Monetary Policy and the Economic Outlook
The U.S. economy posted another exceptional performance in
1999. The ongoing expansion appears to have maintained
strength into early 2000 as it set a record for longevity,
and--aside from the direct effects of higher crude oil
prices--inflation has remained subdued, in marked contrast to the
typical experience during previous expansions. The past year
brought additional evidence that productivity growth has
improved substantially since the mid-1990s, boosting living
standards while helping to hold down increases in costs and
prices despite very tight labor markets.
The Federal Open Market Committee's pursuit of financial
conditions consistent with sustained expansion and low inflation
has required some adjustments to the settings of monetary policy
instruments over the past two years. In late 1998, to cushion the
U.S. economy from the effects of disruptions in world financial
markets and to ameliorate some of the resulting strains, money
market conditions were eased. By the middle of last year,
however, with financial markets resuming normal functioning,
foreign economies recovering, and domestic demand continuing
to outpace increases in productive potential, the Committee
began to reverse that easing.
As the year progressed, foreign economies, in general, recovered
more quickly and displayed greater vigor than had seemed likely
at the start of the year. Domestically, the rapid productivity
growth raised expectations of future incomes and profits and
thereby helped keep spending moving up at a faster clip than
current productive capacity. Meanwhile, prices of most
internationally traded materials rebounded from their earlier
declines; this turnaround, together with a flattening of the
exchange value of the dollar after its earlier appreciation,
translated into an easing of downward pressure on the prices of
imports in general. Core inflation measures generally remained
low, but with the labor market at its tightest in three decades and
becoming tighter, the risk that pressures on costs and prices
would eventually emerge mounted over the course of the year.
To maintain the low-inflation environment that has been so
important to the sustained health of the current expansion, the
FOMC ultimately implemented four quarter-point increases in the
intended federal funds rate, the most recent of which came at the
beginning of this month. In total, the federal funds rate has been
raised 1 percentage point, although, at 5-3/4 percent, it stands
only 1/4 point above its level just before the autumn-1998
financial market turmoil. At its most recent meeting, the FOMC
indicated that risks appear to remain on the side of heightened
inflation pressures, so it will need to remain especially attentive
to developments in this regard.
Monetary Policy, Financial Markets, and the Economy over 1999
and Early 2000
The first quarter of 1999 saw a further unwinding of the
heightened levels of perceived risk and risk aversion that had
afflicted financial markets in the autumn of 1998; investors
became much more willing to advance funds, securities issuance
picked up, and risk spreads fell further--though not back to the
unusually low levels of the first half of 1998. At the same time,
domestic demand remained quite strong, and foreign economies
showed signs of rebounding. The FOMC concluded at its
February and March meetings that, if these trends were to
persist, the risks of the eventual emergence of somewhat greater
inflation pressures would increase, and it noted that a case could
be made for unwinding part of the easing actions of the
preceding fall. However, the Committee hesitated to adjust policy
before having greater assurance that the recoveries in domestic
financial markets and foreign economies were on firm footing.
By the May meeting, these recoveries were solidifying, and the
pace of domestic spending appeared to be outstripping the
growth of the economy's potential, even allowing for an
appreciable acceleration in productivity. The Committee still
expected some slowing in the expansion of aggregate demand,
but the timing and extent of any moderation remained uncertain.
Against this backdrop, the FOMC maintained an unchanged
policy stance but announced immediately after the meeting that it
had chosen a directive tilted toward the possibility of a firming
of rates. This announcement implemented the disclosure policy
adopted in December 1998, whereby major shifts in the
Committee's views about the balance of risks or the likely
direction of future policy would be made public immediately.
Members expected that, by making the FOMC's concerns public
earlier, such announcements would encourage financial market
reactions to subsequent information that would help stabilize the
economy. In practice, however, those reactions seemed to be
exaggerated and to focus even more than usual on possible
near-term Committee action.
Over subsequent weeks, economic activity continued to expand
vigorously, labor markets remained very tight, and oil and other
commodity prices rose further. In this environment, the FOMC
saw an updrift in inflation as a significant risk in the absence of
some policy firming, and at the June meeting it raised the
intended level of the federal funds rate 1/4 percentage point. The
Committee also announced a symmetric directive, noting that the
marked degree of uncertainty about the extent and timing of
prospective inflationary pressures meant that further firming of
policy might not be undertaken in the near term, but that the
Committee would need to be especially alert to emerging
inflation pressures. Markets rallied on the symmetric-directive
announcement, and the strength of this response together with
market commentary suggested uncertainty about the
interpretation of the language used to characterize possible future
developments and about the time period to which the directive
applied.
In the period between the June and August meetings, the
ongoing strength of domestic demand and further expansion
abroad suggested that at least part of the remaining easing put in
place the previous fall to deal with financial market stresses was
no longer needed. Consequently, at the August meeting the
FOMC raised the intended level of the federal funds rate a
further 1/4 percentage point, to 5-1/4 percent. The Committee
agreed that this action, along with that taken in June, would
substantially reduce inflation risks and again announced a
symmetric directive. In a related action, the Board of Governors
approved an increase in the discount rate to 4-3/4 percent. At
this meeting the Committee also established a working group to
assess the FOMC's approach to disclosing its view about
prospective developments and to propose procedural
modifications.
At its August meeting, the FOMC took a number of actions that
were aimed at enhancing the ability of the Manager of the
System Open Market Account to counter potential liquidity
strains in the period around the century date change and that
would also help ensure the effective implementation of the
Committee's monetary policy objectives. Although members
believed that efforts to prepare computer systems for the century
date change had made the probability of significant disruptions
quite small, some aversion to Y2K risk exposure was already
evident in the markets, and the costs that might stem from a
dysfunctional financing market at year-end were deemed to be
unacceptably high. The FOMC agreed to authorize, temporarily,
(1) a widening of the pool of collateral that could be accepted in
System open market transactions, (2) the use of reverse
repurchase agreement accounting in addition to the currently
available matched sale-purchase transactions to absorb reserves
temporarily, and (3) the auction of options on repurchase
agreements, reverse repurchase agreements, and matched
sale-purchase transactions that could be exercised in the period
around year-end. The Committee also authorized a permanent
extension of the maximum maturity on regular repurchase and
matched sale-purchase transactions from sixty to ninety days.
The broader range of collateral approved for repurchase
transactions--mainly pass-through mortgage securities of
government-sponsored enterprises and STRIP securities of the
U.S. Treasury--would facilitate the Manager's task of addressing
what could be very large needs to supply reserves in the
succeeding months, primarily in response to rapid increases in
the demand for currency, at a time of potentially heightened
demand in various markets for U.S. government securities. The
standby financing facility, authorizing the Federal Reserve Bank
of New York to auction the above-mentioned options to the
government securities dealers that are regular counterparties in
the System's open market operations, would encourage
marketmaking and the maintenance of liquid financing markets
essential to effective open market operations. The standby
facility was also viewed as a useful complement to the special
liquidity facility, which was to provide sound depository
institutions with unrestricted access to the discount window, at a
penalty rate, between October 1999 and April 2000. Finally, the
decision to extend the maximum maturity on repurchase and
matched sale-purchase transactions was intended to bring the
terms of such transactions into conformance with market practice
and to enhance the Manager's ability over the following months
to implement the unusually large reserve operations expected to
be required around the turn of the year.
Incoming information during the period leading up to the
FOMC's October meeting suggested that the growth of domestic
economic activity had picked up from the second quarter's pace,
and foreign economies appeared to be strengthening more than
had been anticipated, potentially adding pressure to already-taut
labor markets and possibly creating inflationary imbalances that
would undermine economic performance. But the FOMC viewed
the risk of a significant increase in inflation in the near term as
small and decided to await more evidence on how the economy
was responding to its previous tightenings before changing its
policy stance. However, the Committee anticipated that the
evidence might well signal the need for additional tightening,
and it again announced a directive that was biased toward
restraint.
Information available through mid-November pointed toward
robust growth in overall economic activity and a further
depletion of the pool of unemployed workers willing to take a
job. Although higher real interest rates appeared to have induced
some softening in interest-sensitive sectors of the economy, the
anticipated moderation in the growth of aggregate demand did
not appear sufficient to avoid added pressures on resources,
predominantly labor. These conditions, along with further
increases in oil and other commodity prices, suggested a
significant risk that inflation would pick up over time, given
prevailing financial conditions. Against this backdrop, the FOMC
raised the target for the federal funds rate an additional 1/4
percentage point in November. At that time, a symmetric
directive was adopted, consistent with the Committee's
expectation that no further policy move was likely to be
considered before the February meeting. In a related action, the
Board of Governors approved an increase in the discount rate of
1/4 percentage point, to 5 percent.
At the December meeting, FOMC members held the stance of
policy unchanged and, to avoid any misinterpretation of policy
intentions that might unsettle financial markets around the
century date change, announced a symmetric directive. But the
statement issued after the meeting also highlighted members'
continuing concern about inflation risks going forward and
indicated the Committee's intention to evaluate, as soon as its
next meeting, whether those risks suggested that further
tightening was appropriate.
