE prices excluding the national accounts; this measure food and energy items also slowed a increased 4 percent last year, a very little last year after having moved up in large drop from the 73⁄4 percent increase 2000. The chain-type price index for registered in 2000. One reason that gross domestic purchases—the broadest these two compensation measures may price measure for domestically pur- diverge is that only nonfarm compensa- chased goods and services—decelerated tion per hour captures the cost of stock considerably last year. The small options. Although the two compensa- increase in this index reflected both the tion measures differ in numerous other drop in energy prices and a resumption respects as well, the much sharper decel- of rapid declines for prices of invest- eration in nonfarm compensation per ment goods, especially computers, fol- hour may indicate that stock option lowing a period of unusual firmness in exercises leveled off or declined in 2001 2000. The price index for GDP—the in response to the fall in equity values. broadest price measure for domestically However, because nonfarm compensa- produced goods and services—posted a tion per hour can be revised substan- smaller deceleration of about 1⁄2 percent- tially, one must be cautious in interpret- age point between 2000 and 2001 ing the most recent quarterly figures because lower oil prices have a smaller from this series. weight in U.S. production than in U.S. Unit labor costs, the ratio of hourly purchases. compensation to output per hour in the Consumer energy prices continued to nonfarm business sector, increased about move higher through the early months 2 percent last year. Although down from of 2001 before turning down sharply in a huge 5 percent increase in 2000 that the second half of the year. Despite the reflected that year’s surge in nonfarm fact that crude oil prices were declining compensation per hour, the figure for 2001 is still a little higher than the mod- erate increases seen over the preceding Alternative Measures of Price Change several years. Last year’s increase in Percent unit labor costs was held up by the Price measure 2000 2001 smaller productivity increases that accompanied weak economic activity; Chain-type accordingly, subsequent increases in unit Gross domestic product . . . . . . . . 2.4 1.8 Gross domestic purchases . . . . . . 2.5 1.1 labor costs would be held down if out- Personal consumption put per hour begins to increase more expenditures . . . . . . . . . . . . . . 2.6 1.3 Excluding food and energy . . . 1.9 1.6 rapidly as the economy strengthens. Fixed-weight Consumer price index . . . . . . . . . . 3.4 1.9 Excluding food and energy . . . 2.5 2.7 Prices Note. Changes are based on quarterly averages and Inflation declined in 2001 largely are measured to the fourth quarter of the year indicated because of a steep drop in energy prices. from the fourth quarter of the preceding year. 28 88th Annual Report, 2001 over the first half of the year, retail large increases in livestock prices— gasoline prices increased at an annual especially beef. But these prices soft- rate of 8 percent during that period. The ened later in the year under the influ- sizable increase in margins on gasoline ence of higher supplies, lower domestic reflected both refinery disruptions and demand, and foreign outbreaks of mad low inventory levels going into the sum- cow disease, which apparently damped mer driving season. But gasoline prices demand for beef no matter where fell sharply thereafter as refineries came produced. back on line, imports of gasoline picked Excluding food and energy items, up, and crude oil prices moved consider- PCE prices rose 1.6 percent last year, a ably lower over the latter half of the small deceleration from its 1.9 percent year. In all, gasoline prices were down increase over 2000. That deceleration 19 percent over the year as a whole. was concentrated in prices of goods, Heating oil prices reflected crude oil with prices especially soft for motor developments more directly and vehicles and apparel. By contrast, prices declined sharply through most of the of many services continued to accelerate year. Meanwhile, spot prices of natural last year. In particular, shelter costs— gas peaked in January 2001 at the which include residential rent, the extraordinarily high level of nearly $10 imputed rent of owner-occupied hous- per million BTUs, and prices at the con- ing, and hotel and motel prices— sumer level continued to surge in the increased 41⁄4 percent last year after hav- first few months of the year. These ing risen 31⁄2 percent in 2000. increases reflected the pressure from Standing somewhat in contrast to the ongoing strength in demand coupled small deceleration in core PCE prices, with unusually cold weather early last the core consumer price index (CPI) winter that left stocks at very low levels. increased 23⁄4 percent last year, about But the situation improved as expanded the same rate as in 2000. Although com- supply allowed stocks to be replenished: ponents of the CPI are key inputs of the Spot prices reversed those earlier PCE price index, the two price measures increases, and prices of consumer natu- differ in a variety of ways. One impor- ral gas declined substantially through tant difference is that the PCE measure the rest of the year. is broader in scope; it includes expendi- In contrast, electricity prices rose tures made by nonprofit institutions and through most of last year. The increases consumption of items such as checking reflected the effects of the earlier rises in services that banks provide without the prices of natural gas and coal on fuel explicit charge. Prices for the PCE cate- costs of utilities as well as problems gories that are outside the scope of the with electricity generation in California. CPI decelerated notably in 2001 and California was able to avoid serious accounted for much of the differential power disruptions last summer because movements of inflation measured by the high electricity prices, weak economic two price indexes. Another difference is activity, and moderate weather all that the CPI places a larger weight on helped keep demand in check. housing than does the PCE price index, Consumer food prices increased more and last year’s acceleration of housing rapidly last year, rising about 3 percent prices therefore boosted the CPI relative after having risen only 21⁄2 percent in to the PCE measure. 2000. Early in the year, strong demand, The leveling off or decline in core both domestic and foreign, led to consumer price inflation reflects a vari- Economic and Financial Developments in 2001 and Early 2002 29 ety of factors, including the weakening increased likelihood of federal budget of economic activity and the accompa- deficits and, except in the immediate nying slackening of resource utilization; aftermath of the terrorist attacks, by the decline in energy prices that reduced investors’ optimism about future eco- firms’ costs; and continuing intense nomic prospects. Despite this opti- competitive pressures in product mar- mism, the slowdown in final demand, a kets. These factors also likely helped slump in corporate earnings, and a to reduce inflation expectations late last marked deterioration in credit quality year, and this reduction itself may be of businesses in a number of sectors contributing to lower inflation. Accord- made investors more wary about risk. ing to the Michigan SRC, median one- Although interest rates on higher-rated year inflation expectations, which had investment- grade corporate bonds gen- held near 3 percent through 2000 and erally moved in line with those on into last summer, moved down to comparably dated government securi- 23⁄4 percent in the third quarter and ties, lower-rated firms found credit to plummeted to 1 percent or lower in be considerably more expensive, as October and November. Falling energy risk spreads on speculative-grade debt prices and widespread reports of dis- soared for most of the year before nar- counting following the September 11 rowing somewhat over the last few attacks likely played a role in causing months. Interest rates on commercial this sharp break in expectations. Part of paper and business loans fell last year this drop was reversed in December, and by about as much as the federal funds since then, inflation expectations have rate, but risk spreads generally remained remained around 2 percent—a rate still in the elevated range. In addition, com- well below the levels that had prevailed mercial banks tightened standards and earlier. Meanwhile, the Michigan SRC’s terms for business borrowers throughout measure of longer-term inflation expec- the year. Equity prices were exception- tations, which had also remained close ally volatile and fell further, on balance, to 3 percent through 2000 and the first in 2001. half of 2001, ticked down to 23⁄4 percent Increased caution on the part of lend- in October and stood at that level early ers did not appear to materially damp this year. aggregate credit flows. Private borrow- ing was robust last year, especially when compared with the marked slowing in U.S. Financial Markets nominal spending. Relatively low long- term interest rates encouraged both busi- As a consequence of the Federal nesses and households to concentrate Reserve’s aggressive easing of the borrowing in longer-term instruments, stance of monetary policy in 2001, inter- thereby locking in lower debt-service est rates on short- and intermediate-term obligations. The proceeds of long-term Treasury securities fell substantially borrowing were also used to strengthen over the course of the year. Longer-term balance sheets by building stocks of liq- Treasury bond yields, however, ended uid assets. A shift toward safer and more the year about unchanged, on balance. liquid asset holdings showed through in These rates had already fallen appre- rapid growth of M2, which was spurred ciably in late 2000 in anticipation of further by reduced short-term market monetary policy easing. They may also interest rates and elevated stock market have been held up last year by an volatility. 30 88th Annual Report, 2001 Interest Rates and longer-term interest rates turned down again. Short-term market interest rates moved The terrorist attacks of September 11 down with the FOMC’s cumulative cut dramatically redrew the picture of the in the target federal funds rate of nation’s near-term economic prospects. 43⁄4 percentage points, and yields on Market participants lowered markedly intermediate-term Treasury securities their expected trajectory for the path of declined almost 2 percentage points. the federal funds rate in the immediate Longer-term interest rates had already aftermath of the attacks, and revisions to fallen in the latter part of 2000, when policy expectations, combined with con- investors began to anticipate significant siderable flight-to-safety demands, cut policy easing in response to weakening short- and intermediate-term Treasury economic growth. As the FOMC aggres- yields substantially over subsequent sively eased the stance of monetary pol- days. The FOMC, confronted with evi- icy during the winter and spring, inves- dence of additional weakness in final tors’ expectations of a prompt revival in demand and prices, eased policy further economic activity took hold and were over the balance of the year, and short- manifested in a sharp upward tilt of term market interest rates continued to money market futures rates and an decline. In early November, however, appreciable rise in longer-term interest intermediate- and long-term interest rates over the second quarter. How- rates turned up, as it became apparent ever, signs of the anticipated economic that the economic fallout from the turnaround failed to materialize as attacks would be more limited than the summer progressed. Indeed, the some had originally feared, and as mili- weakening in economic activity was tary success in Afghanistan bolstered becoming more widespread, which investors’ confidence and moderated prompted expectations of further mone- safe-haven demands. By the end of the tary policy easing over the near term, year, yields on intermediate-term Trea- sury securities had reversed about half of their post–September 11 decline, Rates on Selected Treasury Securities while yields on longer-term Treasury Percent securities had risen enough to top their pre-attack levels. In early 2002, how- 7 ever, yields on intermediate- and longer- term Treasuries edged down again, as 6 market participants trimmed their expec- Ten-year 5 tations for the strength of the economic rebound, and the Congress failed to 4 move forward with additional fiscal Two-year 3 stimulus. Yields on higher quality investment- Three-month 2 grade corporate bonds generally fol- lowed those on comparably dated Trea- 1 sury securities last year, although risk spreads widened moderately before 2000 2001 2002 narrowing over the last few months. In Note. The data are daily and extend through Feb- contrast, interest rates on speculative- ruary 21, 2002. grade corporate debt increased steadily Economic and Financial Developments in 2001 and Early 2002 31 in 2001, as risk spreads ballooned came to a halt at the end of the first in response to mounting signs of finan- quarter, with the Wilshire 5000—a very cial distress among weaker firms. Even broad index of stock prices—down with a considerable narrowing over about 13 percent, while the tech-heavy the final two months of the year, risk Nasdaq ended the first quarter at its spreads on below-investment-grade lowest level since 1998 and more than bonds remained quite wide. Spreads for 60 percent below its record high reached high-yield bonds edged down further in in March of 2000. 2002 after rising sharply in early Janu- Companies, especially in the technol- ary, when several important technology ogy sector, reported weak profits for the and telecommunications companies first quarter, but their announcements revised down their earnings forecasts or generally surpassed analysts’ sharply released corrections to past earnings lowered expectations. With the 1 per- statements. Interest rates on commercial centage point reduction in the federal and industrial (C&I) loans at banks fell funds rate over March and April, inves- last year by about as much as the federal tors became more confident that an funds rate. According to the Federal improvement in economic conditions Reserve’s quarterly Survey of Terms of was in train, and equity prices rallied; Business Lending, the spread over the the rebound was particularly strong for target federal funds rate of the average technology companies—the Nasdaq interest rate on C&I loans varied some- rose almost 40 percent between April what over the year, falling for a while and the end of May. The forward then rising sharply between August and momentum in equity markets was November; nonetheless, it has generally checked in June, however, in part remained in the elevated range that has because analysts slashed their estimates persisted since late 1998. The same sur- for near-term corporate earnings growth. vey also indicated that over the course Although the stock market initially of last year commercial banks, like other proved resilient in the face of the bleak lenders, have become especially cau- tious about lending to marginal credits, Major Stock Price Indexes as indicated by the average spread on riskier C&I loans not made under a pre- January 3, 2000 = 100 vious commitment, which soared in 2001. 100 Equity Markets The exceptional volatility of equity S&P 500 prices in 2001 likely reflected the dra- 75 Wilshire matic fluctuations in investors’ assess- 5000 ment of the outlook for the economy and corporate earnings. Share prices 50 Nasdaq tumbled early last year, as pessimism and uncertainty about the direction of the economy were intensified by a spate of negative earnings announcements and 2000 2001 2002 profit warnings in February and March. Note. The data are daily and extend through Feb- The pronounced sell-off of equities ruary 21, 2002. 32 88th Annual Report, 2001 profit news, suggesting that weak earn- 10 percent, while the Nasdaq fell 20 per- ings had been largely anticipated by cent. The widespread decline in equity investors, the steady barrage of dismal prices through the first three quarters of economic news—particularly in the 2001 is estimated to have wiped out technology and telecommunications nearly $31⁄2 trillion in household wealth, sectors—started to exert downward translating into 81⁄4 percent of total pressure on share prices by early household net worth. Of this total, how- August. The slide in stock prices intensi- ever, about $11⁄4 trillion was restored by fied in early September, with technology the stock market rally in the fourth quar- stocks taking an exceptional drubbing. ter. Moreover, the level of household net By September 10, the Wilshire 5000 worth at the end of last year was still was down almost 10 percent from the almost 50 percent higher than it was at end of July, while the Nasdaq had lost the end of 1995, when stepped-up pro- more than 16 percent. ductivity gains had begun to induce The attacks on September 11, a Tues- investors to boost significantly their day, caused stock markets to shut down expectations of long-term earnings and to remain closed for the rest of that growth. In January and early February week. Trading resumed in an orderly of 2002, investors reacted to generally fashion on Monday, September 17, but disappointing news about expected earn- the day ended with the market as a ings, especially in the telecommunica- whole down about 5 percent—with air- tions sector, and to concerns about cor- line and hotel stocks pounded most— porate accounting practices by erasing and trading volume on the New York some of the fourth-quarter gain in equity Stock Exchange hitting a record high. prices. Despite this decline, the price- Major stock price indexes, which sagged earnings ratio for the S&P 500 index further in subsequent days and weeks, (calculated using operating earnings were weighed down by investors’ more expected over the next year) remained pessimistic evaluation of the near-term close to its level at the beginning of economic outlook and by sizable down- 2001. The relatively elevated ratio ward revisions to analysts’ earnings reflected lower market interest rates as projections for the rest of 2001. By the well as investor anticipation of a return third week of the month, broad stock to robust earnings growth. price indexes had fallen a total of 12 percent from their levels on Septem- ber 10. Debt and Depository Intermediation In late September, stock prices staged The growth of the debt of nonfederal a comeback that lasted through the sectors was strong over the first half of fourth quarter, as incoming information the year, as the decline in longer-term suggested that the economy had proven interest rates during the final months of remarkably resilient and economic pros- 2000 prompted some opportunistic tap- pects were improving. On the percep- ping of bond markets by businesses and tion that the worst for the technology helped keep the expansion of household sector would soon pass, share prices of credit brisk. However, the combination firms in technology industries jumped of a stepdown in the growth of con- sharply, lifting the Nasdaq more than sumer durables purchases, a further drop 35 percent from its September nadir. On in capital expenditures, and a substantial balance, last year’s gyrations in stock inventory liquidation over the second prices left the Wilshire 5000 down about half of the year resulted in a signifi- Economic and Financial Developments in 2001 and Early 2002 33 cantly slower pace of private borrowing. October, however, the disruptions to On balance, growth of nonfederal debt business financing patterns and payment retreated about 1 percentage point in systems that bloated bank balance sheets 2001, to 71⁄2 percent. Federal debt con- had largely dissipated, and loans con- tinued to contract early last year; it then tracted sharply. turned up as the budget fell into a deficit Commercial banks reported a marked reflecting the implementation of the tax deterioration in loan performance last cut, the effect of the weaker economy year. Delinquency and charge-off rates on tax receipts, and emergency spending on C&I loans trended up appreciably, in the wake of the terrorist attacks. As although they remained well below rates a result, the federal government paid recorded during the 1990-91 recession. down only 11⁄4 percent of its debt, on Delinquency rates on credit card net, over 2001, compared with 63⁄4 per- accounts increased for the second year cent in the previous year. With nominal in a row, reaching 5 percent for the first GDP decelerating sharply, the ratio of time since early 1992. Banks responded nonfinancial debt to GDP moved up to the deteriorating business and house- notably in 2001, more than reversing its hold balance sheets by tightening credit decrease in the previous year. standards and terms for both types of The economic slowdown and the loan, according to the Federal Reserve’s decline in market interest rates last year Senior Loan Officer Opinion Survey on left a noticeable imprint on the composi- Bank Lending Practices. Banks indi- tion of financial flows, with borrowing cated that they had tightened business by businesses and households migrating lending policies in response to greater toward longer-term bond and mortgage uncertainty about the economic outlook markets. As a consequence, credit at and their reduced tolerance for risk. depository institutions expanded slug- Similarly, the net fractions of banks gishly over the year. Growth of loans at reporting that they had tightened stan- commercial banks dropped off sharply, dards for both credit card and other con- from 12 percent in 2000 to 21⁄4 per- sumer loans rose markedly over the first cent in 2001. The slowdown in total half of last year. As household financial bank credit—after adjustments for conditions continued to slip, the net pro- mark-to-market accounting rules—was portion of banks that tightened stan- less severe, because banks acquired dards on consumer loans remained at an securities, largely mortgage-backed elevated level in the second half of the securities, at a brisk pace throughout the year. year. A healthy banking sector served as In response to rising levels of delin- an important safety valve for several quent and charged-off loans, commer- weeks after September 11, as businesses cial banks significantly boosted the rate tapped backup lines of credit to over- of provisioning for loan losses last year, come problems associated with the which, along with reduced income from repayment of maturing commercial capital market activities, cut into the paper and issuance of new paper. More- banking sector’s profits. Nonetheless, over, with payment flows temporarily through the third quarter of 2001— interrupted by the terrorist attacks, a the latest period for which Call Report substantial volume of overdrafts was data are available—measures of indus- created, causing a spike in the ‘‘other’’ try profitability remained near the loan category that includes loans to elevated range recorded for the past sev- depository institutions. By the end of eral years, and banks continued to hold 34 88th Annual Report, 2001 substantial capital to absorb losses. assets, especially for its liquid deposits Indeed, virtually all assets were at well- (the sum of checking and savings capitalized banks at the end of the third accounts) and retail money funds com- quarter, and the substitution of securities ponents. Moreover, negative returns and for loans on banks’ balance sheets also elevated volatility in equity markets helped edge up risk-based capital ratios. likely raised household demand for M2 In the fourth quarter, a number of large assets through the fall. An unprec- banks saw their profits decline further edented level of mortgage refinancing because of their exposure to Enron and, activity (which results in prepayments to a lesser extent, Argentina. On the that temporarily accumulate in deposit positive side, wider net interest margins accounts before being distributed to helped support profits throughout 2001. investors in mortgage-backed securi- ties), as well as increased foreign demand for U.S. currency, also bolstered The Monetary Aggregates the growth of M2 over the course of the The broad monetary aggregates grew year. very rapidly in 2001. Over the four quar- Involuntary accumulation of liquid ters of the year, M2 increased 101⁄4 per- deposits resulting from payment system cent, a rate significantly above the pace disruptions after the terrorist attacks, of the past several years. Because the combined with elevated safe-haven rates of return provided by many com- demands, caused M2 to surge tempo- ponents of M2 move sluggishly, the rarily in the weeks following Septem- swift decline in short-term market inter- ber 11. At the same time, plunging est rates last year significantly lowered equity prices led to a sharp step-up the opportunity cost of holding M2 in the growth of retail money mar- ket mutual funds. After a substantial M2 Growth Rate unwinding of distortions to money flows in October, M2 growth over the balance Percent of the year was spurred by further declines in its opportunity cost resulting from additional monetary policy easings 10 and by heightened volatility in equity markets. The hefty advance in M2 last 8 year outpaced the anemic expansion of nominal income, and M2 velocity—the 6 ratio of nominal GDP to M2—posted a record decline. 4 M3—the broadest monetary aggregate—grew 13 percent over 2001. 2 In addition to the surge in its M2 com- ponent, huge inflows into institutional money funds boosted M3 growth. Inves- 1991 1993 1995 1997 1999 2001 tors’ appetite for these instruments was Note. M2 consists of currency, travelers checks, enormous last year because their returns demand deposits, other checkable deposits, savings were unusually attractive as they lagged deposits (including money market deposit accounts), the steep decline in market interest rates. small-denomination time deposits, and balances in retail money market funds. Annual growth rates are The slow-down in the growth of bank computed from fourth-quarter averages. credit over the summer, which resulted Economic and Financial Developments in 2001 and Early 2002 35 in a contraction in managed liabilities, expect economic recovery, thereby sup- damped the rise in M3 somewhat. The porting long-term interest rates. Follow- velocity of M3 dropped for the seventh ing the terrorist attacks in September, year in the row, to a record low. interest rates declined around the globe as expected economic activity weak- ened and demand shifted away from International Developments equities and toward the relative safety of Economic activity in foreign economies bonds. However, toward year-end, as the weakened substantially in 2001. Early in period of crisis passed, long-term inter- the year, activity abroad was depressed est rates rebounded strongly. by high oil prices, the global slump in Overall stock indexes in foreign the high-tech sector, and spillover from industrial economies declined for the the U.S. economic slowdown. The Sep- second consecutive year as activity fal- tember terrorist attacks further height- tered and actual and projected corporate ened economic uncertainty. On average, earnings fell sharply. Technology- foreign economic activity was about flat oriented stock indexes again fell more over the year. The weakest performer than the overall indexes. Among emerg- among industrial economies was Japan, ing market economies, the performance where output declined. The euro area of stocks was mixed; stock indexes in eked out a slight increase in its real several Asian emerging market econo- GDP. Activity in most emerging market mies rebounded strongly late in the year, economies in both Asia and Latin a move possibly reflecting market par- America declined. Asian developing ticipants’ hopes for a revival in global economies were particularly hard hit by demand for the high technology prod- the falloff in demand for their high-tech ucts that feature prominently in these exports. In Latin America, the output countries’ exports. Argentine financial decline in Mexico largely reflected markets came under increasing pressure sharply reduced export demand from the United States; Argentina’s financial crisis precipitated a further sharp drop Foreign Equity Indexes in output in that country. An easing of January 1999 = 100 average foreign inflation reflected the weakness of activity as well as a net Latin America decline in global oil prices over the 200 course of the year. 175 In response to the pronounced weak- ness in economic activity, monetary 150 authorities in the major industrial coun- Europe tries eased policy throughout the year. 125 Nevertheless, interest rates on long-term government securities showed little net 100 change from the beginning to the end of Developing Asia 75 the year in most major industrial coun- Japan tries. Weak economic conditions tended to put downward pressure on long-term 1999 2000 2001 2002 rates, but moves toward more stimula- Note. The data are monthly. The last observations tive macroeconomic policies appeared are the average of trading days through February 21, to encourage market participants to 2002. 36 88th Annual Report, 2001 throughout the year because of growing ing U.S. economic performance in the fears of a debt default and the end of the near term. The dollar’s average foreign peso’s peg to the dollar. Near year-end, exchange value against the currencies of Argentine authorities in fact suspended other major industrial countries recorded debt payments to the private sector and, a net increase of 8 percent over 2001 as early in 2002, ended the one-to-one peg a whole. The dollar also strengthened, to the dollar. There was limited negative but by a lesser amount, against the cur- spillover to other emerging financial rencies of our most important develop- markets from the sharp deterioration in ing country trading partners. So far this Argentina’s economic and financial con- year, the dollar’s average value has risen dition, in contrast to the situation that further on balance. prevailed during other emerging market financial crises of recent years. The dollar’s average foreign ex- Industrial Economies change value remained strong through The dollar showed particular strength most of 2001. The dollar continued to against the Japanese yen last year, rise despite mounting evidence of weak- appreciating nearly 15 percent. The ening U.S. economic activity and the weakness of the yen reflected serious significant easing of monetary policy ongoing structural problems and the by the FOMC. Market participants may relapse of the Japanese economy back have felt that the falloff in economic into recession. Early in the year, in growth in foreign economies and expec- response to signs of renewed weakening tations that the United States offered of the economy, the Bank of Japan stronger prospects for economic growth announced that it was easing policy by in the future outweighed disappoint- shifting its operating target from the overnight rate—already not far above Nominal U.S. Dollar Exchange Rate Indexes zero—to balances held by financial institutions at the Bank of Japan. Policy January 1999 = 100 was eased further and more liquidity was injected into the banking system Major currencies when the balances target was raised 115 three times later in the year. The yen received a temporary boost when Junichiro Koizumi, widely seen as more 110 likely to introduce economic reforms, became prime minister in April. The yen 105 again strengthened in the immediate wake of the September terrorist attacks, prompting the Bank of Japan to make Broad 100 substantial intervention sales of yen. However, later in the year, amid signs of a renewed deterioration of economic 1999 2000 2001 2002 conditions, the yen again started to Note. The data are monthly. Indexes are trade- weaken significantly. weighted averages of the exchange value of the dollar For the year as a whole, Japanese real against major currencies and against the currencies of GDP is estimated to have declined more a broader group of important U.S. trading partners. Last observations are the average of trading days than 1 percent, a reversal of the rebound through February 21, 2002. recorded the previous year. Private Economic and Financial Developments in 2001 and Early 2002 37 investment declined and private con- pants appeared to revise downward their sumption moved lower, as households expectation of an early U.S. recovery. curtailed spending in the face of rising Then, later in the year, with more signs unemployment and falling real income. of a further weakening of activity in The winding-down of the large-scale Europe, the euro again declined. On bal- public works programs of recent years ance, the dollar appreciated more than more than offset the effect on growth 5 percent relative to the euro over the from the additional spending contained course of the year. Real GDP in the euro in several supplemental budgets. Last area is estimated to have increased at year marked the third consecutive year less than a 1 percent rate in 2001, a of deflation, with the prices of both con- sharp slowing from the nearly 3 percent sumer goods and real estate continuing growth rate of the previous year. Fixed to move lower. investment and inventory investment The dollar’s movements against the both are estimated to have made nega- euro in 2001 appear to have been mainly tive contributions to the growth of real influenced by market perceptions of the GDP, whereas consumption growth strength of economic activity in the remained near the rate of the previous United States relative to that in the euro year. The slowing of growth in the euro area. In the early part of the year, the area was not uniform across countries, euro weakened as evidence mounted with weakness being more pronounced that the economic slowdown that was in Germany and less so in France. already apparent in the United States as The European Central Bank (ECB) the year began was also taking hold in held off easing monetary policy in the Europe. During the summer, the euro early months of the year, restrained by rose against the dollar as market partici- the euro’s weakness, growth of M3 that remained in excess of the ECB’s refer- ence value, and a euro-area inflation rate U.S. Dollar Exchange Rate against the Euro above its 2 percent target ceiling. In and the Japanese Yen May, evidence of slowing activity prompted the ECB to reduce its key January 1999 = 100 policy rate 25 basis points. Three addi- tional reductions followed later in the 130 year, as activity weakened further and the inflation rate receded toward its tar- Euro 120 get ceiling. The total reduction in the ECB’s key policy rate over the course of 110 the year was 150 basis points. The beginning of 2002 saw the introduction 100 of euro notes and coins, a process that proceeded smoothly. Japanese yen 90 The dollar appreciated 6 percent against the Canadian dollar in 2001 as the Canadian economy slowed abruptly. 