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Monetary policy report to the Congress.

Report submitted to the Congress on July 19, 1995, pursuant to the Full Employment and Balanced Growth Act of 1978

MONETARY POLICY AND THE ECONOMIC

OUTLOOK FOR 1995 AND 1996

During 1994, spending by US. households and businesses grew at an exceptionally rapid pace, and by the end of the year, demands clearly were taxing the productive capacity of the economy. Pressures on resources were particularly intense in sectors of manufacturing that provide inputs for other producers, and sharp increases in the prices of materials and supplies signaled what could have been the first stage of a broader inflationary process. A weakening of the dollar on foreign exchange markets as 1995 began heightened that risk. To damp these inflationary pressures and foster a sustainable economic expansion, the Federal Open Market Committee in February tightened policy somewhat, extending the series of actions undertaken during 1994, and the Board of Governors approved a 1/2 percentage point increase in the discount rate.

The economy's growth began to moderate in the first quarter of 1995. Among the factors contributing to the slowing were the lagged effects of 1994's increases in interest rates on housing and other rate-sensitive sectors and the impact on U.S. exports of the sharp contraction in Mexico's economy and fall in the foreign exchange value of the peso. As final sales moderated, businesses scaled back their desired inventory accumulation. In some key sectors, the slackening in sales was greater than anticipated, leaving firms with excess inventories. As businesses took steps to trim stocks, aggregate production decelerated further in the second quarter and was probably about flat, as measured by real gross domestic product. The inventory adjustment was especially large in the motor vehicle sector, which accounted for much of the downswing in manufacturing activity in the spring. Homebuilding also showed marked weakness, in part because builders hesitated to start new projects until they could work down stocks of unsold new homes.

While output growth was stalling in the first half of this year, the still-high level of resource utilization of the economy, as well as the effects of rapid increases in materials prices, contributed to a pickup in inflation from its 1994 pace. Nonetheless, by July it appeared likely that pressures on resources and hence on prices were in the process of easing. Materials prices were showing signs of softening, and a period of greater stability in the exchange value of the dollar suggested that the rise of import prices might soon slow. With the threat of future inflation thus reduced, the FOMC elected to ease the stance of policy slightly at its meeting in July.

The moderation in economic growth and improvement in inflation prospects over the first half of 1995 sparked a considerable decline in market interest rates. The greater likelihood of significant progress toward a balanced federal budget also seemed to contribute to the decrease in longer-term interest rates. Intermediate- and long-term yields have fallen 1 1/4 to 1 3/4 percentage points since year-end 1994, with the decline in thirty-year fixed mortgage rates this year reversing most of the increases registered since early 1994. Lower interest rates, solid earnings growth, and prospects for sustained economic expansion helped push most broad stock price indexes to record highs.

The drop in longer-term interest rates in the United States contributed to downward pressure on the foreign exchange value of the dollar in 1995. In terms of the currencies of the other G- 10 countries, the dollar has declined 7 1/2 percent on balance. Over the past half-year, foreign long-term interest rates have fallen significantly as growth prospects abroad have weakened, but by less than U.S. long-term interest rates. In addition, the Mexican crisis was seen by market participants as having adverse implications for U.S. growth, especially exports, and it contributed to the dollar's decline in terms of currencies other than the peso in early 1995. With the dollar at times under greater downward pressure than seemed justified by fundamentals, the Federal Reserve, acting on behalf of the Treasury and for its own account, joined other central banks in concerted intervention in support of the currency on several occasions in 1995. In recent weeks, the dollar has fluctuated in a range somewhat above the lows reached in the spring.

Despite the slower expansion of nominal spending this year, net borrowing by households and businesses remained substantial. In fact, total private credit flows strengthened, offsetting slower growth of federal debt and an outright decline in state and local government debt; as a result, total domestic nonfinancial debt expanded at a 5 1/2 percent pace from the fourth quarter of 1994 through May, a little faster than in 1994. Credit supply conditions remained quite favorable, with banks continuing to ease terms and conditions of lending and with risk spreads in securities markets persisting at quite low levels. Household borrowing this year has been a bit more subdued than in 1994 but still appreciable. Nonfinancial businesses have stepped up their borrowing considerably, a move reflecting a widening gap between capital expenditures (including inventory investment) and internally generated funds, and also reflecting the balance sheet restructuring associated with stock repurchases and a surge in merger and acquisition activity. Although the decline in long-term interest rates this year has spurred a significant pickup in bond issuance and fixed rate mortgage borrowing very recently, the increase in credit this year has been concentrated in short-term or floating-rate debt.

Depository institutions, as traditional providers of short-term and floating-rate credit, have enjoyed a sharp increase in loan demand. To fund the growth of their loan portfolios, banks and thrift institutions pulled in more deposits, providing a lift to growth of the broad monetary aggregates. Indeed, M3 expanded at a 6 1/4 percent pace from the fourth quarter through June, slightly exceeding the upper bound of its revised annual range. In their usual fashion, yields on small time deposits and money market mutual funds have adjusted with a lag to the declines in market interest rates this year. Investors have responded by shifting their portfolios toward these assets, boosting M2 growth from the fourth quarter through June to 3 1/4 percent at an annual rate. M2 velocity over the first half of 1995 is estimated to have held about steady, in marked contrast to the rise in M2 velocity over the previous five years.

Unlike the broad monetary aggregates, MI has grown quite sluggishly this year. Low interest returns on transaction deposits have encouraged households and businesses to move excess balances into higher-yielding M2 assets and also into market instruments. This process has been amplified by the expansion of retail sweep accounts offered by a few banks that allow customers to hold a lower average level of transaction balances. Currency growth - although slower than the double-digit pace of the last two years - has remained strong, boosted again by heavy foreign demands.

Money and Debt Ranges for 1995 and 1996

In setting ranges for money and debt in 1995 and 1996, the Committee noted that the velocities of the monetary aggregates have been behaving more in line with historical patterns than was the case earlier in the decade. However, financial innovation, technological change, and deregulation have blurred distinctions among various financial instruments that can serve as savings vehicles and sources of credit. As a consequence, considerable uncertainty remains about the future relationships of money and debt to the fundamental objectives of monetary policy; the Committee will thus continue to rely primarily on a wide range of other information in determining the stance of policy.

The Committee retained its current range of 1 to 5 percent for M2 for 1995 and chose the same range for 1996. If M2 velocity continues on a more normal track, growth of M2 in the upper half of this range in 1995 and near the upper bound of the provisional range in 1996 would be consistent with the Committee's expectations for nominal income growth. The existing range was retained for next year in view of the lingering uncertainties about the money-income relationship and to serve as a benchmark for the rate of growth of M2 that would be expected under conditions of reasonable price stability and historical velocity behavior. The Committee also reaffirmed the 3-to-7 percent range for the debt aggregate and carried this range forward on a provisional basis for 1996, concluding that debt growth within this range would be expected to accompany the moderate economic expansion it was seeking to foster.

With regard to M3, the Committee had noted in its February 1995 report to the Congress that the depressed growth of this aggregate in recent years reflected the balance sheet adjustments of banks and thrift institutions in response to the extraordinary strains they experienced in the early 1990s. The Committee observed that, as these institutions returned to health and intermediation resumed more normal patterns, M3 growth could pick up appreciably and the velocity of M3 might begin to stabilize or even decline, as it had on average over several decades before 1990. In the event, M3 has strengthened considerably so far in 1995, apparently for the reasons noted by the Committee in February. As a consequence, the Committee made a technical adjustment in its M3 range at the July meeting - to 2 to 6 percent for 1995 - and carried that range forward on a provisional basis into 1996. The Committee stressed that this change simply recognized the return of historical financing patterns and bore no implications for the underlying thrust of monetary policy.

