For use at 10:00 a.m., E.D.T.ThursdayJuly 18, 1996

Board of Governors of the Federal Reserve System

Monetary Policy Report to the CongressPursuant to theFull Employment and Balanced Growth Act of 1978

July 18, 1996

Letter of Transmittal

BOARD OF GOVERNORS OF THEFEDERAL RESERVE SYSTEMWashington, D.C., July 18, 1996

THE PRESIDENT OF THE SENATETHE SPEAKER OF THE HOUSE OF REPRESENTATIVES

The Board of Governors is pleased to submit its Monetary Policy Report to the Congress, pursuant to theFull Employment and Balanced Growth Act of 1978.

Sincerely,

Alan Greenspan, Chairman

Table of Contents

Page

Section 1: Monetary Policy and the Economic Outlook 1

Section 2: Economic and Financial Developments in 1996 6

Section 1: Monetary Policy and the Economic Outlook

The U.S. economy performed well in the first halfof 1996. In early February, when the Federal Reserveprepared its last report on monetary policy, there wassome concern about the strength and durability of thecurrent economic expansion: The economy wasoperating at a relatively high level of resource utiliza-tion, but it was not exhibiting a great deal of forwardmomentum. As the year has unfolded, however, eco-nomic activity has proven quite robust. After risingonly fractionally in the fourth quarter of 1995, realgross domestic product posted a solid gain over thefirst half of 1996, providing a considerable lift to jobgrowth. Looking ahead, the members of the FederalOpen Market Committee (FOMC) anticipate that eco-nomic activity will grow more moderately, on aver-age, in coming quarters and that the unemploymentrate will remain around the level it has averaged overthe past year and a half.

Although overall consumer price inflation wasboosted by higher energy prices during the first halfof the year, the underlying trend of prices still appearsto have been well contained. Over the past twelvemonths, the consumer price index excluding food andenergy items has risen 23⁄4 percent—near the lowerend of the narrow range that has prevailed since early1994. Moreover, the deflator for personal consump-tion expenditures on items other than food and energyderived from data reported in the national income andproduct accounts has continued to show a slowingtrend.

The combination of brisk growth and favorableunderlying inflation so far this year has, of course,been welcome. Nonetheless, mounting pressures onresources are apparent in some segments of theeconomy—most notably in the labor market—andthese pressures must be monitored closely. Allowinginflationary forces to intensify would ultimatelydisrupt the growth process. The Federal Reserverecognizes that its contribution to promoting theoptimal performance of the economy involvescontaining the rate of inflation and, over time, mov-ing toward price stability.

Monetary Policy, Financial Markets, andthe Economy over the First Half of 1996

Information available around the turn of the yearsuggested that the economy had downshifted afterposting a strong gain in the third quarter of 1995. Thegrowth of final demand appeared to have slowed,

reflecting importantly a deceleration of consumerspending. In addition, hesitant growth abroad and astrengthening in the foreign exchange value of thedollar relative to the levels prevailing at mid-1995were seen as limiting the prospects for further growthin exports. The slowdown in the growth of finaldemand had given rise to inventory buildups insome industries; in turn, the production cutbacksundertaken in response to those buildups were hav-ing a further damping effect on economic activity.Meanwhile, data on prices and wages suggestedthat inflation performance continued to be fairlysatisfactory—indeed, better than many members ofthe FOMC had expected as of midyear 1995. Tokeep the stance of monetary policy from becomingeffectively more restrictive owing to the slowdownin inflation in the second half of last year, and topromote sustainable growth, the Committee eased thestance of policy in December 1995 and again at theend of January 1996, bringing the federal funds ratedown a half percentage point in total, to 51⁄4 percent.

Most participants in financial markets wereunsurprised by these policy adjustments, given theeconomic backdrop. Moreover, they anticipated thatthere would be scope for additional easing steps in thecoming months. Thus, between mid-December andthe end of January, interest rates on Treasury securi-ties generally moved lower, especially at short andintermediate maturities, and stock price indexesedged higher on balance. The dollar strengthenedslightly on net against the currencies of the otherG-10 countries, reflecting in part disappointing newsabout the pace of activity in Europe and consequentlylarger declines in interest rates there than in theUnited States.

The underlying trends in the economy early in theyear were obscured to a degree by extraordinarilyadverse weather that affected a significant part of thecountry. Through the course of the next few months,however, it became increasingly clear that the econ-omy had regained vitality. Consumer spending perkedup after a lackluster holiday season, and was onlytemporarily depressed by the severe winter. Busi-ness demand for equipment proved quite strong, asdid housing demand. The strengthening in salesfacilitated businesses’ efforts to control their inven-tories, and as that situation improved, industrialproduction rebounded smartly. Overall employmentgrowth was brisk, and by June the unemployment ratereached its lowest level in six years.

1

Inflation during the first half of the year was gener-ally well behaved. Energy prices surged, mainly inresponse to a runup in the world price of oil, and badnews about grain crops raised the prospect of higherfood prices down the road. However, price inflationfor consumer items other than food and energy heldsteady or moved a bit lower. Labor costs presented amixed picture. The increase in total hourly compen-sation over the first three months of the year, asmeasured by the employment cost index, was in linewith its recent moderate trend. However, within totalcompensation, the wage and salary component of theECI surged in the first quarter, and further signals ofwage acceleration came from a more rapid increase inaverage hourly earnings in the second quarter.

Against the backdrop of stronger activity butsubdued inflation trends, the Federal Reserve madeno adjustments to its policy stance after January. Witheconomic activity more clearly on the upswing, how-ever, and prospects for a breakthrough on the fed-eral budget seeming to fade, intermediate- and long-term interest rates reversed course in February andtrended up over subsequent months. Since the end ofDecember, the yield on the 30-year Treasury bond hasincreased about 1 percentage point, on net, while theyield on the 5-year note has risen about 11⁄4 percent-age points over the same period. The rate on three-

month bills has edged up only slightly. Despite thebackup in bond yields, major stock-price indexes roseconsiderably further through the first half of the year;most of those gains were erased in late June and thefirst half of July, however, as company reports raisedquestions about the pace of earnings growth. The risein bond yields has boosted the dollar in foreignexchange markets; since mid-April, the dollar hasgenerally traded against an average of the currenciesof the other major industrial countries about 4 per-cent above its level at the end of December.

During the first half of the year, credit remainedeasily available to most household and business appli-cants. Interest-rate spreads on private debt overTreasury securities remained narrow. In response tothe recent increase in delinquencies on credit-cardaccounts, many banks have tightened their standardsfor approval of new accounts, but this appears to haveonly partially reversed a marked relaxation of suchstandards earlier this decade, and banks overallremain aggressive in the pursuit of new borrowers,especially business clients. The debt of all domesticnonfinancial sectors combined expanded at about a43⁄4 percent annual pace, placing this aggregate nearthe middle of its monitoring range. M2 and M3 arecurrently near the 5 and 6 percent upper boundariesof their respective growth ranges, in line with the

The Discount Rate and Selected Market Interest RatesPercent

4

5

6

7

8

Daily

Thirty-yearTreasury

Five-yearTreasury

Three-monthTreasury

Discount rate

12/20 2/1/95 3/28 5/23 7/6 8/22 9/26 11/15 12/19 1/31/96 3/26 5/21 7/3

1995 1996Note. Dotted vertical lines indicate days on which the Committee announced a monetary policy action.

The ticks on the horizontal axis indicate days on which the Committee held scheduled meetings.The last observations are for July 16, 1996.

2

FOMC’s expectation as of last February. In contrastto the experience of the early 1990s, growth in themonetary aggregates relative to nominal GDP hasbeen broadly in line with historical relationships,given the structure of interest rates.

Economic Projections for 1996 and 1997

As noted previously, the members of the Board ofGovernors and the Reserve Bank presidents, all ofwhom participate in the deliberations of the FederalOpen Market Committee, generally think it likely thateconomic activity will return to a moderate growthpath in the second half of 1996 and in 1997 after thelarger gains in the first half of this year. For 1996 asa whole, this would result in an increase in real grossdomestic product in the range of 21⁄2 to 23⁄4 percent,somewhat above the forecasts in the February report

on monetary policy. For 1997, the central tendency ofthe forecasts spans a range of 13⁄4 to 21⁄4 percent. Thecivilian unemployment rate, which averaged around51⁄2 percent in the second quarter of 1996, is expectedto stay near this level through the end of this year andperhaps to edge higher during 1997.