The FOMC also decided on some modifications to its disclosure
procedures at the December meeting, at which the working group
mentioned above transmitted its final report and proposals. These
modifications, announced in January 2000, consisted primarily of
a plan to issue a statement after every FOMC meeting that not
only would convey the current stance of policy but also would
categorize risks to the outlook as either weighted mainly toward
conditions that may generate heightened inflation pressures,
weighted mainly toward conditions that may generate economic
weakness, or balanced with respect to the goals of maximum
employment and stable prices over the foreseeable future. The
changes eliminated uncertainty about the circumstances under
which an announcement would be made; they clarified that the
Committee's statement about future prospects extended beyond
the intermeeting period; and they characterized the Committee's
views about future developments in a way that reflected policy
discussions and that members hoped would be more helpful to
the public and to financial markets.
Financial markets and the economy came through the century
date change smoothly. By the February 2000 meeting, there was
little evidence that demand was coming into line with potential
supply, and the risks of inflationary imbalances appeared to have
risen. At the meeting, the FOMC raised its target for the federal
funds rate 1/4 percentage point to 5-3/4 percent, and
characterized the risks as remaining on the side of higher
inflation pressures. In a related action, the Board of Governors
approved a 1/4 percentage point increase in the discount rate, to
5-1/4 percent.
Economic Projections for 2000
The members of the Board of Governors and the Federal
Reserve Bank presidents, all of whom participate in the
deliberations of the FOMC, expect to see another year of
favorable economic performance in 2000, although the risk of
higher inflation will need to be watched especially carefully. The
central tendency of the FOMC participants' forecasts of real GDP
growth from the fourth quarter of 1999 to the fourth quarter of
2000 is 3-1/2 percent to 3-3/4 percent. A substantial part of the
gain in output will likely come from further increases in
productivity. Nonetheless, economic expansion at the pace that is
anticipated should create enough new jobs to keep the
unemployment rate in a range of 4 percent to 4-1/4 percent,
close to its recent average. The central tendency of the FOMC
participants' inflation forecasts for 2000--as measured by the
chain-type price index for personal consumption expenditures--is
1-3/4 percent to 2 percent, a range that runs a little to the low
side of the energy-led 2 percent rise posted in 1999.\1 Even
though futures markets suggest that energy prices may turn down
later this year, prices elsewhere in the economy could be pushed
upward by a combination of factors, including reduced restraint
from non-oil import prices, wage and price pressures associated
with lagged effects of the past year's oil price rise, and larger
increases in costs that might be forthcoming in another year of
tight labor markets.
The performance of the economy--both the rate of real growth
and the rate of inflation--will depend importantly on the course
of productivity. Typically, in past business expansions, gains in
labor productivity eventually slowed as rising demand placed
increased pressure on plant capacity and on the workforce, and a
similar slowdown from the recent rapid pace of productivity gain
cannot be ruled out. But with many firms still in the process of
implementing technologies that have proved effective in
reorganizing internal operations or in gaining speedier access to
outside resources and markets, and with the technologies
themselves still advancing rapidly, a further rise in productivity
growth from the average pace of recent years also is possible. To
the extent that rapid productivity growth can be maintained,
aggregate supply can grow faster than would otherwise be
possible.
However, the economic processes that are giving rise to faster
productivity growth not only are lifting aggregate supply but also
are influencing the growth of aggregate spending. With firms
perceiving abundant profit opportunities in
productivity-enhancing high-tech applications, investment in new
equipment has been surging and could well continue to rise
rapidly for some time. Moreover, expectations that the
investment in new technologies will generate high returns have
been lifting the stock market and, in turn, helping to maintain
consumer spending at a pace in excess of the current growth of
real disposable income. Impetus to demand from this source also
could persist for a while longer, given the current high levels of
consumer confidence and the likely lagged effects of the large
increments to household wealth registered to date. The boost to
aggregate demand from the marked pickup in productivity
growth implies that the level of interest rates needed to align
demand with potential supply may have increased substantially.
Although the recent rise in interest rates may lead to some
slowing of spending, aggregate demand may well continue to
outpace gains in potential output over the near term, an
imbalance that contains the seeds of rising inflationary and
financial pressures that could undermine the expansion.
In recent years, domestic spending has been able to grow faster
than production without engendering inflation partly because the
external sector has provided a safety valve, helping to relieve the
pressures on domestic resources. In particular, the rapid growth
of demand has been met in part by huge increases in imports of
goods and services, and sluggishness in foreign economies has
restrained the growth of exports. However, foreign economies
have been firming, and if recovery of these economies stays on
course, U.S. exports should increase faster than they have in the
past couple of years. Moreover, the rapid rise of the real
exchange value of the dollar through mid-1998 has since given
way to greater stability, on average, and the tendency of the
earlier appreciation to limit export growth and boost import
growth is now diminishing. From one perspective, these external
adjustments are welcome because they will help slow the recent
rapid rates of decline in net exports and the current account.
They also should give a boost to industries that have been hurt
by the export slump, such as agriculture and some parts of
manufacturing. At the same time, however, the adjustments are
likely to add to the risk of an upturn in the inflation trend,
because a strengthening of exports will add to the pressures on
U.S. resources and a firming of the prices of non-oil imports will
raise costs directly and also reduce to some degree the
competitive restraints on the prices of U.S. producers.
Domestically, substantial plant capacity is still available in some
manufacturing industries and could continue to exert restraint on
firms' pricing decisions, even with a diminution of competitive
pressures from abroad. However, an already tight domestic labor
market has tightened still further in recent months, and bidding
for workers, together with further increases in health insurance
costs that appear to be coming, seems likely to keep nominal
hourly compensation costs moving up at a relatively brisk pace.
To date, the increases in compensation have not had serious
inflationary consequences because they have been offset by the
advances in labor productivity, which have held unit labor costs
in check. But the pool of available workers cannot continue to
shrink without at some point touching off cost pressures that
even a favorable productivity trend might not be able to counter.
Although the governors and Reserve Bank presidents expect
productivity gains to be substantial again this year, incoming
data on costs, prices, and price expectations will be examined
carefully to make sure a pickup of inflation does not start to
become embedded in the economy.
The FOMC forecasts are more optimistic than the economic
predictions that the Administration recently released, but the
Administration has noted that it is being conservative in regard
to its assumptions about productivity growth and the potential
expansion of the economy. Relative to the Administration's
forecast, the FOMC is predicting a somewhat larger rise in real
GDP in 2000 and a slightly lower unemployment rate. The
inflation forecasts are fairly similar, once account is taken of the
tendency for the consumer price index to rise more rapidly than
the chain-type price index for personal consumption
expenditures.
Money and Debt Ranges for 2000
At its most recent meeting, the FOMC reaffirmed the monetary
growth ranges for 2000 that were chosen on a provisional basis
last July: 1 percent to 5 percent for M2, and 2 percent to 6
percent for M3. As has been the case for some time, these
ranges were chosen to encompass money growth under
conditions of price stability and historical velocity relationships,
rather than to center on the expected growth of money over the
coming year or serve as guides to policy.
Given continued uncertainty about movements in the velocities
of M2 and M3 (the ratios of nominal GDP to the aggregates),
the Committee still has little confidence that money growth
within any particular range selected for the year would be
associated with the economic performance it expected or desired.
Nonetheless, the Committee believes that money growth has
some value as an economic indicator, and it will continue to
monitor the monetary aggregates among a wide variety of
economic and financial data to inform its policy deliberations.
M2 increased 6-1/4 percent last year. With nominal GDP rising 6
percent, M2 velocity fell a bit overall, although it rose in the
final two quarters of the year as market interest rates climbed
relative to yields on M2 assets. Further increases in market
interest rates early this year could continue to elevate M2
velocity. Nevertheless, given the Committee's expectations for
nominal GDP growth, M2 could still be above the upper end of
its range in 2000.
M3 expanded 7-1/2 percent last year, and its velocity fell about
1-3/4 percent, a much smaller drop than in the previous year.
Non-M2 components again exhibited double-digit growth, with
some of the strength attributable to long-term trends and some to
precautionary buildups of liquidity in advance of the century date
change. One important trend is the shift by nonfinancial
businesses from direct holdings of money market instruments to
indirect holdings through institution-only money funds; such
shifts boost M3 at the same time they enhance liquidity for
businesses. Money market funds and large certificates of deposit
also ballooned late in the year as a result of a substantial demand
for liquidity around the century date change. Adjustments from
the temporarily elevated level of M3 at the end of 1999 are
likely to trim that aggregate's fourth-quarter-to-fourth-quarter
growth this year, but not sufficiently to offset the downward
trend in velocity. That trend, together with the Committee's
expectation for nominal GDP growth, will probably keep M3
above the top end of its range again this year.
Domestic nonfinancial debt grew 6-1/2 percent in 1999, near the
upper end of the 3 percent to 7 percent growth range the
Committee established last February. This robust growth
reflected large increases in the debt of businesses and households
that were due to substantial advances in spending as well as to
debt-financed mergers and acquisitions. However, the increase in
private-sector debt was partly offset by a substantial decline in
federal debt. The Committee left the range for debt growth in
2000 unchanged at 3 percent to 7 percent. After an aberrant
period in the 1980s during which debt expanded much more
rapidly than nominal GDP, the growth of debt has returned to its
historical pattern of about matching the growth of nominal GDP
over the past decade, and the Committee members expect debt to
remain within its range again this year.
Economic and Financial Developments in 1999 and Early 2000
The U.S. economy retained considerable strength in 1999.