Economic Projections for 1995 and 1996

The members of the Board of Governors and the Reserve Bank presidents, all of whom participate in the deliberations of the Federal Open Market Committee, generally anticipate that, after a weak second quarter, the economy will experience moderate growth in the second half of 1995 and in 1996. For all of 1995, this would produce growth that was somewhat below forecasts made for the February meeting. In line with these expectations, the unemployment rate in the second half of 1995 may move up somewhat from its recent relatively low level.

A number of factors should contribute to a pickup in demand and production over coming months. Lower interest rates, in particular, likely will directly stimulate spending on housing, motor vehicles and consumer durables, and business investment. Moreover, increases in the value of bond and stock portfolios that have accompanied the decline in interest rates should strengthen aggregate demand more generally. The strong competitive position of the United States likely will bolster net export growth on balance over the remainder of 1995. To be sure, the level of U.S. exports to Mexico probably will remain depressed for some time, but Mexico's external adjustment has already been substantial and further declines in U.S. export demands from this source are likely to be less severe than in the first half of 1995. Finally, the anticipated pickup in spending will help businesses work off excess inventories more rapidly and reduce the need for further production cutbacks to bring inventories back in line with final sales.

The Board members and the Reserve Bank presidents generally expect the rise in the consumer price index over the four quarters of 1995 to end up at around 3 1/4 percent, the same as in the first half of the year. For 1996, inflation is projected to edge down, to the neighborhood of 3 percent. The first half slowdown in the industrial sector has reduced pressure on materials prices; moreover, wage trends have been stable, suggesting that labor costs are unlikely to provide an impetus to inflation.

The Administration has not released an update of the economic projections contained in the February Economic Report of the President. Those earlier forecasts pointed to real GDP growth of 2.4 percent for 1995, well within the central tendency range in the Federal Reserve's February report. Given the slow start this year, that growth pace for the year appears less likely, and the average unemployment rate for the year probably will be around the upper end of the 5.5 to 5.8 percent range in the Administration's February report. The Administration's 3.2 percent CPI forecast is in line with the Federal Reserve's central tendency.

The inflation rates anticipated by the FOMC are marginally above those prevailing in 1993 and 1994 but are considerably below rates of only a few years ago - and lower than many observers seemed to anticipate for the current economic expansion only a few months ago. Nonetheless, they should be regarded as only a milepost along the path toward the long-term goal of price stability. The Federal Reserve recognizes that eliminating the economic distortions associated with inflation is the most important long-run contribution it can make to the economic growth and welfare of the nation.

THE PERFORMANCE OF THE ECONOMY

At the end of 1994, resource utilization in the U.S. economy was high: Manufacturing capacity utilization equaled its 1989 peak, and the unemployment rate was close to the low point of the late 1980s. Moreover, economic expansion was still brisk, with real gross domestic product growing at a 5 percent annual rate in the fourth quarter. Although inflation for 1994 as a whole remained moderate, commodity prices, which can signal the onset of inflationary pressures, were rising rapidly at the end of last year.

A deceleration in activity was widely anticipated, and growth in real GDP did moderate to a 2 3/4 percent annual pace in the first quarter of 1995. But the slowing did not stop there: Spending in several sectors of the economy softened in the spring, industrial production fell, and employment grew relatively little. The level of real GDP appears to have been essentially flat in the second quarter.

A slackening in household demand for big-ticket items was a significant element in the drop-off in economic growth in the first half. After registering sizable gains last year, spending on consumer durables weakened considerably early this year. And residential construction, which continued to grow in the face of rising mortgage rates last year, began to fall this winter and was off sharply in the second quarter. These domestic drags were reinforced by the effects of the plunge in net exports to Mexico, which came in the wake of that nation's financial crisis.

With domestic sales and exports softening, businesses cut orders and production. However, in some cases, the adjustments were not quick enough to avoid an unwanted accumulation of inventories - especially for cars and light trucks, but for some other goods as well. Efforts to trim stocks reinforced the contractionary forces in the manufacturing sector of the economy.

Despite the falloff in growth in the first half, the unemployment rate edged up only slightly, and although manufacturing capacity utilization fell considerably, it remained above historical averages. Under the circumstances, it is not surprising that the mounting inflationary pressures of the latter part of 1994 carried over into the first part of this year and that materials prices surged further. Rising import prices, related to the depreciation of the dollar, also contributed to domestic inflation. Reflecting these and other factors, the consumer price index increased at a 3 1/4 percent annual rate in the first half of this year, up from a 23/4 percent increase for 1994 as a whole.

Nonetheless, increases in hourly wages and benefits remained moderate, holding down unit labor costs. Furthermore, the drop in manufacturing activity in the first half of the year contributed to a flattening in industrial commodity prices, suggesting some lessening of inflationary pressures "in the pipeline." These favorable factors were reflected in some moderation of price increases toward midyear.

The Household Sector

After advancing at more than a 4 percent annual rate in the second half of 1994, growth in consumer spending slowed appreciably on average in the first half of this year. Real personal consumption expenditures increased at just a 1 1/2 percent annual rate in the first quarter, before picking up moderately in the second.

Outlays for consumer durables moved up sharply in 1994, and by the end of the year, the level of spending was high relative to income. Many households may have brought their stocks of durables up to desired levels, limiting further purchases this year. In addition, by early this year, the stimulus to consumer spending from the massive mortgage refinancing wave of 1993 and early 1994 likely had been exhausted. The downturn in interest rates this year has led to a comparatively modest rebound in refinancings recently, which may free up some income for additional spending in coming months.

The slackening in consumer demand in the first quarter was concentrated in motor vehicles, where sales fell off after surging in the fourth quarter of 1994. However, real spending on goods other than motor vehicles also grew less rapidly in the first quarter than in the second half of 1994. Some of the deceleration in other consumer durables may have reflected the weakness in home sales because families often purchase new furnishings and appliances when they change houses. Among nondurable goods, outlays for apparel were especially weak, following rapid growth in spending in the second half of 1994.

The slowing of consumer spending growth so far this year has been about in line with the slowing in income growth. Through the first quarter, wage and salary income posted solid gains, bolstered by a healthy pace of hiring. But increases in wage and salary income faded in the spring, reflecting slow growth in employment and a drop in the workweek. The deceleration in labor income was only partially offset by rapid growth in interest and dividend income in the first half of 1995. Dividend income benefited from the improvement in corporate profits. Growth in interest income was strong in the first quarter, reflecting the lagged effects of increases in market interest rates in 1994, but began to flag in the second quarter as the decline in market interest rates this year showed through to interest earnings.

Surveys suggest that consumer confidence remained high through the first half of 1995. Movements in both of the major surveys - from the Michigan Survey Research Center and the Conference Board - were similar in the first half of 1995: Both spent part of the first half above their 1994 average values, but by June, both had moved back down to their 1994 averages.

Early this year, residential construction activity weakened significantly, and single-family housing starts in the first quarter were 14 percent (not an annual rate) below their fourth-quarter average. Sales of new and existing homes also fell in the first quarter, although not quite so steeply. Single-family starts edged up in April but more than reversed this gain in May; however, building permits, a more reliable indicator, moved up in May. New home sales jumped 20 percent in May, to the highest level since late 1993. Although reported new home sales are volatile, and the initial readings are often revised substantially, other indicators of housing activity also point in a favorable direction: Applications for mortgages to purchase homes rose sharply in May and remained elevated in June, and attitudes of households and builders toward the housing market became more positive in the second quarter.