Economic activity clearly retains considerablemomentum. The trend in final demand is positive, andinventories appear to be well aligned with the cur-rent pace of sales—perhaps even a bit lean. Accord-ingly, the members of the FOMC recognize the pos-sibility that growth could remain elevated a while,with the potential for putting greater pressure onresources. Nonetheless, most members think thatsome slowing from the rapid growth pace recorded,on average, in the first half is the most likelyoutcome. Housing construction and other interest-

Economic Projections for 1996 and 1997

Federal Reserve Governorsand Reserve Bank Presidents Administration

RangeCentralTendency

1996

Percent change,fourth quarter to fourth quarter1

Nominal GDP 43⁄4 to 53⁄4 5 to 51⁄2 5.0Real GDP 21⁄2 to 3 21⁄2 to 23⁄4 2.6Consumer price index 2 3 to 31⁄4 3 to 31⁄4 3.2

Average level in thefourth quarter, percent

Civilian unemployment rate 51⁄4 to 53⁄4 About 51⁄2 5.6

1997

Percent change,fourth quarter to fourth quarter1

Nominal GDP 4 to 51⁄2 41⁄4 to 5 5.1Real GDP 11⁄2 to 21⁄2 13⁄4 to 21⁄4 2.3Consumer price index 2 21⁄2 to 31⁄4 23⁄4 to 3 2.8

Average level in thefourth quarter, percent

Civilian unemployment rate 51⁄2 to 6 51⁄2 to 53⁄4 5.7

1. Change from average for fourth quarter of previous yearto average for fourth quarter of year indicated.

2. All urban consumers.

3

sensitive activity should be restrained to some degreeby the rise in long-term interest rates over the pastseveral months. And, although some of the laggingeconomies abroad are expected to perform better thisyear, there are still concerns about the solidity of thatacceleration and the associated lift to U.S. exports. Inaddition, growth in real business fixed investmentappears to be tapering off, although spending willlikely remain buoyant, owing to the rapid rate ofproduct innovation and dramatic price declines in thecomputer area. Consumer spending is also expectedto grow less rapidly in coming quarters. Householdwealth has been boosted substantially by the runupin stock prices over the past year and a half, but,for many households, debt burdens have risensignificantly in recent years and may represent aconstraint on purchases of big-ticket items.

Most members of the FOMC expect the rise in theconsumer price index over the four quarters of 1996to be in the range of 3 to 31⁄4 percent, about1⁄4 percentage point higher than they predicted lastwinter. The projected increase in the CPI is alsosomewhat larger than that recorded in 1995. How-ever, that stepup would mainly reflect developmentsin the food and energy sectors, which are likely to addto overall inflation in 1996 after having damped it in1995. Apart from these volatile sectors, inflation hasremained in check so far this year despite high levelsof resource utilization and reports that tightness insome parts of the labor market is placing upwardpressure on wages. Assuming no further adverseshocks to food and energy prices, and in the contextof the Federal Reserve’s intent to keep trend infla-tion well contained, the Committee believes thatoverall CPI inflation should recede. Accordingly, thecentral tendency of the FOMC’s forecasts shows CPIinflation dropping back to the range of 23⁄4 to3 percent in 1997.

The Committee’s inflation projections incorporatethe technical improvements the Bureau of LaborStatistics is making to the CPI in 1996 and 1997; theyare expected to shave a little from inflation in bothyears. The Committee also recognizes that theremaining biases in the CPI are non-negligible andmay not be stable over time. Thus, it will continue tomonitor a variety of alternative measures of pricechange as it attempts to gauge progress toward thelong-run goal of price stability.

The Administration has just released its midyearupdate to its economic and budgetary projections. Itsforecasts for real growth and inflation in 1996 and1997 are broadly in line with the central tendencies ofthe forecasts of Federal Reserve policymakers.

Money and Debt Rangesfor 1996 and 1997

At its meeting earlier this month, the Committeereaffirmed the ranges for 1996 growth of money anddebt that it had established in February: 1 percent to5 percent for M2, 2 percent to 6 percent for M3, and3 percent to 7 percent for the debt of the domesticnonfinancial sectors. In addition, the Committee setprovisional growth ranges for 1997 at the same levels.

In setting the ranges for M2 and M3, the Commit-tee intended to communicate its expectation as to thegrowth of these monetary aggregates that wouldresult under conditions of approximate price stabil-ity, assuming that the aggregates exhibit the sametrends relative to nominal spending that prevailed formany years until the early 1990s and that seem tohave reemerged after an intervening period of markeddeviation. Based on that reemergence and on Com-mittee members’ expectations for the growth ofnominal GDP in 1996 and 1997, the Committee

Ranges for Growth of Monetary and Debt AggregatesPercent

Aggregate 1995 1996 Provisional for 1997

M2 1 to 5 1 to 5 1 to 5

M3 2 to 6 2 to 6 2 to 6

Debt1 3 to 7 3 to 7 3 to 7

Note. Change from average for fourth quarter of preced-ing year to average for fourth quarter of year indicated.

1. Monitoring range for debt of domestic nonfinancialsectors.

4

anticipates that both M2 and M3 will probably fin-ish near the upper boundaries of their respectiveranges each year. The Committee expects the debt ofthe domestic nonfinancial sectors to remain near themiddle of its monitoring range in 1996 and 1997. Inlight of the rapid pace of technological change and

innovation still occurring in the financial sector—andthe attending uncertainty about the future behavior ofthe aggregates—the Committee will continue to relyon a wide range of other information in determiningits policy stance.

5

Section 2: Economic and Financial Developments in 1996

Economic activity has increased substantially thusfar this year. Real gross domestic product grew at anannual rate of about 21⁄4 percent in the first quarter of1996, and the available data point to a much largerincrease in the second quarter. The increases in activ-ity have been facilitated by generally supportivefinancial conditions: Although long-term interest rateshave risen considerably on net since early 1996,intermediaries have continued to supply credit tomost borrowers on favorable terms, and interest-ratespreads on corporate securities over Treasury securi-ties have remained narrow. In the foreign exchangemarkets, the dollar has appreciated on average againstthe currencies of the other major industrial countries.

Economic Developments

The Household Sector

After a sluggish performance in late 1995, spend-ing by households has picked up noticeably this year.Consumer expenditures increased about 31⁄2 percentat an annual rate in real terms in the first quarter andappear to have posted another sizable gain in thesecond quarter. In addition, according to indexes suchas those compiled by the Survey Research Center atthe University of Michigan and the ConferenceBoard, consumer sentiment has generally beenrelatively upbeat. In the real estate market, sales ofnew single-family dwellings have posted an averagelevel well above that of last year, encouraging build-ers to boost housing starts.

Outlays for durable goods have continued to be thestrongest component of spending, extending the long-standing uptrend in the share of durables in total realconsumption. Declining relative prices and the avail-ability of innovative products have continued to liftdemand for home electronic equipment and softwareproducts. In addition, sales of light motor vehicles,bolstered by relatively generous incentives and per-haps by the cash freed up by the surge in mortgagerefinancings last winter, averaged a healthy 15 mil-lion unit annual rate in the first half of 1996.

After a lackluster performance in 1995, real outlaysfor nondurable goods have also risen this year; theaverage level of these expenditures in April and Maywas nearly 3 percent at an annual rate above thatrecorded in the fourth quarter. Meanwhile, spendingon services has remained on a moderate uptrend, withshort-run variations reflecting the effects of weatheron household energy use.

Consumer spending has been supported by briskgains in wage and salary income associated withthe better pace of hiring this year. However, othercomponents of before-tax income, taken together,have risen less rapidly than they did in 1995, andgains in after-tax income were restrained by larger-than-usual tax bills (final payments less refunds) thisspring. Accordingly, the level of the personal savingrate in May was somewhat below that recorded in late1995, although fragmentary data suggest that savingrose sharply in June. In any event, taking a longerperspective, spending and income have grown atroughly similar rates over the past few years, and the

Change in Real GDPPercent, annual rate

1991 1992 1993 1994 1995 19962

0–

+

2

4

Q1

Change in Real Income and ConsumptionPercent, annual rate

1991 1992 1993 1994 1995 19964

2

0–

+

2

4

6

Disposable personal income

Personal consumption expenditures

Q1

6

saving rate has generally fluctuated in a fairly nar-row band between 4 percent and 5 percent since1993—a low level historically.

The recent developments in financial markets mayhave had an important influence on the spending deci-sions of individual households. In particular, house-holds holding large stock portfolios have enjoyed siz-able increases in wealth over the past year and a half,which may be inducing them to consume greater frac-tions of their incomes than they would otherwise. Atthe same time, a growing number of households areapparently finding it difficult to meet their debt-service obligations, judging from the appreciable risein delinquency rates on consumer loans in recentyears. In addition, it is possible that job insecurity andlonger-run concerns about retirement income havecaused many households to raise their targets forasset accumulation. However, the relative stabilityof the saving rate over the past few years suggeststhat the net effect of these factors on overallconsumption—at least to date—has been limited.