According to the Commerce Department's advance estimate, the
rise in real gross domestic product over the four quarters of the
year exceeded 4 percent for the fourth consecutive year. The
growth of household expenditures was bolstered by further
substantial gains in real income, favorable borrowing terms, and
a soaring stock market. Businesses seeking to maintain their
competitiveness and profitability continued to invest heavily in
high-tech equipment; external financing conditions in both debt
and equity markets were quite supportive. In the public sector,
further strong growth of revenues was accompanied by a step-up
in the growth of government consumption and investment
expenditures, the part of government spending that enters directly
into real GDP. The rapid growth of domestic demand gave rise
to a further huge increase in real imports of goods and services
in 1999. Exports picked up as foreign economies strengthened,
but the gain fell short of that for imports by a large margin.
Available economic indicators for January of this year show the
U.S. economy continuing to expand, with labor demand robust
and the unemployment rate edging down to its lowest level in
thirty years.
The combination of a strong U.S. economy and improving
economic conditions abroad led to firmer prices in some markets
this past year. Industrial commodity prices turned up--sharply in
some cases--after having dropped appreciably in 1998. Oil
prices, responding both to OPEC production restraint and to the
growth of world demand, more than doubled over the course of
the year, and the prices of non-oil imports declined less rapidly
than in previous years, when a rising dollar, as well as sluggish
conditions abroad, had pulled them lower. The higher oil prices
of 1999 translated into sharp increases in retail energy prices and
gave a noticeable boost to consumer prices overall; the
chain-type price index for personal consumption expenditures
rose 2 percent, double the increase of 1998. Outside the energy
sector, however, consumer prices increased at about the same
low rate as in the previous year, even as the unemployment rate
continued to edge down. Rapid gains in productivity enabled
businesses to offset a substantial portion of the increases in
nominal compensation, thereby holding the rise of unit labor
costs in check, and business pricing policies continued to be
driven to a large extent by the desire to maintain or increase
market share at the expense of some slippage in unit profits,
albeit from a high level.
The Household Sector
Personal consumption expenditures increased about 5-1/2 percent
in real terms in 1999, a second year of exceptionally rapid
advance. As in other recent years, the strength of consumption in
1999 reflected sustained increases in employment and real hourly
pay, which bolstered the growth of real disposable personal
income. Added impetus came from another year of rapid growth
in net worth, which, coming on top of the big gains of previous
years, led households in the aggregate to spend a larger portion
of their current income than they would have otherwise. The
personal saving rate, as measured in the national income and
product accounts, dropped further, to an average of about 2
percent in the final quarter of 1999; it has fallen about 4-1/2
percentage points over the past five years, a period during which
yearly gains in household net worth have averaged more than 10
percent in nominal terms and the ratio of household wealth to
disposable personal income has moved up sharply.
The strength of consumer spending this past year extended
across a broad front. Appreciable gains were reported for most
types of durable goods. Spending on motor vehicles, which had
surged about 13-1/2 percent in 1998, moved up another 5-1/2
percent in 1999. The inflation-adjusted increases for furniture,
appliances, electronic equipment, and other household durables
also were quite large, supported in part by a strong housing
market. Spending on services advanced about 4-1/2 percent in
real terms, led by sizable increases for recreation and personal
business services. Outlays for nondurables, such as food and
clothing, also rose rapidly. Exceptional strength in the purchases
of some nondurables toward the end of the year may have
reflected precautionary buying by consumers in anticipation of
the century date change; it is notable in this regard that grocery
store sales were up sharply in December and then fell back in
January, according to the latest report on retail sales.
Households also continued to boost their expenditures on
residential structures. After having surged 11 percent in 1998,
residential investment rose about 3-1/4 percent over the four
quarters of 1999, according to the advance estimate from the
Commerce Department. Moderate declines in investment in the
second half of the year offset only part of the increases recorded
in the first half. As with consumption expenditures, investment in
housing was supported by the sizable advances in real income
and household net worth, but this spending category was also
tempered a little by a rise in mortgage interest rates, which likely
was an important factor in the second-half downturn.
Nearly all the indicators of housing activity showed upbeat
results for the year. Annual sales of new and existing homes
reached new peaks in 1999, surpassing the previous highs set in
1998. Although sales dropped back a touch in the second half of
the year, their level through year-end remained quite high by
historical standards. Builders' backlogs also were at high levels
and helped support new construction activity even as sales eased.
Late in the year, reports that shortages of skilled workers were
delaying construction became less frequent as building activity
wound down seasonally, but builders also continued to express
concern about potential worker shortages in 2000. For 1999 in
total, construction began on more than 1.3 million single-family
dwellings, the most since the late 1970s; approximately 330,000
multifamily units also were started, about the same number as in
each of the two previous years. House prices rose appreciably
and, together with the new investment, further boosted household
net worth in residential real estate.
The increases in consumption and residential investment in 1999
were, in part, financed by an expansion of household debt
estimated at 9-1/2 percent, the largest increase in more than a
decade. Mortgage debt, which includes the borrowing against
owner equity that may be used for purposes other than
residential investment, grew a whopping 10-1/4 percent. Higher
interest rates led to a sharp drop in refinancing activity and
prompted a shift toward the use of adjustable-rate mortgages,
which over the year rose from 10 percent to 30 percent of
originations. Consumer credit advanced 7-1/4 percent, boosted by
heavy demand for consumer durables and other big-ticket
purchases. Credit supply conditions were also favorable;
commercial banks reported in Federal Reserve surveys that they
were more willing than in the previous year or two to make
consumer installment loans and that they remained quite willing
to make mortgage loans.
The household sector's debt-service burden edged up to its
highest level since the late 1980s; however, with employment
rising rapidly and asset values escalating, measures of credit
quality for household debt generally improved in 1999.
Delinquency rates on home mortgages and credit cards declined
a bit, and those on auto loans fell more noticeably. Personal
bankruptcy filings fell sharply after having risen for several years
to 1997 and remaining elevated in 1998.
The Business Sector
Private nonresidential fixed investment increased 7 percent
during 1999, extending by another year a long run of rapid
growth in real investment outlays. Strength in capital investment
has been underpinned in recent years by the vigor of the
business expansion, by the advance and spread of computer
technologies, and by the ability of most businesses to readily
obtain funding through the credit and equity markets.
Investment in high-tech equipment continued to soar in 1999.
Outlays for communications equipment rose about 25 percent
over the course of the year, boosted by a number of factors,
including the expansion of wireless communications, competition
in telephone markets, the continued spread of the Internet, and
the demand of Internet users for faster access to it. Computer
outlays rose nearly 40 percent in real terms, and the purchases of
computer software, which in the national accounts are now
counted as part of private fixed investment, rose about 13
percent; for both computers and software the increases were
roughly in line with the annual average gains during previous
years of the expansion.
The timing of investment in high-tech equipment over the past
couple of years was likely affected to some degree by business
preparations for the century date change. Many large businesses
reportedly invested most heavily in new computer equipment
before the start of 1999 to leave sufficient time for their systems
to be tested well before the start of 2000; a very steep rise in
computer investment in 1998--roughly 60 percent in real
terms--is consistent with those reports. Some of the purchases in
preparation for Y2K most likely spilled over into 1999, but the
past year also brought numerous reports of businesses wanting to
stand pat with existing systems until after the turn of the year.
Growth in computer investment in the final quarter of 1999, just
before the century rollover, was the smallest in several quarters.
Spending on other types of equipment rose moderately, on
balance, in 1999. Outlays for transportation equipment increased
substantially, led by advances in business purchases of motor
vehicles and aircraft. By contrast, a sharp decline in spending on
industrial machinery early in the year held the yearly gain for
that category to about 2 percent; over the final three quarters of
the year, however, outlays picked up sharply as industrial
production strengthened.
Private investment in nonresidential structures fell 5 percent in
1999 according to the advance estimate from the Commerce
Department. Spending on structures had increased in each of the
previous seven years, rather briskly at times, and the level of
investment, though down this past year, remained relatively high
and likely raised the real stock of capital invested in structures
appreciably further. Real expenditures on office buildings, which
have been climbing rapidly for several years, moved up further
in 1999, to the highest level since the peak of the building boom
of the 1980s. In contrast, investment in other types of
commercial structures, which had already regained its earlier
peak, slipped back a little, on net, this past year. Spending on
industrial structures, which accounts for roughly 10 percent of
total real outlays on structures, fell for a third consecutive year.
Outlays for the main types of institutional structures also were
down, according to the initial estimates. Revisions to the data on
nonresidential structures often are sizable, and the estimates for
each of the three years preceding 1999 have eventually shown a
good bit more strength than was initially reported.
After increasing for two years at a rate of about 6 percent,
nonfarm business inventories expanded more slowly this past
year--about 3-1/4 percent according to the advance GDP report.
During the year, some businesses indicated that they planned to
carry heavier stocks toward year-end to protect themselves
against possible Y2K disruptions, and the rate of accumulation
did in fact pick up appreciably in the fall. But business final
sales remained strong, and the ratio of nonfarm stocks to final
sales changed little, holding toward the lower end of the range of
the past decade. With the ratio so low, businesses likely did not
enter the new year with excess stocks.
After slowing to a 1 percent rise in 1998, the economic profits of
U.S. corporations--that is, book profits with inventory valuation
and capital consumption adjustments--picked up in 1999.
Economic profits over the first three quarters of the year
averaged about 3-1/2 percent above the level of a year earlier.