Like single-family homebuilding, multifamily construction fell early this year, with starts off 11 percent in the first quarter. The drop this year follows a two-year period of recovery, during which starts doubled from their thirty-five-year low reached at the beginning of 1993. Multifamily starts turned back up in April and May. Prospects for a continued gradual increase in multifamily starts appear good, as newly built apartments were quickly filled last year and vacancy rates for apartments continued to move down in the first quarter of this year. However, continuing overhangs of empty apartments in some markets are likely to keep total multifamily starts well below the levels of the 1980s.

The Business Sector

In the second half of 1994, nonfarm inventories increased nearly 5 percent at an annual rate, about keeping pace with growth in final sales, as firms built stocks to ensure adequate supplies - or, in some instances, to beat anticipated price increases. In the first quarter, inventory growth continued at about its late 1994 pace, but growth in final sales moved down to a 2 1/2 percent annual rate, leaving many firms with stocks they did not want.

The first-quarter inventory run-up was disproportionately in motor vehicles, as production increased while sales were falling. To bring inventories back in line, manufacturers cut production sharply; between February and May, output dropped 10 percent. The decline in output of motor vehicles, parts, and related inputs was the most important factor in the 1 percent drop in overall industrial production in this period. Motor vehicle inventories accumulated further in April when sales fell sharply, but there was some progress in trimming excess stocks in May and June. Nonetheless, much of the overhang of vehicles that developed earlier this year remains.

The inventory buildup outside the motor-vehicle sector was also quite large in the first quarter, and it continued at a rapid pace in April. The available data for May suggest a somewhat smaller rate of increase. Although stocks of most goods remained in better alignment with sales than in the motor-vehicle sector, inventory accumulation has been running ahead of sales in a few sectors, particularly in apparel, furniture, and appliances. In response, manufacturers have cut production in these areas. The accumulation of furniture and appliances is likely related to the drop-off in home sales in early 1995, and the revival in home sales that appears to be under way should boost sales in these areas, helping to trim inventories further.

Business fixed investment rose at an extraordinary pace in the first quarter, with strong gains in both the equipment and structures components. Real spending on equipment increased at a 25 percent annual rate. With the exception of motor vehicles, the growth in equipment spending was widespread in the first quarter. For structures, real outlays increased at a 12 percent annual rate in the first quarter, following a 4 1/2 percent gain over the four quarters of 1994. The first-quarter increase in construction was also widespread across components.

Indicators for the second quarter suggest that growth in capital spending continued to be brisk although not quite as fast as in the first quarter. Shipments of capital goods by domestic manufacturers in April and May were up moderately from their first-quarter average. And permits for nonresidential structures, which tend to lead construction by a few months, indicate that construction should continue to trend upward although at a slower pace than in the early part of this year.

The surge in capital spending in recent years has pushed growth of the capital stock to its fastest pace since the late 1970s. This improvement in the rate of capital accumulation may lead to a pickup in productivity growth, but there is as yet little indication of a significant break with past trends. Indeed, when output is measured using the new chain-type alternative index - which will become the official measure later this year - trends in productivity growth in the nonfarm business sector in the 1990s are little changed from those of the 1970s and 1980s.

Corporate operating profits increased at a 7 percent annual rate in the first quarter, a somewhat faster pace than in the second half of 1994. However, first-quarter profits were boosted by an increase in earnings of U.S. corporations on foreign operations; profits on private domestic operations were about unchanged. The increase in profits on foreign operations resulted in part from the decline in the exchange value of the dollar, which pushed up the value of profits earned abroad. Private domestic financial profits improved in the first quarter, in part because of a surge in bank earnings, which were boosted by strong loan growth. First-quarter earnings on domestic operations of U.S. nonfinancial corporations declined slightly, following solid gains in 1994. Profits were 10.6 percent of the output of nonfinancial corporate businesses in the first quarter, about the same as in 1994 as a whole, when the profit share was the highest since

In the farm sector, indications are that production will fall well short of last year's exceptionally high levels. Weather conditions have been less favorable than those of 1994, with unusually heavy rains keeping plantings behind schedule across large parts of the Midwest. Also, with stocks relatively high after last year's large harvests, the U.S. Department of Agriculture reduced the amount of acreage that farmers contracting for subsidy payments were allowed to plant. However, livestock production has remained strong so far in 1995, which will help cushion the effects of smaller harvests on total agricultural production. Because of the likelihood that production will fall this year, farm inventory investment will probably be smaller this year than in 1994, and stocks of some crops will likely be drawn down appreciably.

The Government Sector

The federal government deficit has continued to shrink in the current fiscal year. For the first eight months of the 1995 fiscal year, the budget deficit was 19 percent below the same period a year earlier. Nominal expenditures over this period were 4 percent higher than a year earlier, while receipts were up 8 1/2 percent. In addition to the strong economic growth of 1994, receipts were boosted by changes in rules that allowed some individuals to defer until 1995 certain tax payments that would have been due in 1994 under previous rules.

Higher interest outlays contributed to the increase in federal spending in the first part of the 1995 fiscal year. Excluding interest outlays, nominal federal spending in the first eight months of this fiscal year increased about 2 percent, compared with the year-earlier period. Defense expenditures continued to decline in nominal terms; they have been the main factor holding down federal spending in recent years. Spending on income security programs, such as unemployment insurance and welfare benefits, also edged down, mostly reflecting the economic expansion. Spending on Medicare and other health programs was up 9 percent in the first eight months of the fiscal year; while still quite rapid, this growth is slower than that of the early 1990s, when these expenditures were rising 10 to 20 percent per year. Spending on social security and on other nondefense functions increased less than the recent trend in nominal GDP.

In real terms, federal purchases of goods and services - the part of federal spending included in gross domestic product - fell at an annual rate of 4 percent in the first quarter of 1995. Falling defense spending more than accounted for the decline. As of the first quarter, the level of real federal purchases was 17 percent below the peak reached four years ago.

State and local government deficits on combined capital and operating accounts (that is, excluding social insurance funds) totaled $37 billion in the first quarter of 1995, a small improvement from the deficit a year earlier. Excluding social insurance, tax receipts increased 7 percent between the first quarter of 1994 and the first quarter of 1995, while expenditures were up 6 1/4 percent. Transfer payments continue to grow faster than other spending, although the rate of increase is well below that earlier in the 1990s.

Real purchases of goods and services by state and local governments have been rising only moderately for some time; in the first quarter of 1995, they were little changed. The slowing in the first quarter was concentrated in construction spending, which fell after three quarters of solid increases. Purchases of other goods and services remained on the gradual uptrend that has been evident over the past few years. State and local employment increased about 14,000 per month, on average, over the first six months of 1995, considerably below the pace of the 1992-94 period.

The small improvement in the budget situation for the state and local sector as a whole masks important differences across levels of government. Available evidence suggests that while state budgets are in relatively good shape, budgets at the local level remain under pressure. State aid to localities, particularly to school districts, has been eroding relative to expenses for several years. Also, local governments rely more heavily than state governments on property taxes, and while sales and incomes have rebounded in the current business cycle expansion, property values have lagged behind, limiting property tax receipts.

The External Sector

The nominal trade deficit on goods and services widened somewhat in the first quarter, to $120 billion at an annual rate. However, net investment income improved in the first quarter, as did net transfers, and as a consequence, there was a narrowing of the current account deficit in the first quarter from its fourth-quarter level, to $162 billion at an annual rate. Nonetheless, the first-quarter current account deficit exceeded the 1994 average of $151 billion. In April, the trade deficit increased further from the first-quarter average.