Residential construction has, on the whole, beenrobust this year. Private housing starts averagednearly 1.5 million units at an annual rate throughJune, a pace appreciably above that in 1995. In addi-tion, the volume of shipments of mobile homes(‘‘manufactured housing’’), which has doubled overthe past five years, now stands around 350,000 unitsat an annual rate, the highest level since 1974.

In the single-family sector, starts and sales of newhomes were surprisingly firm in the face of severeweather in early 1996, and they moved still higher inthe second quarter. Moreover, the regular survey of

the National Association of Homebuilders continuedto indicate solid demand through early July, and theMortgage Bankers Association reported that loanapplications for home purchases remained briskthrough midyear.

Relative to the lows reached in early 1996, the rateon 30-year conventional fixed-rate home mortgageshas risen nearly 11⁄2 percentage points and has beenfluctuating around 81⁄4 percent in recent weeks. How-ever, a number of factors seem to have cushioned theeffects of these higher mortgage rates. In particular,rates on adjustable-rate mortgages have risen onlyabout half as much as have those on 30-year fixed-rate loans. Also, house prices have firmed somewhat,which may have raised confidence in the investmentvalue of residential real estate and thus contributed tothe recent rise in the homeownership rate, which isnow at its highest level since the early 1980s. Prob-ably more important in this regard, however, is thetrend in the affordability of housing. One simplemeasure of affordability is the monthly mortgagepayment on a new home having a given set ofattributes, divided by average monthly householdincome. Despite the increase in mortgage rates thisyear, this measure suggests that the cash-flow burdenof homeownership is still only modestly above thelows of the past thirty years.

Construction of multifamily housing averagedabout 300,000 units at an annual rate in the first halfof 1996, a rate somewhat above that in 1995 but afairly low one historically. Market conditions varygeographically, but the rental vacancy rate for thenation as a whole seems to have tilted back up, aftergenerally trending down between mid-1993 and mid-1995. Also, the absorption rate, which measures thepercentage of apartments that are rented within threemonths of their completion, edged back down in 1995after several years of increases.

The Business Sector

Developments in the business sector were quitefavorable in the first half of 1996. After decelerat-ing in 1995, real business fixed investment rose at a121⁄2 percent annual rate in the first quarter of 1996,with sizable advances for both equipment andstructures. And, although real investment appears tohave decelerated again in the second quarter, it prob-ably posted an appreciable gain. Over the past fouryears, real investment has grown around 8 percent peryear, on average, and now stands at a level thatimplies quite substantial growth in the capital stock.The updating of capital and the increase in capital per

Private Housing StartsMillions of units, annual rate

1990 1992 1994 19960

0.5

1

1.5

Quarterly average

Multifamily

Single-family

Q2

7

worker are key to lifting productivity growth and liv-ing standards.

Outlays for producers’ durable equipment rose atan annual rate of about 14 percent in real terms in thefirst quarter, after a 71⁄2 percent rise over the course of1995. As has been true throughout the expansion,much of the first-quarter growth was in real outlaysfor computers and other information-processingequipment; such investment received particularimpetus from extensive price-cutting in virtually allsegments of the computer market and from a pushto acquire the state-of-the-art equipment neededto take full advantage of popular new software andopportunities for information transfer. However,incoming orders data and recent anecdotal reportssuggest that the growth in real computer outlays maybe slowing. Meanwhile, demand for other types ofcapital equipment, which had softened in 1995,firmed somewhat in the first quarter.

In the nonresidential construction area, real invest-ment continued to expand in the first quarter. How-ever, the monthly data suggest that outlays softened inthe second quarter, an occurrence that is consistentwith the downturn in contracts—a forward-lookingindicator of construction outlays—since late 1995.

Trends within the construction sector have beendivergent. In the office sector, the modest recoverythat seemed to be under way appears to have wanedeven though vacancy rates have continued to fall andtransactions prices have continued to rise. Outlaysdropped noticeably in the fourth quarter of 1995 andthe first quarter of 1996, and preliminary data sug-gest that they remained at a fairly low level in the

second quarter. In contrast, spending for commercialstructures other than office buildings, which has beenrising briskly since 1992, continued to advancethrough the first quarter—although further gains maybe limited by an emerging excess of retail space insome parts of the country and the recent leveling outof transactions prices. Elsewhere, outlays for indus-trial construction, which had moved up over 1994 andthe first half of 1995, have been nearly flat over thepast few quarters, while construction of hotels andmotels, which account for less than 10 percent ofstructures outlays, has boomed.

Investment in nonfarm business inventories sloweddramatically in the fourth quarter of 1995 after run-ning at a fairly rapid pace over much of last year, andit nearly ceased in the first quarter of 1996 as motorvehicle stocks plummeted. Automotive stocks hadrisen appreciably over the second half of 1995, andsome reduction was in train even before a Marchstrike at General Motors curbed production; with thestrike, dealer stocks were drawn down sharply. Inaddition, although firms outside motor vehicles appar-ently made considerable progress in rectifying inven-tory imbalances in late 1995, many continued torestrain production in response to continued weakorders in early 1996; producers of household dura-bles and textiles are notable examples.

Inventory investment evidently rebounded in thesecond quarter, mainly because motor vehicle stocksstabilized as sales and production returned torough balance. Outside of motor vehicles, stocksaccumulated moderately, on balance, in April andMay. As of May, inventory–sales ratios for all major

Change in Real Business Fixed InvestmentPercent, annual rate

1991 1992 1993 1994 1995 199620

10

0–

+

10

20

Structures

Producers’ durableequipment Q1

Change in Real Nonfarm Business InventoriesPercent, annual rate

1991 1992 1993 1994 1995 19964

0–

+

4

Q1

8

sectors were noticeably below their levels in late1995; the decline in the ratio for retailers was espe-cially steep.

Economic profits of all U.S. corporations continuedto surge in the first quarter, extending the steep climbthat began in the early 1990s. The strength in profitsin recent quarters has been attributable in large part torobust earnings growth at domestic financial institu-tions and a rebound in profits at foreign subsidiariesof U.S. corporations. In the domestic nonfinancialcorporate sector, the profit share—pre-tax profitsdivided by the sector’s GDP—has been hoveringaround 10 percent since mid-1994, after having risenappreciably over the preceding few years; its currentlevel is similar to the levels attained in the mid-1980s but well below the highs of the 1960s and1970s. About half of the increase in the sector’s profitshare since the early 1990s has reflected a reductionin net interest expenses.

The Government Sector

Although the nation continues to grapple with theprospect of growing federal budget deficits in theyears ahead, the incoming news on the budget for fis-cal 1996 has been extremely favorable. The deficit inthe unified budget over the first eight months of thefiscal year—the period from October to May—wasonly $109 billion, $27 billion less than during thecomparable period of fiscal 1995. The improvementin the deficit primarily reflected exceptionally rapidgrowth in receipts; outlays continued to rise at about

the same pace as had been recorded, on average, overthe preceding four years. If present trends continue,the fiscal 1996 deficit, when measured as a percent-age of nominal GDP, will be the smallest since 1979.

Federal receipts in the first eight months of fiscal1996 were 8 percent higher than in the same period ayear earlier; the rise was considerably greater thanthat of nominal GDP. Boosted by the upswing in busi-ness profits, corporate taxes have been increasing atdouble-digit rates since fiscal 1993, and that path hasextended into fiscal 1996. Individual income taxeshave also risen sharply this year; little information isavailable on the factors behind the surge in individualpayments, but it may have resulted, at least in part,from capital gains realizations associated with thestrong performance in financial markets last year.

In total, federal outlays in the first eight months offiscal 1996 were 4 percent higher than during the cor-responding period of fiscal 1995. Outlay growth wasdamped by the reductions in discretionary domesticspending implied by this year’s appropriationslegislation. However, expenditures for ‘‘mandatory’’programs continued to rise rapidly, and net outlays fordeposit insurance were less negative than in 1995(i.e., insurance premiums and the proceeds from netsales of thrift assets declined). In addition, net inter-est payments increased moderately, reflecting thegrowth in the stock of outstanding federal debt.

Federal expenditures on consumption andinvestment—the part of federal spending includeddirectly in GDP—increased at an annual rate of about6 percent in real terms in the first quarter of 1996after declining about 13 percent in the fourth quarter

Change in Real Federal Expenditureson Consumption and Investment

Percent, annual rate

1991 1992 1993 1994 1995 199615

10

5

0–

+

5

Seasonally adjustedQ1

Before-Tax Profit Share of GDPPercent

1966 1976 1986 19960

5

10

15

Nonfinancial corporations

Q1

Note. Profits from domestic operations with inventory valua-tion and capital consumption adjustments, divided by grossdomestic product of nonfinancial corporate sector.