The earnings of corporations from their operations outside the
United States rebounded in 1999 from a brief but steep decline
in the second half of 1998, when financial market disruptions
were affecting the world economy. The profits earned by
financial corporations on their domestic operations also picked
up after having been slowed in 1998 by the financial turmoil;
growth of these profits in 1999 would have been greater but for
a large payout by insurance companies to cover damage from
Hurricane Floyd. The profits that nonfinancial corporations
earned on their domestic operations in the first three quarters of
1999 were about 2-1/2 percent above the level of a year earlier;
growth of these earnings, which account for about two-thirds of
all economic profits, had slowed to just over 2 percent in 1998
after averaging 13 percent at a compound annual rate in the
previous six years. Nonfinancial corporations have boosted
volume substantially further over the past two years, but profits
per unit of output have dropped back somewhat from their 1997
peak. As of the third quarter of last year, economic profits of
nonfinancial corporations amounted to slightly less than 11-1/2
percent of the nominal output of these companies, compared with
a quarterly peak of about 12-3/4 percent two years earlier.
The borrowing needs of nonfinancial corporations remained
sizable in 1999. Capital spending outstripped internal cash flow,
and equity retirements that resulted from stock repurchases and a
blockbuster pace of merger activity more than offset record
volumes of both seasoned and initial public equity offerings.
Overall, the debt of nonfinancial businesses grew 10-1/2 percent,
down only a touch from its decade-high 1998 pace.
The strength in business borrowing was widespread across
funding sources. Corporate bond issuance was robust,
particularly in the first half of the year, though the markets'
increased preference for liquidity and quality, amid an
appreciable rise in defaults on junk bonds, left issuance of
below-investment-grade securities down more than a quarter
from their record pace in 1998. The receptiveness of the capital
markets helped firms to pay down loans at banks--which had
been boosted to an 11-3/4 percent gain in 1998 by the financial
market turmoil that year--and growth in these loans slowed to a
more moderate 5-1/4 percent pace in 1999. The commercial
paper market continued to expand rapidly, with domestic
nonfinancial outstandings rising 18 percent on top of the 14
percent gain in 1998.
Commercial mortgage borrowing was strong again as well, as
real estate prices generally continued to rise, albeit at a slower
pace than in 1998, and vacancy rates generally remained near
historical lows. The mix of lending shifted back to banks and life
insurance companies from commercial mortgage-backed
securities, as conditions in the CMBS market, especially investor
appetites for lower-rated tranches, remained less favorable than
they had been before the credit market disruptions in the fall of
1998.
Risk spreads on corporate bonds seesawed during 1999. Over the
early part of the year, spreads reversed part of the 1998 run-up
as markets recovered. During the summer, they rose again in
response to concerns about market liquidity, expectations of a
surge in financing before the century date change, and
anticipated firming of monetary policy. Swap spreads, in
particular, exhibited upward pressure at this time. The likelihood
of year-end difficulties seemed to diminish in the fall, and
spreads again retreated, ending the year down on balance but
generally above the levels that had prevailed over the several
years up to mid-1998.
Federal Reserve surveys indicated that banks firmed terms and
standards for commercial and industrial loans a bit further, on
balance, in 1999. In the syndicated loan market, spreads for
lower-rated borrowers also ended the year higher, on balance,
after rising substantially in 1998. Spreads for higher-rated
borrowers were fairly steady through 1998 and early 1999,
widened a bit around midyear, and then fell back to end the year
about where they had started.
The ratio of net interest payments to cash flow for nonfinancial
firms remained in the low range it has occupied for the past few
years, but many measures of credit quality nonetheless
deteriorated in 1999. Moody's Investors Service downgraded
more nonfinancial debt issuers than it upgraded over the year,
affecting a net $78 billion of debt. The problems that emerged in
the bond market were concentrated mostly among borrowers in
the junk sector, and partly reflected a fallout from the large
volume of issuance and the generous terms available in 1997 and
early 1998; default rates on junk bonds rose to levels not seen
since the recession of 1990-91. Delinquency rates on C&I loans
at commercial banks ticked up in 1999, albeit from very low
levels, while the charge-off rate for those loans continued on its
upward trend of the past several years. Business failures edged
up last year but remained in a historically low range.
The Government Sector
Buoyed by rapid increases in receipts and favorable budget
balances, the combined real expenditures of federal, state, and
local governments on consumption and investment rose about
4-3/4 percent from the fourth quarter of 1998 to the fourth
quarter of 1999. Annual data, which smooth through some of the
quarterly noise that is often evident in government outlays,
showed a gain in real spending of more than 3-1/2 percent this
past year, the largest increase of the expansion. Federal
expenditures on consumption and investment were up nearly 3
percent in annual terms; real defense expenditures, which had
trended lower through most of the 1990s, rose moderately, and
outlays for nondefense consumption and investment increased
sharply. Meanwhile, the consumption and investment
expenditures of state and local governments rose more than 4
percent in annual terms; growth of these outlays has picked up
appreciably as the expansion has lengthened.
At the federal level, expenditures in the unified budget rose 3
percent in fiscal 1999, just a touch less than the 3-1/4 percent
rise of the preceding fiscal year. Faster growth of nominal
spending on items that are included in consumption and
investment was offset in the most recent fiscal year by a
deceleration in other categories. Net interest outlays fell more
than 5 percent--enough to trim total spending growth about 3/4
percentage point--and only small increases were recorded in
expenditures for social insurance and income security, categories
that together account for nearly half of total federal outlays. In
contrast, federal expenditures on Medicaid, after having slowed
in 1996 and 1997, picked up again in the past two fiscal years.
Spending on agriculture doubled in fiscal 1999; the increase
resulted both from a step-up in payments under farm safety net
programs that were retained in the "freedom to farm" legislation
of 1996 and from more recent emergency farm legislation.
Federal receipts grew 6 percent in fiscal 1999 after increases that
averaged close to 9 percent in the two previous fiscal years. Net
receipts from taxes on individuals continued to outpace the
growth of personal income, but by less than in other recent
years, and receipts from corporate income taxes fell moderately.
Nonetheless, with total receipts growing faster than spending, the
surplus in the unified budget continued to rise, moving from $69
billion in fiscal 1998 to $124 billion this past fiscal year.
Excluding net interest payments--a charge resulting from past
deficits--the federal government recorded a surplus of more than
$350 billion in fiscal 1999.
Federal saving, a measure that results from a translation of the
federal budget surplus into terms consistent with the national
income and product accounts, amounted to 2-1/4 percent of
nominal GDP in the first three quarters of 1999, up from 1-1/2
percent in 1998 and 1/2 percent in 1997. Before 1997, federal
saving had been negative for seventeen consecutive years, by
amounts exceeding 3 percent of nominal GDP in several
years--most recently in 1992. The change in the federal
government's saving position from 1992 to 1999 more than offset
the sharp drop in the personal saving rate and helped lift national
saving from less than 16 percent of nominal GDP in 1992 and
1993 to a range of about 18-1/2 percent to 19 percent over the
past several quarters.
Federal debt growth has mirrored the turnabout in the
government's saving position. In the 1980s and early 1990s,
borrowing resulted in large additions to the volume of
outstanding government debt. In contrast, with the budget in
surplus the past two years, the Treasury has been paying down
debt. Without the rise in federal saving and the reversal in
borrowing, interest rates in recent years likely would have been
higher than they have been, and private capital formation, a key
element in the vigorous economic expansion, would have been
lower, perhaps appreciably.
The Treasury responded to its lower borrowing requirements in
1999 primarily by reducing the number of auctions of thirty-year
bonds from three to two and by trimming auction sizes for notes
and Treasury inflation-indexed securities (TIIS). Weekly bill
volumes were increased from 1998 levels, however, to help build
up cash holdings as a Y2K precaution. For 2000, the Treasury
plans major changes in debt management in an attempt to keep
down the average maturity of the debt and maintain sufficient
auction sizes to support the liquidity and benchmark status of its
most recently issued securities, while still retiring large volumes
of debt. Alternate quarterly refunding auctions of five- and
ten-year notes and semiannual auctions of thirty-year bonds will
now be smaller reopenings of existing issues rather than new
issues. Thirty-year TIIS will now be auctioned once a year rather
than twice, and the two auctions of ten-year TIIS will be
modestly reduced. Auctions of one-year Treasury bills will drop
from thirteen a year to four, while weekly bill volumes will rise
somewhat. Finally, the Treasury plans to enter the market to buy
back in "reverse auctions" as much as $30 billion of outstanding
securities this year, beginning in March or April.
State and local government debt expanded 4-1/4 percent in 1999,
well off last year's elevated pace. Borrowing for new capital
investment edged up, but the roughly full-percentage-point rise in
municipal bond yields over the year led to a sharp drop in
advance refundings, which in turn pulled gross issuance below
last year's level. Tax revenues continued to grow at a robust rate,
improving the financial condition of states and localities, as
reflected in a ratio of debt rating upgrades to downgrades of
more than three to one over the year. The surplus in the current
account of state and local governments in the first three quarters
of 1999 amounted to about 1/2 percent of nominal GDP, about
the same as in 1998 but otherwise the largest of the past several
years.