1999 2000 2001 2002 Real GDP in Canada is estimated to have been about flat last year after Note. The data are monthly. Exchange rates are in growing more than 3 percent in 2000. A foreign currency units per dollar. Last observations are the average of trading days through February 21, key factor in this slowing was the sharp 2002. drop-off in Canadian exports to the 38 88th Annual Report, 2001 United States. An inventory correction in the year; financial asset prices fell also depressed output. Earlier in the sharply, and funds moved out of the year, consumption was buoyed by con- banking system as the government tinued employment growth, tax cuts, and moved to restructure its debt and the a housing boom. However, later in the one-to-one peg to the dollar looked year, growth of consumption faltered as increasingly precarious. In early Decem- employment prospects worsened and ber, the government imposed capital asset prices weakened. The Bank of controls, including limits on bank Canada has moved aggressively to account withdrawals. These restrictions counter the slowing of economic activ- led to widespread protests, which trig- ity by lowering its key policy interest gered the resignation of President de la rate nine times in 2001 and once in Rua and an interval of political turmoil. January 2002 for a cumulative total of After the resignation of President de la 375 basis points.3 When the Bank of Rua, the government announced it Canada initiated easing moves early in would suspend debt payments to the pri- 2001, inflation was slightly above the vate sector. The government of the new Bank’s target range of 1 percent to president, Eduardo Duhalde, suspended 3 percent; but by the end of the year, Argentina’s currency board arrangement slack activity and falling energy prices and established a temporary dual had pushed the inflation rate down to exchange rate system. In early February, near the bottom of the range. the dual exchange rate system was aban- doned, and the peso’s floating rate moved to about 2 pesos per dollar amid Emerging Market Economies continuing economic uncertainty. For 2001 as a whole, Argentine real GDP is Argentina was a main focus of attention estimated to have fallen at well over a among emerging market economies in 5 percent rate, and prices declined 2001. In the first part of the year, further. worse-than-expected data on the fiscal To date, the negative spillover from situation and concerns that the govern- events in Argentina to other emerging ment would be unable to implement financial markets has been limited, pos- announced fiscal measures heightened sibly because market participants had doubts about whether Argentina would been well aware of Argentina’s prob- be able to avoid a default on its debt. lems for some time and viewed them as Argentine financial markets received largely confined to that country. Brazil only temporary support from a large- was probably most heavily affected by scale debt exchange completed in June events in Argentina, and the bond spread and an enhancement of IMF support on Brazilian debt showed a net increase approved in September. With financial of about 110 basis points over the course market confidence eroding, conditions of last year while the spread on Argen- took a dramatic turn for the worse late tina debt exploded upward. Other important factors weighing on Brazilian economic activity last year likely were 3. Among these reductions was one on Septem- weak growth in the United States— ber 17, when the Bank of Canada (along with the Brazil’s most important export market— ECB) announced a reduction of its policy rate by 50 basis points, following the 50 basis point reduc- and the emergence of an energy short- tion in the federal funds rate announced by the age as drought limited hydroelectric FOMC earlier in the day. output. For the year as a whole, Brazil- Economic and Financial Developments in 2001 and Early 2002 39 ian real GDP is estimated to have risen had fueled rapid export growth in the at less than a 1 percent rate after grow- region in recent years. ing at a 4 percent rate the previous two The economies of Taiwan, Singapore, years. The Brazilian currency registered and Malaysia are highly dependent on a net depreciation against the dollar of exports of semiconductors and other about 16 percent over the course of last high-tech products, and as global year, while stock prices declined more demand for these goods was cut back than 10 percent. The Brazilian central sharply, real GDP in these countries bank tightened policy last year in an declined by an estimated 5 percent on effort to hold down the inflationary average last year. Indonesia and Thai- impact of currency depreciation. land, both relatively less dependent on Real GDP in Mexico declined about high-tech exports and experiencing 1 percent in 2001, a sharp reversal from some reduction in political tension over the 5 percent growth rates recorded in the course of the year, managed to the previous two years. The falloff in record small positive real GDP growth activity was mainly a reflection of the rates last year, albeit well below rates of negative effects on direct trade and con- the previous year. fidence in Mexico arising from the slow- Korean real GDP is estimated to have down of the U.S. economy. In light of increased about 2 percent in 2001. the marked weakening of activity, While in an absolute sense Korea is an declining inflation, and a strong peso, important exporter of high-tech prod- the Bank of Mexico started to loosen the ucts such as semiconductors, it has a stance of monetary policy in May, and relatively more diversified economy short-term interest rates continued to than most of its Asian neighbors, and decline over the rest of the year. In thus the magnitude of its slowdown last February 2002, the Bank of Mexico year was somewhat muted. Government moved to tighten monetary conditions, moves toward monetary and fiscal pol- citing concerns that an increase in icy stimulus over the course of the year administered prices would raise infla- helped support domestic demand in tion. Mexican financial markets fared Korea. quite well last year, with the peso appre- In China, recorded growth of real ciating 5 percent against the dollar and GDP remained robust last year. China’s stock prices rising nearly 15 percent. lesser dependency on exports in general, The effect on Mexican financial markets and high-tech exports in particular, from Argentina’s difficulties appeared cushioned it from last year’s global to have been quite limited, as indicated slowdown, and the government stepped by the net decline of the Mexican debt up the pace of fiscal stimulus to offset spread by 80 basis points over the weakening private demand. Hong Kong, course of the year. with exports not heavily concentrated Economic growth in the Asian emerg- in high-tech goods and an economy ing market economies turned negative closely integrated with a rapidly grow- last year. On average, real GDP in ing Chinese economy, is nevertheless developing Asia is estimated to have estimated to have experienced a decline declined about 1 percent in 2001, com- in real GDP last year. The peg of Hong pared with average growth of 6 percent Kong’s currency to a strengthening U.S. in the previous year. A key factor in this dollar put pressure on its competitive slowing was the sharp falloff in global position, and domestic price deflation demand for the high-tech products that continued. 40 88th Annual Report, 2001 Conditions in financial markets in for the region as a whole, exchange rates emerging Asia were, for the most part, against the dollar generally moved not particularly volatile last year. Debt lower, and stock indexes declined some- spreads were little changed on average what on average. 41 Monetary Policy Reports to the Congress Report submitted to the Congress on their highs earlier in the year, slumped February 13, 2001, pursuant to sec- sharply starting in September, slicing tion 2B of the Federal Reserve Act away a portion of household net worth and discouraging the initial offering of new shares by firms. Many busi- nesses encountered tightening credit Report of February 13, 2001 conditions, including a widening of risk spreads on corporate debt issuance and Monetary Policy and the bank loans. Foreign economic activity Economic Outlook decelerated noticeably in the latter part of the year, contributing to a weakening When the Federal Reserve submitted its of the demand for U.S. exports, which previous Monetary Policy Report to the also was being restrained by an earlier Congress, in July of 2000, tentative appreciation in the exchange value of signs of a moderation in the growth the U.S. dollar. of economic activity were emerging The dimensions of the economic following several quarters of extraor- slowdown were obscured for a time by dinarily rapid expansion. After having the usual lags in the receipt of economic increased the interest rate on federal data, but the situation began to come funds through the spring to bring the into sharper focus late in the year as growth of aggregate demand and poten- the deceleration steepened. Spending on tial supply into better alignment and business capital, which had been ris- thus contain inflationary pressures, the ing rapidly for several years, elevating Federal Reserve had stopped tightening stocks of these assets, flattened abruptly as evidence of an easing of economic in the fourth quarter. Consumers growth began to appear. clamped down on their outlays for motor Indications that the expansion had vehicles and other durables, the stocks moderated from its earlier rapid pace of which also had climbed to high gradually accumulated during the sum- levels. As the demand for goods soft- mer and into the autumn. For a time, this ened, manufacturers adjusted produc- downshifting of growth seemed likely to tion quickly to counter a buildup leave the economy expanding at a pace in inventories. Rising concern about roughly in line with that of its potential. slower growth and worker layoffs con- Over the last few months of the year, tributed to a sharp deterioration of con- however, elements of economic restraint sumer confidence. In response to the emerged from several directions to slow accumulating weakness, the Federal growth even more. Energy prices, rather Open Market Committee (FOMC) low- than turning down as had been antici- ered the intended interest rate on federal pated, kept climbing, raising costs funds 1⁄2 percentage point on January 3 throughout the economy, squeezing of this year. Another rate reduction of business profits, and eroding the income that same size was implemented at the available for discretionary expendi- close of the most recent meeting of the tures. Equity prices, after coming off FOMC at the end of last month. 42 88th Annual Report, 2001 As weak economic data induced ment of low and stable underlying infla- investors to revise down their expecta- tion suggest that the longer-run outlook tions of future short-term interest rates for the economy is still quite favorable, in recent months and as the Federal even though downside risks may remain Reserve eased policy, financial market prominent in the period immediately conditions became more accommoda- ahead. tive. Since the November FOMC meet- ing, yields on many long-term corporate bonds have dropped on the order of a Monetary Policy, Financial full percentage point, with the largest Markets, and the Economy declines taking place on riskier bonds as over the Second Half of 2000 the yield spreads on those securities nar- and Early 2001 rowed considerably from their elevated levels. In response, borrowing in long- As described in the preceding Monetary term credit markets has strengthened Policy Report to the Congress, the very appreciably so far in 2001. The less rapid pace of economic growth over restrictive conditions in financial mar- the first half of 2000 was threatening kets should help lay the groundwork for to place additional strains on the econo- a rebound in economic growth. my’s resources, which already appeared That rebound should also be encour- to be stretched thin. Private long-term aged by underlying strengths of the interest rates had risen considerably in economy that still appear to be present response to the strong economy, and, in despite the sluggishness encountered of an effort to slow the growth of aggregate late. The most notable of these strengths demand and thereby prevent a buildup is the remarkable step-up in structural of inflationary pressures, the Federal productivity growth since the mid- Reserve had tightened its policy settings 1990s, which seems to be closely related substantially through its meeting in to the spread of new technologies. Even May 2000. Over subsequent weeks, pre- as the economy slowed in 2000, evi- liminary signs began to emerge suggest- dence of ongoing efficiency gains were ing that growth in aggregate demand apparent in the form of another year of might be slowing, and at its June meet- rapid advance in output per worker hour ing the FOMC left the federal funds rate in the nonfarm business sector. With unchanged. households and businesses still in the Further evidence accumulated over process of putting recent innovations the summer to indicate that demand in place and with technological break- growth was moderating. The rise in throughs still occurring, an end to profit- mortgage interest rates over the pre- able investment opportunities in the vious year seemed to be damping activ- technology area does not yet seem to ity in the housing sector. Moreover, be in sight. Should investors continue the growth of consumer spending had to seek out emerging opportunities, the slowed from the exceptional pace of ear- ongoing transformation and expansion lier in the year; the impetus to spending of the capital stock will be maintained, from outsized equity price gains in 1999 thereby laying the groundwork for fur- and early 2000 appeared to be partly ther gains in productivity and ongoing wearing off, and rising energy prices advances in real income and spending. were continuing to erode the purchasing The impressive performance of produc- power of households. By contrast, busi- tivity and the accompanying environ- ness fixed investment still was increas- Monetary Policy Reports, February 43 ing very rapidly, and strong growth of meeting. While recognizing that the foreign economies was fostering greater risks in the outlook were shifting, the demand for U.S. exports. Weighing this FOMC believed that the tautness of evidence and recognizing that the effects labor markets and the rise in energy of previous tightenings had not yet been prices meant that the balance of those fully felt, the FOMC decided at its risks still was weighted toward height- meeting in August to hold the federal ened inflation pressures, and this assess- funds rate unchanged. The Committee ment was noted in the balance-of-risks remained concerned that demand could statement. continue to grow faster than potential By the time of the November FOMC supply at a time when the labor market meeting, conditions in the financial mar- was already taut, and it saw the balance kets were becoming less accommoda- of risks still tilted toward heightened tive in some ways, even as the Federal inflation pressures. Reserve held the federal funds rate The FOMC faced fairly similar cir- steady. Equity prices had declined cumstances at its October meeting. By considerably over the previous several then, it had become more apparent months, resulting in an erosion of that the growth in demand had fallen household wealth that seemed likely to to a pace around that of potential sup- restrain consumer spending going for- ply. Although consumer spending had ward. Those price declines, along with picked up again for a time, it did not the elevated volatility of equity prices, regain the vigor it had displayed earlier also hampered the ability of firms to in the year, and capital spending, while raise funds in equity markets and were still growing briskly, had decelerated likely discouraging business investment. from its first-half pace. With increases Some firms faced more restrictive con- in demand moderating, private employ- ditions in credit markets as well, as risk ment gains slowed from the rates seen spreads in the corporate bond market earlier in the year. However, labor mar- widened significantly for firms with kets remained exceptionally tight, and lower credit ratings and as banks tight- the hourly compensation of workers had ened the standards and terms on their accelerated to a point at which unit labor business loans. Meanwhile, incoming costs were edging up despite strong data indicated that the pace of economic gains in productivity. In addition, siz- activity had softened a bit further. Still, able increases in energy prices were the growth of aggregate demand appar- pushing broad inflation measures above ently had moved only modestly below the levels of recent years. Although core that of potential supply. Moreover, while inflation measures were at most only crude oil prices appeared to be topping creeping up, the Committee felt that out, additional inflationary pressures there was some risk that the increase in were arising in the energy sector in the energy prices, which was lasting longer form of surging prices for natural gas, than had seemed likely earlier in the and there had been no easing of the year, would start to leave an imprint on tightness in the labor market. In assess- business costs and longer-run inflation ing the evidence, the members of the expectations, posing the risk that core Committee felt that the risks to the out- inflation rates could rise more substan- look were coming into closer balance tially. Weighing these considerations, but had not yet shifted decisively. At the the FOMC decided to hold the federal close of the meeting, the FOMC left the funds rate unchanged at its October funds rate unchanged once again, and it 44 88th Annual Report, 2001 stated that the balance of risks continued that an intermeeting policy action was to point toward increased inflation. called for. However, in the statement released after Additional evidence that economic the meeting, the FOMC noted the possi- activity was slowing significantly bility of subpar growth in the economy emerged not long after the December in the period ahead. meeting. New data indicated a marked Toward the end of the year, the mod- weakening in business investment, and eration of economic growth gave way, retail sales over the holiday season fairly abruptly, to more sluggish con- were appreciably lower than businesses ditions. By the time of the December had expected. To contain the resulting FOMC meeting, manufacturing activity buildup in inventories, activity in the had softened considerably, especially in manufacturing sector continued to drop. motor vehicles and related industries, In addition, forecasts of near-term cor- and a number of industries had accu- porate profits were being marked down mulated excessive stocks of inventories. further, resulting in additional declines Across a broader set of firms, forecasts in equity prices and in business confi- for corporate sales and profits in the dence. Market interest rates continued to fourth quarter and in 2001 were being fall, as investors became more pessimis- slashed, contributing to a continued tic about the economic outlook. Based decline in equity prices and a further on these developments, the Committee widening of risk spreads on lower-rated held a telephone conference call on corporate bonds. In this environment, January 3, 2001, and decided to cut growth in business fixed investment the intended federal funds rate 1⁄2 per- appeared to be slowing appreciably. centage point. Equity prices surged on Consumer spending showed signs of the announcement, and the Treasury decelerating further, as falling stock yield curve steepened considerably, prices eroded household wealth and con- apparently because market participants sumer confidence weakened. Moreover, became more confident that a prolonged growth in foreign economies seemed to downturn in economic growth would be slowing, on balance, and U.S. export likely be forestalled. Following the pol- performance began to deteriorate. Mar- icy easing, the Board of Governors ket interest rates had declined sharply in approved a decrease in the discount rate response to these developments. Against of a total of 1⁄2 percentage point. this backdrop, the FOMC at its Decem- The Committee’s action improved ber meeting decided that the risks to the financial conditions to a degree. Over outlook had swung considerably and the next few weeks, equity prices rose, now were weighted toward economic on net. Investors seemed to become less weakness, although it decided to wait wary of credit risk, and yield spreads for additional evidence on the extent narrowed across most corporate bonds and persistence of the slowdown before even as the issuance of these securities moving to an easier policy stance. Rec- picked up sharply. But in some other ognizing that the current position of respects, investors remained cautious, as the economy was difficult to discern evidenced by widening spreads in com- because of lags in the data and that mercial paper markets. Incoming data prospects for the near term were particu- pointed to further weakness in the manu- larly uncertain, the Committee agreed at facturing sector and a sharp decline in the meeting that it would be especially consumer confidence. Moreover, slower attentive over coming weeks to signs U.S. growth appeared to be spilling over Monetary Policy Reports, February 45 to several important trading partners. In ployment rate in the fourth quarter of late January, the FOMC cut the intended this year will be about 41⁄2 percent, still federal funds rate 1⁄2 percentage point quite low by historical standards. while the Board of Governors approved The rate of economic expansion over a decrease in the discount rate of an the near term will depend importantly equal amount. Because of the significant on the speed at which inventory over- erosion of consumer and business con- hangs that developed over the latter fidence and the need for additional part of 2000 are worked off. Gains in adjustments to production to work off information technology have no doubt elevated inventory levels, the FOMC enabled businesses to respond more indicated that the risks to the outlook quickly to a softening of sales, which continued to be weighted toward eco- has steepened the recent production cuts nomic weakness. but should also damp the buildup in inventories and facilitate a turnaround. The motor vehicle industry made some Economic Projections for 2001 progress toward reducing excess stocks Although the economy appears likely to in January owing to a combination of be sluggish over the near term, the mem- stronger sales and a further sharp cut- bers of the Board of Governors and the back in assemblies. In other parts of Reserve Bank presidents expect stronger manufacturing, the sizable reductions conditions to emerge as the year in production late last year suggest that progresses. For 2001 overall, the central producers in general were moving tendency of their forecasts of real GDP quickly to get output into better align- growth is 2 percent to 21⁄2 percent, mea- ment with sales. Nevertheless, stocks at sured as the change from the fourth year-end were above desired levels in a quarter of 2000 to the fourth quarter of number of industries. 2001. With growth falling short of its Once inventory imbalances are potential rate, especially in the first half worked off, production should become of this year, unemployment is expected more closely linked to the prospects for to move up a little further. Most of the sales. Household and business expendi- governors and Reserve Bank presidents tures have decelerated markedly in are forecasting that the average unem- recent months, and uncertainties about Economic Projections for 2001 Percent Federal Reserve governors and Reserve Bank presidents Memo: Indicator 2000 actual Central Range tendency Change, fourth quarter to fourth quarter 1 Nominal GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.9 33⁄4–51⁄4 4–5 Real GDP 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.5 2–23⁄4 2–21⁄2 PCE chain-type price index . . . . . . . . . . . . . . . . . . 2.4 13⁄4–21⁄2 13⁄4–21⁄4 Average level, fourth quarter Civilian unemployment rate . . . . . . . . . . . . . . . . . 4.0 41⁄2–5 About 41⁄2 1. Change from average for fourth quarter of 2000 to 2. Chain-weighted. average for fourth quarter of 2001. 46 88th Annual Report, 2001 how events might unfold are consider- some degree and would leave more able. But, responding in part to the eas- discretionary income in the hands of ing of monetary policy, financial mar- households. kets are shifting away from restraint, How quickly investment spending and this shift should create a more starts to pick up again will depend not favorable underpinning to the expected only on the cost of finance but also on pickup in the economy as the year the prospective rates of return to capital. progresses. The sharp drop in mortgage This past year, expectations regarding interest rates since May of last year the prospects of some high-tech compa- appears to have stemmed the decline nies clearly declined, and capital spend- in housing activity; it also has enabled ing seems unlikely to soon regain the many households to refinance existing exceptional strength that was evident mortgages at lower rates, an action that in the latter part of the 1990s and for should free up cash for added spending. a portion of last year. From all indica- Conditions of business finance also have tions, however, technological advance eased to some degree. Interest rates on still is going forward at a rapid pace, investment-grade corporate bonds have and investment will likely pick up again recently fallen to their lowest levels in if, as expected, the expansion of the about 11⁄2 years. Moreover, the premi- economy gets back on more solid foot- ums required of bond issuers that are ing. Private analysts are still anticipating perceived to be at greater risk have high rates of growth in corporate earn- dropped back in recent weeks from the ings over the long-run, suggesting that elevated levels of late 2000. As credit the current sluggishness of the economy conditions have eased, firms have issued has not undermined perceptions of large amounts of corporate bonds so far favorable long-run fundamentals. in 2001. However, considerable caution The degree to which increases in is evident in the commercial paper mar- exports might help to support the U.S. ket and among banks, whose loan offi- economy through a stretch of sluggish- cers have reported a further tightening ness has become subject to greater of lending conditions since last fall. In uncertainty recently because foreign equity markets, prices have recently economies also seem to have deceler- dropped in response to negative reports ated toward the end of last year. How- on corporate earnings, reversing the ever, the expansion of imports has gains that took place in January. slowed sharply, responding in part to the The restraint on domestic demand softening of domestic demand growth. from high energy prices is expected to In effect, some of the slowdown in ease in coming quarters. Natural gas demand in this country is being shifted prices have dropped back somewhat in to foreign suppliers, implying that the recent weeks as the weather has turned adjustments required of domestic pro- milder, and crude oil prices also are ducers are not as great as they otherwise down from their peaks. Although these would have been. prices could run up again in conjunction In adjusting labor input to the slowing with either a renewed surge in demand of the economy, businesses are facing or disruptions in supply, participants in conflicting pressures. Speedy adjust- futures markets are anticipating that ment of production and ongoing gains prices will be trending gradually lower in efficiency argue for cutbacks in labor over time. A fall in energy prices would input, but companies are also reluctant relieve cost pressures on businesses to to lay off workers that have been diffi- Monetary Policy Reports, February 47 cult to attract and retain in the tight 1999, it showed only a slight step-up in labor market conditions of the past few the rate of increase after excluding the years. In the aggregate, the balance that prices of food and energy. Unit labor has been struck in recent months has costs picked up moderately, adding to led, on net, to slower growth of employ- the cost pressures from energy, but the ment, cutbacks in the length of the aver- ability of businesses to raise prices was age workweek, and, in January of this restrained by the slowing of the econ- year, a small increase in the unemploy- omy and the persistence of competitive ment rate. pricing conditions. Inflation is not expected to be a press- ing concern over the coming year. Most of the governors and Reserve Bank The Household Sector presidents are forecasting that the rise Personal consumption expenditures in the chain-type price index for per- increased 41⁄2 percent in real terms in sonal consumption expenditures will be 2000 after having advanced 5 percent in smaller than the price rise in 2000. The 1998 and 51⁄2 percent in 1999. A large central tendency of the range of fore- portion of last year’s gain came in the casts is 13⁄4 percent to 21⁄4 percent. Infla- first quarter, when consumption moved tion should be restrained this coming ahead at an unusually rapid pace. The year by an expected downturn in energy increase in consumer spending over the prices. In addition, the reduced pressure remainder of the year was moderate, on resources that is associated with the averaging about 31⁄2 percent at an annual slowing of the economy should help rate. Consumer outlays for motor vehi- damp increases in labor costs and prices. cles and parts surged to a record high early in 2000 but reversed that gain over the remainder of the year; sales of Economic and Financial vehicles tailed off especially sharply as Developments in 2000 the year drew to a close. Real consumer and Early 2001 purchases of gasoline fell during the The combination of exceptionally strong year in response to the steep run-up in growth in the first half of 2000 and gasoline prices. Most other broad cate- subdued growth in the second half gories of goods and services posted siz- resulted in a rise in real GDP of about able gains over the year as a whole, but 31⁄2 percent for the year overall. Domes- results late in the year were mixed: Real tic demand started out the year with outlays for goods other than motor incredible vigor but decelerated there- vehicles eked out only a small gain in after and was sluggish by year-end. the fourth quarter, while real outlays for Exports surged for three quarters and consumer services rose very rapidly, not then faltered. In the labor market, only because of higher outlays for home growth of employment slowed over the heating fuels during a spell of colder- year but was sufficient to keep the than-usual weather but also because of unemployment rate around the lowest continued strength in real outlays for sustained level in more than thirty years. other types of services. Core inflation remained low in 2000 Changes in income and wealth pro- in the face of sharp increases in energy vided less support to consumption in prices. Although the chain-type price 2000 than in other recent years. Real index for personal consumption expen- disposable personal income rose about ditures (PCE) moved up faster than in 21⁄4 percent last year after a gain of 48 88th Annual Report, 2001 slightly more than 3 percent in 1999. two months ended in January. The Disposable income did not rise quite as marked shift in attitudes toward year- much in nominal terms as it had in 1999, end probably was brought on by a com- and rising prices eroded a larger portion bination of developments, including the of the nominal gain. Meanwhile, the net weakness in the stock market over the worth of households turned down in latter part of the year and more frequent 2000 after having climbed rapidly for reports of layoffs. several years, as the effect of a decline Real outlays for residential invest- in the stock market was only partially ment declined about 21⁄4 percent, on net, offset by a sizable increase in the value over the course of 2000, as construction of residential real estate. With the peak of new housing dropped back from the in stock prices not coming until the year elevated level of the previous year. was well under way, and with valuations Investment in housing was influenced having previously been on a sharp by a sizable swing in mortgage interest upward course for an extended period, rates as well as by slower growth of stock market wealth may well have employment and income and the down- continued to exert a strong positive turn in the stock market. After having effect on consumer spending for several moved up appreciably in 1999, mort- months after share values had topped gage rates continued to advance through out. As time passed, however, the impe- the first few months of 2000. By mid- tus to consumption from this source May, the average commitment rate on most likely diminished. The personal conventional fixed-rate mortgages was saving rate, which had dropped sharply above 81⁄2 percent, up roughly 11⁄2 per- during the stock market surge of pre- centage points from the level of a year vious years, fell further in 2000, but the earlier. New construction held up even rate of decline slowed, on average, after as rates were rising in 1999 and early the first quarter. 2000, but it softened in the spring of last Even with real income growth slow- year. Starts and permits for single- ing and the stock market turning down, family houses declined from the first consumers maintained a high degree quarter to the third quarter. of optimism through most of 2000 But even as homebuilding activity regarding the state of the economy and was turning down, conditions in mort- the economic outlook. Indexes of senti- gage markets were moving back in a ment from both the University of Michi- direction more favorable to housing. gan Survey Research Center and the From the peak in May, mortgage interest Conference Board rose to new peaks rates fell substantially over the remain- in the first quarter of the year, and the der of the year and into the early part of indexes remained close to those levels 2001, reversing the earlier increases. for several more months. Survey read- Sales of new homes firmed as rates ings on personal finances, general busi- turned down, and prices of new houses ness conditions, and the state of the continued to trend up faster than the labor market remained generally favor- general rate of inflation. Inventories of able through most of the year. As of unsold new homes held fairly steady late autumn, only mild softness could over the year and were up only moder- be detected. Toward year-end, however, ately from the lows of 1997 and 1998. confidence in the economy dropped With demand well-maintained and sharply. Both of the indexes of confi- inventories under control, activity stabi- dence showed huge declines over the lized. Starts and permits for single- Monetary Policy Reports, February 49 family houses in the fourth quarter of and terms on consumer loans, particu- 2000 were up from the average for the larly non-credit-card loans, over the third quarter. past several months, perhaps because Households continued to borrow at a of some uneasiness about how the finan- brisk pace last year, with household debt cial position of households will hold up expanding an estimated 83⁄4 percent, as the pace of economic activity slows. well above the growth rate of dispos- able personal income. Consumer credit increased rapidly early in the year, The Business Sector boosted by strong outlays on durable Real business fixed investment rose goods; but as consumer spending cooled 10 percent in 2000 according to the later in the year, the expansion of con- advance estimate from the Commerce sumer credit slowed. For the year as a Department. Investment spending shot whole, consumer credit is estimated to ahead at an annual rate of 21 percent in have advanced more than 81⁄2 percent, the first quarter of the year; its strength up from the 7 percent pace of 1999. in that period came, in part, from high- Households also took on large amounts tech purchases that had been delayed of mortgage debt, which grew an esti- from 1999 by companies that did not mated 9 percent last year, reflecting the want their operating systems to be in a solid pace of home sales. state of change at the onset of the new With the rapid expansion of house- millennium. Expansion of investment hold debt in recent years, the household was slower but still relatively brisk in debt service burden has increased to lev- the second and third quarters, at annual els not seen since the late 1980s. Even rates of about 15 percent and 8 per- so, with unemployment low and house- cent respectively. In the fourth quarter, hold net worth high, the credit quality of however, capital spending downshifted the household sector appears to have abruptly in response to the slowing deteriorated little last year. Personal economy, tightening financial condi- bankruptcy filings held relatively steady tions, and rising concern about the pros- and remain well below their peak from pects for profits; the current estimate several years ago. Delinquency rates on shows real investment outlays having home mortgages, credit cards, and auto fallen at an annual rate of 11⁄2 percent in loans have edged up in recent quarters that period. but are at most only slightly above their Fixed investment in equipment and levels of the fourth quarter of 1999. software was up 91⁄2 percent in 2000, Lenders did not appear to be signifi- with the bulk of the gain coming in the cantly concerned about the credit qual- first half of the year. Spending slowed to ity of the household sector for most of a rate of growth of about 51⁄2 percent in last year, although some lenders have the third quarter and then declined in the become more cautious of late. Accord- fourth quarter. Business investment in ing to surveys of banks conducted by motor vehicles fell roughly 15 percent, the Federal Reserve, few commercial on net, during 2000, with the largest banks tightened lending conditions on portion of the drop coming in the fourth consumer installment loans and mort- quarter; the declines in real outlays on gage loans to households over the first larger types of trucks were particularly three quarters of 2000. However, the sizable. Investment in industrial equip- most recent survey indicates that a ment, tracking the changing conditions number of banks tightened standards in manufacturing, also fell in the fourth 50 88th Annual Report, 2001 quarter but was up appreciably for the mer suggested that some firms might be year overall. Investment in high-tech encountering a bit of backup in stocks equipment decelerated over the year but but that the problems were not severe was still expanding in the fourth quarter: overall. In the latter part of the year, Real outlays for telecommunications however, inventory–sales ratios turned equipment posted exceptionally large up, indicating that more serious over- gains in the first half of the year, flat- hangs were developing. Responding to tened out temporarily in the third quar- the slowing of demand and the increases ter, and expanded again in the fourth. in stocks, manufacturers reduced output Spending on computers and peripherals in each of the last three months of the increased, in real terms, at an average year by successively larger amounts. rate of about 45 percent over the first Businesses also began to clamp down three quarters of the year but slowed on the flow of imports. Despite those abruptly to a 6 percent rate of expansion adjustments, stocks in a number of in the year’s final quarter, the smallest domestic industries were likely well quarterly advance in several years. above desired levels as the year drew to Investment in nonresidential struc- a close. tures rose substantially in 2000, about The Commerce Department’s com- 121⁄2 percent in all, after having declined pilation of business profits currently 13⁄4 percent in 1999. Investment in fac- extends only through the third quarter tory buildings, which had fallen more of 2000, but these data show an evolv- than 20 percent in 1999 in an apparent ing pattern much like that of other eco- reaction to the economic disruptions nomic data. After having risen at an abroad and the associated softness in annual rate of more than 16 percent in demand for U.S. exports, more than the first half of the year, U.S. corpora- recouped that decline over the course of tions’ economic profits—that is, book 2000. Real outlays for office construc- profits with inventory and capital con- tion, which had edged down in 1999 sumption adjustments—slowed to less after several years of strong advance, than a 3 percent rate of growth in the got back on track in 2000, posting a gain third quarter. Profits from operations of about 131⁄2 percent. Real investment outside the United States continued to in commercial buildings other than increase rapidly in the third quarter. offices was little changed after moderate However, economic profits from