For use at 2:00 p.m., E.D.T.TuesdayJuly 22, 1997

Board of Governors of the Federal Reserve System

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

July 22, 1997

Letter of Transmittal

BOARD OF GOVERNORS OF THEFEDERAL RESERVE SYSTEMWashington, D.C., July 22, 1997

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 1997 6

Section 1: Monetary Policy and the Economic Outlook

The economy continued to perform exceptionallywell in the first half of 1997. Real output grewbriskly, while inflation ebbed. Sizable furtherincreases in payrolls pushed the unemployment ratebelow 5 percent for the first time in nearly twenty-five years. Although growth in real gross domesticproduct appears to have slowed in the spring, thisslackening came on the heels of a dramatic surge inthe opening months of the year; all indications arethat the expansion remains well intact. The membersof the Board of Governors and the Reserve Bankpresidents anticipate that the economy will grow at amoderate pace in the second half of this year and in1998 and that inflation will remain low. Conditions infinancial markets are supportive of continued growth:Longer-term interest rates are in the lower portion ofthe range observed in this decade, the stock markethas registered all-time highs, and credit remainsreadily available to private borrowers.

Since the February report on monetary policy, Fed-eral Reserve policymakers have revised upward theirexpectations for growth of real activity in 1997 andtrimmed their forecasts of inflation. This combina-tion of revisions highlights the extraordinarily posi-tive conditions still prevailing more than six yearsinto the current economic expansion. In part, therecent confluence of higher-than-expected output andlower inflation has reflected the favorable influenceson prices of retreating oil prices and a strong dollar.But it may also be attributable to more durablechanges in our economy, notably a greater flex-ibility and competitiveness in labor and productmarkets and more rapid, technology-driven gains inefficiency. In essence, the economy may be experi-encing an upward shift in its longer-range outputpotential.

To the extent that aggregate supply is expandingmore rapidly, monetary policy can accommodateextra growth in demand without fostering increasedinflationary pressures. In late March, however, theFederal Open Market Committee concluded that therewas a significant risk that aggregate demand wouldgrow faster in the coming quarters than availablesupply, which, with utilization already at a veryhigh level, would place the economy’s resourcesunder increasing strain. If such unsustainablegrowth persisted, the resulting inflationary imbal-ances would eventually undermine the health of theexpansion—the all too frequent pattern of past busi-ness cycles. To protect against the possibility of such

an outcome, the Committee tightened policy slightly.With the softening of demand in the spring, the Com-mittee was able to maintain a steady posture in themoney market while closely monitoring economicdevelopments. The ongoing objective of monetarypolicy is to help the nation achieve maximum sustain-able economic growth and the highest average liv-ing standards. The Federal Reserve recognizes that itcan best accomplish this objective by keeping infla-tion in check, because an environment of price stabil-ity is most conducive to sound, long-term planning byhouseholds and businesses.

Monetary Policy, Financial Markets, andthe Economy over the First Half of 1997

The rapid economic growth observed in the clos-ing months of 1996 continued in the first quarter ofthis year, with real GDP advancing almost 6 percentat an annual rate. Consumer spending surged, fueledby a significant increase in income, upbeat consumerattitudes, and the effects of the huge run-up in equityprices over the past couple of years on household networth. Business fixed investment was strong, andcompanies restocked inventories that had become thinas sales soared. The advance in real output providedsupport for considerable new hiring; rising pay andgreater job availability drew additional people intothe workforce, lifting the labor force participation rateto a new high during the first quarter of the year. Theunderlying trend in consumer price inflation was stillsubdued. Inflation pressures were held in check bysmaller food price increases, declining prices for non-oil imports, the marked expansion of industrial capac-ity in recent years, and continuing efforts by busi-nesses to boost efficiency.

At their meeting in late March, Federal OpenMarket Committee (FOMC) members expected thatthe growth of economic activity would ease in thecoming months, but they were uncertain about thelikely extent of that slowing. Although the first-quarter burst in production had owed importantlyto a number of temporary factors, many of thefundamentals underlying consumer and businessdemand remained quite positive. The Committee wasconcerned about the risk that if outsized gains in realoutput continued, pressures on costs and prices wouldemerge that could eventually undermine the expan-sion. Therefore, to help foster more sustainable trendsin output and guard against potential inflationaryimbalances, the Committee firmed policy slightly by

1

raising the expected federal funds rate from around51⁄4 percent to around 51⁄2 percent.

The unsustainably strong pace of economic growthin the first quarter weighed on financial markets.Interest rates rose substantially, even before theSystem’s action, despite favorable news on infla-tion. Because the policy tightening was widelyanticipated, rates were little affected by the announce-ment, but they moved up a little more in the follow-ing weeks as incoming data suggested persistentstrength in economic activity. Equity prices rose earlyin the first quarter and then declined, changingrelatively little on net. The trade-weighted value ofthe dollar in terms of the other G-10 currenciesincreased about 7 percent in the first quarter, reflect-ing the unexpectedly strong economic growth in theUnited States and market uncertainty about eco-nomic performance abroad.

As the second quarter progressed, it becameincreasingly evident that economic activity hadindeed decelerated. The expansion of consumerspending eased considerably, while business fixedinvestment remained strong. Employment continuedto climb rapidly, pushing the unemployment ratedown below 5 percent on average in the secondquarter—the lowest level since the early 1970s.

Despite high levels of employment and productionthrough the first half of the year, there were few signsthat inflation was deviating significantly from recenttrends. Although overall consumer price inflationdipped in the second quarter as energy pricesdeclined, consumer prices excluding food and energyincreased at about the same pace in the first half ofthe year as in 1996.