The External Sector
Trade and the Current Account
U.S. external balances deteriorated in 1999 largely because of
continued declines in net exports of goods and services and some
further weakening of net investment income. The nominal trade
deficit for goods and services widened more than $100 billion in
1999, to an estimated $270 billion, as imports expanded faster
than exports. For the first three quarters of the year, the current
account deficit increased more than one-third, reaching $320
billion at an annual rate, or 3-1/2 percent of GDP. In 1998, the
current account deficit was 2-1/2 percent of GDP.
Real imports of goods and services expanded strongly in
1999--about 13 percent according to preliminary estimates--as
the rapid import growth during the first half of the year was
extended through the second half. The expansion of real imports
was fueled by the continued strong growth of U.S. domestic
expenditures. Declines in non-oil import prices through most of
the year, partly reflecting previous dollar appreciation,
contributed as well. All major import categories other than
aircraft and oil recorded strong increases. While U.S.
consumption of oil rose about 4 percent in 1999, the quantity of
oil imported was about unchanged, and inventories were drawn
down.
Real exports of goods and services rose an estimated 4 percent
in 1999, a somewhat faster pace than in 1998. Economic activity
abroad picked up, particularly in Canada, Mexico, and Asian
developing economies. However, the lagged effects of relative
prices owing to past dollar appreciation held down exports. An
upturn in U.S. exports to Canada, Mexico, and key Asian
emerging markets contrasted with a much flatter pace of exports
to Europe, Japan, and South America. Capital equipment
composed about 45 percent of U.S. goods exports, industrial
supplies were 20 percent, and agricultural, automotive, and
consumer goods were each roughly 10 percent.
Capital Account
U.S. capital flows in 1999 reflected the relatively strong cyclical
position of the U.S. economy and the global wave of corporate
mergers. Foreign purchases of U.S. securities remained
brisk--near the level of the previous two years, in which they had
been elevated by the global financial unrest. The composition of
foreign securities purchases in 1999 showed a continued shift
away from Treasuries, in part because of the U.S. budget surplus
and the decline in the supply of Treasuries relative to other
securities and, perhaps, to a general increased tolerance of
foreign investors for risk as markets calmed after their turmoil of
late 1998. Available data indicate that private foreigners sold on
net about $20 billion in Treasuries, compared with net purchases
of $50 billion in 1998 and $150 billion in 1997. These sales of
Treasuries were more than offset by a pickup in foreign
purchases of their nearest substitute--government agency
bonds--as well as corporate bonds and equities.
Foreign direct investment flows into the United States were also
robust in 1999, with the pace of inflows in the first three
quarters only slightly below the record inflow set in 1998. As in
1998, direct investment inflows last year were elevated by
several large mergers, which left their imprint on other parts of
the capital account as well. In the past two years, many of the
largest mergers have been financed by a swap of equity in the
foreign acquiring firm for equity in the U.S. firm being acquired.
The Bureau of Economic Analysis estimates that U.S. residents
acquired more than $100 billion of foreign equity through this
mechanism in the first three quarters of 1999. Separate data on
market transactions indicate that U.S. residents made net
purchases of Japanese equities. They also sold European equities,
probably in an attempt to rebalance portfolios in light of the
equity acquired through stock swaps. U.S. residents on net
purchased a small volume of foreign bonds in 1999. U.S. direct
investment in foreign economies also reflected the global wave
of merger activity in 1999 and will likely total something near its
record level of 1998.
Available data indicate a return to sizable capital inflows from
foreign official sources in 1999, following a modest outflow in
1998. The decline in foreign official assets in the United States
in 1998 was fairly widespread, as many countries found their
currencies under unwanted downward pressure during the
turmoil. By contrast, the increase in foreign official reserves in
the United States in 1999 was fairly concentrated in a relatively
few countries that experienced unwanted upward pressure on
their currencies vis-a-vis the U.S. dollar.
The Labor Market
As in other recent years, the rapid growth of aggregate output in
1999 was associated with both strong growth of productivity and
brisk gains in employment. According to the initial estimate for
1999, output per hour in the nonfarm business sector rose 3-1/4
percent over the four quarters of the year, and historical data
were revised this past year to show stronger gains than
previously reported in the years preceding 1999. As the data
stand currently, the average rate of rise in output per hour over
the past four years is about 2-3/4 percent--up from an average of
1-1/2 percent from the mid-1970s to the end of 1995. Some of
the step-up in productivity growth since 1995 can be traced to
high levels of capital spending and an accompanying faster rate
of increase in the amount of capital per worker. Beyond that, the
causes are more difficult to pin down quantitatively but are
apparently related to increased technological and organizational
efficiencies. Firms are not only expanding the stock of capital
but are also discovering many new uses for the technologies
embodied in that capital, and workers are becoming more skilled
at employing the new technologies.
The number of jobs on nonfarm payrolls rose slightly more than
2 percent from the end of 1998 to the end of 1999, a net
increase of 2.7 million. Annual job gains had ranged between
2-1/4 percent and 2-3/4 percent over the 1996-98 period. Once
again in 1999, the private service-producing sector accounted for
most of the total rise in payroll employment, led by many of the
same categories that had been strong in previous
years--transportation and communications, computer services,
engineering and management, recreation, and personnel supply.
In the construction sector, employment growth remained quite
brisk--more than 4 percent from the final quarter of 1998 to the
final quarter of 1999. Manufacturing employment, influenced by
spillover from the disruptions in foreign economies, continued to
decline sharply in the first half of the year, but losses thereafter
were small as factory production strengthened. Since the start of
the expansion in 1991, the job count in manufacturing has
changed little, on net, but with factory productivity rising
rapidly, manufacturing output has trended up at a brisk pace.
In 1999, employers continued to face a tight labor market. Some
increase in the workforce came from the pool of the
unemployed, and the jobless rate declined to an average of 4.1
percent in the fourth quarter. In January 2000, the rate edged
down to 4.0 percent, the lowest monthly reading since the start
of the 1970s. Because the unemployment rate is a reflection only
of the number of persons who are available for work and
actively looking, it does not capture potential labor supply that is
one step removed--namely those individuals who are interested
in working but are not actively seeking work at the current time.
However, like the unemployment rate itself, an augmented rate
that includes these interested nonparticipants also has declined to
a low level, as more individuals have taken advantage of
expanding opportunities to work.
Although the supply-demand balance in the labor market
tightened further in 1999, the added pressure did not translate
into bigger increases in nominal hourly compensation. The
employment cost index for hourly compensation of workers in
private nonfarm industries rose 3.4 percent in nominal terms
during 1999, little changed from the increase of the previous
year, and an alternative measure of hourly compensation from
the nonfarm productivity and cost data slowed from a 5-1/4
percent increase in 1998 to a 4-1/2 percent rise this past year.
Compensation gains in 1999 probably were influenced, in part,
by the very low inflation rate of 1998, which resulted in
unexpectedly large increases in inflation-adjusted pay in that year
and probably damped wage increments last year. According to
the employment cost index, the hourly wages of workers in
private industry rose 3-1/2 percent in nominal terms after having
increased about 4 percent in each of the two previous years. The
hourly cost to employers of the nonwage benefits provided to
employees also rose 3-1/2 percent in 1999, but this increase was
considerably larger than those of the past few years. Much of the
pickup in benefit costs came from a faster rate of rise in the
costs of health insurance, which were reportedly driven up by
several factors: a moderate acceleration in the price of medical
care, the efforts of some insurers to rebuild profit margins, and
the recognition by employers that an attractive health benefits
package was helpful in hiring and retaining workers in a tight
labor market.
Because the employment cost index does not capture some forms
of compensation that employers have been using more
extensively--for example, stock options, signing bonuses, and
employee price discounts on in-store purchases--it has likely
been understating the true size of workers' gains. The
productivity and cost measure of hourly compensation captures
at least some of the labor costs that the employment cost index
omits, and this broader coverage may explain why the
productivity and cost measure has been rising faster. However, it,
too, is affected by problems of measurement, some of which
would lead to overstatement of the rate of rise in hourly
compensation.
With the rise in output per hour in the nonfarm business sector
in 1999 offsetting about three-fourths of the rise in the
productivity and cost measure of nominal hourly compensation,
nonfarm unit labor costs were up just a shade more than 1
percent. Unit labor costs had increased slightly more than 2
percent in both 1997 and 1998 and less than 1 percent in 1996.
Because labor costs are by far the most important item in total
unit costs, these small increases have been crucial to keeping
inflation low.
Prices
Rates of increase in the broader measures of aggregate prices in
1999 were somewhat larger than those of 1998. The chain-type
price index for GDP--which measures inflation for goods and
services produced domestically--moved up about 1-1/2 percent, a
pickup of 1/2 percentage point from the increase of 1998. In
comparison, acceleration in various price measures for goods and
services purchased amounted to 1 percentage point or more: The
chain-type price index for personal consumption expenditures
increased 2 percent, twice as much as in the previous year, and
the chain-type price index for gross domestic purchases, which
measures prices of the aggregate purchases of consumers,
businesses, and governments, moved up close to 2 percent after
an increase of just 3/4 percent in 1998. The consumer price
index rose more than 2-1/2 percent over the four quarters of the
year after having increased 1-1/2 percent in 1998.