domes- gains in the two previous years. Spend- tic operations edged down in that period, ing on structures used in drilling for as solid gains for financial corporations energy strengthened in response to the were more than offset by a 4 percent rate surge in energy prices. of decline in the profits of nonfinancial Business inventory investment was corporations. Profits of nonfinancial subdued early in the year when final corporations as a share of their gross sales were surging; aggregate inventory– nominal output rose about 1⁄2 percent- sales ratios, which have trended lower in age point in the first half of 2000 but recent years as companies became more reversed part of that gain in the third efficient at managing stocks, edged quarter. Earnings reports for the fourth down further. As sales moderated in quarter indicate that corporate profits subsequent months, production growth fell sharply in that period. did not decelerate quite as quickly, and Business debt expanded strongly over inventories began to rise more rapidly. the first half of 2000, propelled by Incoming information through the sum- robust capital spending as well as by Monetary Policy Reports, February 51 share repurchases and cash-financed As concerns about risk mounted, merger activity. The high level of capital lenders became more cautious about expenditures outstripped internally gen- extending credit to some borrowers. An erated funds by a considerable margin increasingly large proportion of banks despite continued impressive profits. reported firming terms and standards To meet their borrowing needs, firms on business loans over the course of the tapped commercial paper, bank loans, year. In the corporate bond market, yield and corporate bonds in volume in the spreads on high-yield and lower-rated first quarter. The rapid pace of borrow- investment-grade bonds, measured rela- ing continued in the second quarter, tive to the ten-year swap rate, began although borrowers relied more heavily climbing sharply in September and by on bank loans and commercial paper to year-end were at levels well above those meet their financing needs in response seen in the fall of 1998. Lower-rated to a rise in longer-term interest rates. commercial paper issuers also had to Business borrowing slowed apprecia- pay unusually large premiums late in bly in the second half of the year. As the year, particularly on paper spanning economic growth moderated and profits the year-end. As financial conditions weakened, capital spending decelerated became more stringent, issuance of sharply. In addition, firms held down high-yield debt was cut back sharply in their borrowing needs by curbing their the fourth quarter, although investment- buildup of liquid assets, which had been grade bond issuance remained strong. accumulating quite rapidly in previous Bank lending to businesses was also quarters. Borrowing may have been light at that time, and net issuance of deterred by a tightening of financial con- commercial paper came to a standstill. ditions for firms with lower credit rat- In total, the debt of nonfinancial busi- ings, as investors and lenders apparently nesses expanded at an estimated 51⁄2 per- became more concerned about credit cent rate in the fourth quarter, less than risk. Those concerns likely were exacer- half the pace of the first half of the year. bated by indications that credit quality The slowdown in borrowing in the latter had deteriorated at some businesses. The part of the year damped the growth of default rate on high-yield bonds contin- nonfinancial business debt over 2000, ued to climb last year, reaching its high- although it still expanded an estimated est level since 1991. Some broader mea- 83⁄4 percent. sures of credit quality also slipped. The In early 2001, borrowing appears to amount of nonfinancial debt down- have picked up from its sluggish fourth- graded by Moody’s Investor Services quarter pace. Following the easing of in 2000 was more than twice as large monetary policy in early January, yield as the amount upgraded, and the delin- spreads on corporate bonds reversed a quency rate on business loans at com- considerable portion of their rise over mercial banks continued to rise over the the latter part of 2000, with spreads on year. But while some firms were clearly high-yield bonds narrowing more than a having financial difficulties, many other percentage point. As yields declined, firms remained soundly positioned to corporate bond issuance picked up, and service their debt. Indeed, the ratio of even some below-investment grade net interest payments to cash flow for all issues were brought to the market. In nonfinancial firms moved only mod- contrast, investors in the commercial estly above the relatively low levels of paper market apparently became more recent years. concerned about credit risk, partly in 52 88th Annual Report, 2001 response to the defaults of two Cali- mildly positive over the past couple of fornia utilities on some bonds and com- years. The consumption and investment mercial paper in mid-January related expenditures of state and local govern- to the difficulties in the electricity mar- ments rose about 21⁄2 percent in 2000 ket in that state. After those defaults, after an unusually large increase of spreads between top-tier and second-tier 41⁄4 percent in 1999. The slowdown in commercial paper widened further, and spending was mainly a reflection of a investors became more discriminating downshift in government investment in even within the top rating tier. Some structures, which can be volatile from businesses facing resistance in the com- year to year and had posted a large gain mercial paper market reportedly met in 1999. their financing needs by tapping backup Total federal spending, as reported in credit lines at banks. the unified budget, rose 5 percent in Growth in commercial mortgage fiscal year 2000, the largest increase debt slowed last year to an estimated in several years. A portion of the rise rate of 91⁄4 percent, and issuance of stemmed from shifts in the timing of commercial-mortgage-backed securities some outlays in a way that tended to in 2000 fell back from its 1999 pace. boost the tally for fiscal 2000. But even Spreads on lower-rated commercial- allowing for those shifts, the rise in mortgage-backed securities over swap spending would have exceeded the rates widened by a small amount late in increases of other recent years. Outlays the year, and banks on net reported tight- accelerated for most major functions, ening their standards on commercial real including defense, health, social secu- estate credit over the year. Nevertheless, rity, and income security. Of these, fundamentals in the commercial real spending on health—about three- estate market remain solid, and delin- fourths of which consists of outlays quency rates on commercial mortgages for Medicaid—recorded the biggest stayed around their historic lows. increase. Medicaid grants to the states were affected last fiscal year by increased funding for the child health The Government Sector insurance initiative that was passed in Real consumption and investment ex- 1997 and by a rise in the portion of penditures of federal, state, and local Medicaid expenses picked up by the fed- governments, the part of government eral government. Spending on agricul- spending that is included in GDP, rose ture rose very sharply for a third year only 11⁄4 percent in the aggregate during but not as rapidly as in fiscal 1999. The 2000. The increase was small partly ongoing paydown of debt by the federal because the consumption and invest- government led to a decline of nearly ment expenditures of the federal gov- 3 percent in net interest payments in ernment had closed out 1999 with a fiscal 2000 after a somewhat larger drop large increase in advance of the century in these payments in fiscal 1999. date change. Federal purchases in the Federal receipts increased 103⁄4 per- fourth quarter of 2000 were about 1 per- cent in fiscal year 2000, the largest cent below the elevated level at year- advance in more than a decade. The end 1999. Abstracting from the bumps increase in receipts from taxes on the in the spending data, the underlying income of individuals amounted to more trend in real federal consumption and than 14 percent. In most recent years, investment outlays appears to have been these receipts have grown much faster Monetary Policy Reports, February 53 than nominal personal income as mea- its debt last year at an even faster pace sured in the national income and prod- than in recent years. As of the end of uct accounts. One important factor in fiscal 2000, the stock of marketable the difference is that rising levels of Treasury debt outstanding had fallen income and a changing distribution have about $500 billion from its peak in 1997. shifted more taxpayers into higher tax The existing fiscal situation and the brackets; another is an increase in reve- anticipation that budget surpluses would nues from taxes on capital gains and continue led the Treasury to implement other items that are not included in per- a number of debt management changes sonal income. Receipts from the taxa- during 2000, many designed to preserve tion of corporate profits also moved up the liquidity of its securities. In particu- sharply in fiscal 2000, rebounding from lar, the Treasury sought to maintain a small decline the previous fiscal year. large and regular offerings of new secu- With federal receipts rising much faster rities at some key maturities, because than spending, the surplus in the unified such attributes are thought to impor- budget rose to $236 billion in fiscal tantly contribute to market liquidity. 2000, nearly double that of fiscal 1999. In part to make room for continued The on-budget surplus, which excludes sizable auctions of new securities, the surpluses accumulating in the social Treasury initiated a debt buyback pro- security trust fund, rose from essentially gram through which it can purchase zero in fiscal 1999 to $86 billion in debt that it previously issued. In total, fiscal 2000. Excluding net interest pay- the Treasury conducted twenty buyback ments, a charge resulting from past defi- operations in 2000, repurchasing a total cits, the surplus in fiscal 2000 was about of $30 billion par value of securities $460 billion. with maturities ranging from twelve to Federal saving, which is basically twenty-seven years. Those operations the federal budget surplus adjusted to were generally well received and caused conform to the accounting practices fol- little disruption to the market. Going lowed in the national income and prod- forward, the Treasury intends to conduct uct accounts, amounted to about 31⁄2 per- two buyback operations per month and cent of nominal GDP over the first three expects to repurchase about $9 billion quarters of 2000. This figure has been par value of outstanding securities in rising roughly 1 percentage point a year each of the first two quarters of 2001. over the past several years. Mainly Despite conducting buybacks on that because of that rise in federal saving, scale, the Treasury had to cut back con- the national saving rate has been run- siderably its issuance of new securities. ning at a higher level in recent years To still achieve large sizes of individual than was observed through most of the issues at some maturities, the Treasury 1980s and the first half of the 1990s, implemented a schedule of regular even as the personal saving rate has reopenings—in which it auctions addi- plunged. The rise in federal saving has tional amounts of a previously issued kept interest rates lower than they other- security instead of issuing a new one— wise would have been and has contrib- for its five-, ten-, and thirty-year instru- uted, in turn, to the rapid growth of ments. Under that schedule, every other capital investment and the faster growth auction of each of those securities is a of the economy’s productive potential. smaller reopening of the previously auc- The burgeoning federal budget sur- tioned security. At other maturities, the plus allowed the Treasury to pay down Treasury reduced the sizes of its two- 54 88th Annual Report, 2001 year notes and inflation-indexed securi- pal market improved considerably last ties and eliminated the April auction year, with credit upgrades outnumbering of the thirty-year inflation-indexed downgrades by a substantial margin. bond. In addition, the Treasury recently The only notable exception was in the announced that it would stop issuing not-for-profit health care sector, where one-year bills following the February downgrades predominated. auction, after having cut back the fre- quency of new offerings of that security last year. The External Sector These reductions in the issuance of Trade and Current Account Treasury securities have caused the Federal Reserve to modify some of The current account deficit reached its procedures for obtaining securities at $452 billion (annual rate) in the third Treasury auctions, as described in detail quarter of 2000, or 4.5 percent of GDP, below. In addition, the Treasury made compared with $331 billion and 3.6 per- changes in the rules for auction par- cent for 1999. Most of the expansion ticipation by foreign and international in the current account deficit occurred monetary authority (FIMA) accounts, in the balance of trade in goods and which primarily include foreign central services. The deficit on trade in goods banks and governmental monetary enti- and services widened to $383 billion ties. The new rules, which went into (annual rate) in the third quarter from effect on February 1, 2001, impose lim- $347 billion in the first half of the year. its on the size of non-competitive bids Data for trade in October and Novem- from individual FIMA accounts and on ber suggest that the deficit may have the total amount of such bids that will increased further in the fourth quarter. be awarded at each auction. These lim- Net payments on investments were a bit its will leave a larger pool of securities less during the first three quarters of available for competitive bidding at the 2000 than in the second half of 1999 auctions, helping to maintain the liquid- owing to a sizable increase in income ity and efficiency of the market. More- receipts from direct investment abroad. over, FIMA purchases will be subtracted U.S. exports of goods and services from the total amount of securities rose an estimated 7 percent in real terms offered, rather than being added on as during 2000. Exports surged during the they were in some previous instances, first three quarters, supported by a making the amount of funds raised at pickup in economic activity abroad that the auction more predictable. began in 1999. By market destination, State and local government debt U.S. exports were strongest to Mexico increased little in 2000. Gross issuance and countries in Asia. About 45 percent of long-term municipal bonds was well of U.S. goods exports were capital below the robust pace of the past two equipment, 20 percent were industrial years. Refunding offerings were held supplies, and roughly 10 percent each down by higher interest rates through were agricultural, automotive, con- much of the year, and the need to raise sumer, and other goods. Based on data new capital was diminished by strong for October and November, real exports tax revenues. Net issuance was also are estimated to have declined in the damped by an increase in the retire- fourth quarter, reflecting in part a slow- ment of bonds from previous refunding ing of economic growth abroad. This activity. Credit quality in the munici- decrease was particularly evident in Monetary Policy Reports, February 55 exports of capital goods, automotive Financial Account products, consumer goods, and agricul- tural products. The counterpart to the increased U.S. The quantity of imported goods and current account deficit in 2000 was services expanded rapidly during the an increase in net capital inflows. As first three quarters of 2000, reflecting in 1999, U.S. capital flows in 2000 the continuing strength of U.S. domestic reflected the relatively strong cyclical demand and the effects of past dollar position of the U.S. economy for most of appreciation on price competitiveness. the year and the global wave of corpo- Increases were widespread among trade rate mergers. Foreign private purchases categories. Based on data for October of U.S. securities were exceptionally and November, real imports of goods robust—well in excess of the record set and services are estimated to have risen in 1999. The composition of U.S. securi- only slightly in the fourth quarter. Mod- ties purchased by foreigners continued erate increases in imported consumer the shift away from Treasuries as the and capital goods were partly offset by U.S. budget surplus, and the attendant declines in other categories of imports, decline in the supply of Treasuries, low- particularly industrial supplies and auto- ered their yield relative to other debt. motive products, for which domestic Last year private foreigners sold, on net, demand had softened. The price of about $50 billion in Treasury securities, non-oil imports is estimated to have compared with net sales of $20 billion increased by less than 1 percent during in 1999. Although sizable, these sales 2000. were slightly less than what would have The price of imported oil rose nearly occurred had foreigners reduced their $7 per barrel over the four quarters of holdings in proportion to the reduction 2000. During the year, oil prices gener- in Treasuries outstanding. The increased ally remained high and volatile, with the sale of Treasuries was fully offset by spot price of West Texas intermediate larger foreign purchases of U.S. securi- (WTI) crude fluctuating between a low ties issued by government-sponsored of $24 per barrel in April and a high agencies. Net purchases of agency secu- above $37 per barrel in September. rities topped $110 billion, compared Strong demand—driven by robust world with the previous record of $72 billion economic growth—kept upward pres- set in 1999. In contrast to the shrink- sure on oil prices even as world supply ing supply of Treasury securities, U.S. increased considerably. Over the course government-sponsored agencies accel- of 2000, OPEC raised its official pro- erated the pace of their debt issuance. duction targets by 3.7 million barrels per Private foreign purchases of U.S. corpo- day, reversing the production cuts made rate debt grew to $180 billion, while net in the previous two years. Oil produc- purchases of U.S. equities ballooned to tion from non-OPEC sources rebounded $170 billion compared with $108 billion as well. During the last several weeks of in 1999. 2000, oil prices fell sharply as market The pace of foreign direct investment participants became convinced that the inflows in the first three quarters of 2000 U.S. economy was slowing. In early also accelerated from the record pace 2001, however, oil prices moved back of 1999. As in the previous two years, up when OPEC announced a planned direct investment inflows were driven production cut of 1.5 million barrels per by foreign acquisition of U.S. firms, day. reflecting the global strength in merger 56 88th Annual Report, 2001 and acquisition activity. Of the roughly confidence until late summer. Over the $200 billion in direct investment remainder of the year monthly increases inflows in the first three quarters, about in private employment stepped down $100 billion was directly attributable to further. Job growth came almost to a merger activity. Many of these mergers stop in December, when severe weather were financed, at least in part, by an added to the restraint from a slow- exchange of equity, in which shares in ing economy. In January of this year, the U.S. firm were swapped for equity employment picked up, but the return of in the acquiring firm. Although U.S. milder weather apparently accounted for residents generally appear to have sold a a sizable portion of the gain. portion of the equity acquired through Employment rose moderately in the these swaps, the swaps likely contrib- private service-producing sector of the uted significantly to the $97 billion capi- economy in 2000, about 2 percent over- tal outflow attributed to U.S. acquisition all after an increase of about 3 percent of foreign securities. U.S. direct invest- in 1999. In the fourth quarter, however, ment abroad was also boosted by merger hiring in the services-producing sec- activity and totaled $117 billion in the tor was relatively slow, in large part first three quarters of 2000, a slightly because of a sizable decline in the num- faster pace than that of 1999. ber of jobs in personnel supply—a Capital inflows from foreign official category that includes temporary help sources totaled $38 billion in 2000—a agencies. Employment in construction slight increase from 1999. Nearly all increased about 21⁄2 percent in 2000 of the official inflows were attributable after several years of gains that were to reinvested interest earnings. Modest considerably larger. The number of jobs official sales of dollar assets associated in manufacturing was down for a third with foreign exchange intervention were year, owing to reductions in factory offset by larger inflows from some non- employment in the second half of the OPEC oil exporting countries, which year, when manufacturers were adjust- benefited from the elevated price of oil. ing to the slowing of demand. Those adjustments in manufacturing may also have involved some cutbacks in the The Labor Market employment of temporary hires, which Nonfarm payroll employment increased would help to account for the sharp job about 11⁄2 percent in 2000, measured on losses in personnel supply. The average a December-to-December basis. The job length of the workweek in manufactur- count had risen slightly more than 2 per- ing was scaled back as well over the cent in 1999 and roughly 21⁄2 percent a second half of the year. year over the 1996–98 period. Over the The slowing of the economy did not first few months of 2000, the expansion lead to any meaningful easing in the of jobs proceeded at a faster pace than in tightness of the labor market in 2000. 1999, boosted both by the federal gov- The household survey’s measure of the ernment’s hiring for the decennial Cen- number of persons employed rose 1 per- sus and by a somewhat faster rate of job cent, about in line with the expansion of creation in the private sector. Indications labor supply. On net, the unemployment of a moderation in private hiring started rate changed little; its fourth-quarter to emerge toward mid-year, but because average of 4.0 percent was down just of volatility of the incoming data a slow- a tenth of a percentage point from the down could not be identified with some average unemployment rate in the fourth Monetary Policy Reports, February 57 quarter of 1999. The flatness of the rate picks up some forms of employee com- through the latter half of 2000, when the pensation that the ECI omits but that economy was slowing, may have partly also is more subject to eventual revision reflected a desire of companies to hold than the ECI, showed hourly compensa- on to labor resources that had been diffi- tion advancing 53⁄4 percent this past cult to attract and retain in the tight year, up from a 1999 increase of about labor market of recent years. January of 41⁄2 percent. Tightness of the labor mar- this year brought a small increase in the ket was likely one factor underlying rate, to 4.2 percent. the acceleration of hourly compensation Productivity continued to rise rapidly in 2000, with employers relying both in 2000. Output per hour in the nonfarm on larger wage increases and more business sector was up about 31⁄2 per- attractive benefit packages to attract cent over the year as a whole. Sizable and retain workers. Compensation gains gains in efficiency continued to be evi- may also have been influenced to some dent even as the economy was slowing degree by the pickup of consumer price in the second half of the year. Except for inflation since 1998. Rapid increases in 1999, when output per hour rose about the cost of health insurance contributed 33⁄4 percent, the past year’s increase was importantly to a sharp step-up in benefit the largest since 1992, a year in which costs. the economy was in cyclical recovery Unit labor costs, the ratio of hourly from the 1990–91 recession. Cutting compensation to output per hour, through the year-to-year variations in increased about 21⁄4 percent in the non- measured productivity, the underlying farm business sector in 2000 after hav- trend still appears to have traced out a ing risen slightly more than 1⁄2 percent pattern of strong acceleration since the in 1999. Roughly three-fourths of the middle part of the 1990s. Support for acceleration was attributable to the a step-up in the trend has come from faster rate of increase in compensation increases in the amount of capital per per hour noted above. The remainder worker—especially high-tech capital— stemmed from the small deceleration and from organizational efficiencies that of measured productivity. The labor cost have resulted in output rising faster rise for the latest year was toward the than the combined inputs of labor and high end of the range of the small to capital. moderate increases that have prevailed Alternative measures of the hourly over the past decade. compensation of workers, while differ- ing in their coverage and methods of construction, were consistent in show- Prices ing some acceleration this past year. The Led by the surge in energy prices, the employment cost index for private aggregate price indexes showed some industry (ECI), which attempts to mea- acceleration in 2000. The chain-type sure changes in the labor costs of non- price index for real GDP, the broadest farm businesses in a way that is free measure of goods and services produced from the effects of employment shifts domestically, rose 21⁄4 percent in 2000, among occupations and industries, rose roughly 3⁄4 percentage point more than nearly 41⁄2 percent during 2000 after in 1999. The price index for gross having increased about 31⁄2 percent in domestic purchases, the broadest mea- 1999. Compensation per hour in the sure of prices for goods and services nonfarm business sector, a measure that purchased by domestic buyers, posted a 58 88th Annual Report, 2001 rise of almost 21⁄2 percent in 2000 after demand for heating that resulted from having increased slightly less than 2 per- unusually cold weather in November cent the previous year. Prices paid by and December. Electricity costs jumped consumers, as measured by the chain- for some users, and prices nationally type price index for personal consump- rose faster than in other recent years, tion expenditures, picked up as well, about 21⁄4 percent at the consumer level. about as much as the gross purchases Businesses had to cope with rising index. The consumer price index (CPI) costs of energy in production, trans- continued to move up at a faster pace portation, and temperature control. In than the PCE index this past year, and it some industries that depend particu- exhibited slightly more acceleration—an larly heavily on energy inputs, the rise increase of nearly 31⁄2 percent in 2000 in costs had a large effect on product was 3⁄4 percentage point larger than the prices. Producer prices of goods such 1999 rise. Price indexes for fixed invest- as industrial chemicals posted increases ment and government purchases also that were well above the average rates accelerated this past year. of inflation last year, and rising prices The prices of energy products pur- for natural gas sparked especially steep chased directly by consumers increased price advances for nitrogen fertilizers about 15 percent in 2000, a few per- used in farming. Prices of some services centage points more than in 1999. In also exhibited apparent energy impacts: response to the rise in world oil prices, Producers paid sharply higher prices for consumer prices of motor fuels rose transportation services via air and water, nearly 20 percent in 2000, bringing the and consumer airfares moved up rapidly cumulative price hike for those products for a second year, although not nearly over the past two years to roughly as much as in 1999. Late in 2000 and 45 percent. Prices also rose rapidly for early this year, high prices for energy home heating oil. Natural gas prices inputs prompted shutdowns in produc- increased 30 percent, as demand for that tion at some companies, including those fuel outpaced the growth of supply, pull- producing fertilizers and aluminum. ing stocks down to low levels. Prices of Despite the spillover of energy effects natural gas this winter have been excep- into other markets, inflation outside the tionally high because of the added energy sector remained moderate over- all. The ongoing rise in labor productiv- ity helped to contain the step-up in labor Alternative Measures of Price Change costs, and the slow rate of rise in the Percent prices of non-oil imports meant that Price measure 1999 2000 domestic businesses had to remain cau- tious about raising their prices because Chain-type of the potential loss of market share. Gross domestic product . . . . . . . . 1.6 2.3 Rapid expansion of capacity in manu- Gross domestic purchases . . . . . . 1.9 2.4 Personal consumption facturing prevented bottlenecks from expenditures . . . . . . . . . . . . . . 2.0 2.4 developing in the goods-producing Excluding food and energy . . . 1.5 1.7 sector of the economy when domestic Fixed-weight Consumer price index . . . . . . . . . . 2.6 3.4 demand was surging early in the year; Excluding food and energy . . . 2.1 2.6 later on, an easing of capacity utilization was accompanied by a softening of Note. Changes are based on quarterly averages and are measured to the fourth quarter of the year indicated prices in a number of industries. Infla- from the fourth quarter of the preceding year. tion expectations, which at times in the Monetary Policy Reports, February 59 past have added to the momentum of years, several of which had brought rising inflation, remained fairly quies- small declines in investment prices. cent in 2000. Although the price index for investment Against this backdrop, core inflation in residential structures slowed a little, remained low in 2000. Producer prices to about a 31⁄2 percent rise, the index for of intermediate materials excluding food nonresidential structures sped up from a and energy, after having accelerated 23⁄4 percent increase in 1999 to one of through the first few months of 2000, 41⁄2 percent in 2000. Moreover, the price slowed thereafter, and their four-quarter index for equipment and software ticked rise of 13⁄4 percent was only a bit larger up slightly, after having declined 2 per- than the increase during 1999. Prices cent or more in each of the four pre- of crude materials excluding food and ceding years. To a large extent, that energy fell moderately this past year turnabout was a reflection of a smaller after having risen about 10 percent a rate of price decline for computers; they year earlier. At the consumer level, the had dropped at an average rate of more CPI excluding food and energy moved than 20 percent through the second up 21⁄2 percent in 2000, an acceleration half of the 1990s but fell at roughly half of slightly less than 1⁄2 percentage point that rate in 2000. Excluding computers, from 1999 when put on a basis that equipment prices increased slightly in maintains consistency of measurement. 2000 after having declined a touch in The rise in the chain-type price index 1999. for personal consumption expenditures excluding food and energy was 13⁄4 per- cent, just a bit above the increases U.S. Financial Markets recorded in each of the two previous Financial markets in 2000 were influ- years. enced by the changing outlook for the Consumer food prices rose 21⁄2 per- U.S. economy and monetary policy and cent in 2000 after an increase of about by shifts in investors’ perceptions of and 2 percent in 1999. In large part, the attitudes toward risk. Private longer- moderate step-up in these prices prob- term interest rates generally firmed in ably reflected cost and price consid- the early part of the year as growth erations similar to those at work else- remained unsustainably strong and as where in the economy. Also, farm market participants anticipated a further commodity prices moved up, on net, tightening of monetary policy by the during 2000, after three years of sharp Federal Reserve. Later in the year, as it declines, and this turnabout likely became apparent that the pace of eco- showed through to the retail level to nomic growth was slowing, market par- some extent. Meat prices, which are ticipants began to incorporate expecta- linked more closely to farm prices than tions of significant policy easing into is the case with many other foods, asset prices, and most longer-term inter- recorded increases that were apprecia- est rates fell sharply over the last several bly larger than the increases for food months of 2000 and into 2001. Over the prices overall. course of the year, investors became The chain-type price index for private more concerned about credit risk and fixed investment rose about 13⁄4 per- demanded larger yield spreads to hold cent in 2000, but that small increase lower-rated corporate bonds, especially amounted to a fairly sharp acceleration once the growth of the economy slowed from the pace of the preceding few in the second half. Banks, apparently 60 88th Annual Report, 2001 having similar concerns, reported wid- eurodollar futures, which can be used as ening credit spreads on business loans a rough gauge of policy expectations, and tightening standards for lending were indicating that market participants to businesses. Weakening economic expected additional policy tightening growth and tighter financial conditions going forward. in some sectors led to a slowing in the Signs of a slowdown in the growth pace of debt growth over the course of of aggregate demand began to appear the year. in the incoming data soon after the Stock markets had another volatile May FOMC meeting and continued to year in 2000. After touching record gradually accumulate over subsequent highs in March, stock prices turned months. In response, market participants lower, declining considerably over the became increasingly convinced that last four months of the year. Valuations the FOMC would not have to tighten in some sectors fell precipitously from its policy stance further, which was high levels, and near-term earnings fore- reflected in a flattening of the term casts were revised down sharply late in structure of rates on federal funds and the year. On balance, the broadest stock eurodollar futures. Interest rates on most indexes fell more than 10 percent last corporate bonds declined gradually on year, and the tech-heavy Nasdaq was the shifting outlook for the economy, down nearly 40 percent. and by the end of August had fallen more than 1⁄2 percentage point from their peaks in May. Interest Rates Most market interest rates continued The economy continued to expand at an to edge lower into the fall, as the growth exceptionally strong and unsustainable of the economy seemed to moderate pace in the early part of 2000, prompt- further. Over the last couple months of ing the Federal Reserve to tighten its 2000 and into early 2001, as it became policy stance in several steps ending at apparent that economic growth was its May meeting. Private interest rates slowing more abruptly, market partici- and shorter-term Treasury yields rose pants sharply revised down their expec- considerably over that period, reaching tations for future short-term interest a peak just after the May FOMC meet- rates. Treasury yields plummeted over ing. Investors apparently became more that period, particularly at shorter matu- concerned about credit risk as well; rities: The two-year Treasury yield spreads between rates on lower-rated dropped more than a full percentage corporate bonds and swaps widened in point from mid-November to early Janu- the spring, adding to the upward pres- ary, moving below the thirty-year yield sure on private interest rates. Long-term for the first time since early 2000. Treasury yields, in contrast, remained Yields on inflation-indexed securities below their levels from earlier in the also fell considerably, but by less than year, as market participants became their nominal counterparts, suggesting increasingly convinced that the supply that the weakening of economic growth of those securities would shrink consid- lowered expectations of both real inter- erably in coming years and incorporated est rates and inflation. a ‘‘scarcity premium’’ into their prices. Although market participants had By mid-May, with the rapid expansion come to expect considerable policy eas- of economic activity showing few signs ing over the first part of this year, the of letting up, rates on federal funds and timing and magnitude of the intermeet- Monetary Policy Reports, February 61 ing cut in the federal funds rate in early Overall, yields on most investment- January was a surprise. In response, grade corporate bonds have reached investors built into asset prices anticipa- their lowest levels since the first half of tions of a more rapid policy easing over 1999, while rates on most high-yield the near-term. Indeed, the further sub- bonds have fallen about 2 percentage stantial reduction in the federal funds points from their peaks and have rate implemented at the FOMC meeting reached levels similar to those of mid- later that month was largely expected 2000. and elicited little response in financial Although investors at times in recent markets. Even with a full percentage months appeared more concerned about point reduction in the federal funds rate credit risk than they were in the fall of in place, futures rates have recently 1998, the recent financial environment, pointed to expectations of additional by most accounts, did not resemble policy easing over coming months. the market turbulence and disruption of Investors appear to be uncertain about that time. The Treasury and investment- this outlook, however, judging from the grade corporate bond markets remained recent rise in the implied volatilities of relatively liquid, and the investment- interest rates derived from option