Continued favorable price movements and theslowing of economic growth suggested to financialmarket participants that inflation might remaindamped without a further tightening of financialconditions, and this belief prompted a substantial dropin interest rates from late April to mid-July, revers-ing the earlier advance. With resource utilization stillat very high levels, and with economic and financialconditions conducive to robust increases in spend-ing, the FOMC at its May meeting continued to viewthe risks as skewed toward the re-emergence ofinflationary pressures. But the moderation in aggre-gate demand and uncertainty about the relationshipbetween utilization rates and inflation led the Com-mittee to leave reserve conditions unchanged in Mayand again in July. The drop in market interest rates inthe second quarter may also have been encouraged byfavorable news about this year’s federal budget

Selected Interest RatesPercent

4

5

6

7

8

Daily

Thirty-yearTreasury

Three-yearTreasury

Three-monthTreasury

Discount rate

Intended FederalFunds Rate

5/23 7/6 8/22 9/26 11/15 12/19 1/31 3/26 5/21 7/3 8/20 9/24 11/13 12/17 2/5 3/25 5/20 7/2

1995 1996 1997

Note. Dotted vertical lines indicate days on which the FederalOpen Market Committee (FOMC) announced a monetary policy

action. The dates on the horizontal axis are those on whichthe FOMC held meetings. Last observations are for July 18, 1997.

2

deficit and by the agreement between the Presidentand the Congress to balance the budget in fiscal year2002. Spurred by lower rates and greater optimismabout the long-term outlook for earnings, the stockmarket surged in the second quarter and into July.The value of the dollar rose somewhat further inforeign-exchange markets, on balance, an increasemore than accounted for by an appreciation againstcontinental European currencies.

During the first half of the year, credit remainedavailable on favorable terms to most households andbusinesses. High delinquency rates for consumerloans encouraged many banks to tighten standards,but consumer loan rates generally stayed fairly lowrelative to benchmark Treasury rates, and consumercredit continued to grow faster than income and onlya little below the pace of 1996. Home mortgage debtadvanced at a moderate rate, with home equity loansexpanding especially rapidly in the spring. Busi-nesses continued to have access to ample externalfunding both directly in capital markets and throughfinancial intermediaries. The spreads between yieldson corporate bonds and Treasury securities stayedlow or fell further, and, relative to market rates, bankbusiness loan rates held near the lower end of therange seen in the current expansion.

Total domestic nonfinancial debt expanded moreslowly in the first half of 1997 than in 1996, mainlybecause of a reduced pace of federal borrowing.Trends in the monetary aggregates during the firsthalf of 1997 were similar to those in 1996, with M2near the upper end of the range set by the FOMC andM3 somewhat above its range. This outcome was inline with FOMC expectations, because the ranges hadbeen set to be consistent with conditions of pricestability, and inflation, while damped, remained abovethis level. The behavior of M2 in the first part of theyear was again reasonably well explained by changesin nominal GDP and interest rates.

Economic Projections for 1997 and 1998

After growing swiftly on balance over the first halfof the year, economic activity is expected to expandmore moderately in the second half of 1997 and in1998. For this year, the central tendency of the GDPgrowth forecasts put forth by members of the Boardof Governors and the Reserve Bank presidents is3 percent to 31⁄4 percent, measured as the change inreal output between the final quarter of 1996 and thefinal quarter of 1997. For 1998, most of the forecastsanticipate growth of real GDP within a range of

2 percent to 21⁄2 percent. With this pace of continuedeconomic expansion over the next six quarters, thecentral tendency of forecasts for the civilianunemployment rate remains a little under 5 percentthrough 1998, about the average for the secondquarter of this year.

Economic activity appears to have entered thesecond half with considerable positive momentum.Households have experienced hefty gains in employ-ment, income, and wealth, and their optimism aboutthe future is quite high. These factors seem likely tooutweigh any drag on consumer demand that mightbe associated with the debt-servicing problems thatsome households have experienced. Lower mort-gage rates are buttressing demand for homes. In thebusiness sector, healthy balance sheets and profits anda moderate cost of external funds, along with acontinuing desire to install new technology, areproviding support and impetus for investment inequipment. Meanwhile, investment in structuresshould follow last year’s strong performance withfurther increases, because of declining vacancy ratesin some sectors and ready access to financing.

Notwithstanding the economy’s positive momen-tum, growth is expected to be more moderate in thenext year and a half than in the first half of 1997. Inpart, this deceleration is likely to reflect the influ-ence on demand of the substantial buildup of stocksof household durables and business plant and equip-ment thus far in the expansion. As well, the pace ofinventory investment will need to slacken consider-ably relative to that observed in the first part of thisyear, lest stock-to-sales ratios become uncomfort-ably high. In the external sector, the strength of thedollar on exchange markets since last year coulddamp export sales and encourage U.S. firms andhouseholds to purchase foreign-produced goods andservices.

Federal Reserve policymakers believe that thisyear’s rise in the CPI will be smaller than that of1996, mostly because of favorable developments inthe food and, especially, energy sectors. After lastyear’s run-up, crude oil prices have dropped backsignificantly, pulling down the prices of petroleumproducts. Food price increases also have beensubdued this year, as the decline in grain prices thatbegan in the middle of last year has been working itsway through to the retail level. Looking ahead to nextyear, the governors and Reserve Bank presidentsexpect larger increases in the CPI, with a centraltendency from 21⁄2 percent to 3 percent. Food andenergy prices are not expected to repeat this year’s

3

salutary performance, and non-oil import prices maybe less of a restraining influence than in 1997, absenta continued uptrend in the dollar. Moreover, there is arisk that high levels of resource utilization couldbegin putting upward pressure on business costs.

As noted in past monetary policy reports, theCPI forecasts of Federal Reserve policymakersincorporate the technical improvements that theBureau of Labor Statistics is making to the CPI in1997 and 1998. A series of technical changes isestimated to have trimmed reported rates of CPI infla-tion slightly in recent years, and the additionalchanges will affect the index this year and next. Inlight of the challenges of accurately measuring pricechanges in a complex and dynamic economy, thegovernors and Reserve Bank presidents will continue

placing substantial weight on other price indexes,along with the CPI, in gauging progress toward thelong-run goal of price stability.

The Administration has not yet released an updateof the economic projections contained in the Febru-ary Economic Report of the President. The earlierAdministration forecasts were broadly similar tothose in the Federal Reserve’s February report, withAdministration forecasts for growth and inflationwithin or near the range anticipated by FederalReserve policymakers in February. Because ofdevelopments in the economy since that time, thecentral tendency of forecasts for real GDP growth putforth by the members of the Board of Governorsand the Reserve Bank presidents has moved higher,while their forecasts for the CPI have moved down.