9

of 1995. In part, real spending rose in the first quarterbecause the government shutdowns that occurred dur-ing the budget crisis depressed real spending less inthe first quarter than in the fourth. Even so, given theenacted appropriations, the first-quarter increase wasalmost surely a transitory spike.

The fiscal position of states and localities has beenrelatively stable in the aggregate over the past fewyears. As measured in the national income andproduct accounts, the surplus (net of social insur-ance funds) in the sector’s operating accounts hasfluctuated in the range of $30 billion to $40 billion(annual rate) since the beginning of 1994; it stoodaround the middle of that range in the first quarter. Onthe whole, these governments are in considerably bet-ter shape than they were in the early 1990s. Even so,the sector remains under pressure to balance risingdemand for services—especially in education, correc-tions, and health care—against the public desire fortax relief.

Real expenditures on consumption and grossinvestment—the part of state and local spendingincluded directly in GDP—declined somewhat in thefirst quarter of 1996. However, the decrease reflectedprimarily the effects of the unusually adverse winterweather, and spending appears to have rebounded inthe second quarter. State and local employmentposted a respectable gain, on net, over the first sixmonths of the year. In addition, outlays for construc-tion rose about 31⁄2 percent in real terms over the yearending in the first quarter, reflecting higher spendingon highways and schools; monthly construction datathrough May suggest that spending rose substantiallyin the second quarter.

Receipts of state and local governments rose about4 percent in nominal terms over the year ending in thefirst quarter, about matching the rise in nominal GDP.The sector’s own-source general receipts, whichcomprise income, corporate, and indirect businesstaxes, rose about 1 percentage point faster, with solidgains in all major components. Federal grants havechanged little, on net, over the past four quarters.

The External Sector

The nominal trade deficit in goods and serviceswidened from its low fourth-quarter level of $78 bil-lion at an annual rate to $97 billion in the first quarterof 1996, slightly less than the deficit of $105 billionfor 1995 as a whole. The current account deficit stoodat $142 billion (annual rate) in the first quarter, aboutthe same as the figure for 1995 as a whole. In April,the trade deficit increased from the average level forthe first quarter.

After expanding very slowly during the second halfof 1995, the quantity of U.S. imports of goods andservices rose about 10 percent at an annual rate in thefirst quarter, and preliminary data for April showanother sizable increase. The rebound in importslargely reflected the strengthening of U.S. economicactivity. In addition, non-oil import prices havedeclined somewhat since last fall, after having risensharply in late 1994 and early 1995. A turnaround inimported automotive vehicles, consumer goods, andnon-oil industrial supplies, following more than sixmonths of declines, accounted for most of theincrease in imports during the first four months of1996.

Change in Real State and Local Expenditureson Consumption and Investment

Percent, annual rate

1991 1992 1993 1994 1995 19962

0–

+

2

Seasonally adjusted

Q1

U.S. Current AccountBillions of dollars, annual rate

1991 1992 1993 1994 1995 1996200

150

100

50

0–

+

Q1

10

The quantity of U.S. exports of goods and ser-vices expanded at a 2 percent annual rate during thefirst quarter; it also appears to have expanded at aboutthis pace in April. The somewhat subdued pace ofexport growth so far this year reflects in part a bunch-ing of shipments, particularly of machinery, thatresulted in an unusually strong increase in exports inthe fourth quarter of last year.

Trends in economic activity have varied across themajor foreign industrial countries so far in 1996. InJapan, economic recovery appears to have taken hold,although the underlying pace of real GDP growth isclearly less than the nearly 13 percent annual ratereported for the first quarter; the first-quarter growthrate was boosted in part by a temporary surge ingovernment spending and measurement practicesassociated with the leap year.1 In Canada, growthremained subdued in the first quarter as real GDP roseonly 11⁄4 percent at an annual rate despite muchstronger growth in domestic demand; indicators forthe second quarter suggest some strengthening.

Economic performance so far this year in Europehas been mixed. In Germany, real GDP declinedanother 11⁄2 percent at an annual rate in the firstquarter, largely because severe weather caused asubstantial contraction in construction spending;preliminary data suggest that construction activityrebounded in the second quarter with the return tomore normal weather. In contrast, French real GDP

expanded nearly 5 percent at an annual rate in thefirst quarter, supported by a very sizable rebound inconsumption as well as leap-year effects; strikes dur-ing the fourth quarter of last year depressed eco-nomic activity and contributed to a decline in privateconsumption spending. Indicators for the secondquarter suggest that output growth moderated from itsfirst-quarter pace. In the United Kingdom, real GDPgrew at an annual rate of 11⁄2 percent during the firstquarter, somewhat more slowly than during thesecond half of 1995. On the policy front, most Euro-pean countries are seeking to rein in their fiscaldeficits during 1996 and 1997, in part to comply withthe criterion in the Maastricht Treaty that countriesparticipating in the third stage of the European Mone-tary Union, now scheduled to begin on January 1,1999, not have excessive fiscal deficits. As a refer-ence value, the treaty specifies that deficits greaterthan 3 percent of a country’s GDP are excessive, butit also provides scope for accepting deficits above thatlevel in some circumstances.

In Mexico, robust growth of real GDP in the firstquarter extended the recovery in economic activitythat began in the second half of 1995. Through June,the Mexican trade balance remained roughly stable atthe level reached toward the end of last year, afterhaving improved markedly over the course of 1995.Argentina also appears to be emerging from the steepdeclines in output experienced during the first half of1995, while Chile continues to enjoy steady growth.Activity in Brazil has begun to expand again in recentmonths, following a sharp contraction in mid-1995.

Economic growth in our major Asian tradingpartners (other than Japan) appears to have picked upagain this year after slowing noticeably during thesecond half of 1995 from the extremely rapid ratesrecorded in 1994 and the first half of 1995. The recentpickup in activity was associated with an easing ofmonetary policy in some of these countries in thesecond half of last year and the early part of this year.In China, output appears to have expanded during thefirst quarter at around the 10 percent annual raterecorded in 1995, with a pickup in consumptionspending compensating for weaker growth in theexternal sector.

Consumer price inflation generally stayed low inthe major foreign industrial countries and declined orremained moderate elsewhere. In Japan, prices in thesecond quarter, on average, were slightly above theiryear-earlier levels because of the effects of yen depre-ciation on import prices; this upturn followed a yearof deflation. In western Germany, inflation slowed

1. Although the statistical agencies in many countries take thenumber of working days in the quarter into account when season-ally adjusting data, the statistical agencies in Japan, France, andItaly among the G-10 countries do not make working-dayadjustments.

Change in Real Imports and Exportsof Goods and Services

Percent, annual rate

1991 1992 1993 1994 1995 19960

5

10

Imports

Exports

Q1

11

through June to only about 11⁄4 percent. Inflation inItaly remained higher than in the other major for-eign industrial countries but slowed to below4 percent through June. In Canada, inflation alsomoved down further this year, to about 11⁄2 percent inMay.

Inflation trends in Latin America have been mixed.In Mexico, the twelve-month change in consumerprices diminished to about 32 percent in June,compared with a reading of 52 percent for the twelvemonths ending in December 1995. Consumer priceinflation has also declined further in Brazil andremained low in Argentina. In contrast, prices havepicked up in Venezuela in response to the depre-ciation of its currency associated with the adoption ofa program of macroeconomic stabilization. In Asia,inflation has decreased so far in 1996 in China andremained moderate to low elsewhere.

Labor Market Developments

Labor demand was strong over the first half of1996. Growth in nonfarm payroll employmentexhibited considerable month-to-month variability butaveraged a hefty 235,000 per month. In addition, thecivilian unemployment rate remained low, holding inthe narrow range around 51⁄2 percent that hasprevailed since late 1994.

Employment gains were fairly broadly based overthe first half of the year. The services sector, whichnow accounts for nearly 30 percent of nonfarmemployment, continued to be a mainstay of jobgrowth, showing increases of nearly 120,000 permonth, on average, over the first half. Within ser-

vices, growth in employment in business servicesremained rapid, with large gains at computer and dataprocessing firms as well as at temporary help agen-cies, and employment in health services trended upfurther. In addition, construction payrolls rose a brisk30,000 per month, on average—an annual rate ofabout 7 percent. Elsewhere, payrolls at wholesale andretail trade establishments continued to increase atabout the same pace as that in 1995, and employ-ment in the finance, insurance, and real estate cate-gory picked up after having been nearly flat over1994 and 1995.

Developments in manufacturing were uneven butshowed some improvement in the second quarter. As1996 started, firms were still adjusting employment tothe slower path of output that had been evident sinceearly 1995, and payrolls—especially at firms produc-ing nondurable goods—were reduced further. In thepast three months, manufacturing employment hasheld fairly steady, buoyed by the pickup in indus-trial activity, and the average factory workweek,which had contracted appreciably in 1995, trended upthrough June.