The acceleration in the prices of goods and services purchased
was driven in part by a reversal in import prices. In 1998, the
chain-type price index for imports of goods and services had
fallen 5 percent, but it rose 3 percent in 1999. A big swing in oil
prices--down in 1998 but up sharply in 1999--accounted for a
large part of this turnaround. Excluding oil, the prices of
imported goods continued to fall in 1999 but, according to the
initial estimate, less rapidly than over the three previous years,
when downward pressure from appreciation of the dollar had
been considerable. The prices of imported materials and supplies
rebounded, but the prices of imported capital goods fell sharply
further. Meanwhile, the chain-type price index for exports
increased 1 percent in the latest year, reversing a portion of the
2-1/2 percent drop of 1998, when the sluggishness of foreign
economies and the strength of the dollar had pressured U.S.
producers to mark down the prices charged to foreign buyers.
Prices of domestically produced primary materials, which tend to
be especially sensitive to developments in world markets,
rebounded sharply in 1999. The producer price index for crude
materials excluding food and energy advanced about 10 percent
after having fallen about 15 percent in 1998, and the PPI for
intermediate materials excluding food and energy increased about
1-1/2 percent, reversing a 1998 decline of about that same size.
But further along in the chain of processing and distribution, the
effects of these increases were not very visible. The producer
price index for finished goods excluding food and energy rose
slightly less rapidly in 1999 than in 1998, and the consumer
price index for goods excluding food and energy rose at about
the same low rate that it had in 1998. Large gains in productivity
and a margin of excess capacity in the industrial sector helped
keep prices of goods in check, even as growth of domestic
demand remained exceptionally strong.
"Core" inflation at the consumer level--which takes account of
the prices of services as well as the prices of goods and excludes
food and energy prices--changed little in 1999. The increase in
the core index for personal consumption expenditures, 1-1/2
percent over the four quarters of the year, was about the same as
the increase in 1998. As measured by the CPI, core inflation was
2 percent this past year, about 1/4 percentage point lower than in
1998, but the deceleration was a reflection of a change in CPI
methodology that had taken place at the start of last year; on a
methodologically consistent basis, the rise in the core CPI was
about the same in both years.
In the national accounts, the chain-type price index for private
fixed investment edged up 1/4 percent in 1999 after having
fallen about 3/4 percent in 1998. With construction costs rising,
the index for residential investment increased 3-3/4 percent, its
largest advance in several years. By contrast, the price index for
nonresidential investment declined moderately, as a result of
another drop in the index for equipment and software. Falling
equipment prices are one channel through which faster
productivity gains have been reshaping the economy in recent
years; the drop in prices has contributed to high levels of
investment, rapid expansion of the capital stock, and a step-up in
the growth of potential output.
U.S. Financial Markets
Financial markets were somewhat unsettled as 1999 began, with
the disruptions of the previous autumn still unwinding and the
devaluation of the Brazilian real causing some jitters around
mid-January. However, market conditions improved into the
spring, evidenced in part by increased trading volumes and
narrowed bid-asked and credit spreads, as it became increasingly
evident that strong growth was continuing in the United States,
and that economies abroad were rebounding. In this environment,
market participants began to anticipate that the Federal Reserve
would reverse the policy easings of the preceding fall, and
interest rates rose. Nevertheless, improved profit expectations
apparently more than offset the interest rate increases, and equity
prices continued to climb until late spring. From May into the
fall, both equity prices and longer-term interest rates moved in a
choppy fashion, while short-term interest rates moved up with
monetary policy tightenings in June, August, and November.
Worries about Y2K became pronounced after midyear, and
expectations of an acceleration of borrowing ahead of the fourth
quarter prompted a resurgence in liquidity and credit premiums.
In the closing months of the year, however, the likelihood of
outsized demands for credit and liquidity over the year-end
subsided, causing spreads to narrow, and stock prices surged
once again. After the century date change passed without
disruptions, liquidity improved and trading volumes grew,
although both bond and equity prices have remained quite
volatile so far this year.
Interest Rates
Over the first few months of 1999, short-term Treasury rates
moved in a narrow range, anchored by an unchanged stance of
monetary policy. Yields on intermediate- and long-term Treasury
securities rose, however, as the flight to quality and liquidity of
the preceding fall unwound, and incoming data pointed to
continued robust economic growth and likely Federal Reserve
tightening. Over most of the rest of the year, short-term Treasury
rates moved broadly in line with the three quarter-point increases
in the target federal funds rate; longer-term yields rose less, as
markets had already anticipated some of those policy actions.
Bond and note yields moved sharply higher from early
November 1999 to mid-January 2000, as Y2K fears diminished,
incoming data indicated surprising economic vitality, and the
century date change was negotiated without significant technical
problems. In recent weeks, long-term Treasury yields have
retraced a good portion of that rise on expectations of reduced
supply stemming from the Treasury's new buyback program and
reductions in the amount of bonds to be auctioned. This rally has
been mostly confined to the long end of the Treasury market;
long-term corporate bond yields have fallen only slightly, and
yields are largely unchanged or have risen a little further at
maturities of ten years or less, where most private borrowing is
concentrated.
Concerns about liquidity and credit risk around the century date
change led to large premiums in private money market rates in
the second half of 1999. During the summer, this "safe haven"
demand held down rates on Treasury bills maturing early in the
new year, until the announcement in August that the Treasury
was targeting an unusually large year-end cash balance, implying
that it would issue a substantial volume of January-dated cash
management bills. Year-end premiums in eurodollar, commercial
paper, term federal funds, and other money markets--measured as
the implied forward rate for a monthlong period spanning the
turn relative to the rate for a neighboring period--rose earlier and
reached much higher levels than in recent years.
Those year-end premiums peaked in late October and then
declined substantially, as markets reflected increased confidence
in technical readiness and special assurances from central banks
that sufficient liquidity would be available around the century
date change. Important among these assurances were several of
the Federal Reserve initiatives described in the first section of
this report. Securities dealers took particular advantage of the
widened pools of acceptable collateral for open market
operations and used large volumes of federal agency debt and
mortgage-backed securities in repurchase agreements with the
Open Market Desk in the closing weeks of the year, which
helped to relieve a potential scarcity of Treasury collateral over
the turn. Market participants also purchased options on nearly
$500 billion worth of repurchase agreements under the standby
financing facility and pledged more than $650 billion of
collateral for borrowing at the discount window. With the
smooth rollover, however, none of the RP options were
exercised, and borrowing at the discount window turned out to
be fairly light.
Equity Prices
Nearly all major stock indexes ended 1999 in record territory.
The Nasdaq composite index paced the advance by soaring 86
percent over the year, and the S&P 500 and Dow Jones
Industrial Average posted still-impressive gains of 20 percent
and 25 percent. Last year was the fifth consecutive year that all
three indexes posted double-digit returns. Most stock indexes
moved up sharply over the first few months of the year and were
about flat on net from May through August; they then declined
into October before surging in the final months of the year. The
Nasdaq index, in particular, achieved most of its annual gains in
November and December. Stock price advances in 1999 were
not very broad-based, however: More than half of the S&P 500
issues lost value over the year. So far in 2000, stock prices have
been volatile and mixed; major indexes currently span a range
from the Dow's nearly 10 percent drop to the Nasdaq's 8 percent
advance.
Almost all key industry groups performed well. One exception
was shares of financial firms, which were flat, on balance.
Investor perceptions that rising interest rates would hurt earnings
and, possibly, concern over loan quality apparently offset the
boost resulting from passage in the fall of legislation reforming
the depression-era Glass-Steagall constraints on combining
commercial banking with insurance and investment banking.
Small-cap stocks, which had lagged in 1998, also performed
well; the Russell 2000 index climbed 20 percent over the year
and finally surpassed its April 1998 peak in late December.
At large firms, stock price gains about kept pace with expected
earnings growth in 1999, and the S&P 500 one-year-ahead
earnings-price ratio fluctuated around the historically low level of
4 percent even as real interest rates rose. Meanwhile, the Nasdaq
composite index's earnings-price ratio (using actual twelve-month
trailing earnings) plummeted from an already-slim 1-1/4 percent
to 1/2 percent, suggesting that investors are pricing in
expectations of tremendous earnings growth at technology firms
relative to historical norms.
Debt and the Monetary Aggregates
Debt and Depository Intermediation
The debt of domestic nonfinancial sectors is estimated to have
grown 6-1/2 percent in 1999 on a fourth-quarter-to-fourth-quarter
basis, near the upper end of the FOMC's 3 percent to 7 percent
range and about a percentage point faster than nominal GDP. As
was the case in 1998, robust outlays on consumer durable goods,
housing, and business investment, as well as substantial net
equity retirements, helped sustain nonfederal sector debt growth
at rates above 9 percent. Meanwhile, the dramatically increased
federal budget surplus allowed the Treasury to reduce its
outstanding debt about 2 percent. These movements follow the
pattern of recent years whereby increases in the debt of
households, businesses, and state and local governments relative
to GDP have come close to matching declines in the federal
government share, consistent with reduced pressure on available
savings from the federal sector facilitating private borrowing.
After increasing for several years, the share of total credit
accounted for by depository institutions leveled out in 1999.