Economic Projections for 1997 and 1998Percent

Indicator

Federal Reserve governorsand Reserve Bank presidents

RangeCentral

tendency

1997Change, fourth quarterto fourth quarter 1

Nominal GDP 5 to 6 5 to 51⁄2Real GDP 3 to 31⁄2 3 to 31⁄4Consumer price index 2 2 to 23⁄4 21⁄4 to 21⁄2

Average level in thefourth quarter

Civilian unemployment rate 43⁄4 to 51⁄4 43⁄4 to 5

1998Change, fourth quarterto fourth quarter 1

Nominal GDP 41⁄4 to 53⁄4 41⁄2 to 5Real GDP 2 to 3 2 to 21⁄2Consumer price index 2 21⁄2 to 3 21⁄2 to 3

Average level in thefourth quarter

Civilian unemployment rate 41⁄2 to 51⁄4 43⁄4 to 5

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

2. All urban consumers.

4

Money and Debt Rangesfor 1997 and 1998

At its meeting earlier this month, the Committeereaffirmed the ranges for 1997 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. The Committee also setprovisional ranges for 1998 at the same levels as for1997.

In choosing the ranges for M2 and M3, the Com-mittee recognized the continuing uncertainty aboutthe future behavior of the velocities of the two aggre-gates. For several decades until the 1990s, theseaggregates exhibited fairly stable trends relative tonominal spending, and variations in M2 growtharound its trend were reasonably closely related tochanges in the spread between market rates andyields on the assets in M2. These relationships weredisrupted in the first part of this decade. Between1991 and early 1994, the velocities of M2 and M3climbed well above the levels that were predicted bypast experience, as households shifted substantialamounts out of lower-yielding deposits into higher-yielding stock and bond mutual funds, and as banksand thrift institutions sharply curtailed their lending

to focus on rebuilding capital. Since mid-1994, thevelocities have been moving more nearly in linewith their historical patterns with respect to changesin opportunity costs—albeit at higher levels. Thisrecent period of renewed stability is still brief, how-ever, and has occurred at a time of relatively stablefinancial and economic conditions, leaving open theimportant question of whether the stability would besustained in the future under a wider variety ofcircumstances.

In light of this uncertainty, the Committee againdecided to view the ranges as benchmarks for mone-tary growth rates that would be consistent withapproximate price stability and historical velocityrelationships. If velocities change little over the nextyear and a half, Committee members’ expectations ofnominal GDP growth in 1997 and 1998 imply thatM2 and M3 will likely finish around the upperboundaries of their respective ranges each year. Thedebt of the domestic nonfinancial sectors is expectedto remain near the middle of its range this year andnext. The Committee will continue to monitor thebehavior of the monetary aggregates and domesticnonfinancial debt—as well as a wide range of otherdata—for information about economic and financialdevelopments.

Ranges for Growth of Monetary and Debt AggregatesPercent

Aggregate 1996 1997 Provisional for 1998

M2 1 to 5 1 to 5 1 to 5

M3 2 to 6 2 to 6 2 to 6

Debt 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.

5

Section 2: Economic and Financial Developments in 1997

The economy has continued to perform exception-ally well this year. Real gross domestic productsurged almost 6 percent at an annual rate in the firstquarter of 1997, and available data point to a healthy,though smaller, increase in the second quarter. Finan-cial conditions remained supportive of spending.Despite a modest tightening of money market condi-tions by the System, most interest rates were littlechanged or declined a bit on net during the first halfof the year, and equity prices surged ahead. Withrelatively few exceptions, credit remained readilyavailable from both intermediaries and financial mar-kets on generally favorable terms. The rapid increasesin output led to a further tightening of labor mar-kets in the first six months of 1997, and labor costsaccelerated a little from the pace of a year earlier.Price inflation has been subdued, held down in partby declines in energy prices, smaller increases in foodprices, and lower prices for non-oil imports that havefollowed in the wake of the appreciation of the dol-lar. In addition, intense competition, adequate plantcapacity, and ongoing efficiency gains have helped torestrain inflation pressures in the face of rising wages.

The Household Sector

Spending, Income, and Saving. After post-ing a sizable increase in 1996, real personal consump-tion expenditures jumped 51⁄2 percent at an annualrate in the first quarter of 1997. Although the advancein spending slowed thereafter—partly because ofunusually cool weather in late spring—underlyingfundamentals for the household sector remain favor-

able to further solid gains; notably, real incomes havecontinued to rise, and many consumers havebenefited from sizable gains in wealth. With thisgood news in hand, consumers have become extraor-dinarily upbeat about the economy’s prospects.Indexes of consumer sentiment—such as those com-piled by the Survey Research Center at the Universityof Michigan and the Conference Board—have soaredto some of the highest readings since the 1960s.Despite this generally healthy picture, some house-holds still face difficulties meeting debt obligations,and delinquency rates for consumer loans haveremained at high levels.

Real outlays for consumer durables surged183⁄4 percent (annual rate) in the first quarter ofthis year but apparently slowed considerably in thesecond quarter. After changing little, on net, last year,consumer purchases of motor vehicles increasedrapidly early in the year, a result of soundfundamentals, a bounceback from the strike-depressed fourth quarter, and enlarged incentivesoffered by auto makers. In the second quarter, saleswere once again held down noticeably by strike-related supply constraints, as well as by some pay-back from the elevated first-quarter pace. Smoothingthrough the ups and downs, the underlying pace ofdemand in the first half of the year likely remainedreasonably close to the 15 million unit rate that hasprevailed since the second half of 1995. Purchases ofdurable goods other than motor vehicles also took offin the first quarter; computers and other electronicequipment were an area of notable strength, as house-

Change in Real Income and ConsumptionPercent, annual rate

1992 1993 1994 1995 1996 19974

0–

+

4

8

Disposable personal income

Personal consumption expenditures

Q1

Change in Real GDPPercent, annual rate

1992 1993 1994 1995 1996 19972

0–

+

2

4

6Q1

6

holds took advantage of rapidly falling prices toacquire the latest technology. According to availablemonthly data, purchases of durables other than motorvehicles and electronic equipment moderated in thesecond quarter. Although a pause in the growth ofspending is not surprising after the strong first quarter,unusually cool spring weather, leading to the post-ponement of purchases of some seasonal items, mayalso have contributed to the moderation.

