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Monetary Policy and Economic Developments

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					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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