For the nonfarm business sector as a whole,productivity rose at an annual rate of about2 percent in the first quarter of 1996, echoing theacceleration in output. However, productivity hadposted an outright decline in the fourth quarter of1995; all told, productivity rose about 1 percent overthe year ending in the first quarter of 1996, in linewith the average pace this decade. In the manufactur-ing sector, productivity rose 41⁄4 percent over the past

Net Change in Payroll EmploymentThousands of jobs, average monthly change

1990 1992 1994 1996200

0–

+

200

400

Total nonfarm

H1

Civilian Unemployment RatePercent

1990 1992 1994 19962

4

6

8

June

Note. The break in data at January 1994 marks the introduc-tion of a redesigned survey; data from that point on are notdirectly comparable with the data of earlier periods.

12

year, although the reported increase was probablyoverstated because firms in this sector have been rely-ing increasingly on workers supplied by temporaryhelp firms, who are counted as service industryemployees rather than as manufacturing employees inthe establishment survey of the Bureau of LaborStatistics.

Labor force participation has remained sluggishthis year. The participation rate, which measures thepercentage of the working-age population that iseither employed or looking for work, did retrace thedip that occurred in late 1995. But, taking a longerperspective, the overall participation rate (adjusted

for the redesign of the household survey in 1994) haschanged little, on net, since 1989, after rising fairlysteadily from the mid-1960s to the late 1980s. Theflattening reflects mainly a marked deceleration inwomen’s participation, owing both to a leveling off inthe percentage of women who are in the labor forcefor at least part of a given year and slower growth inthe average number of weeks they spend in the laborforce that year. Moreover, with the average number ofweeks these women spend in the labor force havingrisen to a level only slightly below the average formen, a significant rebound in participation does notseem very likely over the near term. The sluggish-ness in participation tends to restrain the growth ofpotential output unless it is offset by a betterproductivity performance or by faster growth in theworking-age population—neither of which has yetbeen in evidence.

Despite the tightness in labor markets in recentquarters, the broad trends in hourly compensationappear to have held fairly steady. The employmentcost index for private industry—a measure thatincludes wages and benefits—rose at an annual rateof about 3 percent over both the first three months of1996 and over the twelve months ending in March;the ECI had also increased about 3 percent over thetwelve months ending in March 1995. Compensa-tion growth has continued to be damped by a markeddeceleration in employer-paid benefits—especiallypayments for medical insurance, which have beenrestrained by the slowing in medical care costs, theswitch in insurance arrangements from traditionalindemnity plans to HMOs and other managed careplans, and changes in the provisions of health plans(including greater sharing of health care costs byemployees). On the whole, wages also seem to havebeen held in check, although the most recent datamay be hinting at some acceleration. Notably, thewage and salary component of the ECI rose sharply inthe first quarter; although the data are volatile and thefirst-quarter figure likely overstates current wagetrends, the twelve-month change in the series movedup to 31⁄4 percent, nearly1⁄2 percentage point largerthan the increases in the preceding two years.Separate data on average hourly earnings of produc-tion or nonsupervisory workers also show a recent ac-celeration in wages; the twelve-month change in thisseries moved up to about 31⁄2 percent in June.

Price Developments

The underlying trend of prices has remained favor-able this year—notably, the CPI excluding food and

Change in Output per HourPercent, Q4 to Q4

1990 1992 1994 19962

0–

+

2

4

Nonfarm business sector

Note. Value for 1996 is measured from 1995:Q1 to 1996:Q1.

Labor Force Participation RatePercent

1971 1976 1981 1986 1991 199657

60

63

66

Q2

Note. Pre-1994 data adjusted for the redesign of the house-hold survey.

13

energy rose at an annual rate of 23⁄4 percent over thefirst six months of the year, near the lower end ofthe narrow range than has been evident since early1994. Developments in food and energy marketsboosted overall inflation, however, and the total CPIrose at an annual rate of 31⁄2 percent over the firsthalf; this pattern was the reverse of that seen in 1995,when a small drop in energy prices, combined withonly a modest increase in food prices, held the risein the total CPI to just 21⁄2 percent. Meanwhile,the producer price index for finished goods rose

about 23⁄4 percent over the twelve months endingin June; excluding food and energy, the PPI rose11⁄2 percent, a bit less than over the preceding year.

Consumer energy prices picked up around the turnof the year and rose at an annual rate of about12 percent, on net, over the first six months of 1996.With crude oil stocks drained by strong worldwidedemand for heating oil and weather-related supplydisruptions in the North Sea and elsewhere, thespot price of West Texas intermediate (WTI) soaredfrom around $18 per barrel, on average, in the secondhalf of 1995 to a high of around $25 per barrel inmid-April; the WTI price has since retraced muchof that runup. Reflecting the surge in crude oilprices, retail prices of refined petroleum productsrose sharply through May, on balance. However,they fell markedly in June, and private surveys ofgasoline prices imply a further decrease in earlyJuly.

Retail food prices rose at an annual rate of about4 percent over the first six months of 1996, somewhatabove the pace of the preceding few years. At thefarm level, prices of grains and other commoditiesrose to exceptionally high levels as adverse cropconditions in some parts of the country exacerbatedan already tight stock situation. For somefoods—notably, dairy products, cereals and bakeryproducts, poultry, and pork—the pass-through tendsto occur relatively rapidly, and retail prices of suchitems have already risen appreciably. Beef prices fellthrough May as producers sold off herds in responseto higher feed costs and poor range conditions; theyturned around in June and will likely rise further overthe next several quarters as the sell-off of breedingstock will eventually lead to tighter supplies.

Price increases for consumer goods other than foodand energy slowed to 1 percent at an annual rateover the first half of 1996, after averaging about11⁄2 percent per year over the preceding three years.Increases in goods prices have been restrained in partby the uptrend in the dollar since mid-1995, whichhas helped to damp import prices. In addition, withthe operating rate in the manufacturing sector hav-ing fallen to about its long-term average, pressurefrom the materials side has been limited. Indeed, thePPI for intermediate materials (excluding food andenergy) actually fell a bit over the past twelvemonths, after having risen 71⁄2 percent over thepreceding year. Looking ahead, however, the latestreport from the National Association of PurchasingManagers suggests that vendor performancedeteriorated markedly in June, a development that

Change in Consumer Prices ExcludingFood and Energy

Percent, Dec. to Dec.

1990 1992 1994 19960

2

4

6

Note. Consumer price index for all urban consumers. Value for1996 is measured from December 1995 to June 1996, at anannual rate.

Change in Consumer PricesPercent, Dec. to Dec.

1990 1992 1994 19960

2

4

6

Note. Consumer price index for all urban consumers. Value for1996 is measured from December 1995 to June 1996, at anannual rate.

14

could portend some firming of prices of materials andsupplies over the near term.

Prices of non-energy services rose 33⁄4 percent at anannual rate over the first half, about the same as therise over 1995 as a whole. Airfares acceleratedsignificantly in the first half. However, shelter costsincreased less rapidly than they had in 1995, andprices of medical care continued to decelerate; overthe six months ending in June, the CPI for medicalcare services rose at an annual rate of only about31⁄4 percent, roughly 1 percentage point below the1995 pace. Moreover, there is some evidence that theCPI may be understating the recent slowing in medi-cal care inflation, in part because it does not fullycapture the discounts negotiated between medicalproviders and insurers, including managed care plans.The price measure used to deflate consumerexpenditures on medical care in the NIPA betterreflects such factors; it rose less than 2 percent overthe year ending in the first quarter of 1996, after hav-ing risen 41⁄2 percent over the preceding year.

Judging from the various surveys of consumers andforecasters, expectations of near-term CPI inflationdeteriorated slightly in the first half of 1996. Notably,although both the University of Michigan and theConference Board had reported a noticeable drop intheir one-year-ahead measures in the second half of1995, that improvement was not sustained in 1996;the recent monthly readings have bounced around,but the June results from both surveys were similar tothose recorded, on average, in the first half of 1995.In contrast, longer-run inflation expectations, whichhave presumably been less affected by the recentnews in food and energy markets, have held fairlysteady. Smoothing through the monthly data, theUniversity of Michigan’s measure of expected CPIinflation over the next five to ten years has notchanged much since late 1994, and the survey ofprofessional forecasters conducted by the FederalReserve Bank of Philadelphia during the secondquarter of 1996 produced the same expectation for theensuing ten years as that in the survey taken in thefourth quarter of 1995.

Financial Developments

Credit

Financial conditions in the first half of 1996 sup-ported the pickup in the growth of spending. For themost part, lenders continued to pursue credit appli-cants aggressively as reflected, for example, in nar-

row spreads of interest rates on corporate securitiesover those on Treasury securities. The debt of domes-tic nonfinancial sectors increased about 43⁄4 percent atan annual rate from the fourth quarter of 1995through May of this year, a bit more slowly than lastyear but still sufficient to place the level of this aggre-gate in the middle of its monitoring range for 1996.