Growth of real spending for nondurables alsoappears to have slowed considerably from a strongfirst-quarter pace. Within services, weather condi-tions held down growth of real outlays for energy ser-vices in the first quarter and boosted them in thesecond. Growth of real outlays for other services—typically the steadiest component of consumption—picked up at the end of 1996 and appears to havestayed ahead of last year’s 21⁄2 percent pace in thefirst half of 1997.

Consumer spending continued to draw supportfrom healthy advances in income this year, as gains inwages and salaries boosted personal disposableincome. These gains translated into a 4 percent annualrate advance in real disposable income in the firstquarter, after a significant 23⁄4 percent advance lastyear. Although month-to-month movements were af-fected by unevenness in the timing of tax payments,the underlying trend in real disposable incomeremained strong into the second quarter.

On top of rising incomes, further increases in networth—primarily related to the soaring stockmarket—have given many households the financialwherewithal to spend. In light of the very large gainsin wealth, the impetus to consumption appears tohave been smaller than might have been anticipatedon the basis of historical relationships, suggestingthat other factors may be offsetting the effect ofhigher net worth. One such factor could be a greaterfocus on retirement savings, particularly among thelarge cohort of the population reaching middle age.Concerns about the adequacy of saving for retire-ment have likely been heightened by increased publicdiscussion of the financial problems of social secu-rity and federal health programs. In addition, debtproblems may be restraining the spending of somehouseholds.

Residential Investment. The underlying paceof housing activity has remained at a high level thisyear, even though some indicators suggest that activ-ity has edged off a bit from last year’s pace. In thesingle-family sector, housing starts through June aver-

aged 1.14 million units at an annual rate, a shadebelow the pace of starts in 1996. Although startsdipped in the second quarter, the decline was from afirst-quarter level that, doubtless, was boosted by mildweather. Mortgage rates have zig-zagged moderatelythis year; the average level has differed little from thatin 1996. With mortgage rates low and income growthstrong, a relatively large proportion of families hasbeen able to afford the monthly cost of purchasinga home. Home sales have remained strong, helpingto keep inventories of unsold new units relativelylean—a favorable factor for prospective buildingactivity. Other indicators of demand remain quitepositive. According to the latest survey by theNational Association of Homebuilders, builders’ratings of new home sales strengthened in recentmonths to the highest level since last August.Moreover, consumers’ assessments of conditions forhomebuying, as reported by the Survey ResearchCenter at the University of Michigan, remained veryfavorable into July. In addition, the volume of appli-cations for mortgages to purchase homes has movedup recently to a high level.

The pace of multifamily starts has been wellmaintained. These starts averaged close to 320,000units at an annual rate from January to June, a littleabove last year’s figure for starts. Even so, the pace ofmultifamily construction remains well below peaks inthe 1970s and 1980s, partly because of changes in thenation’s demographic composition as the bulge ofrenters in the 1980s has moved on to home owner-ship. Another factor that has restrained multifamilyconstruction is the growing popularity of manufac-tured housing (‘‘mobile homes’’), which provides analternative to rental housing for some households. Inparticular, the price of a typical manufactured unit

Private Housing StartsMillions of units, annual rate

1987 1989 1991 1993 1995 19970

0.5

1.0

1.5

Quarterly averageMultifamily

Single-family

Q2

7

is considerably less than that of a new single-familyhouse, making manufactured homes especially attrac-tive to first-time buyers and to people purchasingsecond houses or retirement homes. Shipments ofthese homes trended up through last fall and then flat-tened out at a relatively high level.

Household Finance. Household balance sheetsstrengthened in the aggregate during the first half of1997, but debt-payment problems continued at a highlevel in several market segments. Indebtedness grewless rapidly than it had in 1996, and further gains inequity markets pushed up the ratio of household networth to disposable personal income to its highestmark in recent decades. Consumer credit increased ata 61⁄4 percent annual rate between December 1996and May 1997, compared with 81⁄4 percent in 1996.The growth of mortgage debt was somewhat slowerin the first quarter than in 1996 and, according toavailable indicators, probably stayed at roughly thesame rate during the second quarter.

The estimated ratio of required payments of loanprincipal and interest to disposable personal incomeremained high in the first quarter, after climbingrapidly between early 1994 and early 1996 and ris-ing more slowly in the second half of last year. Thismeasure of the debt-service burden of households hasnearly returned to the peak reached toward the end ofthe last business cycle expansion. Adding estimatedpayments on auto leases to households’ scheduledmonthly debt payments boosts the ratio a little morethan 1 percentage point and places it just above itsprevious peak.

Indicators of households’ ability to service theirdebt have been mixed. The delinquency rate for mort-gage loans past due sixty days or more is at its low-est level in two decades, but delinquency rates forconsumer loans are relatively high. According to datafrom the Report of Condition and Income filed bybanks (the Call Report), the delinquency rate forcredit card loans was roughly unchanged in the firstquarter of 1997, remaining at its highest value sincelate 1992, when the economy was in the midst of asluggish recovery and the unemployment rate wasmore than 2 percentage points higher than today. For

Household Debt-Service BurdenPercent of disposable personal income

1982 1987 1992 199713

14

15

16

17

QuarterlyQ1

Note. Debt service is the estimated sum of required interestand principal payments on consumer and household-sector mort-gage debt.

Delinquency Rates on Household LoansPercent

1987 1989 1991 1993 1995 19971

2

3

4

5

Quarterly

Credit cardaccounts atbanks

Mortgages (over 60 days)

Auto loans atfinance companies

Q1

Q1

Q1

Note. Data on credit-card delinquencies are from the CallReport; data on mortgage delinquencies are from the MortgageBankers Association.

Household Net WorthPercent of disposable personal income

1965 1975 1985 1995

400

425

450

475

500

Four-quarter moving average Q1

8

auto loans at the finance companies affiliated with themajor manufacturers, the delinquency rate rose againin the first quarter, continuing the steady run-up inthis measure over the past three years.