The quantity of US. imports of goods and services expanded 10 percent at an annual rate during the first quarter, somewhat less rapidly than in 1994. The slower pace of US. income growth contributed to the lower import growth; increased imports from Mexico were a partial offset. In April, real imports continued to grow at about the first-quarter pace. The increases in imports in the first four months of the year were widespread across major trade categories.

Non-oil import prices rose at a 3 1/2 percent annual rate in the first quarter, somewhat less than during the second half of 1994, when they were pushed up by large increases in world commodity prices, especially for coffee. In April and May, non-oil import prices rose at a nearly 6 percent annual rate, with increases for most major trade categories. The pickup in price increases for imported goods reflected, in part, the recent dollar depreciation.

The quantity of U.S. exports of goods and services rose at a 5 percent annual rate in the first quarter, more slowly than the double-digit rate of growth over the four quarters of 1994. In large part, the weaker export performance was the result of the macroeconomic adjustments taking place in Mexico and the reduced Mexican demand for U.S. exports. Preliminary data for April indicated that the quantity of exports expanded a bit further from the first-quarter average. For the first four months of the year, exports to Mexico fell while they increased moderately to most other areas of the world.

Real output in Mexico declined sharply in the first quarter as instability in the financial markets weakened confidence and the government implemented a program of fiscal and monetary restraint. The Mexican economy apparently continued to contract in the second quarter. The crisis and ensuing policy responses induced a dramatic reduction in Mexico's current account deficit during the first quarter of the year. In the wake of the Mexican crisis, the Argentine authorities chose to tighten macroeconomic policies, which has led to a weakening of economic activity in Argentina. In contrast, Brazil experienced very strong growth of real output in the first quarter as consumption spending surged; available indicators suggest some slowing of growth in the second quarter.

In Japan, recovery from the recent recession remains tentative. First-quarter real GDP growth was only 0.3 percent at an annual rate; data for the second quarter also suggest that the recovery may be stalling. Asset prices have continued to fall, adding to concerns about the lack of progress in improving banks' balance sheets and limiting the capacity of banks to extend credit in support of the recovery. In May, the Japanese government announced another package of structural reforms and measures to boost domestic demand. The sluggish pace of activity in Japan and the rise in the value of the yen have eliminated inflation: Consumer prices were unchanged over the twelve months through June.

In other industrial countries, the rate of economic expansion appears to have slowed from its rapid 1994 pace. In Canada, real GDP growth slowed to less than 1 percent at an annual rate in the first quarter; second-quarter indicators suggest continued sluggishness. In the United Kingdom, where the expansion has been vigorous over the past three years, real GDP continued to grow strongly in the first quarter, although at less than the 1994 pace. In most continental European countries, the rate of real output growth in the first half of 1995 was somewhat lower than the rapid pace during the second half of 1994. In Canada and several major European countries, measures intended to reduce government deficits as a share of GDP have been announced.

Inflation rates in the industrial countries generally remain low. However, in the United Kingdom and Italy, currency depreciation has added upward pressure on prices, and consumer prices in the twelve months through June rose 3 1/2 percent in the United Kingdom and nearly 6 percent in Italy. In western Germany, exchange rate appreciation helped offset domestic inflationary pressures, and consumer prices rose only 2 1/4 percent in the twelve months through June.

Among our Asian trading partners other than Japan, real GDP growth has remained near the rapid 1994 pace, in part because substantial depreciations of those countries' currencies against the Japanese yen and the German mark stimulated exports. However, economic activity decelerated somewhat in China and Singapore, reflecting past tightening of monetary policy and the reduction of spare capacity in these economies.

Net capital flows into the United States were large in the first quarter of 1995. Foreign official holdings in the United States rose more than $20 billion, as foreign governments made large intervention purchases of dollars in March in response to strong upward pressure on the foreign exchange value of their currencies. Sizable official inflows continued in April and May. In addition, net private foreign purchases of US. securities were considerable in the first quarter, particularly purchases of Treasury bonds and notes and new Eurobond issues by US. corporations. Private foreign net purchases of U.S. securities moderated a bit in April and May. In contrast, U.S. net purchases of foreign securities, which had fallen substantially last year from their 1993 peak, continued to decline on balance over the first five months of 1995.

U.S. direct investment abroad was considerable in the first quarter, at $18 billion. Investment in Western Europe was particularly strong. Foreign direct investment in the United States, at $10 billion, remained substantial. On net, there was a large outflow of direct investment in the first quarter, after netting to about zero in 1994.

Labor Markets

Employment grew rapidly in 1994, and labor markets tightened considerably. Although job growth slowed in the first quarter of this year, it was still large enough - at 226,000 per month - to keep the unemployment rate at about the same level as in the fourth quarter of 1994. In the second quarter, growth of nonfarm payroll employment slowed to only 60,000 per month and the quarterly average unemployment rate edged up, from 5.5 percent to 5.7 percent.

The deceleration in employment was particularly marked in the goods-producing sector, where payrolls fell during the second quarter after posting strong gains in the early months of the year. In construction, payroll growth averaged 30,000 per month in 1994 and through the first quarter of 1995, but employment then fell 8,000 per month in the second quarter. Manufacturing job growth also averaged 30,000 per month in 1994. Factory hiring slowed in the first quarter, and in the second quarter, 35,000 jobs per month were lost. The decline in manufacturing employment was widespread across industries. Employers have also trimmed the factory workweek, which in 1994 had reached the highest level since 1945.

Although employment continued to rise in most service-producing industries in the first half of 1995, the rate of growth slowed by the second quarter. In wholesale and retail trade, where 75,000 jobs per month were added in the second half of 1994, the pace of job gains fell in the first quarter, and only 12,000 jobs per month were added in the second quarter. Similarly, in business services, where 46,000 jobs per month were added in 1994, employment decelerated in the first quarter and was about flat in the second. Among sectors showing employment gains in the first half of this year, entertainment industries posted considerable growth, and increases in employment in the health sector continued to run at about the same pace as in the second half of 1994.

The rate of increase in hourly compensation moved down further early this year. The employment cost index for private industry workers, a measure of hourly labor costs that includes both wages and benefits, rose 2.9 percent over the twelve months ended in March 1995, down from a 3.3 percent increase over the preceding twelvemonth period. The increase in wages and salaries was the same in both periods, but the pace of benefits gains declined significantly.

The largest contribution to the deceleration in benefits costs in recent years has come from health insurance. Among the factors restraining the increase in health insurance costs are slower medical-sector inflation, increased use of managed-care plans, and efforts by employers to shift a greater proportion of health care costs to employs. Costs of workers' compensation programs ave also contributed to the deceleration in benefits costs; these costs, too, have been affected by lower medical inflation, although regulatory reform has played a role as well. Unemployment insurance costs decelerated sharply over the past two years; firms pay into the unemployment insurance program on the basis of their recent layoff experience, and the improved economy through the first part of this year lowered these payments.

Output per hour in the nonfarm business sector - measured in 1987 dollars - increased at an annual rate of 2.7 percent in the first quarter of 1995. Output per hour increased 2.0 percent over the four quarters ended in the first quarter, down slightly from the rate of growth over the preceding four-quarter period.