prices. grade market easily absorbed the high On balance since the beginning of 2000, volume of bond issuance over 2000. the progressive easing in the economic Investors continued to show a height- outlook, in combination with the effects ened preference for larger, more liquid of actual and prospective reductions in corporate issues, but they did not exhibit the supply of Treasury securities, has the extreme desire for liquidity that was resulted in a sizable downward shift in apparent in the fall of 1998. For exam- the Treasury yield curve. ple, the liquidity premium for the on- The prospect of a weakening in eco- the-run ten-year Treasury note this year nomic growth, along with sizable remained well below the level of that declines in equity prices and downward fall. revisions to profit forecasts, apparently Nonetheless, the Treasury market has caused investors to reassess credit risks become somewhat less liquid than it was in the latter part of last year. Spreads several years ago. Moreover, in 2000, between rates on high-yield corporate particular segments of the Treasury mar- bonds and swaps soared beginning in ket occasionally experienced bouts of September, pushing the yields on those unusually low liquidity that appeared bonds substantially higher. Concerns related to actual or potential reductions about credit risk also spilled over into in the supply of individual securities. the investment-grade sector, where yield Given the possibility that liquidity could spreads widened considerably for lower- deteriorate further as the Treasury rated securities. For most investment- continues to pay down its debt, market grade issuers, though, the effects of the participants reportedly increased their revised policy outlook more than offset reliance on alternative instruments— any widening in risk spreads, resulting including interest rate swaps and in a decline in private interest rates in debt securities issued by government- the fourth quarter. Since the first policy sponsored housing agencies and other easing in early January, yield spreads on corporations—for some of the hedging corporate bonds have narrowed consid- and pricing functions historically pro- erably, including a particularly large vided by Treasury securities. Fannie drop in the spread on high-yield bonds. Mae and Freddie Mac continued to issue 62 88th Annual Report, 2001 large amounts of debt under their ognizing this possibility, last year the Benchmark and Reference debt pro- FOMC initiated a study to consider grams, which are designed to mimic alternative approaches to managing the characteristics of Treasury securities— Federal Reserve’s portfolio, including such as large issue sizes and a regular expanding the use of the discount calendar of issuance—that are believed window and broadening the types of to contribute to their liquidity. By the assets acquired in the open market. As it end of 2000, the two firms together had continues to study various alternatives, more than $300 billion of notes and the FOMC will take into considera- bonds and more than $200 billion of tion the effect that such approaches bills outstanding under those programs. might have on the liquidity and safety of Trading volume and dealer positions its portfolio and the potential for distort- in agency securities have risen consid- ing the allocation of credit to private erably since 1998, and the market for entities. repurchase agreements in those securi- Meanwhile, some measures have ties has reportedly become more active. been taken to prevent the System’s hold- Also, several exchanges listed options ings of individual Treasury securities and futures on agency debt securities. from reaching possibly disruptive levels Open interest on some of those futures and to help curtail any further lengthen- contracts has picked up significantly, ing of the average maturity of the Sys- although it remains small compared to tem’s holdings. On July 5, 2000, the that on futures contracts on Treasury Federal Reserve Bank of New York securities. announced guidelines limiting the Sys- The shrinking supply of Treasury tem’s holdings of individual Treasury securities and the possibility of a con- securities to specified percentages of sequent decline in market liquidity also their outstanding amounts, depending pose challenges for the Federal Reserve. on the remaining maturity of the issue. For many years, Treasury securities Those limits range from 35 percent for have provided the Federal Reserve with Treasury bills to 15 percent for longer- an effective asset for System portfolio term bonds. As a result, the System holdings and the conduct of monetary has redeemed some of its holdings of policy. The remarkable liquidity of Treasury securities on occasions when Treasury securities has allowed the Sys- the amount of maturing holdings has tem to conduct sizable policy operations exceeded the amount that could be quickly and with little disruption to mar- rolled over into newly issued Treasury kets, while the safety of Treasury securi- securities under these limits. Redemp- ties has allowed the System to avoid tions of Treasury holdings in 2000 credit risk in its portfolio. However, exceeded $28 billion, with more than if Treasury debt continues to be paid $24 billion of the redemptions in down, at some point the amount out- Treasury bills. In addition, the Federal standing will be insufficient to meet Reserve accommodated a portion of the Federal Reserve’s portfolio needs. the demand for reserves last year by Well before that time, the proportion increasing its use of longer-term repur- of Treasury securities held by the Sys- chase agreements rather than by pur- tem could reach levels that would sig- chasing Treasury securities outright. nificantly disrupt the Treasury market The System maintained an average of and make monetary policy operations more than $15 billion of longer-term increasingly difficult or costly. Rec- repurchase agreements over 2000, typi- Monetary Policy Reports, February 63 cally with maturities of twenty-eight composite plunged 39 percent, leaving it days. at year-end more than 50 percent below its record high and erasing nearly all of its gains since the beginning of 1999. Equity Prices The broad decline in equity prices last After having moved higher in the first year is estimated to have lopped more quarter of 2000, equity prices reversed than $13⁄4 trillion from household course and finished the year with con- wealth, or more than 4 percent of the siderable declines. Early in the year, total net worth of households. Neverthe- the rapid pace of economic activity less, the level of household net worth is lifted corporate profits, and stock ana- still quite high—about 50 percent above lysts became even more optimistic about its level at the end of 1995. Investors future earnings growth. In response, continued to accumulate considerable most major equity indexes reached amounts of equity mutual funds over record highs in March, with the Wil- 2000, although they may have become shire 5000 rising 63⁄4 percent above its increasingly discouraged by losses on 1999 year-end level and the Nasdaq their equity holdings toward the end soaring 24 percent, continuing its rapid of the year, when flows into equity run-up from the second half of 1999. funds slumped. At that time, money Equity prices fell from these highs dur- market mutual funds expanded sharply, ing the spring, with a particularly steep as investors apparently sought a refuge drop in the Nasdaq, as investors grew for financial assets amid the height- more concerned about the lofty valua- ened volatility and significant drops tions of some sectors and the prospect of in equity prices. So far in 2001, major higher interest rates. equity indexes are little changed, on Broader equity indexes recovered balance, as the boost from lower inter- much of those losses through August, est rates has been countered by con- supported by the decline in market inter- tinued disappointments over corporate est rates and the continued strength of earnings. earnings growth in the second quarter. Some of the most dramatic plunges in But from early September through the share prices in 2000 took place among end of the year, stock prices fell con- technology, telecommunications, and siderably in response to the downshift in Internet shares. While these declines economic growth, a reassessment of the partly stemmed from downward revi- prospects for some high-tech industries, sions to near-term earnings estimates, and disappointments in corporate earn- which were particularly severe in some ings. In December and January, equity cases, they were also driven by a reas- analysts significantly reduced their fore- sessment of the elevated valuations of casts for year-ahead earnings for the many companies in these sectors. The S&P 500. However, analysts apparently price–earnings ratio (calculated using view the slowdown in earnings as short- operating earnings expected over the lived, as long-run earnings forecasts did next year) for the technology compo- not fall much and remain at very high nent of the S&P 500 index fell substan- levels, particularly for the technology tially from its peak in early 2000, sector. although it remains well above the ratio On balance, the Wilshire 5000 index for the S&P 500 index as a whole. For fell 12 percent over 2000—its first the entire S&P 500 index, share prices annual decline since 1994. The Nasdaq fell a bit more in percentage terms than 64 88th Annual Report, 2001 the downward revisions to year-ahead and has remained subdued so far in earnings forecasts, leaving the price– 2001. earnings ratio modestly below its his- torical high. The volatility of equity price move- Debt and the Monetary Aggregates ments during 2000 was at the high end Debt and Depository Intermediation of the elevated levels observed in recent years. In the technology sector, the Aggregate debt of domestic nonfinan- magnitudes of daily share price changes cial sectors increased an estimated were at times remarkable. There were 51⁄4 percent over 2000, a considerable twenty-seven days during 2000 in which slowdown from the gains of almost the Nasdaq composite index moved up 7 percent posted in 1998 and 1999. The or down by at least 5 percent; by com- expansion of nonfederal debt moderated parison, such outsized movements were to 81⁄2 percent in 2000 from 91⁄2 percent observed on a total of only seven days in 1999; the slowing owed primarily to a from 1990 to 1999. weakening of consumer and business Despite the volatility of share price borrowing in the second half of the year, movements and the large declines on as the growth of durables consumption balance over 2000, equity market con- and capital expenditures fell off and ditions were fairly orderly, with few financial conditions tightened for some reports of difficulties meeting margin firms. Some of the slowdown in total requirements or of large losses creating nonfinancial debt was also attributable problems that might pose broader sys- to the federal government, which paid temic concerns. The fall in share prices down 63⁄4 percent of its debt last year, reined in some of the margin debt of compared with 21⁄2 percent in 1999. In equity investors. After having run up 1998 and 1999, domestic nonfinancial sharply through March, the amount of debt increased faster than nominal GDP, outstanding margin debt fell by about despite the reduction in federal debt over 30 percent over the remainder of the those years. The ratio of nonfinancial year. At year-end, the ratio of margin debt to GDP edged down in 2000, debt to total equity market capitaliza- however, as the federal debt paydown tion was slightly below its level a year accelerated and nonfederal borrowing earlier. slowed. The considerable drop in valuations Depository institutions continued to in some sectors and the elevated volatil- play an important role in meeting the ity of equity price movements caused demand for credit by businesses and the pace of initial public offerings to households. Credit extended by slow markedly over the year, despite a commercial banks, after adjustment large number of companies waiting to for mark-to-market accounting rules, go public. The slowdown was particu- increased 10 percent over 2000, well larly pronounced for technology com- above the pace for total nonfinancial panies, which had been issuing new debt. Bank credit expanded at a particu- shares at a frantic pace early in the larly brisk rate through late summer, year. In total, the dollar amount of initial when banks, given their ample capital public offerings by domestic nonfinan- base and solid profits, were willing to cial companies tapered off in the fourth meet strong loan demand by households quarter to its lowest level in two years and businesses. Over the remainder of Monetary Policy Reports, February 65 the year, the growth of bank credit vious years. With delinquency rates for declined appreciably, as banks became consumer and real estate loans having more cautious lenders and as several changed little, on net, last year, banks banks shed large amounts of govern- did not tighten credit conditions signifi- ment securities. cantly for loans to households over the Banks reported a deterioration of the first three quarters of 2000. More quality of their business loan portfolios recently, however, an increasing portion last year. Delinquency and charge-off of banks increased standards and terms rates on C&I loans, while low by his- for consumer loans other than credit torical standards, rose steadily, partly cards, and some of the banks surveyed reflecting some repayment difficulties anticipated a further tightening of condi- in banks’ syndicated loan portfolios. tions on consumer loans during 2001. Several large banks have stated that the uptrend in delinquencies is expected to The Monetary Aggregates continue in 2001. Higher levels of provi- sioning for loan losses and some nar- The monetary aggregates grew rather rowing of net interest margins contrib- briskly last year. The expansion of the uted to a fallback of bank profits from broadest monetary aggregate, M3, was the record levels of 1999. In addition, particularly strong over the first three capitalization measures slipped a bit last quarters of 2000, as the robust growth year. Nevertheless, by historical stan- in depository credit was partly funded dards banks remained quite profitable through issuance of the managed liabili- overall and appeared to have ample ties included in this aggregate, such as capital. In the aggregate, total capital large time deposits. M3 growth eased (the sum of tier 1 and tier 2 capital) somewhat in the fourth quarter because remained above 12 percent of risk- the slowing of bank credit led deposi- weighted assets over the first three quar- tory institutions to reduce their reli- ters of last year, more than two per- ance on managed liabilities. Institutional centage points above the minimum money funds increased rapidly through- level required to be considered well- out 2000, despite the tightening of pol- capitalized. icy early in the year, in part owing In response to greater uncertainty to continued growth in their provision about the economic outlook and a of cash management services for busi- reduced tolerance for risk, increasing nesses. For the year as a whole, M3 proportions of banks reported tightening expanded 91⁄4 percent, well above the standards and terms on business loans 73⁄4 percent pace in 1999. This advance during 2000 and into 2001, with the again outpaced that of nominal income, share recently reaching the highest level and M3 velocity—the ratio of nominal since 1990. The tightening became income to M3—declined for the sixth widespread for loans to large and year in a row. middle-market firms. A considerable M2 increased 61⁄4 percent in 2000, portion of banks reported firming stan- about unchanged from its pace in 1999. dards and terms on loans to small busi- Some slowing in M2 growth would have nesses as well, consistent with surveys been expected based on the rise in short- of small businesses indicating that a term interest rates over the early part of larger share of those firms had difficulty the year, which pushed up the ‘‘opportu- obtaining credit in 2000 than in pre- nity cost’’ of holding M2, given that the 66 88th Annual Report, 2001 Growth of Money and Debt M2 slightly exceeded that of nominal Percent income, and M2 velocity edged down. The behavior of the components of Domestic non- M2 was influenced importantly by inter- Period M1 M2 M3 financial est rate spreads. The depressing effect of debt higher short-term market interest rates Annual 1 was most apparent in the liquid deposit 1990 . . . . . . . . . . . . 4.2 4.2 1.9 6.7 components, including checkable depos- 1991 . . . . . . . . . . . . 7.9 3.1 1.2 4.5 1992 . . . . . . . . . . . . 14.4 1.8 .6 4.5 its and savings accounts, whose rates 1993 . . . . . . . . . . . . 10.6 1.3 1.0 4.9 respond very sluggishly to movements 1994 . . . . . . . . . . . . 2.5 .6 1.7 4.8 in market rates. Small time deposits and 1995 . . . . . . . . . . . . −1.5 3.8 6.1 5.4 1996 . . . . . . . . . . . . −4.5 4.5 6.8 5.3 retail money market mutual funds, 1997 . . . . . . . . . . . . −1.2 5.6 8.9 5.4 whose rates do not lag market rates as 1998 . . . . . . . . . . . . 2.2 8.4 10.9 6.9 1999 . . . . . . . . . . . . 1.8 6.2 7.7 6.8 much, expanded considerably faster than 2000 . . . . . . . . . . . . −1.5 6.3 9.2 5.3 liquid deposits. Currency growth was held down early in the year by a runoff Quarterly of the stockpile accumulated in advance (annual rate) 2 2000:Q1 . . . . . . . . 2.0 5.8 10.6 5.6 of the century date change. In addition, Q2 . . . . . . . . −1.8 6.4 9.0 6.2 Q3 . . . . . . . . −3.7 5.8 8.9 4.7 it was surprisingly sluggish over the bal- Q4 . . . . . . . . −2.7 6.6 7.1 4.1 ance of the year given the rapid pace of income growth, with weakness appar- Note. M1 consists of currency, travelers checks, demand deposits, and other checkable deposits. M2 con- ently in both domestic and foreign sists of M1 plus savings deposits (including money mar- demands. ket deposit accounts), small-denomination time deposits, and balances in retail money market funds. M3 consists of M2 plus large-denomination time deposits, balances in institutional money market funds, RP liabilities (over- International Developments night and term), and eurodollars (overnight and term). Debt consists of the outstanding credit market debt of the In 2000, overall economic activity in U.S. government, state and local governments, house- foreign economies continued its strong holds and nonprofit organizations, nonfinancial busi- performance of the previous year. How- nesses, and farms. 1. From average for fourth quarter of preceding year to ever, in both industrial and developing average for fourth quarter of year indicated. countries, growth was strongest early, 2. From average for preceding quarter to average for and clear signs of a general slowing quarter indicated. emerged later in the year. Among indus- trial countries, growth in Japan last year moved up to an estimated 2 percent, and interest rates on many components of growth in the euro area slowed slightly M2 do not increase by the same amount to 3 percent. Emerging market econo- or as quickly as market rates. However, mies in both Asia and Latin America with the level of long-term rates close to grew about 6 percent on average in that of short-term rates, investors had 2000. For Asian developing economies, much less incentive to shift funds out of this represented a slowing from the M2 assets and into assets with longer torrid pace of the previous year, while maturities, which helped support M2 growth in Latin America, especially growth. M2 was also boosted at times Mexico, picked up from 1999. Average by households’ increased preference for foreign inflation edged up slightly to safe and liquid assets during periods of 3 percent, mainly reflecting higher oil heightened volatility in equity markets. prices. Over the first part of the year, On balance over the year, the growth of monetary authorities moved to tighten Monetary Policy Reports, February 67 conditions in many industrial countries, year when evidence emerged that the in reaction to continued strong growth pace of U.S. activity was slowing much in economic activity that was starting to more sharply than had been expected. impinge on capacity constraints, as well Despite this decline, the dollar’s average as some upward pressures on prices. foreign exchange value against the cur- Interest rates on long-term government rencies of other major foreign industrial securities declined on balance in most countries recorded a net increase of over industrial countries, especially toward 7 percent for the year as a whole. The year-end when evidence of a slowdown dollar also strengthened nearly as much in global economic growth started to on balance against the currencies of the emerge. most important developing country trad- Conditions in foreign financial mar- ing partners of the United States. So far kets were somewhat more unsettled than this year, the dollar’s average value has in the previous year. Overall stock remained fairly stable. indexes in the foreign industrial coun- tries generally declined, most notably Industrial Economies in Japan. As in the United States, technology-oriented stock indexes were The dollar showed particular strength extremely volatile during the year. After last year against the euro, the common reaching peaks in the first quarter, they currency of much of Europe. During the started down while experiencing great first three quarters of the year, the euro swings toward mid-year, then fell continued to weaken, and by late Octo- sharply in the final quarter, resulting in ber had fallen to a low of just above net declines for the year of one-third or 82 cents, nearly one-third below its more. Stock prices in emerging market value when it was introduced in January economies were generally quite weak, 1999. The euro’s decline against the dol- especially in developing Asia, where lar through most of last year appeared to growth in recent years has depended be due mainly to the vigorous growth of heavily on exports of high-tech goods. real GDP and productivity in the United Although there was no major default or States contrasted with steady but less devaluation among emerging market impressive improvements in Europe. In economies, average risk spreads on addition, investors may have perceived developing country debt still moved that Europe was slower to adopt ‘‘new higher on balance over the course of the economy’’ technologies, making it a year, as the threat of potential crises in relatively less attractive investment cli- several countries, most notably Argen- mate. In September, a concerted inter- tina and Turkey, heightened investor vention operation by the monetary concerns. authorities of the G-7 countries, includ- The dollar’s average foreign ex- ing the United States, was undertaken at change value increased over most of the request of European authorities to the year, supported by continued robust provide support for the euro. The Euro- growth of U.S. activity, rising interest pean Central Bank also made interven- rates on dollar assets, and market per- tion purchases of euros on several occa- ceptions that longer-term prospects for sions acting on its own. Late in the year, U.S. growth and rates of return were the euro abruptly changed course and more favorable than in other industrial started to move up strongly, reversing countries. Part of the rise in the dollar’s over half of its decline of earlier in the average value was reversed late in the year. This recovery of the euro against 68 88th Annual Report, 2001 the dollar appeared to reflect mainly a had maintained for nearly a year and a market perception that, while growth half, and its target for the overnight rate was slowing in both Europe and the was raised to 25 basis points. Later in United States, the slowdown was much the year, evidence emerged suggesting sharper for the United States. For the that the nascent recovery in economic year as a whole, the dollar appreciated, activity was losing steam, and in on net, about 7 percent against the response the yen started to depreciate euro. sharply against the dollar. The European Central Bank raised its For the year as a whole, Japanese real policy interest rate target six times by a GDP is estimated to have increased total of 175 basis points over the first about 2 percent, a substantial improve- ten months of the year. These increases ment from the very small increase of the reflected concerns that the euro’s previous year and the decline recorded depreciation, tightening capacity con- in 1998. Growth, which was concen- straints and higher oil prices would put trated in the first part of the year, was upward pressure on inflation. While led by private nonresidential invest- core inflation—inflation excluding food ment. In contrast, residential investment and energy—remained well below the slackened as the effect of tax incentives 2 percent inflation target ceiling, higher waned. Consumption rebounded early in oil prices pushed the headline rate above the year from a sharp decline at the end the ceiling for most of the year. Real of 1999 but then stagnated, depressed in GDP in the euro area is estimated to part by record-high unemployment and have increased about 3 percent for 2000 concerns that ongoing corporate restruc- as a whole, only slightly below the rate turing could lead to further job losses. of the previous year, although activity Public investment, which gave a major slowed toward the end of the year. boost to the economy in 1999, remained Growth was supported by continued strong through the first half of last year strong increases in investment spending. but then fell off sharply, and for the year Net exports made only a modest contri- as a whole the fiscal stance is estimated bution to growth, as rapid increases in to have been somewhat contractionary. exports were nearly matched by robust Inflation was negative for the second imports. Overall activity was sufficiently consecutive year, with the prices of both strong to lead to a further decline in the consumer goods and real estate continu- average euro-area unemployment rate to ing to move lower. below 9 percent, a nearly 1 percentage The dollar appreciated 4 percent rela- point reduction for the year. tive to the Canadian dollar last year. The dollar rose about 12 percent Among the factors that apparently against the Japanese yen over the course contributed to the Canadian currency’s of 2000, roughly reversing the decline weakness were declines in the prices of of the previous year. Early in the year, commodities that Canada exports, such the yen experienced periods of upward as metals and lumber, and a perception pressure on evidence of a revival of by market participants of unfavorable activity in Japan. On several of these differentials in rates of return and eco- occasions, the Bank of Japan made nomic growth prospects in Canada rela- substantial intervention sales of yen. By tive to the United States. For the year as August, signs of recovery were strong a whole, real GDP growth in Canada enough to convince the Bank of Japan to is estimated to have been only slightly end the zero interest rate policy that it below the strong 5 percent rate of 1999, Monetary Policy Reports, February 69 although, as in most industrial countries, time of a general heightening of finan- there were signs that the pace of growth cial market volatility and rising interest was tailing off toward the end of the rates in industrial countries, as well as year. Domestic demand continued to be increased political uncertainty in several robust, led by surging business invest- developing countries. After narrowing ment and solid personal consumption at mid-year, risk spreads on emerging increases. In the first part of the year, the market economy debt again widened sustained rapid growth of the economy later in the year, reflecting a general led Canadian monetary authorities to movement on financial markets away become increasingly concerned with a from riskier assets, as well as concerns buildup of inflationary pressures, and that Argentina and Turkey might be fac- the Bank of Canada matched all of the ing financial crises that could spread to Federal Reserve’s interest rate increases other emerging market economies. Risk in 2000, raising its policy rate by a total spreads generally narrowed in the early of 100 basis points. By the end of the part of 2001. year, the core inflation rate had risen to Among Latin American countries, near the middle of the Bank of Canada’s Mexico’s performance was noteworthy. 1 percent to 3 percent target range, Real GDP rose an estimated 7 percent, while higher oil prices pushed the an acceleration from the already strong overall rate above the top of the range. result of the previous year. Growth was So far this year, the Bank of Canada boosted by booming exports, especially has only partially followed the Federal to the United States, favorable world Reserve in lowering interest rates, and oil prices, and a rebound in domestic the Canadian dollar has remained little demand. In order to keep inflation on a changed. downward path in the face of surging domestic demand, the Bank of Mexico Emerging Market Economies tightened monetary conditions six times last year, pushing up short-term interest In emerging market economies, the rates, and by the end of the year the rate average growth rate of economic activ- of consumer price inflation had moved ity in 2000 remained near the very below the 10 percent inflation target. strong 6 percent rate of the previous The run-up to the July presidential elec- year. However, there was a notable and tion generated some sporadic financial widespread slowing near the end of the market pressures, but these subsided year, and results in a few individual in reaction to the smooth transition to countries were much less favorable. the new administration. Over the course Growth in developing Asian economies of the year, the risk spread on Mexi- slowed on average from the torrid pace can debt declined on balance, probably of the previous year, while average reflecting a favorable assessment by growth in Latin America picked up market participants of macroeconomic somewhat. No major developing coun- developments and government policies, try experienced default or devaluation in reinforced by rating upgrades of Mexi- 2000, but nonetheless, financial markets can debt. During 2000, the peso depre- did undergo several periods of height- ciated slightly against the dollar, but by ened unrest during the year. In the less than the excess of Mexican over spring, exchange rates and equity prices U.S. inflation. weakened and risk spreads widened in Argentina encountered considerable many emerging market economies at a financial distress last year. Low tax 70 88th Annual Report, 2001 revenues due to continued weak activity developing economies following their along with elevated political uncertainty financial crises. In addition, a sharp fall greatly heightened market concerns in Korean equity prices over the course about the ability of the country to fund of the year, as well as continued diffi- its debt. Starting in October, domestic culties with the process of financial and interest rates and debt risk spreads corporate sector restructuring, tended soared amid market speculation that to depress consumer and business confi- the government might lose access to dence. These developments contributed credit markets and be forced to abandon to the downward pressure on the won the exchange rate peg to the dollar. seen near the end of the year. Elsewhere Financial markets began to recover after in Asia, market concerns over height- an announcement in mid-November ened political instability were a major that an IMF-led international finan- factor behind financial pressures last cial support package was to be put year in Indonesia, Thailand, and the in place. Further improvement came Philippines. In China, output continued in the wake of an official announcement to expand rapidly in 2000, driven by a in December of a $40 billion support combination of surging exports early in package. The fall in U.S. short-term the year, sustained fiscal stimulus, and interest rates in January eased pressure some recovery in private consumption. on Argentina’s dollar-linked economy In contrast, growth in both Hong Kong as well. and Taiwan slowed, especially in the Late in the year, Brazilian financial latter part of the year. In Taiwan, the markets received some negative spill- exchange rate and stock prices both over from the financial unrest in Argen- came under downward pressure as a tina, but conditions did not approach result of the slowdown in global elec- those prevailing during Brazil’s finan- tronics demand and apparent market cial crisis of early 1999. For 2000 as a concerns over revelations of possible whole, the Brazilian economy showed weaknesses in the banking and corpo- several favorable economic trends. Real rate sectors. GDP growth increased to an estimated Turkey’s financial markets came 4 percent after being less than 1 percent under severe strain in late November as the previous two years, inflation contin- international investors withdrew capital ued to move lower, and short-term inter- amid market worries about the health of est rates declined. Turkey’s banks, the viability of the gov- Growth in Asian developing coun- ernment’s reform program and its crawl- tries in 2000 slowed from the previous ing peg exchange rate regime, and the year, when they had still been experienc- widening current account deficit. The ing an exceptionally rapid bounceback resulting liquidity shortage caused short- from the 1997–1998 financial crises term interest rates to spike up and led to experienced by several countries in the a substantial decline in foreign exchange region. In Korea, real GDP growth last reserves held by the central bank. Mar- year is estimated to have been less than kets stabilized somewhat after it was half of the blistering 14 percent rate announced in December that Turkey had of 1999. Korean exports, especially been able to reach loan agreements with of high-tech products, started to fade the IMF, major international banks, and toward the end of 2000. Rapid export the World Bank in an effort to provide growth had been a prominent feature of liquidity and restore confidence in the the recovery of Korea and other Asian banking system. Monetary Policy Reports, July 71 Report submitted to the Congress on confidence, raised the possibility of July 18, 2001, pursuant to section 2B of becoming increasingly self-reinforcing the Federal Reserve Act were households and businesses to post- pone spending while reassessing their Report of July 18, 2001 situations. In addition, other financial developments, including a higher for- eign exchange value of the dollar, lower Monetary Policy and the equity prices, and tighter lending terms Economic Outlook and standards at banks, were tending When the Federal Reserve submitted to restrain aggregate demand and thus its report on monetary policy in mid- were offsetting some of the influence February, the Federal Open Market of the lower federal funds rate. Finally, Committee (FOMC) had already re- despite some worrisome readings early duced its target for the federal funds rate in the year, price increases remained twice to counter emerging weakness in fairly well contained, and prospects the economy. As the year has unfolded, for inflation have become less of a con- the weakness has become more persis- cern as rates of resource utilization have tent and widespread than had seemed declined and energy prices have shown likely last autumn. The shakeout in the signs of turning down. high-technology sector has been espe- The information available at midyear cially severe, and with overall sales and for the recent performance of both the profits continuing to disappoint, busi- U.S. economy and some of our key trad- nesses are curtailing purchases of other ing partners remains somewhat down- types of capital equipment as well. The beat, on balance. Moreover, with inven- slump in demand for capital goods has tories still excessive in some sectors, also worked against businesses’ efforts orders for capital goods very soft, and to correct the inventory imbalances that the effects of lower stock prices and emerged in the second half of last year the weaker job market weighing on and has contributed to sizable declines consumers, the economy may expand in manufacturing output this year. At only slowly, if at all, for a while longer. the same time, foreign economies have Nonetheless, a number of factors are slowed, limiting the demand for U.S. in place that should set the stage for exports. stronger growth later this year and in To foster financial conditions that will 2002. In particular, interest rates have support strengthening economic growth, declined since last fall; the lower rates the FOMC has lowered its target for the have helped businesses and house- federal funds rate four times since Feb- holds strengthen their financial posi- ruary, bringing the cumulative decline tions and should show through to aggre- this year to 23⁄4 percentage points. A gate demand in coming quarters. The number of factors spurred this unusually recently enacted tax cuts and the appar- steep reduction in the federal funds rate. ent cresting of energy prices should also In particular, the slowdown in growth bolster aggregate demand fairly soon. In was rapid and substantial and carried addition, as firms at some point become considerable risks that the sluggish per- more satisfied with their inventory hold- formance of the economy in the first ings, the cessation of liquidation will half of this year would persist. Among boost production and, in turn, provide other things, the abruptness of the slow- a lift to employment and incomes; a ing, by jarring consumer and business subsequent shift to inventory accumula- 72 88th Annual Report, 2001 tion in association with the projected that slowing was only beginning to strengthening in demand should pro- come into focus. At that meeting, the vide additional impetus to production. FOMC concluded that the risks to the Moreover, with no apparent sign of economy in the foreseeable future had