The Government Sector. Federal debt out-standing increased about 4 percent at an annual rateover the first half of 1996, a shade below the aver-age rate of increase last year. The impasse over thedebt ceiling disrupted the timing and size of someTreasury auctions but did not alter the longer-termtrajectory of federal debt.

The pattern of net borrowing by state and localgovernments in the last several years has been heavilyinfluenced by their efforts to retire debt issued atrelatively high interest rates in the mid-1980s. Theyhave pursued these efforts through a strategy ofadvance refunding: In the early 1990s, when bondyields were seen as especially favorable, state andlocal governments issued new debt, even before callprovisions on the older bonds could be exercised, andplaced the proceeds in escrow accounts. As it becamepossible to do so, the issuing governments began call-ing the older debt, using the contents of the escrowaccounts to complete the transactions. Reflectingthese retirements, the amount of state and localgovernment debt outstanding declined about4 percent per year in 1994 and 1995. This process isstill in train but evidently on a smaller scale; avail-able information suggests that state and local govern-ment debt outstanding declined only marginally dur-ing the first half of this year.

Debt: Annual Range and Actual LevelBillions of dollars

O N D J F M A M J

1995 1996

13600

13800

14000

14200

14400

Domestic nonfinancial sectors

7%

3%

15

The Household Sector. The pace of borrowingby households appears to have moderated somewhatfrom the elevated rates of 1994 and 1995, but itremains substantial. In particular, consumer creditexpanded at a 91⁄2 percent annual rate from the fourthquarter of 1995 through May of this year, down from141⁄2 percent over the four quarters of 1995. Mort-gage debt actually expanded somewhat more rapidlyduring the first quarter than in 1995 (73⁄4 percent at anannual rate versus 61⁄2 percent), and available indica-tors suggest that growth during the second quarterdropped back only to about last year’s pace. Therecent backup in mortgage rates, which only began inFebruary, has had little effect on borrowing thus far,and might even have increased it temporarily byaccelerating transactions.

The rapid growth in household debt during the pastfew years has resulted in a sizable increase in theestimated ratio of scheduled payments of principaland interest to disposable personal income. Thismeasure of debt-servicing burden has trended up overthe past two years, and as of the first quarter of 1996,was approaching—but still short of—the levelsattained toward the end of the last business cycleexpansion.

Several other recent indicators suggest that somehouseholds are experiencing financial strains. Forexample, the Consolidated Report of Condition andIncome shows that the delinquency rate on credit-card receivables at commercial banks has increasedsignificantly in recent quarters, retracing about one-third of the improvement that took place during the

first few years of the current economic expansion.The delinquency rate on auto loans at the financecompanies affiliated with the major manufacturersmoved up sharply beginning about two years ago, andsince late last year has hovered around historicallyhigh levels. Anecdotal evidence suggests that the risein both credit-card and auto-loan delinquency ratesreflects a strategy to liberalize lending standards aspart of an overall marketing effort. The auto loandelinquency rate has also been boosted a bit by theincreased prevalence of leasing. Lease customers tendto be better credit risks than the average conventionalborrower, and the shift toward leasing has had theeffect of skimming the more financially secure carbuyers and thus degrading somewhat the remainingpool of people financing their purchases throughconventional loan contracts.

The personal bankruptcy rate also surged to a newhigh this year. The extent to which this develop-ment reflects mounting financial difficulties of house-holds is clouded, however, by changes in federal law(effective at the start of 1995) that may haveincreased the attractiveness of bankruptcy by increas-ing the value of assets that can be protected fromliquidation in bankruptcy proceedings. The ‘‘cost’’ ofbankruptcy to households also has been effectivelylowered by the greater willingness of lenders toextend credit to riskier borrowers—even those with aprevious bankruptcy on their records.

Other indicators are less suggestive of a deteriora-tion in the financial condition of households. Forexample, the delinquency rate for mortgage loanssixty days or more past due at all lenders is near its

Household Debt Service BurdenPercent of disposable personal income

1984 1986 1988 1990 1992 1994 199614

15

16

17

Quarterly

Note. Debt service is the sum of required interest and principalpayments on household-sector mortgage and consumer debt.

Delinquency Rates on Household LoansPercent

1980 1984 1988 1992 19961

2

3

4

5

Quarterly

Credit cardaccounts atbanks

Mortgages(over 60 days)

Auto loans atfinance companies

Q1

Q2*

Q1

*The last data point is an average of the delinquency rates forApril and May 1996.

16

lowest level in two decades, while the rate on closed-end consumer loans—despite having moved up overthe past eighteen months—remains low by historicalstandards. Moreover, the aggregate balance sheet ofthe household sector clearly is in very good shape;owing in large part to the surge in equity prices overthe past year and a half, the ratio of household networth to disposable personal income moved up intorecord territory recently.

Apparently in response to the recent runup indelinquency and charge-off rates on consumer loans,banks have selectively tightened their standards forconsumer lending. These actions reversed steps takenearlier in the decade, when many card issuersincreased the growth of their credit card receivablesby offering accounts to customers who previouslywould have been denied credit. The belief was thatmore sophisticated credit scoring techniques wouldcontrol risks adequately, but it appears that some‘‘adverse selection’’ occurred and that the uptick indelinquencies has been larger than at least somebanks had planned. About 20 percent of therespondents in the Federal Reserve’s most recentsurvey of senior loan officers reported havingtightened standards for approving applications forcredit cards, and 10 percent reported tighteningstandards for other consumer loans. Notwithstand-ing the recent tightening of standards, supply condi-tions for loans from banks to consumers still appearaccommodative.

The Business Sector. The debt of nonfinancialbusinesses also appears to have expanded somewhatless rapidly during the first half of 1996 than it didlast year. In part, the moderation in borrowing can be

traced to the behavior of the financing gap forincorporated nonfinancial enterprises—the excess oftheir capital expenditures (including inventory invest-ment) over their internally generated funds. During1995, this gap narrowed quite substantially, reflect-ing strong profits and a marked reduction in inven-tory investment. Available indications are that the gaphas remained small this year.

External funding for business spending has been inplentiful supply thus far this year. One piece ofevidence on this point is that interest-rate spreads oninvestment-grade bonds have edged down slightlysince the beginning of the year. Additionally, spreadson high-yield bonds have declined markedly, andare as low as they have been in at least a decade.Also, supply conditions for loans from banks to busi-nesses continue to look quite favorable. According tothe Federal Reserve’s most recent survey of banklending officers, standards for approval of com-mercial and industrial loans were about unchangedfrom January to May of this year, and terms on suchloans were eased on net. Surveys by the NationalFederation of Independent Business indicate thatsmall businesses have not faced difficulty gettingcredit, and stories abound of new small-businesslending programs of banks.

Gross offerings of long-term bonds by nonfinancialcorporations have been running about in line with lastyear’s pace. However, the mix of issuers has shiftedsomewhat, reflecting the changing structure of rates.Late last year and early this year, investment-gradecorporations were issuing a hefty volume of bonds inorder to pay down commercial paper and to refinanceexisting long-term debt. As the rates on investment-grade bonds increased this year, issuance of such debtdropped off. Rates on high-yield bonds moved upless, however, and issuers of those bonds continued tooffer new debt at a rapid pace.

Gross issuance of equity shares by nonfinancialcorporations has been exceedingly strong this year.Indeed, total offerings in each of the three months ofthe second quarter set successive monthly records.This activity has been fueled by initial public offer-ings and other equity issuance by relatively youngcompanies. Share retirements by nonfinancialcorporations have also been very heavy. Announcedstock buybacks by such firms in both the first andsecond quarters ran at $28 billion per quarter—thefastest pace since the late 1980s. On net, availableinformation suggests that nonfinancial corporationsretired even more equity during the first half of 1996than they had in 1995.

Household Net WorthPercent of disposable personal income

1966 1972 1978 1984 1990 1996

400

425

450

475

500

Four-quarter moving average

17

Share retirements and merger activity have gener-ated much less issuance of debt recently than they didin the 1980s. Recent share repurchases have beenundertaken mostly by companies seeking to return theexcess cash on their balance sheets to stockholders.And recent mergers and acquisitions have mainlybeen accomplished through stock swaps betweencompanies in similar lines of business, rather than theleveraged transactions commonplace in the 1980s. Inline with the limited extent of debt financing, themergers executed thus far in 1996 have resulted inlittle net change in bond ratings—again in markedcontrast to the experience of the 1980s.