Price Developments

The pickup in consumer price inflation so far this year was a bit larger for the index that excludes food and energy than for overall prices: The CPI excluding food and energy increased at a 3.6 percent annual rate over the first six months of 1995, up from a 2.6 percent increase in 1994. The acceleration in the first half was mostly in non-energy services prices, which increased at a 4 1/2 percent annual rate over the first six months of 1995, up from a 3 1/4 percent increase over the twelve months of 1994. Airfares increased sharply in the first half of 1995, rising at more than a 40 percent annual rate after falling 10 percent in 1994; this acceleration accounted for two-thirds of the pickup in services inflation in the first half Auto finance rates also increased rapidly early in 1995-rising at a 38 percent annual rate in the first four months the year - following a large increase in the second half of 1994. However, the CPI for auto finance declined sharply in May and June as interest rates on auto loans began to reflect the declines in market rates in the first half of 1995. Price increases for other services were, on balance, roughly in line with their rate of increase in 1994.

As a result of the brisk expansion of the industrial sector in 1994 and the consequent rapid increases in prices of basic manufactured products, the producer price index for intermediate materials other than food and energy increased at a 7 1/2 percent annual rate over the second half of 1994. In the first quarter of this year, these materials prices rose even faster - nearly 10 percent at an annual rate. The rapid increases in materials prices began to affect finished goods prices in early 1995, and the PPI for finished goods other than food and energy, which covers domestically produced consumer goods and capital equipment, increased at a 3 percent annual rate over the first six months of 1995, up from a 1 1/2 percent rate of increase over the twelve months of 1994.

The consumer price index for commodities other than food and energy increased at a 1 1/2 percent annual rate over the first six months of 1995, about the same as in 1994. Prices accelerated at the retail level for some items for which producer prices have been rising rapidly, such as household paper products. But this pickup was partly offset by declines in prices where there have been large inventory buildups. Notably, apparel prices continued to decline in the first half, and prices of appliances, which had increased in 1994, fell in the first half of 1995.

The slowdown in the industrial sector has begun to relieve pressure on materials prices, and the PPI for intermediate materials other than food and energy increased just 0.2 percent per month in May and again in June, suggesting reduced pressures on finished goods prices in the near term.

Consumer food prices increased at a 1 3/4 percent annual rate over the first six months of 1995, down about a percentage point from 1994. Coffee prices, which had increased 64 percent in 1994, fell 12 percent over the first six months of this year. The swing in coffee prices can more than account for the deceleration in food prices. Prices of meats continued to fall in the first half of 1995, as production remained strong.

Energy prices increased at a 2 percent annual rate in the first half of 1995, about the same as last year. Natural gas prices have continued to decline. Regulatory changes have led to increased competition among suppliers of natural gas; in addition, natural gas prices were depressed early this year by the relatively warm winter, which held down demand. Gasoline prices increased at a 12 percent annual rate in the second quarter, reflecting the run-up in crude oil prices that occurred between December and April. Since April, crude oil prices have reversed nearly all of their earlier run-up, indicating that gasoline prices will move down in coming months.

Survey data suggest that expectations of inflation have changed little since the end of 1994. According to the survey of households conducted by the Survey Research Center of the University of Michigan, as of the first half of 1995, the expected increase in consumer prices over the coming twelve months was the same as it was in the fourth quarter of 1994. In the Conference Board survey of households, the expected rate of inflation over the coming year remained at 4 1/4 percent in the first half of 1995, the same as in each of the four quarters of 1994. Expectations of inflation over longer periods also have not changed much on balance this year. In the University of Michigan survey, the expectation in the second quarter of 1995 for the rate of consumer price inflation over the next five to ten years was the same as it was in the fourth quarter of 1994. Similarly, in the May 1995 survey of professional forecasters conducted by the Federal Reserve Bank of Philadelphia, expectations of inflation over the coming ten years were about 3 1/2 percent, the same as in the survey taken at the end of 1994.

Financial, Credit, and Monetary

Developments

In charting the course of monetary policy this year, the Federal Reserve has sought to promote sustainable economic growth and continued progress toward price stability. Despite the tightening actions undertaken during 1994, economic data at the beginning of 1995 suggested that the economy was operating beyond its long-run potential and might continue to do so for some time - a situation that would no doubt lead to a significant pickup in inflation if allowed to persist. Against this backdrop, the Federal Open Market Committee voted in February to tighten reserve conditions somewhat further, resulting in a 1/2 percentage point increase in the federal funds rate. In the months following the February FOMC meeting, economic activity seemed to be leveling out, at least temporarily, considerably reducing pressures on resources. In early July, with the risks of a prolonged upturn in inflation fading, the FOMC decided to ease reserve pressures slightly, resulting in a decline in the federal funds rate of 1/4 percentage point.

As incoming data in 1995 increasingly suggested slower economic growth and an attendant relief of inflation pressures, intermediate- and long-term interest rates moved down substantially. Additional downward pressures seemed also to arise from the growing conviction of market participants of the commitment of the Congress and Administration to making progress toward a balanced budget. On balance, most longer-term interest rates have declined 120 to 180 basis points since the end of last year, with the sharpest drops at intermediate maturities. The trade-weighted exchange value of the dollar has depreciated about 71/2 percent against the other G-10 currencies - in large part reflecting the decline in US. long-term interest rates relative to those in the other G-10 countries. In addition, the fall in interest rates, coupled with continued strong corporate earnings, fueled a run-up in equity prices; most major stock price indexes have climbed 15 to 35 percent since the beginning of the year.

Despite slower economic expansion this year, growth rates of broad money and credit have picked up, and the decline in intermediate- and long-term interest rates has only recently begun to leave an imprint on the composition of borrowing. Total domestic nonfinancial debt increased 5 1/2 percent from the fourth quarter of 1994 through May - a little above last year's pace - as stronger private sector borrowing more than offset slower growth of the federal debt and a decline in state and local government debt. Borrowing in the non-financial business sector has been largely concentrated in short-term or floating-rate debt such as bank loans and commercial paper. Recently, however, declines in longer-term interest rates have stimulated a sharp jump in corporate bond issuance. Household borrowing this year has been considerable, although below the pace of 1994. Tax-exempt debt is estimated to have declined outright again this year as many state and local units have called securities that had been advance refunded. Federal debt growth has edged down a bit this year, extending the trend toward slower expansion of federal debt that began in 1991.

Depository institutions have been especially important suppliers of credit to both businesses and households this year. Borrowers' demands were concentrated in the types of credit in which depositories are traditional lenders and, on the supply side, commercial banks continued to pursue new lending opportunities aggressively. The health and profitability of depositories have remained solid to date, although federal regulators have cautioned depositories that their lending standards should take account of the potential for deterioration of loan performance in a less favorable economic climate.

The surge in bank lending and the flattening of the yield curve this year have provided a significant impetus for growth of the broad monetary aggregates. M3 advanced 61/4 percent at an annual rate from the fourth quarter of 1994 through June - slightly above the upper bound of its revised 2 to 6 percent annual range set at the July FOMC meeting-as banks pulled in deposits to fund loans. The drop in market interest rates has enhanced the attractiveness of M2, which increased at a 3 3/4 percent rate over the same period - a little above the midpoint of its annual range. In contrast to the expansion of the broad monetary aggregates, MI growth has been quite weak, reflecting the low yields on these assets and the implementation by a few banks of retail sweep accounts, which move funds out of NOW accounts and into nontransaction balances.

The Course of Policy and Interest Rates

The Federal Reserve entered 1995 having tightened policy appreciably during 1994, thereby boosting short-term rates 2 1/2 percentage points. Nonetheless, data reviewed at the FOMC meeting in December 1994 suggested that pressures on resources were intensifying and that inflation threatened to move higher. Although the Committee took no action to increase rates further at this meeting, it did adopt a directive indicating a bias toward additional tightening in the intermeeting period.