abatement in the rapid pace of tech- shifted to being weighted mainly toward nological innovation, the outlook for conditions that may generate economic productivity growth over the longer weakness and that economic and finan- run remains favorable. The efficiency cial developments could warrant further gains made possible by these innova- close review of the stance of policy well tions should spur demand for the capi- before the next scheduled meeting. Sub- tal equipment that embodies the new sequent data indicated that holiday retail technologies once the overall economic sales had come in below expectations situation starts to improve and should and that conditions in the manufacturing support consumption by leading to solid sector had deteriorated. Corporate profit increases in real incomes over time. forecasts had also been marked down, Even though an appreciable recovery and it seemed possible that the resulting in the growth of economic activity by decline in equity values, along with the early next year seems the most likely expense of higher energy costs, could outcome, there is as yet no hard evi- damp future business investment and dence that this improvement is in train, household spending. In response, the and the situation remains very uncer- FOMC held a telephone conference on tain. In these circumstances, the FOMC January 3, 2001, and decided to reduce continues to believe that the risks are the target federal funds rate 1⁄2 percent- weighted toward conditions that may age point, to 6 percent, and indicated generate economic weakness in the that the risks to the outlook remained foreseeable future. At the same time, weighted toward economic weakness. the FOMC recognizes the importance The timing and size of the cut in the of sustaining the environment of low target rate seemed to ease somewhat the inflation and well-anchored inflation concerns of financial market participants expectations that enabled the Federal about the longer-term outlook for the Reserve to react rapidly and forcefully economy. Equity prices generally rose to the slowing in real GDP growth over in January, risk spreads on lower-rated the past several quarters. When, as the corporate bonds narrowed significantly, FOMC expects, activity begins to firm, and the yield curve steepened. However, the Committee will continue to ensure incoming data over the month revealed that financial conditions remain consis- that the slowing in consumer and busi- tent with holding inflation in check, a ness spending late last year had been key requirement for maximum sustain- sizable. Furthermore, a sharp erosion able growth. in survey measures of consumer con- fidence, a backup of inventories, and a steep decline in capacity utilization Monetary Policy, Financial posed the risk that spending could Markets, and the Economy remain depressed for some time. In light over the First Half of 2001 of these developments, the FOMC at its By the time of the FOMC meeting on scheduled meeting on January 30 and 31 December 19, 2000, it had become evi- cut its target for the federal funds rate dent that economic growth had down- another 1⁄2 percentage point, to 51⁄2 per- shifted considerably, but the extent of cent, and stated that it continued to Monetary Policy Reports, July 73 judge the risks to be weighted mainly rise in mid-April as financial market toward economic weakness. investors became more confident that a The information reviewed by the cumulative downward spiral in activity FOMC at its meeting on March 20 sug- could be avoided, reports continued to gested that economic activity continued suggest flagging economic performance to expand, but slowly. Although con- and risks of extended weakness ahead. sumer spending seemed to be rising In particular, spending by consumers moderately and housing had remained had leveled out and their confidence had relatively firm, stock prices had declined fallen further. The FOMC discussed substantially in February and early economic developments in conference March, and reduced equity wealth and calls on April 11 and April 18, deciding lower consumer confidence had the on the latter occasion to reduce its target potential to damp household spending for the federal funds rate another 1⁄2 per- going forward. Moreover, manufac- centage point, to 41⁄2 percent. The Com- turing output had contracted further, mittee again indicated that it judged as businesses continued to work down the balance of risks to the outlook as their excess inventories and cut back on weighted toward economic weakness. capital equipment expenditures. In addi- When the FOMC met on May 15, tion, economic softness abroad raised economic conditions remained quite the likelihood of a weakening in U.S. sluggish, especially in manufacturing, exports. Core inflation had picked up a where production and employment had bit in January, but some of the increase declined further. Although members reflected the pass-through of a rise in were concerned that some indicators of energy prices that was unlikely to con- core inflation had moved up in the early tinue, and the FOMC judged that the months of the year and that part of the slowdown in the growth of aggregate recent backup in longer-term interest demand would ease inflationary pres- rates may have owed to increased infla- sures on labor and other resources. tion expectations, most saw underly- Accordingly, the FOMC on March 20 ing price increases as likely to remain lowered its target for the federal funds damped as continued subpar growth rate another 1⁄2 percentage point, to relieved pressures on resources. In light 5 percent. The members also continued of the prospect of continued weakness to see the risks to the outlook as remain- in the economy and the significant risks ing weighted mainly toward economic to the economic expansion, the FOMC weakness. Furthermore, the FOMC reduced its target for the federal funds recognized that in a rapidly evolving rate an additional 1⁄2 percentage point, to economic situation, it would need to 4 percent. With the softening in aggre- be alert to the possibility that a con- gate demand still of unknown persis- ference call would be desirable dur- tence and dimension, the FOMC con- ing the relatively long interval before tinued to view the risks to the outlook the next scheduled meeting to discuss as weighted toward economic weakness. the possible need for a further policy Still, the FOMC recognized that it had adjustment. eased policy substantially this year and Capital markets continued to soften that, in the absence of further sizable in late March and early April, in part adverse shocks to the economy, at future because corporate profits and economic meetings it might need to consider activity remained quite weak. Although adopting a more cautious approach to equity prices and bond yields began to further policy actions. 74 88th Annual Report, 2001 Subsequent news on economic activ- tendency of the forecasts for real GDP ity and corporate profits failed to point growth in 2002 is 3 percent to 31⁄4 per- to a rebound. In June, interest rates on cent. The civilian unemployment rate, longer-term Treasuries and on higher- which averaged 41⁄2 percent in the sec- quality private securities declined, some ond quarter of 2001, is expected to move risk spreads widened, and stock prices up to the area of 43⁄4 percent to 5 percent fell as financial market participants by the end of this year. In 2002, with the trimmed their expectations for eco- economy projected to expand at closer nomic activity and profits. When the to its trend rate, the unemployment rate FOMC met on June 26 and 27, con- is expected to hold steady or perhaps to ditions in manufacturing appeared to edge higher. With pressures in labor and have worsened still more. It also seemed product markets abating and with energy likely that slower growth abroad would prices no longer soaring, inflation is restrain demand for exports and that expected to be well contained over the weakening labor markets would hold next year and a half. down growth in consumer spending. In Despite the projected increase in real light of these developments, but also GDP growth, the uncertainty about the taking into account the cumulative near-term outlook remains considerable. 250 basis points of easing already under- taken and the other forces likely to be Economic Projections for 2001 and 2002 stimulating spending in the future, the Percent FOMC lowered its target for the fed- eral funds rate 1⁄4 percentage point, to Board of Governors 33⁄4 percent, and continued to view the and Reserve Bank presidents risks to the outlook as weighted toward Indicator economic weakness. Range Central tendency The Board of Governors of the Fed- eral Reserve System approved cuts in 2001 the discount rate in the first half of the year that matched the FOMC’s cuts in Change, fourth quarter the target federal funds rate. As a result, to fourth quarter 1 Nominal GDP . . . . . . . . . . . . 31⁄4–5 31⁄2–41⁄4 the discount rate declined from 6 per- Real GDP 2 . . . . . . . . . . . . . . . 1–2 11⁄4–2 PCE prices . . . . . . . . . . . . . . . 2–23⁄4 2–21⁄2 cent to 31⁄4 percent over the period. Average level, fourth quarter Civilian unemployment Economic Projections rate . . . . . . . . . . . . . . . . . . 43⁄4–5 43⁄4–5 for 2001 and 2002 2002 The members of the Board of Governors and the Federal Reserve Bank presi- Change, fourth quarter dents, all of whom participate in the to fourth quarter 1 Nominal GDP . . . . . . . . . . . . 43⁄4–6 5–51⁄2 deliberations of the FOMC, expect eco- Real GDP 2 . . . . . . . . . . . . . . . 3–31⁄2 3–31⁄4 nomic growth to remain slow in the near PCE prices . . . . . . . . . . . . . . . 11⁄2–3 1 ⁄ –21⁄2 34 term, though most anticipate that it will Average level, pick up later this year at least a little. fourth quarter Civilian unemployment The central tendency of the forecasts rate . . . . . . . . . . . . . . . . . . 43⁄4–51⁄2 43⁄4–51⁄4 for the increase in real GDP over the 1. Change from average for fourth quarter of previous four quarters of 2001 spans a range of year to average for fourth quarter of year indicated. 11⁄4 percent to 2 percent, and the central 2. Chain-weighted. Monetary Policy Reports, July 75 This uncertainty arises not only from the lative macroeconomic policies in some difficulty of assessing when businesses countries. will feel that conditions are sufficiently The chain-type price index for per- favorable to warrant a pickup in capi- sonal consumption expenditures rose tal spending but also from the difficulty 21⁄4 percent over the four quarters of of gauging where businesses stand in 2000, and most FOMC participants the inventory cycle. Nonetheless, all the expect inflation to remain around that FOMC participants foresee a return to rate through next year; indeed, the cen- solid growth by 2002. By then, the tral tendency of their forecasts for the inventory correction should have run its increase in this price measure is 2 per- course, and the monetary policy actions cent to 21⁄2 percent in 2001 and 13⁄4 per- taken this year, as well as the recently cent to 21⁄2 percent in 2002. One favor- enacted tax reductions, should be pro- able factor in the inflation outlook is the viding appreciable support to final behavior of energy prices. Those prices demand. have declined recently after having In part because of lower interest rates, increased rapidly in the past couple of many firms have been able to shore up years, and prospects are good that they their balance sheets. And although some could stabilize or even fall further lower-rated firms, especially in tele- in coming quarters. In addition to their communications and other sectors with direct effects, lower energy prices gloomy near-term prospects, may con- should tend to limit increases in other tinue to find it difficult to obtain financ- prices by reducing input costs for a wide ing, businesses generally are fairly well range of energy-intensive goods and ser- positioned to step up their capital spend- vices and by helping damp inflation ing once the outlook for sales and prof- expectations. More broadly, the com- its improves. By all accounts, techno- petitive conditions that have restricted logical innovation is still proceeding businesses’ ability to raise prices in rapidly, and these advances should even- recent years are likely to persist. And tually revive high-tech investment, espe- although labor costs could come under cially with the price of computing power upward pressure as wages tend to catch continuing to drop sharply. up to previous increases in productiv- In addition, consumer spending is ity, the slackening in resource utiliza- expected to get a boost from the tax tion this year is expected to contribute cuts and from falling energy prices, to reduced inflation pressures going which should help offset the effects of forward. the weaker job market and the decline over the past year in stock market wealth. Housing activity, which has Economic and Financial been buoyed in recent quarters by low Developments in 2001 mortgage interest rates, is likely to Economic growth remained very slow remain firm into 2002. Significant in the first half of 2001 after having concerns remain about the foreign eco- downshifted in the second half of 2000. nomic outlook and the prospects for U.S. Real gross domestic product rose at an exports. Nevertheless, economic activity annual rate of just 11⁄4 percent in the abroad is expected to benefit from a first quarter, about the same as in the strengthening of the U.S. economy, a fourth quarter, and appears to have stabilization of the global high-tech posted at best a meager gain in the sector, an easing of oil prices, and stimu- second quarter. Businesses have been 76 88th Annual Report, 2001 working to correct the inventory imbal- stantial expansion of incentives and rose ances that emerged in the second half to just a tad below the record pace of of last year, which has led to sizable 2000 as a whole. In addition, outlays declines in manufacturing output, and for non-auto goods posted a solid gain, capital spending has weakened apprecia- and spending on services rose modestly bly. In contrast, household spending— despite a weather-related drop in outlays especially for motor vehicles and for energy services. In the second quar- houses—has held up well. Employment ter, however, the rise in consumer spend- increased only modestly over the first ing seems to have lessened as sales of three months of the year and turned light motor vehicles dropped a bit, on down in the spring; the unemployment average, and purchases of other goods rate in June stood at 41⁄2 percent, 1⁄2 per- apparently did not grow as fast in real centage point higher than in the fourth terms as they had in the first quarter. quarter of last year. The rise in real consumption so far The inflation news early this year was this year has been considerably smaller not very favorable, as energy prices than the outsized gains in the second continued to soar and as measures of half of the 1990s and into 2000. But the core inflation—which exclude food and increase in spending still outstripped energy—registered some pickup. More the growth in real disposable personal recently, however, energy prices have income (DPI), which has been restrained moved lower, and the monthly readings this year by further big increases in con- on core inflation have returned to more sumer energy prices and by the dete- moderate rates. Moreover, apart from rioration in the job market; between the energy, prices at earlier stages of pro- fourth quarter of 2000 and May, real cessing have been quiescent this year. DPI increased just about 2 percent at an annual rate, well below the average pace of the preceding few years. In addition, The Household Sector the net worth of households fell again Growth in household spending has in the first quarter, to a level 8 percent slowed noticeably from the rapid pace below the high reached in the first quar- of the past few years. Still, it was fairly ter of 2000. On net, the ratio of house- well maintained in the first half of 2001 hold net worth to DPI has returned to despite the weaker tenor of income, about the level reached in 1997, signifi- wealth, and consumer confidence, and cantly below the recent peak but still the personal saving rate declined a bit high by historical standards. In addition, further. A greater number of households consumer sentiment indexes, which had encountered problems servicing debt, risen to extraordinary levels in the late but widespread difficulties or restric- 1990s and remained there through last tions on the availability of credit did not fall, fell sharply around the turn of the emerge. year. However, these indexes have not deteriorated further, on net, since the winter and are still at reasonably favor- Consumer Spending able levels when compared with the Real consumer spending grew at an readings for the pre-1997 period. annual rate of 31⁄2 percent in the first Rising household wealth almost cer- quarter. Some of the increase reflected tainly was a key factor behind the surge a rebound in purchases of light motor in consumer spending between the mid- vehicles, which were boosted by a sub- 1990s and last year, and thus helps to Monetary Policy Reports, July 77 explain the sharp fall in the personal able, mainly because of perceptions that saving rate over that period. The saving mortgage rates are low. rate has continued to fall this year— Likely because of the sustained from −0.7 percent in the fourth quarter strength of housing demand, home of 2000 to −1.1 percent in May—even prices have continued to rise faster than though the boost to spending growth overall inflation, although the various from the earlier run-up in stock prices measures that attempt to control for has likely run its course and the effects shifts in the regional composition of of lower wealth should be starting to sales and in the characteristics of houses feed through to spending. The apparent sold provide differing signals on the decline in the saving rate may simply magnitude of the price increases. Nota- reflect noisiness in the data or a slower bly, over the year ending in the first response of spending to wealth than quarter, the constant-quality price index average historical experience might sug- for new homes rose 4 percent, while gest. In addition, consumers probably the repeat-sales price index for existing base their spending decisions on income homes was up nearly 9 percent. Despite prospects over a longer time span than the higher prices, the share of income just a few quarters. Thus, to the extent required to finance a home purchase— that consumers do not expect the current one measure of affordability—has fallen sluggishness in real income growth to in recent quarters as mortgage rates have persist, the tendency to maintain spend- dropped back after last year’s bulge, and ing for a time by dipping into savings or that share currently is about as low as it by borrowing may have offset the effect has been at any time in the past decade. of the decline in wealth on the saving Rates on thirty-year conventional fixed- rate. rate loans now stand around 71⁄4 percent, and ARM rates are at their lowest levels in a couple of years. Residential Investment In the multifamily sector, housing Housing activity remained buoyant in starts averaged 343,000 units at an the first half of this year as lower mort- annual rate over the first five months of gage interest rates appear to have offset the year, matching the robust pace that the restraint from smaller gains in has been evident since 1997. Moreover, employment and income and from lower conditions in the market for multifamily levels of wealth. In the single-family housing continue to be conducive to sector, starts averaged an annual rate new construction. The vacancy rate for of 1.28 million units over the first five multifamily rental units in the first quar- months of the year—4 percent greater ter held near its low year-earlier level, than the hefty pace for 2000 as a whole. and rents and property values continued Sales of new and existing homes to rise rapidly. strengthened noticeably around the turn of the year and were near record levels Household Finance in March; they fell back in April but reversed some of that drop in May. The growth of household debt is esti- Inventories of new homes for sale are mated to have slowed somewhat in the exceptionally low; builders’ backlogs first half of this year to a still fairly hefty are sizable; and, according to the Michi- 71⁄2 percent annual rate—about a per- gan survey, consumers’ assessments of centage point below its average pace homebuying conditions remain favor- over the previous two years. Households 78 88th Annual Report, 2001 have increased both their home mort- loans they are willing to make, substan- gage debt and their consumer credit tial increases from the November sur- (debt not secured by real estate) substan- vey. Of those that had tightened, most tially this year, although in both cases cited actual or anticipated increases in the growth has moderated a bit recently. delinquency rates as a reason. The relatively low mortgage interest rates have boosted mortgage borrowing both by stimulating home purchases The Business Sector and by making it attractive to refinance The boom in capital spending that has existing mortgages and extract some of helped fuel the economic expansion the buildup in home equity. The rapid came to a halt late last year. After hav- growth in consumer credit has been con- ing risen at double-digit rates over the centrated in credit card debt, perhaps preceding five years, real business fixed reflecting households’ efforts to sustain investment flattened out in the fourth their consumption in the face of weaker quarter of 2000 and rose only a little in income growth. the first quarter of 2001. Demand for The household debt service burden— capital equipment has slackened appre- the ratio of minimum scheduled pay- ciably, reflecting the sluggish economy, ments on mortgage and consumer debt sharply lower corporate profits and cash to disposable personal income—rose flow, earlier overinvestment in some to more than 14 percent at the end of sectors, and tight financing conditions the first quarter, a twenty-year high, and facing some firms. In addition, inven- available data suggest a similar reading tory investment fell substantially in the for the second quarter. In part because first quarter as businesses moved to of the elevated debt burden, some mea- address the overhangs that began to sures of household loan performance develop late last year. With investment have deteriorated a bit in recent quar- spending weakening, businesses have ters. The delinquency rate on home cut back on new borrowing. Following mortgage loans has edged up but the drop in longer-term interest rates remains low, while the delinquency rate in the last few months of 2000, credit on credit card loans has risen noticeably demands have been concentrated in and is in the middle part of its range longer-term markets, though cautious over the past decade. Personal bankrupt- investors have required high spreads cies jumped to record levels in the from marginal borrowers. spring, but some of the spurt was prob- ably the result of a rush to file before Fixed Investment Congress passed bankruptcy reform legislation. Real spending on equipment and soft- Lenders have tightened up somewhat ware (E&S) began to soften in the sec- in response to the deterioration of house- ond half of last year, and it posted small hold financial conditions. In the May declines in both the fourth quarter of Senior Loan Officer Opinion Survey on 2000 and the first quarter of 2001. Much Bank Lending Practices, about a fifth of of the weakness in the first quarter was the banks indicated that they had tight- in spending on high-tech equipment and ened the standards for approving appli- software; such spending, which now cations for consumer loans over the pre- accounts for about half of E&S out- ceding three months, and about a fourth lays when measured in nominal terms, said that they had tightened the terms on declined at an annual rate of about Monetary Policy Reports, July 79 12 percent in real terms—the first real surprisingly, one bright spot is the quarterly drop since the 1990 recession. energy sector, where expenditures for An especially sharp decrease in outlays drilling and mining have been on a for communications equipment reflected steep uptrend since early 1999 (mainly the excess capacity that had emerged as because of increased exploration for a result of the earlier surge in spending, natural gas) and the construction of the subsequent re-evaluation of profit- facilities for electric power generation ability, and the accompanying financing remains very strong. difficulties faced by some firms. In addi- tion, real spending on computers and Inventory Investment peripheral equipment, which rose more than 40 percent per year in the second A sharp reduction in the pace of inven- half of the 1990s, showed little growth, tory investment was a major damping on net, between the third quarter of 2000 influence on real GDP growth in the and the first quarter of 2001. The level- first quarter of 2001. The swing in real ing in real computer spending report- nonfarm inventory investment from an edly reflects some stretching out of busi- accumulation of $51 billion at an annual nesses’ replacement cycles for personal rate in the fourth quarter of 2000 to a computers as well as a reduced demand liquidation of $25 billion in the first for servers. Outside the high-tech area, quarter of 2001 subtracted 3 percentage spending rose in the first quarter as pur- points from the growth in real GDP in chases of motor vehicles reversed some the first quarter. Nearly half of the nega- of the decline recorded over the second tive contribution to GDP growth came half of 2000 and as outlays for industrial from the motor vehicle sector, where a equipment picked up after having been sizable cut in assemblies (added to the flat in the fourth quarter. reduction already in place in the fourth Real E&S spending likely dropped quarter) brought the overall days’ sup- further in the second quarter. In addition ply down to comfortable levels by the to the ongoing contraction in outlays end of the first quarter. A rise in truck on high-tech equipment, the incoming assemblies early in the second quarter data for orders and shipments point to a led to some backup of inventories in decline in investment in non-high-tech that segment of the market, but truck equipment, largely reflecting the weak- stocks were back in an acceptable range ness in the manufacturing sector this by June; automobile assemblies were up year. only a little in the second quarter, and Outlays on nonresidential construc- stocks remained lean. tion posted another sizable advance in Firms outside the motor vehicles early 2001 after having expanded nearly industry also moved aggressively to 13 percent in real terms in 2000, but address inventory imbalances in the first the incoming monthly construction data half of the year, and this showed through imply a sharp retrenchment in the sec- to manufacturing output, which, exclud- ond quarter. The downturn in spending ing motor vehicles, fell at an annual rate comes on the heels of an increase in of 71⁄2 percent over this period. These vacancy rates for office and industrial production adjustments—along with a space in many cities. Moreover, while sharp reduction in the flow of imports— financing generally remains available contributed to a small decline in real for projects with viable tenants, lenders non-auto stocks in the first quarter, and are now showing greater caution. Not book-value data for the manufactur- 80 88th Annual Report, 2001 ing and trade sector point to a further The decline in C&I loans and com- decrease, on net, in April and May. As mercial paper owes, in part, to less of May, stocks generally seemed in line hospitable conditions in shorter-term with sales at retail trade establishments, funding markets. The commercial paper but there were still some notable over- market was rattled in mid-January by hangs in wholesale trade and especially the defaults of two large California utili- in manufacturing, where inventory– ties. Commercial paper is issued only by shipments ratios for producers of com- highly rated corporations, and default is puters and electronic products, primary extremely rare. The defaults, along with and fabricated metals, and chemicals some downgrades, led investors in com- remained very high. mercial paper to pull back and reevalu- ate the riskiness of issuers. For a while, issuance by all but top-rated names Business Finance became very difficult and quality The economic profits of U.S. corpora- spreads widened significantly, pushing tions fell at a 19 percent annual rate in some issuers into the shortest maturities the first quarter after a similar decline and inducing others to exit the market in the fourth quarter of 2000. As a result, entirely. As a consequence, the amount the ratio of profits to GDP declined of commercial paper outstanding plum- 1 percentage point over the two quar- meted. In the second quarter, risk ters, to 8.5 percent; the ratio of the prof- spreads returned to more typical levels its of nonfinancial corporations to sector and the runoff moderated. By the end output fell 2 percentage points over of June, the amount of nonfinancial the interval, to 10 percent. Investment commercial paper outstanding was spending has declined by more than nearly 30 percent below its level at the profits, however, reducing somewhat the end of 2000, with many firms still not still-elevated need of nonfinancial cor- having returned to the market. porations for external funds to finance Even though banks’ C&I loans were capital expenditures. Corporations have boosted in January and February by bor- husbanded their increasingly scarce rowers substituting away from the com- internal funds by cutting back on cash- mercial paper market, loans declined, on financed mergers and equity repur- net, over the first half of the year, in part chases. While equity retirements have because borrowers paid down their bank therefore fallen, so has gross equity issu- loans with proceeds from bond issues. ance, though by less. Inflows of venture Many banks reported on the Federal equity capital, in particular, have been Reserve’s Bank Lending Practices sur- reduced substantially. Businesses have veys this year that they had tightened met their financing needs by borrowing standards and terms—including the pre- heavily in the bond market while paying miums charged on riskier loans, the cost down both commercial and industrial of credit lines, and loan covenants— (C&I) loans at banks and commercial on C&I loans. Loan officers cited a paper. In total, after having increased worsened economic outlook, industry- 91⁄2 percent last year, the debt of non- specific problems, and a reduced toler- financial businesses rose at a 5 percent ance for risk as the reasons for having annual rate in the first quarter of this tightened. Despite these adjustments to year and is estimated to have risen at banks’ lending stance, credit appears to about the same pace in the second remain amply available for sound bor- quarter. rowers, and recent surveys of small Monetary Policy Reports, July 81 businesses indicate that they have not other measures of credit performance found credit significantly more difficult have shown a more moderate worsen- to obtain. ing. The ratio of the liabilities of failed Meanwhile, the issuance of corporate businesses to those of all nonfinancial bonds this year has proceeded at about businesses and the delinquency rate on double the pace of the preceding two C&I loans at banks have risen notice- years. With the yields on high-grade ably from their lows in 1998, but both bonds back down to their levels in the remain well below levels posted in the first half of 1999 and with futures early 1990s. quotes suggesting interest rates will be Commercial mortgage debt increased rising next year, corporations apparently at about an 83⁄4 percent annual rate in judged it to be a relatively opportune the first half of this year, and the issu- time to issue. Although investors remain ance of commercial-mortgage-backed somewhat selective, they have been securities (CMBS) maintained its robust willing to absorb the large volume of pace of the past several years. While issuance as they have become more con- spreads of the yields on investment- and fident that the economy would recover speculative-grade CMBS over swap and a prolonged disruption to earnings rates have changed little this year, sig- would be avoided. The heavy pace of nificant fractions of banks reported issuance has been supported, in part, by on the Bank Lending Practices survey inflows into bond mutual funds, which that they have tightened terms and may have come at the expense of equity standards on commercial real estate funds. loans. Although the delinquency rates The flows are forthcoming at rela- on CMBS and commercial real estate tively high risk spreads, however. loans at banks edged up in the first Spreads of most grades of corporate debt quarter, they remained near record lows. relative to rates on swaps have fallen Nevertheless, those commercial banks a little this year, but spreads remain that reported taking a more cautious unusually high for lower investment- approach toward commercial real estate grade and speculative-grade credits. The lending stated that they are doing so, in elevated spreads reflect the deteriora- part, because of a less favorable eco- tion in business credit quality that has nomic outlook in general and a worsen- occurred as the economy has slowed. ing of the outlook for commercial real While declines in interest rates have estate. held aggregate interest expense at a relatively low percentage of cash flow, many individual firms are feeling the The Government Sector pinch of decreases in earnings. Over the The fiscal 2001 surplus in the federal twelve months ending in May, 11 per- unified budget is likely to be smaller cent of speculative-grade bonds, by dol- than the surplus in fiscal 2000 because lar volume, have defaulted—the highest of the slower growth in the economy percentage since 1991 and a substan- and the recently enacted tax legislation. tial jump from 1998, when less than Nonetheless, the unified surplus will 2 percent defaulted. This deterioration remain large, and the paydown of the reflects not only the unusually large federal debt is continuing at a rapid defaults by the California utilities, but clip. As a consequence, the Treasury has also stress in the telecommunications taken a number of steps to preserve sector and elsewhere. However, some liquidity in a shrinking market. The 82 88th Annual Report, 2001 weaker economy is also reducing reve- technology-driven boom in domestic nues at the state and local level, but investment in recent years. these governments remain in reasonably Federal receipts in the first eight good fiscal shape overall and are taking months of the current fiscal year were advantage of historically low interest just 41⁄2 percent higher than during the rates to refund existing debt and to issue first eight months of fiscal 2000—a new debt. much smaller gain than those posted, on average, over the preceding several years. Much of the slowing was in cor- Federal Government porate receipts, which dropped below The fiscal 2001 surplus in the federal year-earlier levels, reflecting the recent government’s unified budget is likely to deterioration in profits. In addition, indi- come in below the fiscal 2000 surplus of vidual income tax payments rose less $236 billion. Over the first eight months rapidly than over the preceding few of the fiscal year—October to May—the years, mainly because of slower growth unified budget recorded a surplus of in withheld tax payments. This spring’s $137 billion, $16 billion higher than nonwithheld payments of individual during the comparable period last year. taxes, which are largely payments on the But over the balance of the fiscal year, previous year’s liability, were relatively receipts will continue to be restrained strong. Indeed, although there was no by this year’s slow pace of economic appreciable ‘‘April surprise’’ this year— growth and the associated decline in that is, these payments were about in corporate profits. Receipts will also be line with expectations—liabilities again reduced significantly over the next few appear to have risen faster than the months by the payout of tax rebates and NIPA tax base in 2000. One factor that the shift of some corporate payments has lifted liabilities relative to income into fiscal 2002, provisions included in in recent years is that rising levels of the Economic Growth and Tax Relief income and a changing distribution have Reconciliation Act of 2001. shifted more taxpayers into higher tax Federal saving, which is basically brackets. Higher capital gains realiza- the unified budget surplus adjusted to tions also have helped raise liabilities conform to the accounting practices fol- relative to the NIPA tax base over this lowed in the national income and prod- period. (Capital gains are not included uct accounts (NIPA), has risen dramati- in the NIPA income measure, which, by cally since hitting a low of −31⁄2 percent design, includes only income from cur- of GDP in 1992 and stood at 33⁄4 percent rent production.) of GDP in the first quarter—a swing of The faster growth in outlays that more than 7 percentage points. Reflect- emerged in fiscal 2000 has extended ing the high level of federal saving, into fiscal 2001. Smoothing through national saving, which comprises saving some timing anomalies at the start of the by households, businesses, and govern- fiscal year, nominal spending during the ments, has been running at a higher rate first eight months of fiscal 2001 was since the late 1990s than it did over more than 4 percent higher than during most of the preceding decade, even as the same period last year; excluding the the personal saving rate has plummeted. sizable drop in net interest outlays that The deeper pool of national saving, has accompanied the paydown of the along with large inflows of foreign federal debt, the increase in spending capital, has provided resources for the so far this year