Anecdotal evidence suggests that the recentincreases in consumer credit delinquency rates hadbeen partly anticipated by lenders, reflecting thenormal seasoning of loans as well as banks’ efforts tostimulate borrowing by making credit more broadlyavailable and automakers’ attempts to stimulate salesusing the same approach. During the past severalyears, lenders have aggressively sought business frompeople who might not have been granted credit pre-viously, in part because of lenders’ confidence innew ‘‘credit scoring’’ models that statistically evalu-ate an individual’s creditworthiness. Despite thesenew tools, banks evidently have been surprised by theextent of the deterioration of their consumer loansand have tightened lending standards as a result.Nearly half the banks responding to the FederalReserve’s May survey on bank lending practices hadimposed more stringent standards for new credit cardaccounts over the preceding three months, with asmaller fraction reining in other consumer loans.About one-third more of the responding banksexpected charge-off rates on consumer loans toincrease further over the remainder of the year thanexpected charge-off rates to decrease; many of thoseexpecting an increase cited consumers’ growingwillingness to declare bankruptcy. Rising delinquencyrates have also put pressure on firms specializing insubprime auto loans, with some reporting reducedprofits and acute liquidity problems.

According to the most recently available data,personal bankruptcies surged again in the first quarterof the year after rising 30 percent in 1996. The rapidincreases of late are partly related to the sameincrease in financial stress evident in the delinquencystatistics, but they may also be tied to more wide-spread use of bankruptcy as a means of dealing withsuch stress. Changes in federal bankruptcy law effec-tive at the start of 1995 increased the value of assetsthat may be protected from liquidation, and there mayalso be a secular trend toward less stigma beingassociated with declaring bankruptcy.

The Business Sector

Investment Expenditures. Following a fifthyear of sizable increases in 1996, real business fixedinvestment rose at an annual rate of 11 percent in thefirst quarter. The underlying determinants of invest-ment spending remain solid: strong business sales,

sizable increases in cash flow, and a favorable cost ofcapital, especially for high-tech equipment. To besure, a significant portion of this investment has beenrequired to update and replace depreciated plant andequipment; nevertheless, the current pace of invest-ment implies an appreciable expansion of the capitalstock.

Real outlays for producers’ durable equipmentjumped at an annual rate of 123⁄4 percent in the firstquarter of this year after rising 93⁄4 percent last year.As in recent years, purchases of computers andother information processing equipment contributedimportantly to this gain. The computer sector hasbeen propelled by declining prices of new and morepowerful products and by a drive in the business sec-tor to improve efficiency with these latest technologi-cal developments. Real purchases of communica-tions equipment also have been robust, boosted byrapidly growing demand for wireless phone servicesand Internet connections as well as by upgrades totelephone switching and transmission equipment inanticipation of eventual deregulation of local phonemarkets. In addition, purchases of aircraft by domes-tic airlines moved higher on net in 1995 and 1996and—on the basis of orders and production plans ofaircraft makers—are expected to rise considerablyfurther this year. For the second quarter, data onorders and shipments of nondefense capital goods inApril and May imply that healthy increases in equip-ment investment have continued.

Real business spending for nonresidential struc-tures posted another sizable increase in the firstquarter after advancing a hefty 9 percent in 1996.Although the latest data suggest a slowing of the pace

Change in Real Business Fixed InvestmentPercent, annual rate

1992 1993 1994 1995 1996 199710

0–

+

10

20

Structures

Producers’ durableequipment

Q1

9

of advance in the second quarter, the economicfactors underlying this sector point to continuedincreases. Vacancy rates have been falling and rentshave been improving. Financing for commercialconstruction reportedly is in abundant supply, espe-cially with substantial amounts of capital flowing toreal estate investment trusts (REITs).

Trends in construction continue to differ amongsectors. Increases in office construction were espe-cially robust in recent quarters, as vacancy rates fellfor both downtown and suburban properties. Withoffice-based employment expanding, this sector hascontinued to recover from the severe slump of the late1980s and early 1990s; even so, the level of construc-tion activity is barely more than half that of the mid-1980s. Construction of other commercial buildingshas increased steadily during the past five years, andthe gain in the first quarter of this year was sizable.Since the current expansion began, the non-officecommercial sector has provided a large contributionto overall construction spending. Industrial construc-tion dropped back in the first quarter after jumping atthe end of last year; the trend for this sector has beenrelatively flat on balance in recent years.

During 1996, investment in real nonfarm businessinventories was modest compared with the growth ofsales, and the year ended with lean inventories inmany sectors. In the first quarter of this year, busi-nesses moved to rebuild stocks, and inventory invest-ment picked up substantially. Outside of motor vehi-cles, stocks rose in the first quarter, with particularlysizable increases coming from a continued ramp-upin production of aircraft and from a restocking ofpetroleum products during a period when prices

eased. Nevertheless, with extraordinarily strong sales,inventory–sales ratios still moved down further inthe major sectors. Available monthly data suggestthat vigorous inventory investment outside of motorvehicles continued through mid-spring, as firmsresponded to strength in current and prospective sales.For motor vehicles, inventories moved up some in thefirst quarter of this year, after strike-related reduc-tions in the fourth quarter. In the second quarter, themonthly pattern of motor vehicles stocks wasbounced around somewhat by strikes; cutting throughthe noise, inventories of light vehicles still appear tobe in balance.

Corporate Profits and Business Finance.The continued rapid advance of business investmentthis year has been financed through both strong cashflow and substantial borrowing at relatively favor-able terms. Economic profits (book profits afterinventory valuation and capital consumption adjust-ments) in the first quarter were 73⁄4 percent higherthan a year earlier. For the nonfinancial sector,domestic profits were more than 9 percent higher,reaching their highest share of those firms’ domesticoutput in the current expansion. Despite abundantprofits, the financing gap for these companies—theexcess of capital expenditures (including inventoryinvestment) over internally generated funds—haswidened somewhat since the middle of 1996. To fundthat gap, and the ongoing net retirement of equityshares, nonfinancial corporations increased their debt61⁄2 percent at an annual rate in the first quarter,compared with 51⁄4 percent during 1996.

Change in Real Nonfarm Business InventoriesPercent, annual rate

1992 1993 1994 1995 1996 19974

0–

+

4

Q1

Before-Tax Profit Share of GDPPercent

1977 1982 1987 1992 19976

9

12

Nonfinancial corporations

Q1

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

10

External funding has remained readily available tobusinesses on favorable terms. The spreads betweenyields on investment-grade bonds and yields onTreasury securities have stayed low since the begin-ning of the year, while the spreads on high-yieldbonds have declined further to historically narrowlevels. Price–earnings ratios are high, implying alow cost of equity financing. Further, banks remainaccommodative lenders to businesses. According tothe Federal Reserve’s most recent survey of busi-ness lending, the spreads between loan rates andmarket rates have held about steady for borrowers ofall sizes, with rate spreads for large loans near thelower end of the range seen over the past decade.Moreover, surveys by the National Federation ofIndependent Business indicate that small businesseshave not had difficulty obtaining credit.