Information reviewed at the February meeting suggested that despite some fragmentary evidence of slowing, the economic expansion remained brisk in an economy already operating at or beyond its long-run potential. The demand for consumer durables and homes was softening, but output and employment had posted substantial gains near yea-rend, and capacity utilization had moved up from already high levels. In addition, a marked rise in materials prices during the second half of 1994 posed a threat of increased consumer price inflation in coming months. In these circumstances, the Board of Governors approved the pending requests of several Reserve Banks for a 1/2 percentage point increase in the discount rate, and the Committee agreed to allow this increase to show through fully to the federal funds rate. In light of the tightening of policy called for at this meeting and the anticipated lagged effects of previous tightenings, the Committee viewed the odds of a need for further policy action developing over the intermeeting period as relatively small and evenly balanced, and therefore issued a symmetric directive to guide any intermeeting changes in reserve conditions.

In subsequent weeks, evidence suggested that economic activity was moderating, especially in the interest-sensitive sectors. Financial markets appeared to view these signs as indicating that the previous policy actions of the Federal Reserve had substantially reduced the odds of rising inflation and thus also the need for additional monetary restraint. Indeed, yields on Treasury securities at maturities ranging from one to ten years fell 60 to 70 basis points between the February and March FOMC meetings.

At its meeting in late March, it was not clear to the Committee whether the deceleration in economic activity was only temporary or was a lasting shift toward a sustainable rate of economic expansion. On balance, the Committee viewed the economy as retaining considerable upward momentum and observed that the decline in longer-term interest rates, the rise in stock prices, and the sharp depreciation of the exchange value of the dollar could be expected to buoy aggregate demand in the months ahead. Moreover, consumer prices, as anticipated, had risen more rapidly in 1995. In these circumstances, the Committee determined that it would be prudent to await further information before taking any additional policy actions, but the Committee's directive included a bias toward additional monetary restraint over the intermeeting period. The asymmetric directive was considered appropriate to emphasize the Committee's commitment to containing and ultimately reducing inflation, in a period when it seemed to be moving higher.

Following the March meeting, incoming data signaled a further deceleration of economic activity. In addition, financial markets appeared to view budget discussions in the Congress as foreshadowing significant fiscal restraint over the balance of the decade. Shorter-term interest rates began to incorporate the possibility of an easing of monetary policy, and yields on longer-term securities - especially those at intermediate maturities - moved down sharply as well.

Information reviewed at the May FOMC meeting provided persuasive evidence that the pace of the economic expansion had slowed, relieving pressures on resources and reducing the threat of a pickup in inflation. The Committee observed that an adjustment to inventory imbalances that had developed earlier in the year was contributing to the slowdown and that the underlying trajectory of final sales was still unclear. The Committee determined that the existing stance of policy was appropriate in these circumstances and adopted a symmetric directive regarding potential policy adjustments during the intermeeting period.

Employment data released shortly after the May FOMC meeting were surprisingly weak, prompting considerable speculation in financial markets of an imminent monetary policy easing. The sharpness of the downward movement in longer-term rates seemed to reflect, in addition to economic fundamentals, trading dynamics associated with the attempts of investors to rebalance their portfolios in light of the substantial change in interest rates. At one point in late June, the spread between the thirty-year Treasury bond yield and the federal funds rate reached a low of 48 basis points but edged higher in subsequent weeks.

From the information reviewed at the July meeting of the FOMC, it appeared that the economy flattened out during the second quarter as businesses sought to pare inventories to desired levels. This pause in the expansion, in turn, had alleviated the inflation pressures that had loomed large earlier in the year. In these circumstances, the Committee voted to ease reserve pressures slightly, resulting in a 1/4 percentage point decline in the federal funds rate. Although financial markets had anticipated a decline in the federal funds rate at some point, both bond and equity markets rallied strongly after the change in policy was announced. At the close on July 7, the thirty-year bond rate was down about 165 basis points from its recent high of last November.

Credit and Money Flows

The debt of domestic nonfinancial sectors grew 5 1/2 percent at an annual rate from the fourth quarter of 1994 through May of this year - a modest pickup over the pace of recent years but well within its annual range of 3 to 7 percent. Slower growth of federal debt and a decline in the debt of state and local governments in 1995 were more than offset by strength in business and household borrowing. Although declines in longer-term interest rates and the flattening of the yield curve have stimulated long-term, fixed rate borrowing of late, both households and businesses continued during much of the year to favor borrowing that was short-term or floating-rate. In part, the reliance on such debt contributed to the larger share of private debt intermediated through the depository sector. In meeting increased credit demands, depositories turned more heavily to time deposits and other liabilities included in M2 and M3. Stronger funding needs and increased reliance on deposits provided a considerable lift to growth of the broad monetary aggregates.

Slower growth of federal debt this year relative to 1994 reflects stronger tax revenues and diminished growth of expenditures, especially defense-related outlays. In the state and local sector, debt outstanding has continued to decline, largely driven by calls of higher-cost debt issued during the 1980s.(1) Yields on municipal bonds relative to Treasuries had moved up considerably after Orange County defaulted on its debt late in 1994 but reversed much of this increase early in 1995. The ratio of municipal yields to Treasury bond yields has chmbed again more recently as various budget proposals before the Congress raised the prospect of reduced federal tax advantages for municipal debt. In addition, the recent decision by Orange County voters not to raise taxes to cover the county's losses has tended to boost risk premiums for the obligations of many municipalities in California and, to a lesser extent, for other borrowers in the municipal bond market.

Borrowing by households - although off a bit from last year's pace - has generally remained strong this year. Weaker auto sales and the associated slower growth of auto loans resulted in a modest deceleration of consumer credit. Growth of revolving credit - principally credit card debt - trended higher from the already brisk pace recorded last year. The profiferation of incentive programs offered with many credit cards has likely encouraged greater convenience use for transactions in recent quarters.

Growth of home mortgage debt moderated somewhat in the first quarter, a pattern consistent with the overall sluggish demand for housing. As long-term rates moved down this year, the pronounced shift toward adjustable rate mortgages (ARMs) evident last year dissipated. As of May, 60 percent of new mortgage originations were fixed rate mortgages (FRMs). In addition, the decline in long-term rates in recent months has sparked renewed interest in refinancing. Households carrying ARMs with rates that are (or soon will be) above rates offered on FRMS have reportedly begun to refinance with FRMs.

Household debt-service burdens - measured as the ratio of scheduled principal and interest payments on debt relative to income - have risen in 1995 but remain well below levels reached in the late 1980s and early 1990s. Mortgage refinancings undertaken at lower interest rates in recent years have helped to keep the level of debt-service burdens relatively low despite the growth of household debt relative to income. In fact, some measures of delinquency rates on home mortgages have edged down this year to the lowest levels in more than twenty years. The picture for delinquency rates on consumer credit is less clear: Some measures such as the delinquency rates on consumer installment credit remain quite low, while others - especially auto loans booked at finance companies - have moved up considerably.

Borrowing by nonfinancial businesses has increased in 1995, propelled in large part by a rise in capital expenditures in excess of internal sources of funds and a jump in merger activity. In addition, a number of firms have initiated stock repurchases financed in part with debt. As in 1994, the composition of business borrowing this year has been heavily weighted toward short-term commercial paper and bank loans. Lower long-term interest rates, however, have stimulated a flurry of new bond issues very recently. 326 Various unsettling developments in financial markets, including the Orange County debacle, losses associated with complex derivatives and cash instruments, the failure of Barings Brothers, and the financial crisis in Mexico, have had some limited effects on the specific companies or sectors involved. They have not, however, had a large impact on broad market perceptions of credit risks; spreads of yields on short- and long-term corporate debt over Treasuries have widened only a bit this year, a situation that likely reflects the elevated supply of new corporate debt and perhaps a small uptick in risk premiums.