Growth in credit extended by those institutions edged down to
6-1/2 percent from 6-3/4 percent in 1998. Adjusted for
mark-to-market accounting rules, bank credit growth retreated
from 10-1/4 percent in 1998 to 5-1/2 percent last year, with a
considerable portion of the slowdown attributable to an
unwinding of the surge in holdings of non-U.S. government
securities, business loans, and security loans that had been built
up during the market disruptions in the fall of 1998. Real estate
loans constituted one of the few categories of bank credit that
accelerated in 1999. By contrast, thrift credit swelled 9 percent,
up from a 4-1/2 percent gain in 1998, as rising mortgage interest
rates led borrowers to opt more frequently for adjustable-rate
mortgages, which thrifts tend to keep on their books. The trend
toward securitization of consumer loans continued in 1999: Bank
originations of consumer loans were up about 5 percent, while
holdings ran off at a 1-3/4 percent pace.
The Monetary Aggregates
Growth of the broad monetary aggregates moderated
significantly last year. Nevertheless, as was expected by the
FOMC last February and July, both M2 and M3 finished the
year above their annual price-stability ranges. M3 rose 7-1/2
percent in 1999, somewhat outside the Committee's range of 2
percent to 6 percent but far below the nearly 11 percent pace of
1998. M3 growth retreated early in 1999, as the surge in
depository credit in the final quarter of 1998 unwound and
depository institutions curbed their issuance of the managed
liabilities included in that aggregate. At that time, the expansion
of institution-only money funds also slowed with the ebbing of
heightened preferences for liquid assets. However, M3 bulged
again in the fourth quarter of 1999, as loan growth picked up
and banks funded the increase mainly with large time deposits
and other managed liabilities in M3. U.S. branches and agencies
of foreign banks stepped up issuance of large certificates of
deposit, in part to augment the liquidity of their head offices
over the century date change, apparently because it was cheaper
to fund in U.S. markets. Domestic banks needed the additional
funding because of strong loan growth and a buildup in vault
cash for Y2K contingencies. Corporations apparently built up
year-end precautionary liquidity in institution-only money funds,
which provided a further boost to M3 late in the year. Early in
2000, these effects began to unwind.
M2 increased 6-1/4 percent in 1999, somewhat above the
FOMC's range of 1 percent to 5 percent. Both the easing of
elevated demands for liquid assets that had boosted M2 in the
fourth quarter of 1998 and a rise in its opportunity cost (the
difference between interest rates on short-term market
instruments and the rates available on M2 assets) tended to bring
down M2 growth in 1999. That rise in opportunity cost also
helped to halt the decline in M2 velocity that had begun in
mid-1997, although the 1-3/4 percent (annual rate) rise in
velocity over the second half of 1999 was not enough to offset
the drop in the first half of the year. Within M2, currency
demand grew briskly over the year as a whole, reflecting
booming retail sales and, late in the year, some precautionary
buildup for Y2K. Money stock currency grew at an annualized
rate of 28 percent in December and then ran off in the weeks
after the turn of the year. In anticipation of a surge in the
public's demand for currency, depository institutions vastly
expanded their holdings of vault cash, beginning in the fall to
avoid potential constraints in the ability of the armored car
industry to accommodate large currency shipments late in the
year. Depositories' cash drawings reduced their Federal Reserve
balances and drained substantial volumes of reserves, and, in
mid-December, large precautionary increases in the Treasury's
cash balance and in foreign central banks' liquid investments at
the Federal Reserve did as well. The magnitude of these flows
was largely anticipated by the System, and, to replace the lost
reserves, during the fourth quarter the Desk entered into a
number of longer-maturity repurchase agreements timed to
mature early in 2000. The Desk also executed a large number of
short-term repurchase transactions for over the turn of the year,
including some in the forward market, to provide sufficient
reserves and support market liquidity.
The public's demand for currency through year-end, though
appreciable, remained well below the level for which the banking
system was prepared, and vault cash at the beginning of January
stood about $38 billion above its year-ago level. This excess
vault cash, and other century date change effects in money and
reserve markets, unwound quickly after the smooth transition
into the new year.
International Developments
Global economic conditions improved in 1999 after a year of
depressed growth and heightened financial market instability.
Financial markets in developing countries, which had been hit
hard by crises in Asia and Russia in recent years, recovered last
year. The pace of activity in developing countries increased, with
Asian emerging-market economies in particular bouncing back
strongly from the output declines of the preceding year. Real
growth improved in almost all the major industrial economies as
well. This strengthening of activity contributed to a general rise
in equity prices and a widespread increase in interest rates.
Despite stronger activity and higher prices for oil and other
commodities, average foreign inflation was lower in 1999 than in
1998, as output remained below potential in most countries.
Although the general theme in emerging financial markets in
1999 was a return to stability, the year began with heightened
tension as a result of a financial crisis in Brazil. With the effects
of the August 1998 collapse of the ruble and the default on
Russian government debt still reverberating, Brazil was forced to
abandon its exchange-rate-based stabilization program in January
1999. The real, allowed to float, soon fell nearly 50 percent
against the dollar, generating fears of a depreciation-inflation
spiral that could return Brazil to its high-inflation past. In
addition, there were concerns that the government might default
on its domestic-currency and dollar-indexed debt, the latter
totaling more than $50 billion. In the event, these fears proved
unfounded. The turning point appears to have come in March
when a new central bank governor announced that fighting
inflation was a top priority and interest rates were substantially
raised to support the real. Over the remainder of the year,
Brazilian financial markets stabilized on balance, despite
continuing concerns about the government's ability to reduce the
fiscal deficit. Inflation, although accelerating from the previous
year, remained under 10 percent. Brazilian economic activity
also recovered somewhat in 1999, after declining in 1998, as the
return of confidence allowed officials to lower short-term interest
rates substantially from their crisis-related peak levels of early in
the year.
The Brazilian crisis triggered some renewed financial stress in
other Latin American economies, and domestic interest rates and
Brady bond yield spreads increased sharply from levels already
elevated by the Russian crisis. However, as the situation in
Brazil improved, financial conditions in the rest of the region
stabilized relatively rapidly. Even so, the combination of elevated
risk premiums and diminished access to international credit
markets tended to depress activity in much of the region in the
first half of 1999. Probably the most strongly affected was
Argentina, where the exchange rate peg to the dollar was
maintained only at the cost of continued high real interest rates
that contributed to the decline in real GDP in 1999. In contrast,
real GDP in Mexico rose an estimated 6 percent in 1999, aided
by higher oil prices and strong export growth to the United
States. The peso appreciated against the dollar for the year as a
whole, despite a Mexican inflation rate about 10 percentage
points higher than in the United States.
The recovery of activity last year in Asian developing countries
was earlier, more widespread, and sharper than in Latin America,
just as the downturn had been the previous year. After a steep
drop in activity in the immediate wake of the financial crises that
hit several Asian emerging-market economies in late 1997, the
preconditions for a revival in activity were set by measures
initiated to stabilize shaky financial markets and banking sectors,
often in conjunction with International Monetary Fund programs
that provided financial support. Once financial conditions had
been stabilized, monetary policies turned accommodative in
1998, and this stimulus, along with the shift toward fiscal deficits
and an ongoing boost to net exports provided by the sharp
depreciations of their currencies, laid the foundation for last
year's strong revival in activity. Korea's recovery was the most
robust, with real GDP estimated to have increased more than 10
percent in 1999 after falling 5 percent the previous year. The
government continued to make progress toward needed financial
and corporate sector reform. However, significant weaknesses
remained, as evidenced by the near collapse of Daewoo, Korea's
second largest conglomerate. Other Asian developing countries
that experienced financial difficulties in late 1997 (Thailand,
Malaysia, Indonesia, and the Philippines) also recorded increases
in real GDP in 1999 after declines the previous year. Indonesian
financial markets were buffeted severely at times during 1999 by
concerns about political instability, but the rupiah ended the year
with a modest net appreciation against the dollar. The other
former crisis countries also saw their currencies stabilize or
slightly appreciate against the dollar. Inflation rates in these
countries generally declined, despite the pickup in activity and
higher prices for oil and other commodities. Inflation was held
down by the elevated, if diminishing, levels of excess capacity
and unemployment and by a waning of the inflationary impact of
previous exchange rate depreciations.
In China, real growth slowed moderately in 1999. Given China's
exchange rate peg to the dollar, the sizable depreciations
elsewhere in Asia in 1997 and 1998 led to a sharp appreciation
of China's real effective exchange rate, and there was speculation
last year that the renminbi might be devalued. However, with
China's trade balance continuing in substantial, though reduced,
surplus, Chinese officials maintained the exchange rate peg to
the dollar last year and stated their intention of extending it
through at least this year. After the onset of the Asian financial
crisis, continuance of Hong Kong's currency-board-maintained
peg to the U.S. dollar was also questioned. In the event, the tie
to the dollar was sustained, but only at the cost of high real
interest rates, which contributed to a decrease in output in Hong
Kong in 1998 and early 1999 and a decline of consumer prices
over this period. However, real GDP started to move up again
later in the year, reflecting in part the strong revival of activity
in the rest of Asia.
In Russia, economic activity increased last year despite persistent
and severe structural problems. Real GDP, which had dropped
nearly 10 percent in 1998 as a result of the domestic financial
crisis, recovered about half the loss last year. Net exports rose
strongly, boosted by the lagged effect of the substantial real
depreciation of the ruble in late 1998 and by higher oil prices.
The inflation rate moderated to about 50 percent, somewhat
greater than the depreciation of the ruble over the course of the
year.