was nearly 6 percent. Monetary Policy Reports, July 83 Spending in the past couple of years following the market turmoil in the fall has been boosted by sizable increases of 1998. in discretionary appropriations as well The Treasury has taken a number of as by faster growth in outlays for the steps to limit the deterioration in the major health programs. The especially liquidity of its securities. In recent years, rapid increase in Medicaid outlays it has concentrated its issuance into reflects the higher cost and utilization fewer securities, so that the auction sizes of medical care (including prescription of the remaining securities are larger. drugs), growing enrollments, and a rise Last year, in order to enable issuance of in the share of expenses picked up a larger volume of new securities, the by the federal government. Outlays for Treasury began buying back less-liquid Medicare have been lifted, in part, by older securities, and it also made every the higher reimbursements to providers second auction of its 5- and 10-year that were enacted last year. notes and 30-year bond a reopening of Real federal expenditures for con- the previously issued security. In Febru- sumption and gross investment, the part ary, the Treasury put limits on the non- of government spending that is included competitive bids that foreign central in GDP, rose at a 5 percent annual rate banks and governmental monetary enti- in the first quarter. Over the past couple ties may make, so as to leave a larger of years, real nondefense purchases have and more predictable pool of securities remained on the moderate uptrend that available for competitive bidding, help- has been evident since the mid-1990s, ing to maintain the liquidity and effi- while real defense purchases have ciency of the market. In May, the Trea- started to rise slowly after having bot- sury announced that it would begin tomed out in the late 1990s. issuing Treasury bills with a four-week The Treasury has used the substantial maturity to provide it with greater flex- federal budget surpluses to pay down ibility and cost efficiency in manag- its debt further. At the end of June, the ing its cash balances, which, in part outstanding Treasury debt held by the because new securities are now issued public had fallen nearly $600 billion, or less frequently, have become more vola- 15 percent, from its peak in 1997. Rela- tile. Finally, also in May, the Treasury tive to nominal GDP, publicly held debt announced it would in the next few has dropped from nearly 50 percent in months seek public comment on a plan the mid-1990s to below 33 percent in to ease the ‘‘35 percent rule,’’ which the first quarter, the lowest it has been limits the bidding at auctions by those since 1984. holding claims on large amounts of an Declines in outstanding federal debt issue. With reopenings increasingly and the associated reductions in the sizes being used to maintain liquidity in indi- and frequency of auctions of new issues vidual issues, this rule was constraining have diminished the liquidity of the many potential bidders. As discussed Treasury market over the past few years. below, the reduced issuance of Trea- Bid–asked spreads are somewhat wider, sury securities has also led the Federal quote sizes are smaller, and the differ- Reserve to modify its procedures for ence between yields on seasoned versus acquiring such securities and to study most-recently issued securities has possible future steps for its portfolio. increased. In part, however, these devel- In early 2000, as investors focused opments may also reflect a more cau- on the possibility that Treasury securi- tious attitude among securities dealers ties were going to become increasingly 84 88th Annual Report, 2001 scarce, they became willing to pay a managed to adopt balanced budgets for premium for longer-dated securities, fiscal 2002 with only minor adjustments pushing down their yields. However, to taxes and spending. these premiums appear to have largely Real consumption and investment unwound later in the year as market spending by state and local governments participants made adjustments to the rose at nearly a 5 percent annual rate new environment. These adjustments in the first quarter and apparently posted include the substitution of alternative a sizable increase in the second quarter instruments for hedging and pricing, as well. Much of the strength this year such as interest rate swaps, prominent has been in construction spending, high-grade corporate bonds, and securi- which has rebounded sharply after a ties issued by government-sponsored reported decline in 2000 that was hard enterprises (GSEs). To benefit from to reconcile with the sector’s ongoing adjustments by market participants, in infrastructure needs and the good finan- 1998, Fannie Mae and Freddie Mac ini- cial condition of most governments. tiated programs to issue securities that Hiring also remained fairly brisk during share some characteristics with Trea- the first half of the year; on average, sury securities, such as regular issuance employment rose 30,000 per month, calendars and large issue sizes; in the about the same as the average monthly first half of this year they issued $88 bil- increase over the preceding three lion of coupon securities and $502 bil- years. lion of bills under these programs. The Although interest rates on munici- GSEs have also this year begun buy- pal debt have edged up this year, they ing back older securities to boost the remain low by historical standards. size of their new issues. Nevertheless, State and local governments have taken the market for Treasury securities advantage of the low interest rates to remains considerably more liquid than refund existing debt and to raise new markets for GSE and other fixed-income capital. Credit quality has remained securities. quite high in the municipal sector even as tax receipts have softened, with State and Local Governments credit upgrades outpacing downgrades in the first half of this year. Most State and local governments saw an notable among the downgrades was that enormous improvement in their budget of California’s general obligation bonds. positions between the mid-1990s and Standard and Poor’s lowered Califor- last year as revenues soared and spend- nia’s debt two notches from AA to A+, ing generally was held in check; accord- citing the financial pressures from the ingly, these governments were able both electricity crisis and the likely adverse to lower taxes and to make substan- effects of the crisis on the state’s tial allocations to reserve funds. More economy. recently, however, revenue growth has slowed in many states, and reports of fiscal strains have increased. Nonethe- The External Sector less, the sector remains in relatively The deficits in U.S. external balances good fiscal shape overall, and most gov- narrowed sharply in the first quarter of ernments facing revenue shortfalls have this year, largely because of a smaller Monetary Policy Reports, July 85 deficit in trade in goods and services. quarter, slightly higher than the rate of Most of the financial flows into the increase recorded in 2000. United States continued to come from U.S. real exports were hit by slower private foreign sources. growth abroad, the strength of the dollar, and plunging global demand Trade and Current Account for high-tech products. Real exports of goods and services, which had grown After widening continuously during the strongly in the first three quarters of past four years, the deficits in U.S. exter- 2000, fell 61⁄2 percent at an annual rate nal balances narrowed in the first quar- in the fourth quarter of last year and ter of 2001. The current account deficit declined another 1 percent in the first in the first quarter was $438 billion at an quarter of this year. The largest declines annual rate, or 4.3 percent of GDP, com- in both quarters were in high-tech capi- pared with $465 billion in the fourth tal goods and automotive products (pri- quarter of 2000. Most of the reduction marily in intrafirm trade with Canada). of the current account deficit can be By market destination, the largest traced to changes in U.S. trade in goods increases in U.S. goods exports during and services; the trade deficit narrowed the first three quarters of 2000 had been from an annual rate of $401 billion in to Mexico and countries in Asia; the the fourth quarter of 2000 to $380 bil- recent declines were mainly in exports lion in the first quarter of this year. The to Asia and Latin America. In contrast, trade deficit in April continued at about goods exports to Western Europe the same pace. Net investment income increased steadily throughout the entire payments were a bit less in the first period. About 45 percent of U.S. goods quarter than the average for last year exports in the first quarter of 2001 were primarily because of a sizable decrease capital equipment; 20 percent were in earnings by U.S. affiliates of foreign industrial supplies; and 5 to 10 percent firms. each were agricultural, automotive, con- As U.S. economic growth slowed in sumer, and other goods. the second half of last year and early After increasing through much of this year, real imports of goods and 2000, the spot price of West Texas inter- services, which had grown very rapidly mediate (WTI) crude oil reached a peak in the first three quarters of 2000, above $37 per barrel in September, the expanded more slowly in the fourth highest level since the Gulf War. As quarter and then contracted 5 percent world economic growth slowed in the at an annual rate in the first quarter. latter part of 2000, oil price declines The largest declines were in high-tech reversed much of the year’s price gain. products (computers, semiconductors, In response, OPEC reduced its official and telecommunications equipment) production targets in January of this year and automotive products. In contrast, and again in March. As a result, oil imports of petroleum and petroleum prices have remained relatively high in products increased moderately. A tem- 2001 despite weaker global economic porary surge in the price of imported growth and a substantial increase in natural gas pushed the increase of the U.S. oil inventories. Oil prices have also average price of non-oil imports above been elevated by the volatility of Iraqi an annual rate of 1 percent in the first oil exports arising from tense relations 86 88th Annual Report, 2001 between Iraq and the United Nations. ing, and the unemployment rate rose. During the first six months of this year, Increases in hourly compensation have the spot price of WTI has fluctuated, continued to trend up in recent quarters, with only brief exceptions, between $27 while measured labor productivity has and $30 per barrel. been depressed by the slower growth of output. Financial Account In the first quarter of 2001, as was the Employment and Unemployment case in 2000 as a whole, nearly all of the After having risen an average of net financial flows into the United States 149,000 per month in 2000, private pay- came from private foreign sources. For- roll employment increased an average eign official inflows were less than of only 63,000 per month in the first $5 billion and were composed primar- quarter of 2001, and it declined an aver- ily of the reinvestment of accumulated age of 117,000 per month in the second interest earnings. Reported foreign quarter. The unemployment rate moved exchange intervention purchases of dol- up over the first half of the year and in lars were modest. June stood at 41⁄2 percent, 1⁄2 percentage Inflows arising from private foreign point higher than in the fourth quarter of purchases of U.S. securities accelerated last year. further in the first quarter and are on a Much of the weakness in employment pace to exceed last year’s record. All of in the first half of the year was in the the pickup is attributable to larger net manufacturing sector, where job losses foreign purchases of U.S. bonds, as for- averaged 78,000 per month in the first eign purchases of both corporate and quarter and 116,000 per month in the agency bonds accelerated and private second quarter. Since last July, manufac- foreign sales of Treasuries paused. For- turing employment has fallen nearly eign purchases of U.S. equities are only 800,000. Factory job losses were wide- slightly below their 2000 pace despite spread in the first half of the year, with the apparent decline in expected returns some of the biggest cutbacks at indus- to holding U.S. equities. tries struggling with sizable inventory The pace at which U.S. residents overhangs, including metals and indus- acquired foreign securities changed little trial and electronic equipment. The between the second half of last year and weakness in manufacturing also cut into the first quarter of this year. As in previ- employment at help-supply firms and at ous years, most of the foreign securities wholesale trade establishments. acquired were equities. Apart from manufacturing and the Net financial inflows associated with closely related help-supply and whole- direct investment slowed a good bit in sale trade industries, employment the first quarter, as there were signifi- growth held up fairly well in the first cantly fewer large foreign takeovers of quarter but began to slip noticeably in U.S. firms and U.S. direct investment the second quarter. Some of the slowing abroad remained robust. in the second quarter reflected a drop in construction employment after a strong The Labor Market first quarter that likely absorbed a por- tion of the hiring that normally takes Labor demand weakened in the first place in the spring; on average, con- half of 2001, especially in manufactur- struction employment rose a fairly brisk Monetary Policy Reports, July 87 15,000 per month over the first half, through the annual revision process— about the same as in 2000. Hiring in the shows a steady uptrend over the past services industry (other than help-supply couple of years; it rose 6 percent over firms) also slowed markedly in the sec- the year ending in the first quarter after ond quarter. Employment in retail trade having risen 41⁄2 percent over the pre- remained on a moderate uptrend over ceding year. the first half of the year, and employ- According to the ECI, wages and ment in finance, insurance, and real salaries rose at an annual rate of about estate increased modestly after having 41⁄2 percent in the first quarter. Exclud- been unchanged, on net, last year. ing sales workers, wages rose 5 percent (annual rate) in the first quarter and 41⁄4 percent over the year ending in Labor Costs and Productivity March; this compares with an increase Through the first quarter, compensation of 33⁄4 percent over the year ending in growth remained quite strong—indeed, March 2000. Separate data on average trending higher by some measures. hourly earnings of production or non- These gains likely reflected the influ- supervisory workers also show a dis- ence of earlier tight labor markets, cernible acceleration of wages: The higher consumer price inflation— twelve-month change in this series was largely due to soaring energy prices— 41⁄4 percent in June, 1⁄2 percentage point and the greater real wage gains made above the reading for the preceding possible by faster structural productivity twelve months. growth. The upward pressures on labor Benefit costs as measured in the ECI costs could abate in coming quarters if have risen faster than wages over the pressures in labor markets ease and past year, with the increase over the energy prices fall back. twelve months ending in March totaling Hourly compensation, as measured by 5 percent. Much of the pressure on bene- the employment cost index (ECI) for fits is coming from health insurance, private nonfarm businesses, moved up where employer payments have acceler- in the first quarter to a level about ated steadily since bottoming out in the 41⁄4 percent above its level of a year mid-1990s and are now going up about earlier; this compares with increases of 8 percent per year. The surge in spend- about 41⁄2 percent over the preceding ing on prescription drugs accounts for year and 3 percent over the year before some of the rise in health insurance that. The slight deceleration in the most costs, but demand for other types of recent twelve-month change in the ECI medical care is increasing rapidly as is accounted for by a slowdown in the well. Moreover, although there has growth of compensation for sales work- been some revamping of drug coverage ers relative to the elevated rates that had to counter the pressures of soaring prevailed in early 2000; these workers’ demand, many employers have been pay includes a substantial commission reluctant to adjust other features of the component and thus is especially sensi- health benefits package in view of the tive to cyclical developments. Compen- need to retain workers in a labor market sation per hour in the nonfarm business that has been very tight in recent years. sector—a measure that picks up some Measured labor productivity in the forms of compensation that the ECI nonfarm business sector has been omits but that sometimes has been bounced around in recent quarters by revised substantially once the data go erratic swings in hours worked by self- 88 88th Annual Report, 2001 employed individuals, but on balance, it May but eased in June and early July. In has barely risen since the third quarter addition, core PCE price inflation has of last year after having increased about dropped back after the first-quarter 3 percent per year, on average, over the spurt, and the twelve-month change in preceding three years. This deceleration this series, which is a useful indicator of coincides with a marked slowing in out- the underlying inflation trend, stood at put growth and seems broadly in line 11⁄2 percent in May, about the same as with the experience of past business the change over the preceding twelve cycles; these readings remain consistent months. The core consumer price index with a noticeable acceleration in struc- (CPI) continued to move up at a faster tural productivity having occurred in the pace than the core PCE measure over second half of the 1990s. Reflecting the the past year, rising 21⁄2 percent over the movements in hourly compensation and twelve months ending in May, also the in actual productivity, unit labor costs in same rate as over the preceding year. the nonfarm business sector jumped in PCE energy prices rose at an annual the first quarter and have risen 31⁄2 per- rate of about 11 percent in the first quar- cent over the past year. ter and, given the big increases in April Looking ahead, prospects for favor- and May, apparently posted another able productivity performance will sizable advance in the second quarter. hinge on a continuation of the rapid Unlike the surges in energy prices in technological advances of recent years 1999 and 2000, the increases in the first and on the willingness of businesses to half of 2001 were not driven by devel- expand and update their capital stocks opments in crude oil markets. Indeed, to take advantage of the new efficiency- natural gas prices were the major factor enhancing capital that is becoming boosting overall energy prices early this available at declining cost in many year as tight inventories and concerns cases. To be sure, the current weakness about potential stock-outs pushed spot in business investment will likely damp prices to extremely high levels; natu- the growth of the capital stock relative ral gas prices have since receded as to the pace of the past couple of years. additional supplies have come on line But once the cyclical weakness in the and inventories have been rebuilt. In economy dissipates, continued advances the spring, gasoline prices soared in in technology should provide impetus to response to strong demand, refinery renewed capital spending and a return to disruptions, and concerns about lean solid increases in productivity. inventories; with refineries back on line, imports up, and inventories restored, gasoline prices have since fallen notice- Prices ably below their mid-May peaks. Elec- Inflation moved higher in early 2001 but tricity prices also rose substantially has moderated some in recent months. in the first half of the year, reflecting After having risen 21⁄4 percent in 2000, higher natural gas prices as well as the the chain price index for personal con- problems in California. Capacity prob- sumption expenditures (PCE) increased lems in California and the hydropower about 31⁄4 percent in the first quarter of shortages in the Northwest persist, 2001 as energy prices soared and as core though California’s electricity consump- consumer prices—which exclude food tion has declined recently and whole- and energy—picked up. Energy prices sale prices have dropped. In contrast, continued to rise rapidly in April and capacity in the rest of the country Monetary Policy Reports, July 89 has expanded appreciably over the past firms facing foreign competition to year and, on the whole, appears ade- raise prices for fear of losing market quate to meet the normal seasonal rise in share. In addition, apart from energy, demand. price pressures at earlier stages of Core PCE prices rose at a 21⁄2 percent processing have been minimal. Indeed, annual rate in the first quarter—a hefty excluding food and energy, the producer increase by the standards of recent price index (PPI) for intermediate mate- years. But the data are volatile, and the rials has been flat over the past year, and first-quarter increase, no doubt, exagger- the PPI for crude materials has fallen ates any pickup. Based on monthly data 11 percent. Moreover, inflation expec- for April and May, core PCE inflation tations, on balance, seem to have appears to have slowed considerably in remained quiescent: According to the the second quarter; the slowing was con- Michigan survey, the median expecta- centrated in the goods categories and tion for inflation over the upcoming year seems consistent with reports that retail- generally has been running about 3 per- ers have been cutting prices to spur sales cent this year, similar to the readings in in an environment of soft demand. 2000. Core consumer price inflation— In contrast to the step-up in consumer whether measured by the PCE index or prices, prices for private investment by the CPI—in recent quarters almost goods in the NIPA were up only a little certainly has been boosted by the effects in the first quarter after having risen of higher energy prices on the costs of about 2 percent last year. In large part, producing other goods and services. this pattern was driven by movements in Additional pressure has come from the the price index for computers, which fell step-up in labor costs. That said, firms at an annual rate of nearly 30 percent in appear to have absorbed much of these the first quarter as demand for high-tech cost increases in lower profit margins. equipment plunged. This drop in com- Meanwhile, non-oil import prices have puter prices was considerably greater remained subdued, thus continuing to than the average decrease of roughly restrain input costs for many domestic 20 percent per year in the second half industries and to limit the ability of of the 1990s and the unusually small Alternative Measures of Price Change Percent, Q1 to Q1 1998 1999 2000 Price measure to to to 1999 2000 2001 Chain-type Gross domestic product . . . . . . . . . . . . . . . . . . . . . . . . . . 1.5 1.8 2.3 Gross domestic purchases . . . . . . . . . . . . . . . . . . . . . . . . 1.2 2.3 2.2 Personal consumption expenditures . . . . . . . . . . . . . . . 1.5 2.5 2.2 Excluding food and energy . . . . . . . . . . . . . . . . . . . . . 1.8 1.6 1.7 Fixed-weight Consumer price index . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.7 3.3 3.4 Excluding food and energy . . . . . . . . . . . . . . . . . . . . . 2.2 2.2 2.7 Note. A fixed-weight index uses quantity weights to change each year. The consumer price indexes are for from a base year to aggregate prices from each distinct all urban consumers. Changes are based on quarterly item category. A chain-type index is the geometric aver- averages. age of two fixed-weight indexes and allows the weights 90 88th Annual Report, 2001 11 percent decrease in 2000. Monthly first half of this year as near-term cor- PPI data suggest that computer prices porate earnings were revised down sub- were down again in the second quarter, stantially. Rates on longer-term Trea- though much less than in the first sury issues rose a little, but those on quarter. corporate bonds were about unchanged, All told, the GDP chain-type price with the narrowing spread reflecting index rose at an annual rate of 31⁄4 per- greater investor confidence in the out- cent in the first quarter and has risen look. But risk spreads remained wide 21⁄4 percent over the past four quarters, by historical standards for businesses an acceleration of 1⁄2 percentage point whose debt was rated as marginally from the comparable year-earlier period. investment grade or below; many of The price index for gross domestic these firms had been especially hard purchases—which is defined as the hit by the slowdown and the near-term prices paid for consumption, investment, oversupply of high-tech equipment and and government purchases—also accel- services, and defaults by these firms erated in the first quarter—to an increase became more frequent. Nevertheless, for of about 23⁄4 percent; the increase in this most borrowers the environment for measure over the past year was 21⁄4 per- long-term financing was seen to be quite cent, about the same as over the preced- favorable, and firms and households ing year. Excluding food and energy, the tended to tap long-term sources of credit latest four-quarter changes in both GDP in size to bolster their financial condi- and gross domestic purchases prices tions and lock in more favorable costs. were roughly the same as over the pre- ceding year. Interest Rates In response to the abrupt deceleration U.S. Financial Markets in economic growth and prospects for Longer-term interest rates and equity continued weakness in the economy, the prices have shown remarkably small net FOMC lowered the target federal funds changes this year, given the consider- rate 23⁄4 percentage points in six steps able shifts in economic prospects and in the first half of this year, an unusually major changes in monetary policy. To steep decline relative to many past eas- some extent, the expectations of the eco- ing cycles. Through March, the policy nomic and policy developments in 2001 easings combined with declining equity had already become embedded in finan- prices and accumulating evidence that cial asset prices as last year came to a the slowdown in economic growth was close; from the end of August through more pronounced than had been ini- year-end, the broadest equity price tially thought led to declines in yields indexes fell 15 percent and investment- on intermediate- and longer-term Trea- grade bond yields declined 40 to sury securities. Over the second quar- 70 basis points. In addition, however, ter, despite the continued decrease in equity prices and long-term interest rates short-term rates and further indications were influenced importantly by growing of a weakening economy, yields on optimism in financial markets over the intermediate-term Treasury securities second quarter of 2001 that the econ- were about unchanged, while those on omy and profits would rebound strongly longer-term securities rose appreciably. toward the end of 2001 and in 2002. On On net, yields on intermediate-term net, equity prices fell 6 percent in the Treasury securities fell about 3⁄4 per- Monetary Policy Reports, July 91 centage point in the first half of this vated. Spreads of corporate bond yields year, while those on longer-term Trea- relative to swap rates narrowed a bit, sury securities rose about 1⁄4 percentage although they still remain high. Amidst point. signs of deteriorating credit quality and The increase in longer-term Treasury a worsening outlook for corporate earn- yields in the second quarter appears to ings, risk spreads on speculative-grade have been the result of a number of bonds had risen by about 2 percentage factors. The main influence seems to points late last year, reaching levels not have been increased investor confidence seen since 1991. Much of this widening that the economy would soon pick up. was reversed early in the year, as inves- That confidence likely arose in part from tors became more confident that corpo- the aggressive easing of monetary pol- rate balance sheets would not deterio- icy and also in part from the improving rate substantially, but speculative-grade prospects for, and passage of, a sizable bond spreads widened again recently in tax cut. The tax cut and the growing response to negative news about second- support for certain spending initiatives quarter earnings and declines in share implied stronger aggregate demand and prices, leaving these spreads at the end less federal saving than previously of the second quarter only slightly anticipated. The prospect that the fed- below where they began the year. None- eral debt might be paid down less rap- theless, investors, while somewhat idly may also have reduced slightly selective, appear to remain receptive the scarcity premiums investors were to new issues with speculative-grade willing to pay for Treasury securities. ratings. Finally, a portion of the rise may have Interest rates on commercial paper been the result of increased inflation and C&I loans have fallen this year by expectations. Inflation compensation as about as much as the federal funds rate, measured by the difference between although some risk spreads widened. nominal Treasury rates and the rates The average yield spread on second-tier on inflation-indexed Treasury securities commercial paper over top-tier paper rose about 1⁄4 percentage point in the widened to about 100 basis points in second quarter. Despite this increase, late January, about four times its typi- there is little evidence that inflation is cal level, following defaults by a few expected to go up from its current level. prominent issuers. As the year pro- At the end of last year, inflation com- gressed, investors became less con- pensation had declined to levels suggest- cerned about the remaining commer- ing investors expected inflation to fall, cial paper borrowers, and this spread and the rise in inflation compensation in has returned to a more normal level. the second quarter largely reversed those According to preliminary data from the declines. Moreover, survey measures of Federal Reserve’s quarterly Survey of longer-term inflation expectations have Terms of Business Lending, the spread changed little since the middle of last over the target federal funds rate of year. the average interest rate on commercial Yields on longer-maturity corporate bank C&I loans edged up between bonds were about unchanged, on net, November and May and remains in the over the first half of this year. Yields on elevated range it shifted to in late 1998. investment-grade bonds are near their Judging from the widening since 1998 lows for the past ten years, but those of the average spread between rates on on speculative-grade bonds are ele- riskier and less-risky loans, banks have 92 88th Annual Report, 2001 become especially cautious about lend- time. This measure of the earnings– ing to marginal credits. price ratio remains near the levels reached in 1999, suggesting that inves- Equity Markets tors still anticipate robust long-term earnings growth, likely reflecting expec- After rising in January in response to the tations for continued strong gains in initial easing of monetary policy, stock productivity. prices declined in February and March Despite the substantial variation in in reaction to profit warnings and weak share prices over the first half of this economic data, with the Wilshire 5000, year, trading has been orderly, and the broadest major stock price index, financial institutions appear to have ending the first quarter down 13 percent. encountered no difficulties that could Stock prices retraced some of those pose broader systemic concerns. Market losses in the second quarter, rising 7 per- volatility and a less ebullient outlook cent, as first-quarter earnings releases have led investors to buy a much smaller came in a little above sharply reduced share of stock on margin. At the end of expectations and as investors became May, margin debt was 1.15 percent of more confident that economic growth total market capitalization, equal to its and corporate profits would soon pick level at the beginning of 1999 and well up. On net, the Wilshire 5000 ended the below its high of 1.63 percent in March half down 6 percent, the DJIA declined of last year. 3 percent, and the tech-heavy Nasdaq fell 13 percent. Earnings per share of the Federal Reserve Open Market S&P 500 in the first quarter decreased Operations 10 percent from a year earlier. A dispro- portionate share of the decline in S&P As noted earlier, the Federal Reserve earnings—more than half—was attribut- has responded to the diminished size of able to a plunge in the technology sec- the auctions of Treasury securities by tor, where first-quarter earnings were modifying its procedures for acquiring down nearly 50 percent from their peak such securities. To help maintain supply in the third quarter of last year. in private hands adequate for liquid mar- The decline in stock prices has left kets, since July of last year the System the Wilshire 5000 down by about has limited its holdings of individual 20 percent, and the Nasdaq down by securities to specified percentages, rang- about 60 percent, from their peaks in ing from 15 percent to 35 percent, of March 2000. Both of these indexes are outstanding amounts. To stay within near their levels at the end of 1998, these limits, the System has at times not having erased the sharp run-up in rolled over all of its holdings of matur- prices in 1999 and early 2000. But both ing securities, generally investing the indexes remain more than two and one- difference by purchasing other Treasury half times their levels at the end of securities on the open market. The Fed- 1994, when the bull market shifted into eral Reserve also has increased its hold- a higher gear. The ratio of expected one- ings of longer-term repurchase agree- year-ahead earnings to equity prices ments (RPs), including RPs backed by began to fall in 1995 when, as produc- agency securities and mortgage-backed tivity growth picked up, investors began securities, as a substitute for outright to build in expectations that increases purchases of Treasury securities. In the in earnings would remain rapid for some first half of the year, longer-term RPs, Monetary Policy Reports, July 93 typically with maturities of twenty-eight in the growth of nonfederal and federal days, averaged $13 billion. debt this year have mostly offset each As reported in the previous Monetary other. The growth of nonfederal debt Policy Report, the FOMC also initiated moderated from 81⁄2 percent in 2000 to a a study to evaluate assets to hold on its still-robust 71⁄4 percent pace in the first balance sheet as alternatives to Treasury half of this year. Households’ borrowing securities. That study identified several slowed some but was still substantial, options for further consideration. In the buoyed by continued sizable home and near term, the Federal Reserve is con- durable goods purchases. Similarly, sidering purchasing and holding Ginnie business borrowing moderated even as Mae mortgage-backed securities, which bond issuance surged, as a good portion are explicitly backed by the full faith of the funds raised was used to pay and credit of the U.S. government, down commercial paper and bank loans. and engaging in repurchase operations Tending to boost debt growth was a against foreign sovereign debt. For pos- slowing in the decline in federal debt to sible implementation later, the Federal a 61⁄4 percent rate in the first half of this Reserve is studying whether to auction year from 63⁄4 percent last year, largely longer-term discount window credit, and because of a decline in tax receipts on it will over time take a closer look at corporate profits. a broader array of assets for repurchase The share of credit to nonfinancial and for holding outright, transactions sectors held at banks and other deposi- that would require additional legal tory institutions edged down in the first authority. half of the year. Bank credit, which accounts for about three-fourths of depository credit, increased at a 31⁄2 per- Debt and the Monetary Aggregates cent annual rate in the first half of the The growth of domestic nonfinancial year, well off the 91⁄2 percent growth debt in the first half of 2001 is estimated registered in 2000. Banks’ loans to busi- to have remained moderate, slowing nesses and households decelerated even slightly from the pace in 2000 as a more, in part because borrowers pre- reduction in the rate of increase in non- ferred to lock in the lower rates avail- federal debt more than offset the effects able from longer-term sources of funds of smaller net repayments of federal such as bond and mortgage markets and debt. In contrast, the monetary aggre- perhaps also in part because banks gates have grown rapidly so far this firmed up their lending stance in reac- year, in large part because the sharp tion to concerns about loan perfor- decline in short-term market interest mance. Loan delinquency and charge- rates has reduced the opportunity cost of off rates have trended up in recent holding the deposits and other assets quarters, and higher loan-loss provisions included in the aggregates. have weighed on profits. Nevertheless, through the first quarter, bank profits Debt and Depository Intermediation remained in the high range recorded for the past several years, and virtually all The debt of the domestic nonfinancial banks—98 percent by assets—were well sectors is estimated to have expanded at capitalized. With banks’ financial condi- a 43⁄4 percent annual rate over the first tion still quite sound, they remain well half of 2001, a touch below the 51⁄4 per- positioned to meet future increases in cent growth recorded in 2000. Changes the demand for credit. 