The gap between the capital expenditures and internal cash flow of nonfinancial corporations the financing gap) began widening in mid-1994 and has grown even larger in 1995. In part, the bulge in the financing gap is the result of the large buildup of inventories earlier in the year. Most external funding for the purpose of carrying inventories apparently has taken the form of commercial paper or bank loans.

A surge in merger activity beginning in late 1994 has also spurred business borrowing. Many of the largest mergers have been strategic, intra-industry combinations, concentrated especially in areas such as defense, pharmaceuticals, telecommunications, and (most recently) banking. In contrast to the merger and acquisition wave during the late 1980s, the current acquisition boom has not entailed highly leveraged takeovers financed heavily with junk bonds. Indeed, until quite recently, junk bond issuance this year had been anemic. Merger activity in recent quarters has involved substantial use of stock swaps coupled with reductions in financial assets and new investment-grade debt issuance (often in the form of commercial paper). Survey evidence indicates that banks have played only a modest role in directly funding recent mergers, although they have facilitated transactions by providing backup lines for merger-related commercial paper.

Equity retirements associated with mergers have accounted for a sizable portion of the decline in net equity shares outstanding. In addition, gross issuance of new equity has ebbed as price-earnings ratios have fallen and many firms have repurchased their stock with both accumulated cash and the proceeds of new debt.

The shift to short-term funding in the business sector has been a boon to intermediaries that tend to specialize in short-term lending. Finance companies and commercial banks, in particular, have enjoyed a prominent role as suppliers of credit over the past year. To date, there are few indications that the health of these institutions has deteriorated. Credit ratings for finance companies have been stable, and bank profitability and capital ratios have been solid.

An important factor contributing to the overall strength of depository credit has been the stabilization of the thrift industry, especially savings and loan associations. After several years of sharp contraction, thrift assets expanded slightly over the second half of 1994 and continued a modest recovery in 1995. The number of thrift institutions continues to decline, however, with many filing for bank charters or being acquired by banks.

The growth of bank credit picked up appreciably during the first half of 1995, with strength especially evident in bank loans. Indeed, over the past twelve months, the share of the increase in nonfederal domestic debt funded by bank loans climbed to record levels. Surveys of bank lending officers have indicated banks' increased willingness to extend consumer credit as well as continued easing of terms and standards applied to business loans. Data from the Federal Reserve's Survey of Terms of Bank Lending to Business show that spreads of loan rates over the federal funds rate for large commercial loans have been about the same as last year but well below those prevailing through much of the late 1980s and early 1990s. Comparable spreads for smaller commercial loans are wider than in the late 1980s but have continued the narrowing trend of recent years. The strength of bank lending has been viewed favorably in financial markets-bank stock prices have risen this year about in line with or faster than the climb in broad stock price indexes, while spreads on bank debt relative to Treasuries have widened only slightly.

The continued easing of bank lending standards after more than a year of monetary policy restraint has attracted the attention of federal regulators. The Office of the Comptroller of the Currency warned banks against allowing their standards to fall to a point that could expose them to heavy losses in an economic downturn. In the same spirit, the Federal Reserve issued a supervisory letter cautioning banks that loan terms and standards should be set with a long-term view that takes loan performance in less favorable economic conditions into account.

Banks have funded the bulge in their loan portfolios this year in part by liquidating a portion of the large holdings of securities they had accumulated earlier in the 1990S.(2) In addition, banks have increased their habilities. Last year, banks relied heavily on borrowings from their non-U.S. offices to fund growth of their domestic assets. Deposit growth at the foreign offices of U.S. banks has slowed considerably this year. Consistent with this development, borrowing by domestically chartered banks from their foreign offices has increased in 1995 but not at the pace of last year.

Depositories' shift back into funding with domestic liabilities has helped spur the growth of the broad monetary aggregates this year. From the fourth quarter of 1994 through June, growth of M3 has averaged 6 1/4 percent, placing the level of M3 above the upper bound of its annual range. Over the same period, M2 growth has averaged 3 3/4 percent, placing the level of M2 in the upper half of its annual range.

The pickup in M3 growth this year reflects stronger expansion in both its M2 and non-m2 components. The acceleration of "wholesale" funding sources, especially large time deposits, has been quite marked this year. Banks' heavier reliance on wholesale funds is typical during periods in which bank loan portfolios are expanding swiftly. The non-M2 portion of M3 has also been boosted by a sharp jump in institution-only money funds. The yields on these funds tend to lag movements in short-term market interest rates and, as a result, became especially attractive to investors when short-term market interest rates began falling on expectations of a near-term easing of monetary policy.

The acceleration of M2 this year results chiefly from the warning influence of previous increases in short-term interest rates and a marked flattening of the yield curve. On balance this year, the returns on assets in M2 have become more attractive relative to both short- and long-term market instruments. Sizable inflows to stock mutual funds have continued, but the flatter yield curve has damped the demand for other long-term investments. Inflows to bond mutual funds - while stronger than during the bond market rout last year - have been much smaller than inflows earlier in the 1990s. Also, judging from noncompetitive tenders at recent Treasury auctions, households' direct investments in Treasury securities have dwindled sharply this year. At least a portion of the flows that previously had been directed to mutual funds and direct investments in securities appears to have boosted M2 growth. Growth of money market mutual funds and small time deposits, in particular, has been especially brisk. Indeed, more than half of the increase in M2 since April is attributable to a steep climb in M2 money funds.

In contrast to the marked expansion of the broader aggregates, MI growth has weakened this year, primarily as a result of wide opportunity costs on transaction deposits and the introduction and expansion of retail sweep accounts at some large banks. Interest rates offered on other checkable deposits (OCDs) have edged up only slightly since the beginning of 1994 despite the sharp rise in short-term market interest rates. Households have responded by reducing balances in these accounts in favor of higher-yielding assets.

The development of sweep accounts by a few large banks for their retail customers has facilitated the shift away from transaction balances. Sweep accounts transfer a customer's OCD account balances in excess of a certain threshold into a money market deposit account (MMDA). Automatic transfers from the customer's NMDA account back to the OCD account are initiated as checks and other withdrawals deplete OCD balances. Such sweep accounts may allow customers to earn more interest and benefit the bank by reducing its required reserves.3 Estimates suggest that retail sweep accounts have reduced M1 by about $12 billion so far this year. These programs affect the composition but not the level of M2 because balances are swept from transaction deposits into other accounts included in M2.

The expansion of retail sweep accounts poses some potential problems for the implementation of monetary policy by the Federal Reserve. To date, such accounts have been offered by large banks that must maintain a balance at a Federal Reserve Bank to meet their reserve requirements. As a result, the reduction in required reserves associated with sweep accounts has implied a nearly equivalent reduction in aggregate required reserve balances; estimates suggest that the $12 billion dollar decline in OCDs this year translates to a reduction in required reserve balances of nearly $1.2 billion.4 In early 1991, following the cut in reserve requirements at the end of 1990, unusually low levels of aggregate reserve balances were associated with greater variability in the federal funds rate as banks' volatile clearing needs began to dominate the demand for reserves. If many banks begin to offer retail sweep programs in the future, the aggregate level of required reserve balances would likely fall substantially, potentially leading to instability in the aggregate demand for reserves.