The plentiful supply of credit probably stems fromseveral factors. Most banks are well positioned tolend: Their profits are strong, rates of return on equityand on assets are high, and capital is ample. In addi-tion, continued substantial inflows into stock andhigh-yield bond mutual funds suggest that investorsmay now perceive less risk in these areas or may bemore willing to accept risk. In fact, businesses gener-ally are in very good financial condition, with theestimated ratio of operating cash flow to interestexpense for the median nonfinancial corporationremaining quite high in the first part of the year.

Moreover, delinquency rates for business loans atbanks have stayed extremely low, as has the defaultrate on speculative-grade debt.

The increase in the pace of business borrowing inthe first half of 1997 was widespread across sourcesof finance. Nonfinancial corporations stepped up theirborrowing from banks. The outstanding commercialpaper of these corporations also increased on net fromDecember through June, after declining a little in1996. Meanwhile, these businesses’ net issuance oflong-term bonds in the first half of the year exceededlast year’s pace, with speculative-grade offeringsaccounting for the highest share of gross issuance onrecord.

At the same time, the pace of gross equity issu-ance by nonfinancial corporations dropped consider-ably in the first half of this year. In particular, themarket for initial public offerings has been coolerthan in 1996, despite some pickup of late; new issueshave been priced below the intended range moreoften than above it, and first-day trading returns havebeen relatively low. Net equity issuance has beendeeply negative again this year, as gross issuance hasbeen more than offset by retirements through sharerepurchases and mergers. The bulk of merger activ-ity in the 1980s involved share retirements financedby borrowing, but the recent surge—which largelyinvolves friendly intra-industry mergers—has beenfinanced about equally through borrowing and stockswaps. Structuring deals as stock swaps can reduceshareholders’ tax liabilities and enable the combinedfirm to use a more advantageous method of finan-cial accounting. The dollar value of nonfinancialmergers in which the target firm was worth more thana billion dollars set a record in 1996, and mergeractivity appears to be on a very strong track this yearas well.

The Government Sector

Federal. The federal budget deficit has comedown considerably in recent years and shouldregister another substantial decline this fiscal year.Over the first eight months of fiscal year 1997—theperiod October through May—the deficit in the uni-fied budget was $65 billion, down $43 billion fromthe comparable period of fiscal 1996. The recentreduction in the deficit primarily reflected extremelyrapid growth of receipts for the second year in arow, although a continuation of subdued growth inoutlays also contributed to the improvement. Givenrecent developments, the budget deficit as a share

Spreads Between Yields onPrivate and Treasury Securities

Percent

1987 1989 1991 1993 1995 19970

2

4

6

8

10

Monthly

High-yield bonds

Investment-grade bondsJune

Note. Yield on Merrill Lynch Master II Index of high-yield bondsis compared with that on a seven-year Treasury note; yield onMoody’s index of A-rated investment-grade bonds is comparedwith that on a ten-year Treasury note.

11

of nominal GDP this fiscal year is likely to be at itslowest level since 1974.

Federal receipts were almost 81⁄2 percent higher inthe first eight months of fiscal year 1997 than in theyear-earlier period and apparently are on track tooutpace the growth of nominal GDP for the fifthyear in a row. Individual income tax payments haverisen sharply this fiscal year—on top of a heftyincrease last year—reflecting strong increases inhouseholds’ taxable labor and capital income;preliminary data from the Daily Treasury Statementindicate that individual income tax revenues remainedstrong in June. Moreover, corporate tax paymentsposted another sizable advance through May of thisfiscal year.

Federal outlays during the first eight months ofthe fiscal year rose 31⁄2 percent in nominal termsfrom the comparable period last year. Although thisincrease is up from the restrained rate of growth infiscal 1996—which was held down by the govern-ment shutdown—spending growth remained sub-dued across most categories. Outlays for incomesecurity programs rose modestly in the first eightmonths of the fiscal year, partly as a result of thecontinued strong economy, and spending on themajor health programs grew somewhat more slowlythan their average pace in recent years. Althoughstill restrained, outlays for defense have ticked upthis fiscal year after trending down for severalyears.

As for the part of federal spending that is includeddirectly in GDP, real federal expenditures on con-sumption and gross investment declined 31⁄4 percentin the first quarter of 1997, a shade more than theaverage rate of decline in recent years. An increase inreal nondefense spending was more than offset by adecline in real defense outlays.

The substantial drop in the unified budget deficitreduced federal borrowing in the first half of 1997compared with the first half of 1996. The Treasuryresponded to the smaller-than-expected borrowingneed by reducing sales of bills; this traditionalstrategy of allowing borrowing swings to be absorbedprimarily by variation in bill issuance enables theTreasury to have predictable coupon auctions andto issue sufficient quantities of coupon securities tomaintain their liquidity. The result this past springwas an unusually large net redemption of bills, whichpushed yields on short-term bills down relative toyields on other Treasury securities and on short-term private paper.

The issuance of inflation-indexed securities atseveral maturities has been a major innovation in fed-eral debt management this year. The Treasury soldindexed ten-year notes in January and April andadded five-year notes earlier this month. A smallnumber of agency and other borrowers issued theirown inflation-indexed debt immediately after the firstTreasury auction, and the Chicago Board of Traderecently introduced futures and options contractsbased on inflation-indexed securities. As one wouldexpect at this stage, however, the market for indexeddebt has not yet fully matured: Trading volume as ashare of the outstanding amount is much smaller thanfor nominal debt, and a market for stripped securi-ties has yet to emerge.

State and Local. The fiscal condition of state andlocal governments has remained positive over thepast year, as the surplus of receipts over currentexpenditures has been stable at a relatively high level.Strong growth in sales and incomes has led to robustgrowth in revenues, despite numerous small tax cuts,and many states have held the line on spending in thepast several years. Additionally, the welfare reformlegislation passed in August 1996, while presentinglong-term challenges to state and local governments,actually has eased fiscal pressures in recent quarters:Block grants to states are based largely on 1992–94grant levels, but caseloads more recently have beenfalling. Overall, at the state level, accumulatedsurpluses—current surpluses plus those from pastyears—were on track to end fiscal year 1997 at a

Change in Real Federal Expenditureson Consumption and Investment

Percent, Q4 to Q4

1992 1993 1994 1995 1996 199710

5

0–

+

Q1

Note. Value for 1997:Q1 is a quarterly percent change at anannual rate.