94 88th Annual Report, 2001 The Monetary Aggregates kept headline inflation rates somewhat elevated, but even though core rates of The monetary aggregates have expanded inflation have edged up in countries rapidly so far this year, although growth where economic slack has diminished, rates have moderated somewhat inflationary pressures appear to be well recently. M2 rose 101⁄4 percent at an under control. annual rate in the first half of this year Monetary authorities in most cases after having grown 61⁄4 percent in 2000. reacted to signs of slowdown by lower- The interest rates on many of the com- ing official rates, but by less than in the ponents of M2 do not adjust quickly or United States. Partly in response to these fully to changes in market interest rates. actions, yield curves have steepened As a consequence, the steep declines in noticeably so far in 2001. Although short-term market rates this year have long-term interest rates moved down left investments in M2 assets relatively during the first quarter, they more than more attractive, contributing importantly reversed those declines in most cases to the acceleration in the aggregate. M2 as markets reacted to a combination of has also probably been buoyed by the the anticipation of stronger real growth volatility in the stock market this year, and the risk of increased inflationary and perhaps by lower expected returns pressure. Foreign equity markets— on equity investments, leading investors especially for high-tech stocks—were to seek the safety and liquidity of M2 buffeted early this year by many of assets. the same factors that affected U.S. M3, the broadest monetary aggre- share prices: negative earnings reports, gate, rose at a 131⁄4 percent annual rate weaker economic activity, buildups of through June, following 91⁄4 percent inventories of high-tech goods, and growth in 2000. All of the increase in uncertainties regarding the timing and M3, apart from that accounted for by extent of policy responses. In recent M2, resulted from a ballooning of insti- months, the major foreign equity tutional money market funds, which indexes moved up along with U.S. stock expanded by nearly a third. Yields on prices, but they have edged off lately these funds lag market yields somewhat, and in most cases are down, on balance, and so the returns to the funds, like for the year so far. those on many M2 assets, became rela- Slower U.S. growth, monetary easing tively attractive as interest rates on by the Federal Reserve, fluctuations short-term market instruments declined. in U.S. stock prices, and the large U.S. external deficit have not undermined International Developments dollar strength. After the December 2000 FOMC meeting, the dollar lost So far this year, average foreign growth ground against the major currencies; but has weakened further and is well below shortly after the FOMC’s surprise rate its pace of a year ago. Activity abroad cut on January 3, the dollar reversed all was restrained by the continued high of that decline as market participants level of oil prices, the global slump evidently reassessed the prospects for of the high-technology sector, and recovery in the United States versus that spillover effects from the U.S. eco- in our major trading partners. The dollar nomic slowdown, but in some countries as measured by a trade-weighted index domestic demand softened as well in against the currencies of major indus- reaction to local factors. High oil prices trial countries gained in value steadily Monetary Policy Reports, July 95 in the first three months of 2001, reach- inflation moves up to zero or above. ing a fifteen-year high in late March. After the yen had moved near the end of Continued flows of foreign funds into March to its weakest level relative to the U.S. assets appeared to be contribut- dollar in more than four years, Japanese ing importantly to the dollar’s increase. financial markets were buoyed by the Market reaction to indications that the surprise election in May of Junichiro U.S. economy might be headed toward Koizumi to party leadership and thereby a more prolonged slowdown undercut to prime minister. The yen firmed the dollar’s strength somewhat in early slightly for several weeks thereafter, but April, and the dollar eased further after continued weak economic fundamentals the unexpected April 18 rate cut by the and increased market focus on the FOMC. However, the dollar has more daunting challenges facing the new gov- than made up that loss in recent months ernment helped push the yen back down as signs of weakness abroad have and beyond its previous low level. emerged more clearly. On balance, the At the start of 2001, economic activ- dollar is up about 7 percent against the ity in the euro area had slowed notice- major currencies so far this year; against ably from the more rapid rates seen a broader index that includes currencies early last year but still was fairly robust. of other important trading partners, the Average GDP growth of near 2 per- dollar has appreciated 5 percent. cent was only slightly below estimated The dollar has gained about 9 percent rates of potential growth, although some against the yen, on balance, as the Japa- key countries (notably Germany) were nese economy has remained troubled showing signs of faltering further. by structural problems, stagnant growth, Although high prices for oil and food and continuing deflation. Industrial pro- had raised headline inflation, the rate of duction has been falling, and real GDP change of core prices was below the declined slightly in the first quarter, with 2 percent ceiling for overall inflation set both private consumption and invest- by the European Central Bank (ECB). ment contracting. Japanese exports also The euro also was showing some signs have sagged because of slower demand of strength, having moved well off the from many key trading partners. Early low it had reached in October. However, in the year, under increasing pressure to negative spillovers from the global respond to signs that their economy was slowdown started to become more evi- weakening further, the Bank of Japan dent in weaker export performance in (BOJ) slightly reduced the uncollateral- the first quarter, and leading indicators ized overnight call rate, its key policy such as business confidence slumped. interest rate. By March, the low level Nevertheless, the ECB held policy of equity prices, which had been declin- steady through April, as further weaken- ing since early 2000, was provoking ing of the euro against the dollar (fol- renewed concerns about the solvency of lowing a trend seen since the FOMC’s Japanese banks. In mid-March, the BOJ rate cut in early January), growth of M3 announced that it was shifting from aim- in excess of the ECB’s reference rate, ing at a particular overnight rate to tar- and signs of an edging up of euro-area geting balances that private financial core inflation were seen as militating institutions hold at the Bank, effectively against an easing of policy. returning the overnight rate to zero; In early May, the ECB surprised mar- the BOJ also announced that it would kets with a 25 basis point reduction of continue this easy monetary stance until its minimum bid rate and parallel reduc- 96 88th Annual Report, 2001 tions of its marginal lending and deposit dian dollar has regained much of the rates. In explaining the step, the ECB ground it had lost earlier and is down noted that monetary developments no about 2 percent on balance since the longer posed a threat to price stability beginning of the year. and projected that moderation of GDP Global financial markets were rattled growth would damp upward price pres- in February by serious problems in the sure. The euro has continued to fall Turkish banking sector. Turkish interest since then and, on balance, has declined rates soared and, after market pressures 9 percent against the dollar since the led authorities to allow the Turkish lira beginning of the year. Faced with a simi- to float, it experienced a sharp deprecia- lar slowdown in the U.K. economy that tion of more than 30 percent. An IMF was exacerbated by the outbreak of foot- program announced in mid-May that and-mouth disease, the Bank of England will bring $8 billion in support this year also cut its official call rate three times and require a number of banking and (by a total of 75 basis points) during the other reforms helped steady the situa- first half of the year. The Labor Party’s tion temporarily, but market sentiment victory in parliamentary elections in started to deteriorate again in early July. early June seemed to raise market In Argentina, the weak economy and expectations of an early U.K. euro refer- the government’s large and growing endum and put additional downward debt burden stoked market fears that pressure on sterling, but that was partly the government would default on its offset by signs of stronger inflationary debt and alter its one-for-one peg of the pressure. On balance, the pound has lost peso to the dollar. In April, spreads about 6 percent against the dollar this on Argentina’s internationally traded year, while it has strengthened against bonds moved up sharply, and interest the euro. rates spiked. In June, the government The exchange value of the Canadian completed a nearly $30 billion debt dollar has swung over a wide range in exchange with its major domestic and 2001. In the first quarter, the Canadian international creditors aimed at alleviat- dollar fell about 5 percent against the ing the government’s cash flow squeeze, U.S. dollar as the Canadian economy improving its debt amortization profile, showed signs of continuing a decelera- and giving it time to enact fiscal reforms tion of growth that had started in late and revive the economy. Argentine 2000. Exports—especially autos, auto financial conditions improved somewhat equipment, and electronic equipment— following agreement on the debt swap. suffered from weaker U.S. demand. However, this improvement proved tem- Softer global prices for non-oil com- porary, and an apparent intensification modities also appeared to put downward of market concerns about the possibility pressure on the Canadian currency. With of a debt default triggered a sharp fall in inflation well within its target range, the Argentine financial asset prices at mid- Bank of Canada cut its policy rate sev- July. This financial turbulence in Argen- eral times by a total of 125 basis points. tina negatively affected financial mar- So far this year, industries outside of kets in several other emerging market manufacturing and primary resources economies. The turmoil in Argentina appear to have been much less affected took a particular toll on Brazil, where an by external shocks, and domestic energy crisis added to other problems demand has maintained a fairly healthy that have kept growth very slow since pace. Since the end of March, the Cana- late last year. Intervention purchases of Monetary Policy Reports, July 97 the real by the Brazilian central bank Singapore, and Hong Kong, for exam- and a 300 basis point increase in its ple, fell from a 15 percent annual rate in main policy interest rate helped take late 2000 to close to zero in mid-2001. some pressure off the currency, but the The turnaround of the high-tech compo- real has declined about 24 percent so far nent of industrial production in those this year. countries was even more abrupt—from The weak performance of the Mexi- more than a 30 percent rate of increase can economy at the end of last year to a slight decline by midyear. In the caused largely by a fall in exports to Philippines and Indonesia, economic the United States (notably including a difficulties were compounded by serious sharp drop in exports of automotive political tensions. Currencies in many products) and tight monetary policy car- of these countries moved down versus ried over into early 2001. With inflation the dollar, and stock prices declined. declining, the Bank of Mexico loosened In Korea, the sharp slump in activity monetary policy in May for the first that began late last year continued into time in three years. Problems with 2001, as weakness in the external sector Mexican growth did not spill over to spread to domestic consumption and financial markets, however. The peso investment. The Bank of Korea lowered has remained strong and is up about its target interest rate a total of 50 basis 3 percent so far this year, and stock points over the first half of the year in prices have risen. response to the weakening in activity. Average growth in emerging Asia The Chinese economy, which is less slowed significantly in the first half; dependent on technology exports than GDP grew more slowly or even declined many other countries in the region, con- in economies that were more exposed to tinued to expand at a brisk pace in the the effects of the global drop in demand first half of this year, as somewhat softer for high-tech products. Average growth export demand was offset by increased of industrial production in Malaysia, government spending. 99 Domestic Open Market Operations during 2001 Implementation of in the following section. The conduct of Monetary Policy in 2001 open market operations in the aftermath of the terrorist attacks on the World The directives pertinent to the imple- Trade Center and Pentagon on Septem- mentation of domestic open market ber 11 is reviewed in the final section. operations issued by the Federal Open Market Committee (FOMC) instruct the Trading Desk at the Federal Reserve Overview of Operating Procedures Bank of New York (FRBNY) to foster to Control the Federal Funds Rate conditions in the market for reserves The FOMC lowered the federal funds consistent with maintaining the federal rate target on eleven different occasions funds rate at an average around a speci- during 2001, reducing it by a cumula- fied rate. This indicated rate is com- tive 43⁄4 percentage points to end the monly referred to as the federal funds year at a level of 13⁄4 percent (table). rate target. The Desk arranges open mar- Three of these rate changes were made ket operations to target the funds rate, between regularly scheduled FOMC while at the same time achieving cer- meetings. Associated with each FOMC tain other objectives that may affect the policy move, the Board of Governors structure of the Federal Reserve balance approved an equal-sized reduction in the sheet. basic discount rate, which preserved a This report reviews the conduct of 50 basis point spread of the target funds open market operations in 2001. It rate over the discount rate. begins with a description of the operat- To target the federal funds rate, the ing procedures that are used to control Desk uses open market operations to the funds rate and a summary of the key new developments in the policy imple- Changes in the Federal Funds Rate mentation framework. The demand for Specified in FOMC Directives balances at the Federal Reserve and the Percent behavior of autonomous factors outside the control of the Desk that affect the Date of change Target federal Associated funds rate discount rate supply of these balances are described in the following sections. Next, the dif- May 16, 2000 . . . . . . 6 1⁄ 2 6 ferent domestic financial assets held January 3, 2001 1 . . . 6 5 3⁄ 4 by the Federal Reserve, and the various (51⁄2 on Jan. 4) types of open market operations used to January 31 . . . . . . . . . 5 1⁄ 2 5 March 20 . . . . . . . . . . 5 4 1⁄ 2 adjust them, are reviewed. The behavior April 18 1 . . . . . . . . . . 4 1⁄ 2 4 May 15 . . . . . . . . . . . 4 3 1⁄ 2 of the federal funds rate in 2001 and use June 27 . . . . . . . . . . . 3 3⁄ 4 3 1⁄ 4 of the discount window are discussed August 21 . . . . . . . . . 31⁄2 3 September 17 1 . . . . . 3 21⁄ 2 October 2 . . . . . . . . . 21⁄2 2 Note. This chapter is adapted from the annual November 6 . . . . . . . 2 1 1⁄ 2 report of the Manager of the System Open Market December 11 . . . . . . 13⁄4 1 1⁄ 4 Account to the Federal Open Market Commit- tee. The original report is available at http:// 1. Policy change came between regularly scheduled www.ny.frb.org/pihome/Omo/omo2001.pdf. meetings. 100 88th Annual Report, 2001 align the supply of balances held by their holdings of balances over the days depository institutions at the Federal within a maintenance period to meet Reserve—or Fed balances—with banks’ their requirements gives them consider- demand for holding balances at the tar- able leeway in managing their accounts get rate. Each morning, the Desk consid- from day to day. This flexibility limits ers whether open market operations are the volatility in rates that can develop needed based on estimates of the supply when the Desk mis-estimates either the of and demand for balances, taking supply of or demand for balances. None- account of possible forecast errors and theless, the funds rate will firm if the minimal levels of aggregate Fed bal- level of balances falls so low that some ances that in practice are needed to banks have difficulty finding sufficient facilitate settlement of wholesale finan- funds to cover late-day deficits in their cial payments by banks. When the funds Fed accounts; the rate will soften if rate is already near its target, the Desk balances are so high that some banks aims to supply a level of balances in line risk ending a period holding undesired with its best estimate of demand. And excess balances. when the funds rate deviates from the target, the Desk may adjust the level of Fed balances it aims to supply accord- New Developments in 2001 ingly, to nudge the rate in the appro- There were no changes made to the priate direction. Operations designed FOMC’s Authorization for Domestic to alter the supply of Fed balances that Open Market Operations in 2001 same day, most commonly of a short- (appendix A). At its January meeting, term temporary nature, are typically the FOMC once again extended tempo- arranged around 9:30 a.m. eastern time rarily, through its first regularly sched- each morning, shortly after a complete uled meeting in 2002, its authorization set of estimates is available. Open mar- for an expanded pool of eligible collat- ket operations that are designed pri- eral for the Desk’s repurchase agree- marily to meet other objectives that ments (RPs). The principal effect was influence the size or composition of to continue the inclusion of pass-through the Fed’s balance sheet can generally be mortgage securities of the Government arranged at other times of the day, but National Mortgage Association, Freddie their use must be coordinated with those Mac, and Fannie Mae, and of stripped operations geared toward achieving a securities of government agencies. To particular level of Fed balances on each implement this decision, the FOMC day. voted to extend temporarily its suspen- The average level of balances banks sion of several provisions of its ‘‘Guide- demand over two-week reserve mainte- lines for the Conduct of System Open nance periods is in large measure deter- Market Operations in Federal Agency mined by certain requirements to hold Issues,’’ which impose restrictions on balances, with only a small level of transactions in federal agency securities additional, or excess, balances typically (appendix B). Late in 2001, the Desk demanded. Levels of requirements and began to accept permanently the direct period-average demands for excess are debt obligations of the Student Loan relatively insensitive to changes in the Marketing Association as collateral on target level of the federal funds rate or its repurchase transactions. only respond with some lag. The ability The Desk continued to operate under of depository institutions to average the guidelines first articulated in July Domestic Open Market Operations during 2001 101 2000 that limit the permanent holdings and, under lagged reserve accounting of single Treasury securities in the rules in effect since August 1998, System Open Market Account (SOMA) reserve balance requirements are deter- to a given share of the total outstand- mined prior to the start of each mainte- ing amount.1 These guidelines were nance period, which facilitates estima- prompted by the prospect of paydowns tion of the demand for Fed balances. of marketable debt associated with But not all as-of adjustments are known projected budget surpluses. Meanwhile, when a period starts. Most problemati- Federal Reserve staff continued work cally, when large as-of adjustments are begun in 2000 on various studies of applied or reported to the Desk on the alternative assets the Federal Reserve settlement day, it affords the Desk little might hold in its portfolio. or no opportunity to adjust its estimates of demand and its operations. Decreases in short-term interest rates Banks’ Demand for Fed Balances contributed to an increase in the under- The Desk aims to satisfy banks’ demand lying level of requirements, particularly for holding Fed balances. Total demand over the second half of the year (chart). may be viewed as the sum of two com- Falling interest rates spurred growth ponents: the portion needed to meet all in reservable deposits over the year.3 requirements, and the portion held in As a consequence, aggregate reserve excess of requirements. requirements rose above the level of banks’ applied vault cash, lifting the level of reserve balance requirements Total Balance Requirements in a sustained fashion for the first time A bank’s total balance requirement mea- since the wholesale adoption of sweep sures the level of balances it must hold programs in 1995. The reduction in at the Federal Reserve on average over interest rates also contributed to a rise a two-week maintenance period to meet in clearing balance requirements, which various regulatory obligations. Total registered their first significant increase balance requirements may be decom- in several years. With the Fed using posed into two basic parts: reserve bal- lower interest rates linked to the target ance requirements (the level of reserve funds rate to compute earning credits requirements not met with applied vault on clearing balance requirements, banks cash) and clearing balance requirements. that wish to have the maximum useful In addition, various as-of accounting adjustments may be applied that affect bank’s total balance requirements, and hence its the actual level of Fed balances a bank demand for Fed balances. In published data on must hold to meet all these require- reserves, these three variables are treated as ments.2 Clearing balance requirements sources of reserve supply. 3. At the same time, there was little further growth in new sweep account programs, which in 1. A detailed description of these guidelines the past had been a major source of decline in and their motivation can be found on the web reserve requirements. The estimated amount of site of the Federal Reserve Bank of New York demand deposits swept by commercial banks at http://www.ny.frb.org/pihome/news/announce/ through the introduction of new sweep programs 2000/an000705.html. They were also discussed in during 2001 was about $40 billion, somewhat more detail in the Domestic Open Market Opera- down from recent years and well below the peak tions report for 2000. level. A reduction in interest rates also reduces the 2. Clearing balance requirements, applied vault incentive banks have to expand sweeps to reduce cash, and as-of adjustments affect the level of a the level of their requirements. 102 88th Annual Report, 2001 Total Balance Requirements Excess Demands and and Components Actual Excess Levels Billions of dollars Period-average and daily levels of Fed balances are measured relative to the Total balance requirements 20 period-average level of requirements, to obtain measures of excess balances. 15 Demands for excess balances display fairly stable and predictable patterns that Reserve balance requirements1 10 are insensitive to the level of require- 5 ments, and the Desk must estimate these Clearing balance requirements excess demand patterns as part of esti- mating total demand for Fed balances.4 1998 1999 2000 2001 The reasons for the severe distortions Note. Maintenance period averages through Janu- to excess levels in the aftermath of the ary 9, 2002. September 11 attacks are described in 1. Reserve requirements minus applied vault cash, and less all as-of adjustments. the final section of this report. Over the last two months of the year, period-average levels of excess balances level of clearing balance requirements, became more elevated, most notably at that is, the level that generates just smaller banking institutions where posi- enough income credits to pay for all tive excess levels historically are con- covered Fed services, had room to centrated (chart). To some degree, typi- increase these requirements. Over the twelve months ending in December, the underlying level of total balance requirements rose about $5 billion, with 4. In this section, actual levels of excess bal- ances on average over time are used as an approxi- somewhat more than half coming from mation of excess demand, even though a number the higher reserve balance requirements. of factors can cause actual excess levels to deviate This aggregate increase is not large from demand on any day or for any period. when measured against the size of the Fed’s balance sheet, but it is significant as a portion of total requirements. Excess Balances Total balance requirements increased dramatically, but temporarily, in the two Billions of dollars maintenance periods ended October 17 and October 31, as a byproduct of dis- 3.0 ruptions following the September 11 2.5 attacks. Reservable deposits soared at All institutions 2.0 a handful of key money center banks 1.5 that were not able to transfer out funds 1.0 on behalf of their customers, and under Large banks .5 lagged reserve accounting rules, these + 0 institutions faced much higher reserve – requirements in October. These banks 1999 2000 2001 were able to restore their operational capabilities within days, and the higher Note. Maintenance period averages through Janu- ary 9, 2002. levels of reserve requirements were Period ended September 19, 2001, not shown (total transitory. excess, $38 billion). Domestic Open Market Operations during 2001 103 Median Levels of Excess Balances, adopt a lower target rate at its meetings by Day in a Maintenance Period during the year, most of which happened Millions of dollars to fall on the second Tuesday of a main- tenance period, which pushed demands Day of period 1998–2000 2001 for balances toward the end of these Week 1 periods. Thursday . . . . . . . . . . . . . . 725 775 Friday . . . . . . . . . . . . . . . . . −400 −1,000 Monday . . . . . . . . . . . . . . . 975 200 Tuesday . . . . . . . . . . . . . . . 675 0 Autonomous Factors Affecting Wednesday . . . . . . . . . . . . 725 0 the Supply of Fed Balances Week 2 Autonomous factors are the assets and Thursday . . . . . . . . . . . . . . 675 −475 Friday . . . . . . . . . . . . . . . . . −175 −625 liabilities on the Federal Reserve bal- Monday . . . . . . . . . . . . . . . 3,450 2,550 Tuesday . . . . . . . . . . . . . . . 2,925 4,250 ance sheet that are outside the direct Wednesday . . . . . . . . . . . . 6,075 8,150 control of the Trading Desk.6 They exclude the domestic financial assets controlled through open market opera- cal seasonal factors, the size of which tions, discount window loans, and the can vary from year to year, may account deposit balances held by depository for this late-year increase. But anec- institutions at the Fed. Federal Reserve dotal evidence also suggests that the low note liabilities represent the largest absolute level to which interest rates single autonomous factor on the Fed’s have dropped, thereby lowering the op- balance sheet by far, and for this reason portunity cost of holding excess bal- the net value (assets minus liabilities) of ances, may have contributed to the all autonomous factors has a large nega- increase. No evidence suggests that tive value; the net value of all other excess demand at larger banks has been factors is close to zero. Net movements increasing. in autonomous factors affect the supply The daily intraperiod distribution of of Fed balances, and thereby create a excess balances in 2001 continued to need for open market operations to reflect banks’ strong preference for con- change the levels of the various domes- centrating their accumulation of Fed bal- tic financial assets on the Fed’s balance ances late in a maintenance period, after sheet to offset the effects of these fac- the second weekend (table).5 The degree tors.7 The behavior of key factors in the of skew was more pronounced over this aftermath of the September 11 attacks past year, with banks typically holding is discussed in the final section of this somewhat lower levels of excess on report. most days ahead of the second weekend and larger excess balances on the settle- ment day. This greater concentration of excess accumulated on the final day was 6. Autonomous factors are defined to include encouraged by strongly held market liabilities arising from matched sale–purchase agreements arranged with foreign official insti- expectations that the FOMC would tutions as part of the foreign RP pool. The for- eign RP pool is not reported directly on the Fed’s balance sheet, but it is a factor that affects the 5. Median values are shown in table 2 because supply of Fed balances. they are less influenced than average values by the 7. In fact, the Desk retains a small degree of extreme and unrepresentative deviations from nor- discretionary influence over the levels of some mal levels of daily excess that arise from time to autonomous factors, which may be used to shape time. the need for open market operations on some days. 104 88th Annual Report, 2001 Federal Reserve Notes Changes in Federal Reserve notes expanded by Other Autonomous Factors nearly $50 billion over the year and By comparison, the change in the net were once again the largest source of value of all other autonomous factors exogenous change on the Fed’s balance was small over the year. Some huge sheet (chart).8 Federal Reserve notes temporary changes in the foreign RP outstanding increased at an 8 percent pool, Federal Reserve float, and foreign pace over the twelve-month period end- exchange holdings followed the Septem- ing in December, somewhat faster than ber 11 attacks, but most quickly returned their 63⁄4 percent average annual rate of to their pre-attack values. The greatest expansion over the preceding five-year exception was the level of the foreign interval. Lower interest rates likely RP pool, which remained elevated spurred demand for Federal Reserve throughout the fourth quarter of the year. notes in 2001 by reducing the economic Primarily as a consequence of these cost of holding non-interest-bearing higher pool levels, the net value of notes. Foreign demand also contributed autonomous factors other than Federal to faster growth late in the year, com- Reserve notes fell a bit, by roughly pounding the seasonal increase in $2 billion, over 2001. Federal Reserve notes that occurred ahead of the holidays. Unsettled eco- nomic conditions in Argentina seemed Volatility and Predictability of to stimulate demand throughout much Key Autonomous Factors of the second half of the year. Excluding the roughly two-week period following the September 11 attacks, the 8. The unusual decline in Federal Reserve notes average of the daily absolute changes over the twelve months ended in December 2000 in the net value of autonomous factors was a byproduct of the temporary bulge in Federal Reserve notes outstanding around the century date was down from the previous year, and change. same-day predictability showed a slight improvement (table). Reduced volatility in currency in circulation, which is used Net Value of All Autonomous Factors and as a proxy for Federal Reserve notes Value of Federal Reserve Notes in putting together daily forecasts of autonomous factors, mostly reflected the Billions of dollars impact of the huge swings in this factor –450 around the century date change, which All autonomous factors –475 elevated volatility in each of the two Federal –500 previous years.9 Although the foreign Reserve –525 RP pool was somewhat more volatile notes –550 –575 –600 9. Currency in circulation consists mostly of Federal Reserve notes, but it also includes about $30 billion of coins, which are liabilities of the 1998 1999 2000 2001 Treasury. In absolute terms, changes in currency Note. Net value equals assets minus liabilities. Main- in circulation almost entirely reflected movements tenance period averages through January 9, 2002. in Federal Reserve notes. Domestic Open Market Operations during 2001 105 Daily Changes and Forecast Misses in Key Autonomous Factors: Average and Maximum of Absolute Values Millions of dollars 2001 2001, 1999 2000 excluding Sept.11–28 Item Sept. 11–28 Average Maximum Average Maximum Average Maximum Average Maximum Daily change Currency in circulation . . . . . . 918 5,379 970 8,087 851 2,696 919 2,537 Treasury balance . . . . . 911 7,446 1,460 23,434 823 7,413 2,297 5,671 Foreign RP pool . . . . . . 588 6,050 485 4,015 586 3,273 3,699 7,812 Float . . . . . . . . . . . . . . . . 712 6,217 887 9,677 894 4,923 6,888 32,099 Net value . . . . . . . . . . . . 1,709 17,653 2,058 23,896 1,828 7,918 7,028 30,770 Daily forecast miss Currency in circulation . . . . . . 233 1,361 238 1,648 210 1,043 502 1,135 Treasury balance . . . . . 599 3,284 615 6,866 534 2,975 608 1,821 Foreign RP pool . . . . . . 224 1,817 129 976 81 1,127 2,070 4,966 Float . . . . . . . . . . . . . . . . 394 4,274 392 2,742 447 2,084 2,312 10,398 Net value . . . . . . . . . . . . 811 5,443 787 7,218 762 3,503 2,568 12,723 Note. Forecast misses are based on New York staff estimates. Currency in circulation is used as a proxy for Federal Reserve notes. during 2001, forecasting errors were cash balances. This helped moderate down. volatility in the Treasury’s Fed balance The Treasury’s Fed balance was by reducing the number of days on much less volatile during 2001 than it which the Fed balance jumped because was during 2000, and somewhat more of insufficient TT&L capacity, and it predictable. Over the past few years, the also may have improved indirectly the ability of the staff to forecast the Trea- ability to forecast the Treasury’s Fed sury’s Fed balance on a same-day basis balance.10 has benefited from improved methods for collecting tax payment information early each morning from around the Domestic Financial Assets on the financial system. In 2001, predictability Federal Reserve Balance Sheet was also enhanced by a new cash and Open Market Operations management technique adopted by the The total value of all domestic financial Treasury, called dynamic investing, that assets (less any matched sale–purchase enabled it to move some portion of unexpected flows arriving in its Fed 10. In 2001, the Treasury’s general cash bal- account into its Treasury tax and loan ance exceeded TT&L capacity, including Special (TT&L) accounts at commercial banks Direct Investment capacity, by more than the nor- mal level of balances placed at the Fed (usually on a same-day basis. Throughout the $5 billion) on only two days, compared with six year, TT&L capacity remained high days in 2000. The number of such occasions was relative to the level of Treasury’s total seven in 1999 and sixteen in 1998. 106 88th Annual Report, 2001 agreements arranged in the market) roughly corresponded to the increase in held by the Federal Reserve mirrors Federal Reserve note liabilities.14 the net level of autonomous factors The distribution of SOMA holdings and of Fed balances.11 More substan- by remaining maturity and across indi- tively, the behavior of various autono- vidual issues is intended to achieve vari- mous factors and of sources of demand ous objectives associated with having for Fed balances will influence the a liquid portfolio without distorting the choice of open market operations used yield curve or impairing the liquidity to adjust the Fed’s domestic financial of the market for individual Treasury portfolio.12 securities. In pursuit of these objectives, the Desk continued to adhere to the per-issue guideline limits on SOMA Permanent Holdings in the holdings of individual Treasury issues, System Open Market Account articulated in July 2000. It also contin- and Outright Open Market Activity ued to limit SOMA purchases of newly The domestic SOMA includes all the issued Treasury securities, as it has no domestic securities held on an outright particular portfolio need for some of the basis. By and large, changes in the level liquidity characteristics that can add to of the SOMA have been used to accom- the value of these issues in the market. modate net changes in autonomous factors and in demands for Fed balances that are expected to endure. For this Auction Participation reason, these holdings are often charac- and Redemptions terized as being ‘‘permanent,’’ although Typically, any needed expansion of the their net value can be reduced whenever SOMA is achieved by making outright needed. The par value of the SOMA purchases of Treasury securities in the stood at $575 billion at year-end, con- secondary market, which are then sus- sisting almost entirely of Treasury secu- tained by replacing maturing holdings rities, about $42 billion higher than with newly issued debt at Treasury auc- one year earlier.13 The expansion in tions. At Treasury auctions of coupons the SOMA in 2001, as in many years, and bills in 2001, the FRBNY continued to place add-on bids for the SOMA 11. In this report, the securities sold under tem- equal to the lesser of (1) its maturing porary matched sale–purchase agreements (MSPs) holdings on the issue date of a new as part of the foreign RP pool or in the market are security or (2) the amount that would considered financial assets held by the Fed, bring SOMA holdings as a percentage although they are not officially recorded as such on the Fed’s balance sheet. See footnote 6 for the of the issue to the percentage guideline treatment of the foreign RP pool as an autonomous limits.15 There were no issues maturing factor liability. In keeping with this treatment, in this report MSPs arranged in the market are con- sidered a financial liability arranged at the discre- 14. By comparison, the slight increase in net tion of the Desk. balance sheet liabilities from movements in other 12. Discount window activity is discussed in autonomous factors and the rise in total balance the section ‘‘The Federal Funds Rate and Discount requirements added only modestly to any need for Window Credit.’’ a ‘‘permanent’’ increase in the value of financial 13. The increase reflects almost entirely new assets in the Fed’s portfolio. purchases in excess of redemptions but also 15. Foreign add-ons, which are not known at includes a $529 million increase in the inflation the time the Desk determines its level of participa- compensation component of inflation-indexed tion at auctions, were assumed to be zero in this securities, bringing its level to $961 million. calculation. Domestic Open Market Operations during 2001 107 on dates when newly auctioned Trea- budget situation and Treasury issuance sury Inflation Indexed Securities (TIIS) patterns. Also during the year, $120 mil- settled. In cases where maturing hold- lion of holdings of Federal agency secu- ings were to be rolled into more than rities were called, which left a mere one new issue of different maturities, $10 million of agency holdings in the the Desk allocated the maturing amount SOMA at year-end. in such a way as to leave the same gap, measured in percentage points, between Secondary Market Purchases and the per-issue cap and the actual per- Operational Techniques centage holding of each new issue. A slightly different approach was taken for With redemptions again so large over the weekly bill auctions after the intro- the year as a whole and growth in Fed- duction of the new twenty-eight-day eral Reserve notes strong, the necessary bill because of the potential volatility in expansion of the SOMA required a amounts of twenty-eight-day bills auc- record value of outright purchases of tioned from week to week. The Desk Treasury securities by the Trading Desk, determined the amount of maturing bills amounting to $68.5 billion (table). There to be rolled over and its allocation on were no sales of securities. the basis of the smallest twenty-eight- About $15 billion of bills were pur- day bill auction size experienced to date, chased, and bill holdings increased by a rather than the actual auction size. significant amount for the first time in Remaining within the per-issue per- several years. Altogether, the Desk pur- centage caps while the Treasury contin- chased $8 billion of bills in the market ued to cut back on auction sizes through in four operations. Another $7 billion the first half of the year forced another were purchased directly from foreign $27 billion of redemptions of matur- central banks, in small daily increments ing Treasury holdings in 2001, roughly on days when sell orders from these equal to the previous year’s total; this accounts were available and consistent includes about $1.5 billion of maturing with SOMA portfolio guidelines.16 holdings that were redeemed because of the cancellation of a twenty-eight-day 16. The Desk sets a $250 million limit on total bill auction on September 11. Redemp- daily purchases from foreign accounts, subject tions tapered off over the year, largely as to review if reserve needs or orders warrant an a consequence of the changed federal exception. Purchases and Redemptions of Treasury Bills and Coupons Billions of dollars Item 1997 1998 1999 2000 2001 Treasury bills Purchased outright . . . . . . . . . . . . . 5.5 0 0 6.2 8.4 Purchased from internal foreign accounts . . . . . . . . . . . 3.6 3.6 0 2.5 7.1 Redemptions . . . . . . . . . . . . . . . . . . 0 −2.0 0 −23.8 −10.1 Treasury coupons Purchased outright . . . . . . . . . . . . . 35.0 26.4 45.4 35.7 53.2 Redemptions . . . . . . . . . . . . . . . . . . −2.0 −.6 −1.4 −4.1 −16.8 108 88th Annual Report, 2001 The Desk also purchased $53 billion $228 billion of marketable Treasury of coupon securities in the market, securities remained purchasable under arranging a record sixty-four coupon the Desk’s guidelines for percentage operations.17 These operations contin- holdings—compared with $260 billion ued to be segmented into separate at the end of the previous year. The tranches across different portions of the gross remaining purchasable amount yield curve to facilitate rapid execution. was $183 billion if account is taken Given the frequent need for secondary of the practices of avoiding purchases market purchases, the Desk sought to of recently issued debt, purchases that distribute its purchases evenly over time would contribute to sizable redemptions, as much as possible and did not attempt and purchases of issues that mature to concentrate operations in periods within four weeks. when Federal Reserve note growth was fastest. The selection of specific issues in Temporary Holdings and each operation was based on the rela- Open Market Operations tive attractiveness of propositions and Long-Term Repurchase Agreements portfolio considerations. In addition to remaining within the per-issue-guideline Over the past two years, long-term RPs, limits and avoiding on-the-run issues, defined as operations with an original the Desk avoided purchases that would maturity of more than fifteen days, be expected to cause a sizable redemp- have been a standard asset in the Fed’s tion on any day in the foreseeable future, domestic financial portfolio.18 Tempo- and it bought no issues in the secondary rarily increasing the total size of out- market that had less than four weeks standing long-term RPs has proved to be remaining to maturity. an effective way of addressing signifi- cant increases in the net value of autono- General Characteristics of mous factor liabilities or increases in Domestic Permanent SOMA Holdings demands for Fed balances that are at Year-End expected to last for a number of weeks or months, but not permanently. Long- The average maturity of the entire term RPs can also be adjusted readily SOMA portfolio of Treasury securities to accommodate an extended mismatch was 53.5 months at year-end, up slightly between changes in the permanent from 52.9 months one year earlier. SOMA and in levels of autonomous fac- The share of all outstanding marketable tors and total balance requirements. Treasury securities held in the SOMA During the year, the Desk adhered to was 19 percent, about a percentage point the practice of arranging an RP with a higher than a year earlier. The SOMA held 25 percent of all bills (compared with 31 percent a year ago), and 17 per- 18. The choice of any maturity to distinguish cent of all coupons including TIIS (com- long-term from short-term RPs is somewhat arbi- pared with 14 percent a year earlier). trary. Fifteen days had been the maximum allow- able maturity under the FOMC’s Authorization for At the end of the year, approximately many years until 1998, and it approximates the length of a reserve maintenance period. Fifteen days is designated to be the longest ‘‘short-term’’ 17. This total includes five TIIS operations, maturity because, as noted in this section, the RPs totaling $3.3 billion. On one day, two separate the Desk used that carried a fifteen-day maturity coupon operations were arranged. had a clear short-term operational focus. Domestic Open Market Operations during 2001 109 twenty-eight-day maturity on the Mon- Temporary Operations Outstanding day or Thursday (or both) of each Billions of dollars week.19 These operations are typically arranged early in the morning, before 60 final daily reserve estimates are avail- Long-term 50 able, as their use is not geared toward 40 addressing daily volatility in autono- Short-term 30 mous factors and excess demands. In 20 other respects, these RPs are opera- 10 tionally just like those for short-term + 0 maturities. Dealer participation in these MSPs – long-term RPs has consistently been 1999 2000 2001 very strong, measured by the size of Note. Maintenance period averages through Janu- propositions. ary 9, 2002. The sizes of the twenty-eight-day RPs arranged over the year ranged from $2 billion to $5 billion. Over most of the day volatility in autonomous factors and first half of 2001, their total outstanding in demands for Fed balances. These value stood at $12 billion, which was operations are also used to fill tempo- also the lowest outstanding total for rarily the gaps left by more-enduring the year (chart). In the third quarter, the changes in autonomous factors and Fed Desk built up their underlying level balance demands that are not immedi- modestly, but in the immediate after- ately met by changes in the permanent math of the September 11 attacks the SOMA or long-term RPs outstanding. Desk allowed two long-term RPs to Daily volatility in short-term tempo- mature without replacement, to simplify rary operations outstanding (RPs less its market involvement at the time. As MSPs), measured by the average of reserve deficiencies deepened late in the absolute daily changes in short-term year, at first when requirements bulged agreements outstanding, has been in October and then as Federal Reserve around $31⁄2 billion in each of the past notes began to grow from seasonal two years. Daily levels of net short- factors, long-term RPs were gradually term operations outstanding ranged increased, peaking at a level of $31 bil- from −$4 billion to +$81 billion; exclud- lion in the year-end maintenance period. ing the days immediately following the September 11 attacks, the peak Short-term RPs and MSPs was +$31 billion. On a period-average basis, short-term operations outstanding Short-term temporary operations, RPs ranged from $4 billion to $38 billion; and matched sale-purchases (MSPs), are excluding the two exceptionally high the primary tool used to address day-to- period-average levels that covered late September, the period-average peak was 19. This practice was first begun in March $14 billion. For the year as a whole, 2000. In January 2002, the Desk began to arrange short-term temporary operations out- these twenty-eight-day RPs just once per week, on standing averaged $10 billion. The aver- each Thursday, adjusting the size of each opera- age was closer to $8 billion excluding tion to achieve the same desired total outstanding amount. This weekly schedule will continue to the September 19 maintenance period, provide the desired flexibility to the portfolio at which was somewhat above the $5 bil- even lower operational cost. lion average outstanding level in 2000. 110 88th Annual Report, 2001 Number of Temporary Operations, by Maturity and Type Item 1998 1999 2000 2001 One business day . . . . . . . . . . . . . . . . . . . . 144 147 142 133 Term RPs up to fifteen days . . . . . . . . . . 62 83 46 85 Term RPs over fifteen days . . . . . . . . . . 3 14 61 88 One-business-day MSPs . . . . . . . . . . . . . 21 13 16 10 Term MSPs . . . . . . . . . . . . . . . . . . . . . . . . . 1 0 3 0 Volatility in autonomous factors and dates, by the time the Desk was pre- in demand for Fed balances requires the pared to arrange its short-term opera- Desk to be prepared to arrange these tions, dealers had already met a greater- operations each day, and often an over- than-normal share of their total over- lapping structure of short-term opera- night borrowing needs, in response to tions is constructed. By far the most heightened demand from their institu- common operation was an overnight RP tional customers. These cash investors (which includes all RPs that cover just had greater amounts to invest on an one business day), of which 133 were overnight basis with the dealers because arranged in 2001 (table). As usual, the the borrowers with whom they normally Fed’s portfolio continued to be struc- placed cash on a term basis were issuing tured in such a way as to keep reliance less term debt on days of expected rate on MSPs relatively low.20 cuts. In general, propositions were suffi- Also in 2001, the Desk arranged two cient to cover the intended size of the short-term RPs, an overnight operation short-term operations the Desk wished and a term agreement of up to fifteen to arrange. However, ahead of days on days, on seven different maintenance which propositions were expected to period settlement dates, usually out of run low, the Desk sometimes layered- concern that propositions on the over- in term agreements of short duration night RP alone might not be adequate to to ensure this outcome. For example, address all of the remaining period need. dealer participation on overnight RPs Given banks’ usual preference for hold- was relatively low on quarter-end dates, ing higher excess levels on settlement when high excess needs usually required dates, which was even more pronounced a large amount of short-term RPs to be in 2001, the Desk sometimes faced a outstanding. Propositions on RPs on larger remaining ‘‘add need’’ on these FOMC meeting dates in 2001 also days than it was comfortable addressing tended to be low, as a byproduct of with a single, overnight operation. The expected imminent rate cuts. On these term agreements arranged on these occa- sions were used to help meet needs in 20. One reason the Desk avoids heavy reliance the following maintenance period. on MSPs is that propositions on these operations in general are low compared with RPs, reflecting dealers’ net borrowing needs. Also, given the Collateral Distribution structure of the Fed’s balance sheet, routine reli- The Desk solicited propositions across ance on MSPs would require expanding the Fed’s holdings of financial assets above the level that is the entire pool of eligible collateral on needed to meet its net autonomous factor liabili- all RPs arranged in 2001. But with the ties and demands for Fed balances. exception of nine RPs arranged on the Domestic Open Market Operations during 2001 111 Average Annual RPs Outstanding, by Collateral Tranche Billions of dollars 2000 2001 Item Short-term RPs Long-term RPs Short-term RPs Long-term RPs Treasury . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3 7.1 4.1 8.0 Agency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.3 3.7 2.2 4.1 Mortgage-backed . . . . . . . . . . . . . . . . . . . . 1.5 5.3 3.4 4.5 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.1 16.1 9.7 16.6 days immediately following the Septem- the next. In 2001, tranches in which ber 11 attacks, all RPs were arranged as mortgage-backed securities were eli- three separate simultaneous operations gible tended to account for a somewhat differentiated by type of collateral eli- smaller share of total outstanding RPs. gible. In the first of these, only Treasury Their share on short-term RPs in 2001 debt was accepted; in the second, direct was about the same as in the previous federal agency obligations (in addition year, but only because of the large, to Treasury debt) were eligible; and in single-tranche RPs arranged in the after- the third, mortgage-backed agency debt math of September 11 (table).21 was eligible (in addition to the other two categories of debt). For the purposes of this report, these separate operations are The Federal Funds Rate and counted as different tranches of a single Discount Window Credit RP. In order to simplify the structure of its operations, for several days after Sep- The Federal Funds Rate tember 11 the Desk arranged only RPs Daily volatility in the federal funds rate with a single tranche, under which deal- and deviations of effective rates from ers had the option to deliver Treasury, target in 2001 were slightly higher than agency, or mortgage-backed collateral. in the preceding year, but still to the low All RPs arranged in 2001 settled under side of recent norms (table). Deviations the triparty agreements established with of morning funds rates from target, often two clearing banks in 1999. Under a measure of market expectations for these agreements, dealers have flexibil- likely rate behavior later in the day, con- ity to choose, and to change from day to tinued to show the kinds of recurring day, the specific securities they deliver patterns associated with certain calen- within each tranche. dar events seen in previous years. The The distribution of accepted propo- deviations of the morning rate from tar- sitions across collateral categories on get on high-payment-flow days and on multi-tranche RPs was determined by Fridays were a touch smaller than in the relative attractiveness of rates in past years. However, morning premiums each tranche benchmarked against cur- rent market financing rates for that class of collateral. Distributions of collateral 21. These tranches reflect options that dealers have for delivering different categories of collat- by tranche on outstanding RPs tend eral on outstanding RPs where, for example, a to be reasonably stable, but they can dealer has the option to deliver Treasury debt on be very volatile from one operation to agency RPs but not vice versa. 112 88th Annual Report, 2001 Federal Funds Rate Behaviors: Medians and Averages of Daily Values Basis points Item 1998 1999 2000 2001 Deviations of effective rate from target Median . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 −1 1 0 Average . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 −1 2 −1 Absolute deviations of effective rate from target Median . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 7 4 5 Average . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 11 7 9 Intraday standard deviations Median . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 9 6 7 Medians of morning rates less target rate on High-payment-flow days (excluding quarter-ends) . . . . 25 19 19 16 Fridays . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . −6 −6 −6 −3 Maintenance period settlement days . . . . . . . . . . . . . . . . . 13 0 0 6 on maintenance period settlement days, credit is seasonal borrowing, which which had been common in the past behaviorally is more akin to an autono- but which had largely disappeared over mous factor in terms of its implications the preceding couple of years, were for open market operations.22 Adjust- again evident in 2001, averaging around ment credit is typically quite small, but 6 basis points. The higher levels of the existence of the adjustment credit excess reserves that had to be accumu- facility is an important part of the mone- lated on the final day to meet require- tary policy implementation framework. ments in 2001 may have contributed It acts as a stabilizer, moderating the to funding anxieties of bank reserve upward movements in the federal funds managers. rate in the event a shortage of Fed bal- ances leaves a bank overdrawn on its Fed account at the end of any day or Discount Window Credit deficient in meeting its requirements on Discount window credit makes up a a maintenance period settlement day. relatively small portion of the total domestic financial assets held by the 22. There were no instances of extended credit Federal Reserve (table). Much of this borrowing at the discount window. Discount Window Borrowing Activity 2001 Item 1998 1999 2000 2001 excluding Sept. 11–13 Average daily amount outstanding (millions of dollars) Seasonal credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 127 258 73 73 Adjustment credit . . . . . . . . . . . . . . . . . . . . . . . . . . 66 95 108 319 77 Number of days on which total adjustment borrowing by large banks More than $100 million–$500 million . . . . . . . 23 17 12 10 10 More than $500 million . . . . . . . . . . . . . . . . . . . . 10 13 14 11 8 Domestic Open Market Operations during 2001 113 The critical role of the adjustment credit night basis. Communications disruptions facility during times of severe stress in prevented many borrowers from having financing markets is highlighted by the normal access to their investor base for discussion in the following section of its the first few days after September 11, use immediately following the Septem- even among those not directly affected ber 11 attacks. For meeting more-routine by the attacks, and the impaired ability reserve shortfalls and payments difficul- of a major clearing bank to process ties, even levels of adjustment borrow- funds and securities transfers for itself ing that are small relative to the total and on behalf of its customers created supply of Fed balances can help allevi- additional uncertainties. Banks and deal- ate the degree of upward rate pressure ers, uncertain about their general cash that can develop in the market. position or the availability of financing, Large banks as a group borrowed an tended to refrain from making cash out- amount in excess of $500 million on lays until later than normal in the day. eleven different days in 2001, including In the federal funds market, several of three occasions coming in the imme- the major brokers ceased operations for diate aftermath of the September 11 a time, and many large banks resorted attacks. This total is in line with the to arranging trades directly with one number of occasions banks borrowed another. Although not fully back to nor- at least that much in the preceding mal levels of operating efficiency, the three years. Large banks borrowed a payments and communications infra- somewhat smaller but still significant structure most critical to the functioning amount, in excess of $100 million, on of the financing market had recovered another ten occasions in 2001, but this considerably by Monday, September 17, number was somewhat below the fre- and participation levels were much quency in most other recent years. improved. The Conduct of Monetary Behavior of Autonomous Factors Operations after September 11 Levels of several of the autonomous fac- This section presents an overview of the tors on the Fed’s balance sheet were context and conduct of open market dramatically affected by some of the operations in the aftermath of the ter- responses to the World Trade Center rorist attacks on the World Trade Cen- and Pentagon attacks. Over the three- ter and Pentagon on Tuesday, Septem- day interval September 12 through ber 11. September 14 (Wednesday through Fri- day), net autonomous factor movements increased the supply of Fed balances General Financing Market dramatically, and then net factor move- Conditions ments began to drain large quantities. Immediately following the attacks, The level of float in the banking system, many financial markets effectively normally around $1 billion, peaked at ceased operations. But with Fedwire $47 billion on that Thursday as a result and other wholesale payments networks of the temporary curtailment of air traf- remaining open, securities dealers and fic nationwide. Another $20 billion of banks faced a continuing need to obtain Fed balances was created that day when funding for large pre-existing positions the European Central Bank drew on a that they typically finance on an over- temporary foreign currency swap line 114 88th Annual Report, 2001 that had just been established. Mean- demands for financing far surpassed any while, investments in the foreign RP need to arrange operations simply to pool jumped between $15 billion and provide an aggregate level of Fed bal- $20 billion above recent norms, reduc- ances that would help banks meet their ing the supply of Fed balances. The requirements or their desired end-of-day factors that were adding to the supply holdings of balances at the Fed. To more of Fed balances returned to something effectively serve as a source of financ- like normal levels by Monday, Septem- ing of last resort and to help encourage ber 17, but persistent high levels of the dealers to continue to intermediate on pool began to leave large underlying behalf of some of their own customers, deficiencies. the Desk operated relatively late in the day, after dealers had a good opportu- nity to assess their full financing needs Federal Reserve Monetary and to secure all available financing in Operations, and the Level and the market. Distribution of Fed Balances The size of the overnight RPs, On the morning of September 11, the which typically may be around $3 bil- Federal Reserve issued a public release lion, peaked on Thursday and Friday at stating, ‘‘The Federal Reserve System $70 billion and $81 billion, respectively, is open and operating. The discount the same days that autonomous factors window is available to meet liquidity also added the most to the supply of Fed needs,’’ to encourage banks to view the balances. Before discount window bor- discount window as a source of liquid- rowing, Fed balances on both those days ity. September 11 fell in the middle of topped $110 billion, and, in general, Fed the maintenance period ended Septem- balances before borrowing were extraor- ber 19; for the remainder of that period, dinarily elevated from Wednesday the Desk arranged only overnight RPs through Monday (chart). But even with for same-day settlement because of the such high levels of Fed balances, severe high degree of volatility in the needed dislocations that interfered with their level of RPs outstanding from one day distribution in the first few days after to the next. From Wednesday through the follow- ing Monday, the sizes of open market Total Federal Reserve Balances operations were aimed at satisfying all around September 11 the financing that dealers wished to arrange with the Desk, in order to miti- Billions of dollars gate to the extent possible the disrup- Nonborrowed tions to normal trading and settlement balances 100 arrangements.23 On these four days, all propositions with rates at or above the 80 prevailing target were accepted, which Borrowed 60 was the vast majority. Dealers’ total balances 40 20 23. The RP on September 12 was arranged from the FRBNY’s Main Building. Subsequent operations were arranged out of the contingency 9/5 9/11 9/17 9/19 10/3 site at the Bank’s East Rutherford Operations Note. Vertical dashed lines separate reserve mainte- Center. nance periods. Domestic Open Market Operations during 2001 115 the attacks caused many banks to bor- In part to simplify the nature of our row at the discount window to cover direct market involvement under exi- overdraft positions. As a result, levels of gent circumstances, from September 11 adjustment borrowing soared to record through the remainder of the mainte- levels on Tuesday and Wednesday. nance period under way, the Desk did By the final days of the maintenance not replace any of its maturing long- period, after financing markets began to term RPs, and it arranged no outright function more normally, the Desk aimed operations. On the settlement day, its operations at maintaining a more the Desk arranged three term RPs that traditional balance between the supply settled on a forward basis on the first of and demand for Fed balances, consis- day of the following maintenance tent with the federal funds rate trading period, totaling $23 billion, in order to around the target level, lowered to 3 per- reduce the level of intervention that cent on September 17. With cumula- would be needed in financing mar- tive excess positions so high and with kets in upcoming days. Other changes financing rates generally quite low, were also made to simplify operations. reflecting the weight of these excess Instead of differentiating between collat- positions, the Desk was aiming to leave eral types, each RP was arranged as a relatively low levels of Fed balances single tranche where dealers had the in place each day. The size of the RPs option to deliver any of the three catego- needed to provide even these relatively ries of collateral. Because some dealers low levels of balances remained large lacked connectivity at their contingency for a time, reflecting the impact of sites, the Desk operated in a semi- autonomous factors that were now manual mode, inputting propositions for reducing the supply of Fed balances many dealers (although the automated below normal levels. As dealers increas- trade processing system continued to ingly were able to communicate with operate uninterrupted). Because of the and obtain financing from their usual time required to establish voice commu- customers, the Desk had to move up nications with dealers lacking electronic its operating time to ensure a suffi- connections and the time needed to cient level of participation for the receive bids by phone, the time between large RPs that were still needed, and when an operation was first announced it had to accept the vast majority of and when it was closed was lengthened, propositions—even those offered at and the Desk often pre-announced its rates well below the new 3 percent tar- time frame for operating. get level—in order to arrange RPs of sufficient size. Even with the low levels of excess Financing Rate Behavior provided late in the maintenance period, From Tuesday, September 11, through the average level of excess balances most of Thursday, September 13, mar- for the period ended September 19 was ket participants in both the government $38 billion. This excess was highly con- securities RP markets and in the federal centrated at a small number of institu- funds market simply priced their trades tions that accumulated high balances as at the target funds rate, a response to the a result of an inability to make payments attacks that likely helped maintain some or to sell funds in the first days after the order in these markets. The high levels attacks, and it did not reflect any desire of excess balances provided through the to hold huge excess balances. Desk’s RPs first began to weigh heavily 116 88th Annual Report, 2001 Federal Funds Rates around September 11 zation in effect at the end of 2001 is reprinted below. Percentage points Target rate Authorization for Domestic 3 Open Market Operations 1. The Federal Open Market Committee Effective authorizes and directs the Federal Reserve rate 2 Bank of New York, to the extent neces- sary to carry out the most recent domestic policy directive adopted at a meeting of the Committee: 9/5 9/11 9/17 9/19 10/3 (a) To buy or sell U.S. Government Note. Vertical dashed lines separate reserve mainte- securities, including securities of the Federal nance periods. Financing Bank, and securities that are direct obligations of, or fully guaranteed as to principal and interest by, any agency of the United States in the open market, from or on the funds rate during late trading on to securities dealers and foreign and inter- Thursday and again on Friday, although national accounts maintained at the Federal through Monday, September 17, morn- Reserve Bank of New York, on a cash, regu- ing rates generally reverted back to lar, or deferred delivery basis, for the System Open Market Account at market prices, and, the target (chart). Thereafter, extremely for such Account, to exchange maturing U.S. low rates prevailed in the funds and RP Government and Federal agency securities markets for several days, falling even with the Treasury or the individual agencies below 1 percent. These low rates in or to allow them to mature without replace- large measure reflected misperceptions ment; provided that the aggregate amount of U.S. Government and Federal agency securi- that the Desk was continuing to provide ties held in such Account (including forward high levels of balances, a view rein- commitments) at the close of business on the forced by the continuing large sizes day of a meeting of the Committee at which of the RPs and widespread reports that action is taken with respect to a domestic were crediting the Desk with providing policy directive shall not be increased or abundant liquidity to the market. Sev- decreased by more than $12.0 billion during the period commencing with the opening of eral episodes of rates being pushed business on the day following such meeting higher in late-day trading, induced by and ending with the close of business on the the relatively low levels of Fed balances day of the next such meeting; the Desk was leaving in place, were (b) To buy U.S. Government securities, needed to nullify these perceptions and obligations that are direct obligations of, or to bring the funds rate back up closer to fully guaranteed as to principal and interest the target. by, any agency of the United States, from dealers for the account of the Federal Reserve Bank of New York under agree- ments for repurchase of such securities or Appendix A: obligations in 65 business days or less, at Authorization for Domestic rates that, unless otherwise expressly autho- Open Market Operations rized by the Committee, shall be determined by competitive bidding, after applying rea- Open market operations were conducted sonable limitations on the volume of agree- under the Authorization for Domestic ments with individual dealers; provided that Open Market Operations. The Authori- in the event Government securities or agency Domestic Open Market Operations during 2001 117 issues covered by any such agreement are imposed on purchases and sales of securities not repurchased by the dealer pursuant to the in paragraph 1(b), repurchase agreements in agreement or a renewal thereof, they shall be U.S. Government and agency securities, and sold in the market or transferred to the Sys- to arrange corresponding sale and repurchase tem Open Market Account. agreements between its own account and foreign and international accounts main- (c) To sell U.S. Government securities tained at the Bank. Transactions undertaken that are direct obligations of, or fully guar- with such accounts under the provisions of anteed as to principal and interest by, any this paragraph may provide for a service fee agency of the United States to dealers for when appropriate. System Open Market Account under agree- ments for the resale by dealers of such secu- 4. In the execution of the Committee’s rities or obligations in 65 business days or decision regarding policy during any inter- less, at rates that, unless otherwise expressly meeting period, the Committee authorizes authorized by the Committee, shall be deter- and directs the Federal Reserve Bank of mined by competitive bidding, after apply- New York, upon the instruction of the Chair- ing reasonable limitations on the volume of man of the Committee, to adjust somewhat agreements with individuals dealers. in exceptional circumstances the degree of pressure on reserve positions and hence the 2. In order to ensure the effective conduct intended federal funds rate. Any such adjust- of open market operations, the Federal Open ment shall be made in the context of the Market Committee authorizes the Federal Committee’s discussion and decision at its Reserve Bank of New York to lend on an most recent meeting and the Committee’s overnight basis U.S. Government securities long-run objectives for price stability and held in the System Open Market Account to sustainable economic growth, and shall be dealers at rates that shall be determined by based on economic, financial, and mone- competitive bidding but that in no event shall tary developments during the intermeeting be less than 1.0 percent per annum of the period. Consistent with Committee prac- market value of the securities lent. The Fed- tice, the Chairman, if feasible, will consult eral Reserve Bank of New York shall apply with the Committee before making any reasonable limitations on the total amount of adjustment. a specific issue that may be auctioned and on the amount of securities that each dealer may borrow. The Federal Reserve Bank of New Appendix B: York may reject bids which could facilitate Guidelines for the Conduct of a dealer’s ability to control a single issue System Open Market Operations as determined solely by the Federal Reserve in Federal Agency Issues Bank of New York. The FOMC has established specific 3. In order to ensure the effective conduct guidelines for operations in agency of open market operations, while assisting in the provision of short-term investments securities to ensure that Federal Reserve for foreign and international accounts main- operations do not have undue market tained at the Federal Reserve Bank of New effects and do not serve to support York, the Federal Open Market Committee individual issuers. Provisions 3–6 of authorizes and directs the Federal Reserve the guidelines were first temporarily Bank of New York (a) for System Open Market Account, to sell U.S. Government suspended in August 1999, in order to securities to such foreign and international expand the types of agency securities accounts on the bases set forth in para- the Desk could accept in its operations graph 1(a) under agreements providing for around the century date change. This the resale by such accounts of those securi- suspension was extended in March ties in 65 business days or less on terms 2000, in light of anticipated paydowns comparable to those available on such trans- actions in the market; and (b) for New York of federal debt, and it was reaffirmed in Bank account, when appropriate, to under- January 2001 until the FOMC’s first take with dealers, subject to the conditions meeting in 2002. 118 88th Annual Report, 2001 Guidelines for the Conduct of 4. Purchases will be limited to fully tax- System Open Market Operations able issues not eligible for purchase by the Federal Financing Bank, for which there is in Federal Agency Issues an active secondary market. Purchases will 1. System open market operations in Fed- also be limited to issues outstanding in eral agency issues are an integral part of total amounts of $300 million or over in cases System open market operations designed to where the obligations have maturity of five influence bank reserves, money market con- years or less at the time of issuance, and to ditions, and monetary aggregates. issues outstanding in amounts of $200 mil- lion or over in cases where the securities 2. System open market operations in Fed- have a maturity of more than five years at eral agency issues are not designed to sup- the time of issuance. port individual sectors of the market or 5. System holdings of any one issue at to channel funds into issues of particular any one time will not exceed 30 percent of agencies. the amount of the issue outstanding. Aggre- gate holdings of the issues of any one agency 3. System holdings of agency issues shall will not exceed 15 percent of the amount of be modest relative to holdings of U.S. Gov- outstanding issues of that agency. ernment securities, and the amount and tim- ing of System transactions in agency issues 6. All outright purchases, sales, and hold- shall be determined with due regard for the ings of agency issues will be for the System desirability of avoiding undue market effects. Open Market Account.
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