The monetary base expanded at a 5 1/2 percent rate from the fourth quarter of 1994 through June. Currency growth this year - at 7 1/4 percent from 1994:Q4 through June - is off a bit from last year's pace but still quite robust. Foreign demands for U.S. currency have generally remained strong this year. In concert with the decline in transaction deposits, total reserves contracted at a 6 percent rate from 1994:Q4 through June. In the absence of the increase in sweep accounts, the decline in total reserves over this period would have been 2 1/2 percent at an annual rate.

International Financial Developments

At the turn of the year, the foreign exchange value of the dollar was under downward pressure, and that pressure continued through the first months of 1995. On balance, the multilateral trade-weighted value of the dollar in terms of the other G-10 currencies has depreciated about 7 1/2 percent since the end of December 1994. The dollar declined as economic indicators began to suggest that economic growth in the United States was slowing, lowering the likelihood of further increases in U.S. market interest rates. In addition, the Mexican crisis appeared to weigh on the dollar in early 1995. External adjustment by Mexico was rightly expected to involve, to an important extent, a corresponding decrease in U.S. net exports. Primarily for that reason, financial turmoil in Mexico and depreciation of the peso were seen as having possible adverse implications for U.S. growth and external accounts and, in general, as negative for dollar-denominated assets.

The dollar was supported only briefly by the increase in the discount rate and the federal funds rate at the February FOMC meeting. With the U.S. economic expansion softening, market participants came to expect that no further increases in these rates were likely in the near term. Downward pressure on the dollar intensified in late February, and on March 2, in somewhat thin and disorderly market conditions, the dollar fell sharply further against the mark and the yen. The foreign exchange Trading Desk at the New York Federal Reserve Bank entered the market, selling both marks and yen on behalf of the Treasury and the Federal Reserve System. The next day several other central banks joined the Desk in concerted intervention in support of the dollar. Intervention by the Desk on behalf of the Treasury and the Federal Reserve System totaled $1.42 billion. In a statement confirming the intervention, Secretary Rubin highlighted official concern about the dollar's exchange value. Downward pressure on the dollar continued, particularly against the yen, and on April 3 and 5 the Desk, acting on behalf of the Treasury and Federal Reserve System, again joined several other central banks in intervention to support the dollar. Secretary Rubin issued a statement that these actions were in response to recent movement on exchange markets and that the Administration was committed to a strong dollar.

The dollar fell further through mid-April, particularly against the yen, and on April 19 it touched a record low of less than 80 yen per dollar. After recovering slightly and remaining fairly stable through mid-May, the dollar rebounded sharply but subsequently relinquished some of those gains. On May 31, the Desk - on behalf of the Treasury and the Federal Reserve - joined the central banks of the other G-10 countries in intervention purchases of dollars. Secretary Rubin stated that the intervention was in keeping with the objectives of the April 28 communique of the G-7 finance ministers and central bank governors, which endorsed the orderly reversal of the decline in the dollar in terms of other G-7 currencies. Through May and June, the dollar fluctuated in a range somewhat above its lows of mid-April and early May. On July 7, following moves by both the Federal Reserve and the Bank of Japan to ease monetary conditions, the Desk joined the Japanese monetary authorities in intervention purchases of dollars; the dollar moved up a bit in response.

Long-term (ten-year) interest rates in the major foreign industrial countries have, on average, declined about 100 basis points since December as economic indicators have suggested some slowing of real output growth abroad as well as in the United States. With U.S. long-term rates falling much more, about 170 basis points on balance, the change in the long-term interest differential is consistent with some decline in the exchange value of the dollar. Long-term rates have dropped about 150 basis points in Japan, nearly as much as the decline in U.S. long-term rates. Rates in Germany are down about 90 basis points. Three-month market interest rates in these countries have declined about 90 basis points on average since year-end 1994; central bank official lending rates were lowered in 1995 in several countries, including Japan, Germany, and Canada. Following the Federal Reserve easing on July 6, the central banks of Canada and Japan lowered overnight lending rates.

Since December 1994, the dollar has depreciated about 12 percent on balance against the Japanese yen, despite declines in Japanese long-term rates that nearly matched the decline in U.S. rates. The yen fluctuated in response to progress, or lack of progress, in the resolution of trade disputes with the United States. Persistent strength in the yen appears to reflect the large Japanese current account surplus and market perceptions that some adjustment of that surplus, through yen appreciation, is inevitable, especially given the slow growth of the Japanese economy. Japanese financial markets more broadly have reflected the weak state of the Japanese economy. Stock prices have fallen considerably so far this year, with the Nikkei down about 16 percent since the end of December, and land prices have fallen further. These declines in asset prices have added to the perceived risks in the Japanese banking system and concerns that the recovery in economic activity is stalling.

Net depreciation of the dollar in terms of the German mark over this period has been about 10 percent. Some of the upward pressure on the mark over the past several months resulted from shifts within the Exchange Rate Mechanism (ERM) of the European Monetary System, as political uncertainties and fiscal problems in Italy, Sweden, Spain, and later France, led at times to the selhng of their respective currencies for marks. Realignment within the ERM on March 5 that lowered the values of the Spanish peseta and the Portuguese escudo contributed to the upward movement of the mark. In contrast to the dollar's movement against the yen and the mark since December, the dollar is down only 3 percent in terms of the Canadian dollar. Early in the year, the US. dollar appreciated against the Canadian dollar; uncertainty about whether fiscal problems in Canada would be addressed and spillover from the Mexican crisis caused the Canadian dollar to fall. Since then, the Canadian dollar has regained those losses.

Over the past several months, the Mexican peso has recovered somewhat in terms of the U.S. dollar from the lows reached during the height of the crisis. On balance, the peso has depreciated 40 percent in nominal terms from December 19, 1994, before the crisis broke out. Mexican officials have drawn on the Treasury Department's Exchange Stabilization Fund facility and the Federal Reserve's swap line in addressing Mexico's intemational liquidity problems. Outstanding net drawings to date total $12.5 billion. Tbe outstanding total of tesebonos, the govermnent's dollar-denominated short-term obligations, has been reduced below $10 billion.

(1.) Many state and local units took advantage of historically low long-term interest rates in 1993 to issue bonds that were targeted to replace existing high-cost debt issued during the 1980s as the call dates on those bonds arrived. Calls on previously issued debt likely will continue to depress net state and local borrowing for some time. (2.) Published data on changes in securities portfolios at banks may not accurately portray funding strategies because recent accounting changes have increased the share of securities and off-balance-sheet contracts that must be marked to market on banks' balance sheets. Estimates suggest that changes in the market valuation of securities and off-balance-sheet contracts under these accounting rules have added about I percentage point at an annual rate to the growth of bank credit from the fourth quarter of 1994 through June of this year. (3.) Under the current structure of reserve requirements, OCD accounts are subject to a 10 percent reserve requirement at banks with more than $54 million of net transaction deposits. By law, personal MMDAs are exempt from reserve requirements. (4.) The reduction in required reserve balances is not necessarily identical to the reduction in required reserves because banks typically use vault cash in addition to reserve balances to satisfy reserve requirements. The level of vault cash held by banks is primarily determined by their customers' needs. Required reserves for some banks are nearly or even completely satisfied by vault cash. In these cases, a reduction in required reserves due to sweeps would not show through to a decline in required reserve balances on a one-for-one basis.
COPYRIGHT 1995 Board of Governors of the Federal Reserve System
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Title Annotation:Federal Reserve Board report of July 19, 1995
Publication:Federal Reserve Bulletin
Date:Aug 1, 1995
Words:12668
Previous Article:Treasury and Federal Reserve foreign exchange operations.
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