The dollar's average foreign exchange value, measured on a
trade-weighted basis against the currencies of a broad group of
important U.S. trading partners, ended 1999 little changed from
its level at the beginning of the year. There appeared to be two
main, roughly offsetting, pressures on the dollar last year. On the
one hand, the continued very strong growth of the U.S. economy
relative to foreign economies tended to support the dollar. On the
other hand, the further rise in U.S. external deficits--with the
U.S. current account deficit moving up toward 4 percent of GDP
by the end of the year--may have tended to hold down the dollar
because of investor concerns that the associated strong net
demand for dollar assets might prove unsustainable. So far this
year, the dollar's average exchange value has increased slightly,
boosted by new evidence of strong U.S. growth. Against the
currencies of the major foreign industrial countries, the dollar's
most notable movements in 1999 were a substantial depreciation
against the Japanese yen and a significant appreciation relative to
the euro.
The dollar depreciated 10 percent on balance against the yen
over the course of 1999. In the first half of the year, the dollar
strengthened slightly relative to the yen, as growth in Japan
appeared to remain sluggish and Japanese monetary authorities
reduced short-term interest rates to near zero in an effort to
jumpstart the economy. However, around mid-year, several signs
of a revival of activity--particularly the announcement of
unanticipated strong growth in real GDP in the first
quarter--triggered a depreciation of the dollar relative to the yen
amid reports of large inflows of foreign capital into the Japanese
stock market. Data releases showing that the U.S. current
account deficit had reached record levels in both the second and
third quarters of the year also appeared to be associated with
depreciations of the dollar against the yen. Concerned that a
stronger yen could harm the fledgling recovery, Japanese
monetary authorities intervened heavily to weaken the yen on
numerous occasions. So far this year, the dollar has firmed about
7 percent against the yen. Japanese real GDP increased
somewhat in 1999, following two consecutive years of decline.
Growth was concentrated in the first half of the year, when
domestic demand surged, led by fiscal stimulus. Later in the
year, domestic demand slumped, as the pace of fiscal expansion
flagged. Net exports made virtually no contribution to growth for
the year as a whole. Japanese consumer prices declined slightly
on balance over the course of the year.
The new European currency, the euro, came into operation at the
start of 1999, marking the beginning of stage three of European
economic and monetary union. The rates of exchange between
the euro and the currencies of the eleven countries adopting the
new currency were set at the end of 1998; based on these rates,
the value of the euro at its creation was just under $1.17. From a
technical perspective, the introduction of the euro went smoothly,
and on its first day of trading its value moved higher. However,
the euro soon started to weaken against the dollar, influenced by
indications that euro-area growth would remain very slow. After
approaching parity with the dollar in early July, the euro
rebounded, partly on gathering signs of European recovery.
However, the currency weakened again in the fall, and in early
December it reached parity with the dollar, about where it closed
the year. The euro's weakness late in the year was attributed in
part to concerns about the pace of market-oriented structural
reforms in continental Europe and to a political wrangle over the
proposed imposition of a withholding tax on investment income.
On balance, the dollar appreciated 16 percent relative to the euro
over 1999. So far this year, the dollar has strengthened 2 percent
further against the euro. Although the euro's foreign exchange
value weakened in its first year of operation, the volume of
euro-denominated transactions--particularly the issuance of debt
securities--expanded rapidly.
In the eleven European countries that now fix their currencies to
the euro, real GDP growth remained weak early in 1999 but
strengthened subsequently and averaged an estimated 3 percent
rate for the year as a whole. Net exports made a significant
positive contribution to growth, supported by a revival of
demand in Asia and Eastern Europe and by the effects of the
euro's depreciation. The areawide unemployment rate declined,
albeit to a still-high rate of nearly 10 percent. In the spring, the
European central bank lowered its policy rate 50 basis points, to
2-1/2 percent. This decline was reversed later in the year in
reaction to accumulating evidence of a pickup in activity, and the
rate was raised an additional 25 basis points earlier this month.
The euro-area inflation rate edged up in 1999, boosted by higher
oil prices, but still remained below the 2 percent target ceiling.
Growth in the United Kingdom also moved higher on balance in
1999, with growth picking up over the course of the year. Along
with the strengthening of global demand, the recovery was
stimulated by a series of official interest rate reductions, totaling
250 basis points, undertaken by the Bank of England over the
last half of 1998 and the first half of 1999. Later in 1999 and
early this year, the policy rate was raised four times for a total of
100 basis points, with officials citing the need to keep inflation
below its 2-1/2 percent target level in light of the strength of
consumption and the housing market and continuing tight
conditions in the labor market. On balance, the dollar appreciated
slightly against the pound over the course of 1999.
In Canada, real growth recovered in 1999 after slumping the
previous year in response to the global slowdown and the related
drop in the prices of Canadian commodity exports. Last year,
strong demand from the United States spurred Canadian exports
while rising consumer and business confidence supported
domestic demand. In the spring, the Bank of Canada lowered its
official interest rate twice for a total of 50 basis points in an
effort to stimulate activity in the context of a rising Canadian
dollar. This decline was reversed by 25-basis-point increases near
the end of the year and earlier this month, as Canadian inflation
moved above the midpoint of its target range, the pace of output
growth increased, and U.S. interest rates moved higher. Over the
course of 1999, the U.S. dollar depreciated 6 percent on balance
against the Canadian dollar.
Concerns about liquidity and credit risk related to the century
date change generated a temporary bulge in year-end premiums
in money market rates in the second half of the year in some
countries. For the euro, borrowing costs for short-term interbank
funding over the year changeover--as measured by the interest
rate implied by the forward market for a one-month loan
spanning the year-end relative to the rates for neighboring
months--started to rise in late summer but then reversed nearly
all of this increase in late October and early November before
moving up more moderately in December. The sharp
October-November decline in the year-changeover funding
premium came in response to a series of announcements by
major central banks that outlined and clarified the measures these
institutions were prepared to undertake to alleviate potential
liquidity problems related to the century date change. For yen
funding, the century date change premium moved in a different
pattern, fluctuating around a relatively low level before spiking
sharply for several days just before the year-end. The
late-December jump in the yen funding premium was partly in
response to date change-related illiquidity in the Japanese
government bond repo market that emerged in early December
and persisted into early January. To counter these conditions,
toward the end of the year the Bank of Japan infused huge
amounts of liquidity into its domestic banking system, which
soon brought short-term yen funding costs back down to near
zero.
Bond yields in the major foreign industrial countries generally
moved higher on balance in 1999. Long-term interest rates were
boosted by mounting evidence that economic recovery was
taking hold abroad and by rising expectations of monetary
tightening in the United States and, later, in other industrial
countries. Over the course of the year, long-term interest rates
increased on balance by more than 100 basis points in nearly all
the major industrial countries. The notable exception was Japan,
where long-term rates were little changed.
Equity prices showed strong and widespread increases in 1999,
as the pace of global activity quickened and the threat from
emerging-market financial crises appeared to recede. In the
industrial countries equity prices on average rose sharply,
extending the general upward trend of recent years. The average
percentage increase of equity prices in developing countries was
even larger, as prices recovered from their crisis-related declines
of the previous year. The fact that emerging Latin American and
Asian equity markets outperformed those in industrial countries
lends some support to the view that global investors increased
their risk tolerance, especially during the last months of the year.
Oil prices increased dramatically during 1999, fully reversing the
declines in the previous two years. The average spot price for
West Texas intermediate, the U.S. benchmark crude, more than
doubled, from around $12 per barrel at the beginning of the year
to more than $26 per barrel in December. This rebound in oil
prices was driven by a combination of strengthening world
demand and constrained world supply. The strong U.S. economy,
combined with a recovery of economic activity abroad and a
somewhat more normal weather pattern, led to a 2 percent
increase in world oil consumption. Oil production, on the other
hand, declined 2 percent, primarily because of reduced supplies
from OPEC and other key producers. Starting last spring, OPEC
consistently held production near targeted levels, in marked
contrast to the widespread lack of compliance that characterized
earlier agreements. So far this year, oil prices have risen further
on speculation over a possible extension of current OPEC
production targets and the onset of unexpectedly cold weather in
key consuming regions.
The price of gold fluctuated substantially in 1999. The price
declined to near a twenty-year low of about $250 per ounce at
mid-year as several central banks, including the Bank of England
and the Swiss National Bank, announced plans to sell a sizable
portion of their reserves. The September announcement that
fifteen European central banks, including the two just mentioned,
would limit their aggregate sales of bullion and curtail leasing
activities, saw the price of gold briefly rise above $320 per
ounce before turning down later in the year. Recently, the price
has moved back up, to above $300 per ounce.
-----------
1. In past Monetary Policy Reports to the Congress, the FOMC
has framed its inflation forecasts in terms of the consumer price
index. The chain-type price index for PCE draws extensively on
data from the consumer price index but, while not entirely free
of measurement problems, has several advantages relative to the
CPI. The PCE chain-type index is constructed from a formula
that reflects the changing composition of spending and thereby
avoids some of the upward bias associated with the fixed-weight
nature of the CPI. In addition, the weights are based on a more
comprehensive measure of expenditures. Finally, historical data
used in the PCE price index can be revised to account for newly
available information and for improvements in measurement
techniques, including those that affect source data from the CPI;
the result is a more consistent series over time. This switch in
presentation notwithstanding, the FOMC will continue to rely on
a variety of aggregate price measures, as well as other
information on prices and costs, in assessing the path of
inflation.
|