12

healthy level, according to a survey by the NationalAssociation of State Budget Officers taken shortlybefore the end of most states’ fiscal years.

Real expenditures for consumption and grossinvestment by state and local governments increasedmoderately in the first quarter of this year, about thesame as the pace of advance in the past two years. Forconstruction, the average level of real outlays dur-ing the first five months of the year was a little higherthan in the fourth quarter. Hiring by state and localgovernments over the first half of the year wassomewhat above last year’s pace, with most of theincrease at the local level.

The pace of gross issuance of state and local debtwas roughly the same in the first half of the year as in1996. Net issuance turned up noticeably, however, asretirements of debt that had been pre-refunded in theearly 1990s waned.

The External Sector

Trade and the Current Account. The nominaldeficit on trade in goods and services was $116 bil-lion at an annual rate in the first quarter, somewhatlarger than the $105 billion in the fourth quarterof last year. The current account deficit of $164 bil-lion (annual rate) in the first quarter exceeded the$148 billion deficit for 1996 as a whole becauseof the widening of the trade deficit and furtherdeclines in net investment income. In April and May,the trade deficit was slightly narrower than in thefirst quarter.

The quantity of U.S. imports of goods and ser-vices surged in the first quarter at an annual rate ofabout 20 percent. Continued strength in the pace ofU.S. economic activity largely accounted for the rapidgrowth, but a rebound in automotive imports fromCanada from their strike-depressed fourth-quarterlevel boosted imports as well. Preliminary data forApril and May suggest that strong real import growthcontinued. Non-oil import prices fell through thesecond quarter, extending the generally downwardtrend that began in mid-1995.

Change in Real State and Local Expenditureson Consumption and Investment

Percent, Q4 to Q4

1992 1993 1994 1995 1996 19970

2

Q1

Note. Value for 1997:Q1 is a quarterly percent change at anannual rate.

U.S. Current AccountBillions of dollars, annual rate

1992 1993 1994 1995 1996 1997250

200

150

100

50

0–

+

Q1

Change in Real Imports and Exportsof Goods and Services

Percent, Q4 to Q4

1992 1993 1994 1995 1996 19970

10

20

Imports

Exports

Q1

Note. Value for 1997:Q1 is a quarterly percent change at anannual rate.

13

The quantity of U.S. exports of goods and ser-vices expanded at an annual rate a bit above10 percent in the first quarter, about the same rapidpace as during the second half of last year. Growth ofoutput in our major trading partners, particularly theindustrial countries, helped to sustain the growth ofexports, as did increased deliveries of civilian aircraft.Exports to western Europe and to Canada grewstrongly while those to the Asian developingcountries declined somewhat. Preliminary data forApril and May suggest that real exports rosemoderately.

Capital Flows. Large gross capital inflows andoutflows continued during the first quarter of 1997,reflecting the continued trend toward globalization offinancial and product markets. Both foreign directinvestment in the United States and U.S. direct invest-ment abroad were very strong, swelled by mergersand acquisitions.

Private foreign net purchases of U.S. securitiesamounted to $85 billion in the first quarter, downsomewhat from the very high figure in the previousquarter but still above the record pace for 1996 as awhole. Net purchases of U.S. Treasury securities wereparticularly robust. Private foreigners also showedincreased interest in the U.S. stock market in the firstquarter of 1997. U.S. net purchases of foreign securi-ties amounted to $15 billion in the first quarter, downfrom the strong pace of 1996. Private foreignerscontinued to add to their holdings of U.S. paper cur-rency in the first quarter, but at a rate substantiallybelow earlier peaks.

Foreign official assets in the United States, whichrose a record $122 billion in 1996, increased another$28 billion in the first quarter of 1997. Apart fromthe oil-producing countries, which benefited fromhigh oil prices, significant increases in holdings wereassociated with efforts by some emerging-marketcountries to temper the impact of large private capitalinflows on their economies. Information for April andMay suggests that official inflows have abated.

Foreign Economies. Economic activity in themajor foreign industrial countries has generallystrengthened so far this year from the pace in thesecond half of last year. In Japan, real GDP acceler-ated to a 61⁄2 percent annual growth rate in the firstquarter, boosted by extremely strong growth ofconsumer spending ahead of an increase in theconsumption tax on April 1. Activity appears to havefallen in the second quarter, but continued improve-ment in business sentiment suggests that the current

weakness is only temporary. In Canada, growth ofreal output increased to 31⁄2 percent at an annual ratein the first quarter. Final domestic demand more thanaccounted for this expansion, as business invest-ment, consumption, and residential construction allprovided significant contributions. Indicators suggestthat output growth remained healthy in the secondquarter.

Economic activity has remained vigorous so farthis year in the United Kingdom and appears to havestrengthened in Germany and France. In the firstquarter, U.K. real GDP grew at an annual rate of31⁄2 percent as domestic demand, particularly invest-ment, accelerated from its already strong pace in thefourth quarter. Strong household consumption spend-ing supported demand in the second quarter. Weakdemand for exports, associated with the appreciationof the pound since mid-1996, and some tightening ofmonetary conditions should moderate growth in thecurrent quarter. In Germany, economic expansionrevived in the first quarter and appears to have firmedin the second quarter. After growing very little in thefourth quarter of last year, German real GDP rose atan annual rate of 13⁄4 percent in the first quarter, ledby government consumption, equipment investment,and exports. Manufacturing orders and indicatorsof business sentiment suggest additional gains inthe second quarter. French real GDP grew only three-quarters percent at an annual rate in the first quarter,as declines in investment offset strong export growth,but data on manufacturing output and consumptionsuggest a pick up in activity during the secondquarter.