Depository Intermediation. The growth ofcredit provided by depository institutions slowedsharply in the fourth quarter of last year and firstquarter of this year, and commercial bank credit—acomponent of total depository credit for which morerecent data are available—slowed further in thesecond quarter. The share of thrift institutions in totaldepository credit has continued to decline in recentquarters. This long–standing trend may have beengiven additional impetus last summer by the open-ing up of a differential between the premium ratespaid by banks and thrifts for their deposit insur-ance; this differential has reduced the cost of fundsfor banks relative to the cost of funds for thriftinstitutions.

The reduction and subsequent elimination of thedeposit insurance premium for financially soundbanks probably played a role in shifting bank fund-ing toward deposits. During the first half of 1996,banks increased their deposit liabilities more rapidlythan their nondeposit liabilities—a contrast fromthe preceding few years when banks relieddisproportionately for their funding on nondepositsources, including borrowing from their foreignoffices.

The Monetary Aggregates

The increased reliance on deposit sources of fund-ing by banks has helped support the growth of thebroad money aggregates of late. Between the fourthquarter of last year and June of this year, M3expanded at an annual rate of about 6 percent, put-ting it at the upper boundary of its annual growthcone. As in 1995, the growth in M3 this year was ledby those components not included in M2. In aggre-gate, these components increased about 11 percent atan annual rate between the fourth quarter of last yearand June of this year, only moderately below the 1995average pace of 141⁄2 percent. Institution-only money-

market mutual funds increased about 18 percent at anannual rate over this period. This component of themoney stock increased especially rapidly during thefirst three months of the year. Often, the yields onthese funds lag changes in short-term market inter-est rates, making them particularly attractive invest-ments when short-term market rates are declining, asthey were around the turn of the year when the Fed-eral Reserve eased policy.

M2 increased 43⁄4 percent at an annual rate betweenthe fourth quarter of 1995 and June of this year, leav-ing it near the upper boundary of its growth range.For many years before the early 1990s, the velocity ofM2 (defined as the ratio of nominal GDP to M2)moved roughly in tandem with the opportunity cost of

M3: Annual Range and Actual LevelBillions of dollars

O N D J F M A M J

1995 1996

4500

4550

4600

4650

4700

47506%

2%

M2: Annual Range and Actual LevelBillions of dollars

O N D J F M A M J

1995 1996

3600

3650

3700

37505%

1%

18

holding M2—that is, the interest earnings forgone byholding M2 assets rather than market instrumentssuch as Treasury bills. This relationship implied thatM2 tended to move in proportion to nominal GDP,except as it was influenced by changes in the op-portunity cost of holding it. When the opportunitycost rose, owners of M2 tended to economize on theirholdings, driving up the velocity of M2.

Beginning around the early 1990s, however, thishistorical relationship began to break down. Indeed,in 1991 and 1992, the velocity of M2 rose sharplyeven as the opportunity cost of holding M2 declined.A number of reasons for this development have beenadduced, including the unusually steeply sloped yieldcurve and very low level of short-term interest rates,which helped to attract the public out of liquid bal-ances and into more readily available long-termmutual funds; the credit crunch at banks and theresolution of troubled thrifts, which reduced theaggressiveness with which these institutions soughtretail deposits; and household balance-sheetrestructuring, which entailed in part repayment ofloans out of liquid money balances. The divergentmovement of the velocity of M2 and its opportunitycost continued until the end of 1992. More recently,the variables have once again been moving essen-tially in parallel. In light of the rapid ongoing pace ofinnovation and technological change in financial ser-

vices, however, it is impossible to know whetherthe new parallel movement of velocity and theopportunity cost will persist into the future.

M1 declined about 13⁄4 percent at an annual rateduring the first half of 1996, just as it had done overthe four quarters of 1995. The recent sluggishbehavior of M1 reflects the ongoing spread of so-called sweep programs, under which idle reservabledeposits are ‘‘swept’’ into money-market-depositaccounts (MMDAs). (An appendix provides addi-tional information on sweep accounts.) Estimatesbased on initial amounts swept suggest that M1would have expanded at about a 7 percent annual rateduring the first half of 1996 in the absence of theseprograms. Another factor contributing to the recentweakness in M1 has been the growth of currency,which has been sluggish by the standards of the early1990s. Foreign demand for currency apparently hastailed off somewhat. In large part, the slackening innet foreign demand owes to substantial reflows fromArgentina and Mexico, where earlier worst-case fearsabout the stability of the financial system have notbeen realized. Reflows from Western Europe andAsia have also been significant, but net shipments tothe former Soviet Union remain sizable. On thewhole, demand for the new $100 bill has beensubstantial, but this has not had any detectable effecton the stock of currency outstanding.

M2 Velocity and the Opportunity Cost of Holding M2Ratioscale Percentagepoints, ratioscale

1980 1984 1988 1992 1996

1

2

34

1980 1984 1988 1992 19961.6

1.7

1.8

1.9

2.0

10

25

Quarterly

M2 velocity

M2 opportunity cost

Note. M2 opportunity cost is two-quarter moving average of three-month Treasury billless weighted average rate paid on M2 components.

19

The sluggish growth of currency has held downexpansion of the monetary base to only about2 percent at an annual rate thus far this year. Theother restraint on the growth of the base has been theturnaround in the behavior of required reserves. Aftersurging at double-digit rates in 1992 and 1993,required reserves have been on a downward trend,and at an increasing rate. Thus far this year, requiredreserves have contracted about 71⁄2 percent at anannual rate. The emergence of this trend is perhapsthe most direct consequence of the spread of sweepprograms. Absent such programs, required reservesprobably would have increased about 10 percent overthe same period, owing to strong growth in demanddeposits. Continued spread of sweep programs couldaffect the federal funds market, perhaps leading togreater volatility like that experienced in early 1991following the elimination of reserve requirements onnon-transactions deposits. Thus far, such instabilitieshave not been realized, but the Federal Reserve ismonitoring the situation carefully.

Interest Rates, Equity Prices,and Exchange Rates

Interest Rates. Interest rates on Treasury securi-ties rose over the first half of 1996, with the mostpronounced increases occurring for intermediate-term securities. Between the end of December 1995and the middle of July, the rate on three-month billsincreased somewhat less than1⁄4 percentage point, therate on 5-year notes rose about 11⁄4 percentage points,and the rate on 30-year bonds rose about 1 percent-age point. Despite these increases, nominal Treasury

rates overall continued to be relatively low by thestandards of the past twenty years.

The spread between interest rates on investment-grade private bonds and those on comparable-maturity Treasury securities remained narrow duringthe first half of the year. In particular, the averagespread on Baa-rated industrial bonds over 30-yearTreasury bonds continued to fluctuate near where ithas been for the last several years and well below thelevels typical of the 1980s. The spread on investment-grade utility bonds continued to drift upward, but thisappeared to reflect the market’s increasing percep-tion that some firms in that industry might becomeriskier as a result of deregulation and new compe-titive pressures. The rate spread on high-yieldbonds over the comparable Treasury notes narrowedsharply, reversing the upward drift of 1995, andreturning this measure to the low end of its range overthe last decade. The continuing low level of spreadson most investment-grade securities, as well as themarked decline of the spread on high-yield securi-ties, appeared to reflect in part market participants’increasing confidence in the durability of the eco-nomic expansion and consequent optimism about thecreditworthiness of corporate borrowers.

Equity Prices. Share prices have fallen in recentweeks, most notably those of ‘‘high-tech’’ compa-nies whose ability to maintain steep earnings tra-jectories has come into question. On net, though,broad indexes of equity prices have held steady ormoved up slightly since the end of 1995. As ofJuly 16, the S&P 500 composite index of stock prices

Selected Treasury RatesPercent

1965 1975 1985 19950

5

10

15

Monthly

Thirty-yearTreasury*

Five-yearTreasury

Three-monthTreasury

*The twenty-year Treasury bond rate is shown until the firstissuance of the thirty-year Treasury bond in February 1977.

Major Stock Price IndexesIndex (December 29, 1995=100)

1995 199670

80

90

100

110

DailyNasdaq

S&P 500

Note. Last observations are for July 16, 1996.

20

had increased 2 percent thus far this year, while theNASDAQ had returned to its beginning-of-year level.Even this performance has been impressive, giventhat it occurred in the face of appreciable upwardmovement in long-term interest rates.

Exchange Rates. Since mid-April, the weightedaverage value of the dollar in terms of the other G-10currencies has generally been about 4 percent aboveits level at the end of December, although the dollarhas moved down somewhat in mid-July. Whencompared with an index of currencies from a some-what broader group of U.S. trading partners, the dol-lar has appreciated 3 percent since December afteradjustment for changes in relative consumer prices.The dollar has risen on balance about 4 percent interms of the German mark and about 6 percent interms of the Japanese yen.

The dollar has been supported by perceptions of adisparity in the performance of the U.S. economyrelative to that of many of our major trading partnersand the resulting expectations for the course of rela-tive interest rates. Specifically, while data suggest-ing robust growth in the United States caused inter-est rates to rise, questions remained about the strengthof expansions in a number of other industrialcountries, particularly in Europe. Average long-term(ten-year) interest rates in the other G-10 countrieshave risen only slightly, about 20 basis points, sincethe end of December. With U.S. rates risingsubstantially more than that, the appreciation of thedollar over this period is consistent with the shift in

the long-term interest differential in favor of the dol-lar. In addition, the dollar was lifted to an extentagainst the yen by data early in the year showing thatthe Japanese external surpluses were narrowing.

Despite a weak output performance, long-terminterest rates in Germany have risen about 50 basispoints, with much of that increase coming during thefirst quarter. Long-term interest rates have actually

fallen since the end of last year in some Europeancountries, such as France and Italy, where politicaland economic policy uncertainties have been reduced.In Japan, long-term interest rates have risen about30 basis points, on balance. Short-term market inter-est rates abroad are generally lower than they were at

Exchange Value of the U.S. DollarIndex, March 1973 = 100

1991 1992 1993 1994 1995 199670

80

90

100

Nominal

June

Note. In terms of the currencies of the other G-10 countries.Weights are based on 1972–76 global trade of each of the tencountries.

U.S. and Foreign Interest RatesThree-month

Percent

2

6

10

Monthly

Monthly

Average foreign

U.S. large CD

Ten-yearPercent

Average foreign

U.S. Treasury

Note. Average foreign rates are the global trade-weightedaverage, for the other G-10 countries, of yields on instrumentscomparable to U.S. instruments shown.

1984 1986 1988 1990 1992 1994 19964

8

12

21

the end of last year. German short-term market ratesare down nearly 50 basis points while rates in Franceare down more than 100 basis points and those in theUnited Kingdom are down 70 basis points. Officiallending rates have been reduced by the central banksin Germany, France, the United Kingdom, and severalother European countries in 1996. In Japan, short-term market interest rates remain near the histori-cally low levels reached during the second half of1995 as the Bank of Japan’s official rates have beenunchanged. Stock markets in the foreign G-10countries have risen 3 to 15 percent since the end ofDecember, except in the United Kingdom, wherestock prices, on balance, are about unchanged.

The Mexican peso traded during the first half of1996 in a range somewhat stronger than that whichprevailed at the end of 1995. Mexican 28-day treasurybill (cetes) rates have declined from nearly50 percent in December to around 30 percent as therate of inflation has fallen. The economic positions ofMexican households and firms have improved sinceearly 1995, but problems in the financial systemremain, as evidenced by increasing non-performingloans at banks. Stock prices have risen, on balance,about 5 percent in peso terms since December,buoyed by the interest rate declines and evidence ofrecovery in the Mexican economy.

The pace at which private foreigners acquired U.S.assets increased markedly in the first quarter.

Although private net purchases of U.S. Treasurysecurities were small, there were large increases inthe private holdings of U.S. government agencybonds and U.S. corporate bonds, as U.S. corpora-tions issued heavily in the Eurobond market. In addi-tion, direct investment capital inflows surged toalmost $30 billion in the first quarter, reflecting apickup in foreign acquisitions of U.S. firms. Together,these gross inflows totaled nearly $80 billion, roughlytwice the U.S. current account deficit for the quarter.U.S. net purchases of foreign stocks and bonds werealso sizable in the first quarter, with net purchases offoreign stocks from Japan particularly large. U.S.direct investment abroad slowed somewhat betweenthe fourth quarter of 1995 and the first quarter of1996, but remained near the record pace for all of lastyear. In April and May, private foreign interest in U.S.securities continued to be strong while U.S. investorinterest in foreign stocks cooled somewhat from thestrong first-quarter pace.

Foreign official holdings in the United Statesincreased about $52 billion in the first quarter of1996, after a record $110 billion rise in 1995. Theseincreases reflected both intervention to support theforeign exchange value of the dollar by certain indus-trial countries and substantial reserve accumulationby several developing countries. Data for April andMay indicated continued increases in official hold-ings in the United States, but on a much more mod-est scale.

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Appendix: Sweeps of Retail TransactionDeposits

In January 1994, depository institutions beganimplementing sweep programs for retail customers.2

In such programs, balances in household transactionaccounts (typically NOW accounts, but also somedemand deposits, both of which are included in M1)are swept into savings deposits, which are part of thenon-M1 portion of M2. Such sweeps shift depositsfrom reservable (transactions) accounts to nonreserv-able (savings) accounts without impairing deposi-tors’ ability to access the funds for transactions pur-poses. Depositories have an incentive to establishthese programs because reserves held at the FederalReserve earn no interest. Retail sweep programsreduce reported reserves, the monetary base, and M1.They have no effect on M2, since both transactionsand savings accounts are in M2.

Retail sweep programs have been established eitheras daily sweeps or as weekend sweeps. Under a dailysweep, a depositor’s transaction balances above atarget level are shifted each night into a special sav-ings account created for the purpose. If debitsthreaten to reduce the remaining transaction accountbalances below zero, enough funds are transferredback from the savings account to reestablish thetarget level of transaction balances. Because only sixtransfers are allowed out of a savings account withina statement month, on the sixth transfer, the entiresavings balance is returned to the transaction account.Alternatively, in a weekend sweep program, allaffected transaction account balances are sweptinto the special purpose savings account over theweekend, and then returned on Monday. Some‘‘weekend sweep’’ programs undertake sweeps oncertain holidays as well.

No information is available on the current amountsof transaction balances that are being swept into sav-ings accounts. The Federal Reserve has obtained datafrom depositories only on the initial amounts swepton the date each program was established. The tablebelow, which is updated and made available to thepublic on an ongoing basis, shows that the initialamounts swept under programs implemented throughMay 1996 have cumulated to $98 billion. With amarginal reserve requirement of 10 percent onmost of these balances, the cumulative reduction ofrequired reserves attributable to the initial amountsswept has been nearly $10 billion.

2. Sweep accounts for business customers of banks becamewidespread in the mid-1970s. They involve sweeps of demanddeposits into RPs or other money market instruments whose mini-mum sizes are too large to accommodate households.

Sweeps of Transaction Depositsinto Savings Accounts*Billions of dollars

Monthlyaveragesof initialamounts

Cumu-lativetotal

1994January 5.3 5.3February 2.2 7.5March 0.0 7.5April 0.0 7.5May 0.0 7.5June 0.0 7.5July 0.0 7.5August 0.0 7.5September 1.5 9.0October 0.6 9.6November 0.3 9.9December 0.0 9.9

1995January 0.0 9.9February 0.0 9.9March 0.0 9.9April 0.0 9.9May 5.0 14.9June 7.3 22.2July 0.6 22.8August 4.6 27.4September 5.9 33.3October 7.7 41.0November 4.3 45.3December 9.2 54.5

1996January 13.7 68.2February 7.0 75.2March 6.4 81.6April 7.8 89.4May 8.4 97.8

*Figures are the estimated total of transaction account bal-ances inititally swept into savings accounts owing to the introduc-tion of new sweep programs. Monthly totals are averages of dailydata.Regular monthly updates of initital amounts swept may be

obtained by email by sending an email address along witha phone number to sweeps_frb@frb.gov. Those without access toemail may request data by calling (202) 872-7577.

23

Growth of Money and DebtPercent

Period M1 M2 M3

Domesticnonfinancial

debt

Annual1

1980 7.5 8.7 9.6 9.51981 5.4 (2.5)2 9.0 12.4 10.21982 8.8 8.8 9.7 9.81983 10.3 11.8 9.5 11.91984 5.4 8.1 10.8 14.6

1985 12.0 8.6 7.7 14.41986 15.5 9.2 9.0 13.31987 6.3 4.2 5.9 10.01988 4.3 5.7 6.3 8.81989 0.6 5.2 4.0 7.9

1990 4.1 4.1 1.8 6.81991 7.9 3.1 1.2 4.61992 14.3 1.8 0.6 4.71993 10.5 1.4 1.0 5.21994 2.4 0.6 1.6 5.2

1995 −1.8 4.0 5.9 5.6

Quarterly(annual rate)3

1995 Q1 −0.1 1.0 4.5 5.4Q2 −0.5 3.8 6.3 7.1Q3 −1.5 6.9 7.9 4.9Q4 −5.1 4.1 4.5 4.7

1996 Q1 −2.7 5.9 7.2 4.7Q2 −0.5 4.1 5.3 n.a.

1. From average for fourth quarter of preceding year toaverage for fourth quarter of year indicated.2. Adjusted for shifts to NOW accounts in 1981.

3. From average for preceding quarter to average forquarter indicated.

24