In most major Latin American countries, realoutput growth remained vigorous. In Mexico, realeconomic expansion slowed some in the first quarterfrom its very rapid pace in the second half of last yearbut remained robust. The industrial sector continuedto be the source of strength, while the service sectorlagged. A pickup in import growth has resulted in anarrowing of the trade surplus; through May, the tradebalance of $13⁄4 billion was about half the size it wasin the same period last year. In Argentina, continuedhealthy economic growth in the first quarter hasbrought real GDP back to its level before the reces-sion induced by the Mexican crisis of 1995. In Brazil,real output declined in the first quarter after threequarters of strong expansion.

Economic growth in our major Asian tradingpartners other than Japan slowed a bit on average inthe first quarter but appears to have rebounded in thesecond quarter. Nationwide labor strikes in Korea

14

affected many of the country’s key export industriesand were partly responsible for weakness in first-quarter output and a ballooning of the current accountdeficit. Data for April and May show recovery inindustrial production, and the trade balance improvedin the second quarter. Real output growth in Taiwanremains strong so far this year, though not quite sovigorous as during the second half of 1996. In China,real GDP continues to expand at an annual rate ofnearly 10 percent, about the same brisk pace as lastyear.

Despite the pickup in growth, considerable excesscapacity remains in the major foreign industrialcountries. As a consequence, inflation has generallyremained quiescent. The increase in the Japaneseconsumption tax lifted the twelve-month change inthe consumer price index to about 11⁄2 percent, butelevation of the inflation rate should be temporary.CPI inflation remains less than 2 percent in Germany,France, Canada, and Italy. Only in the United King-dom, where output growth has resulted in tight labormarkets and consumer prices are rising at an annualrate of more than 21⁄2 percent, are inflation pres-sures currently a concern.

In most major countries in Latin America, infla-tion either is falling or is already low. Mexican infla-tion continues to improve: The monthly inflationrate was below 1 percent in May and June, thelowest monthly rates since the 1994 devaluation.In Argentina, consumer prices were essentially flatthrough the second quarter after almost no increaselast year. Brazilian inflation has declined to his-torically low rates. In contrast, Venezuelan inflation,though it has come down from its 1996 rate of morethan 100 percent per year, remains near 50 percent.Consumer price inflation remains generally low inAsia, including in China, where it fell to less than3 percent in the twelve months through May.

The Labor Market

Payroll employment continued to expand solidlyduring the first half of 1997. The growth in nonfarmpayrolls averaged about 230,000 per month; thisfigure may overstate slightly the underlying rate ofemployment growth in the first half because techni-cal factors boosted payroll figures in April. Thestrength in labor demand drew additional people intothe job market, raising the labor force participationrate to historical highs during the first half. Neverthe-less, the civilian unemployment rate moved down to4.9 percent, on average, in the second quarter.

Employment gains in the private service-producing sector, in which nearly two-thirds of allnonfarm workers are employed, accounted for muchof the expansion in payrolls through June of this year.Within this sector, higher employment in services,transportation, and retail trade contributed impor-tantly to the gain. After advancing substantially forseveral years, payrolls in the personnel supplyindustry—a category that includes temporary helpagencies—actually turned down in the secondquarter; anecdotal reports suggest that sometemporary help firms are having difficulty findingworkers, especially for highly skilled and technicalpositions.

Net Change in Payroll EmploymentThousands of jobs, average monthly change

1992 1993 1994 1995 1996 1997200

0–

+

200

400

Total nonfarm

H1

Civilian Unemployment RatePercent

1987 1989 1991 1993 1995 19972

4

6

8

June

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

15

Employment gains were also posted in the goods-producing sector. In the construction industry, pay-rolls increased substantially between December andJune. Factory employment moved somewhat higherin the first part of the year after declining a littleduring 1996, and manufacturing overtime hoursremained at a high level. Producers of durable goodsincreased employment further between December andJune, while makers of nondurable goods continuedto reduce payrolls. Since the end of 1994, factoryemployment and total hours worked in manufactur-ing have changed little. Even so, manufacturers haveboosted output considerably over this period, pri-marily through ongoing improvements in workerproductivity.

Although productivity for the broader nonfarmbusiness sector rose substantially in the first quarter, itwas just 1 percent above its value a year earlier.Moreover, output per hour changed little from the endof 1992 to the last quarter of 1995. The average rateof measured productivity growth in the 1990s is stillsomewhat below that of the 1980s and is even furtherbelow the average gains realized in the twenty-fiveyears after World War II. The slower reported pro-ductivity growth during this expansion could partlyreflect measurement problems. Productivity is theratio of real output to hours worked, and officialproductivity indexes rely on a measure of real outputbased on expenditures. In theory, a matching measureof real output should be derivable by summing laborand capital inputs on the ‘‘income side’’ of thenational accounts. However, the income-side measure

of real output has increased considerably faster thanthe expenditure-side measure in recent years, raisingthe possibility that productivity growth has beensomewhat better than reported in the official indexes.

Measurement difficulties may also affect estimatesof the longer-term trajectory of productivity growth.In particular, if inflation were overstated by officialmeasures—as a considerable amount of recentresearch suggests it is—then real output growthwould be understated. This understatement wouldarise because too much inflation would be removedfrom nominal output growth in the calculation ofreal output growth. Indeed, productivity growth fornonfinancial corporations—a sector for which outputgrowth arguably is measured more accurately thanin broader sectors—has been more rapid than fornonfarm business overall. In particular, productivityfor nonfinancial corporations increased at an aver-age annual pace of about 11⁄2 percent between 1990and 1996, while productivity in the nonfarm busi-ness sector rose a little less than 1 percent peryear over the same period. This difference—whichimplies very weak measured productivity growthoutside of the nonfinancial corporate sector—raisesthe possibility that overall productivity growth isstronger than indicated by official indexes fornonfarm business.1 Of course, a critical—and stillunanswered—question is the extent to which anyunderstatement of productivity growth has becomelarger over time. If productivity growth were morerapid than indicated by official statistics, then theeconomy’s capacity to produce goods and serviceswould be increasing faster than indicated by currentofficial statistics. But if the amount of mismeasure-ment has not increased over time, then the economy’sproductive capacity also increased more rapidlyin earlier years than shown by published measures.In this case, the official statistics on productivitygrowth—though perhaps understated—would notgive a misleading impression about changes in pro-ductivity trends.

After changing little, on net, since the late 1980s,the labor force participation rate turned up earlylast year; it reached a record high 67.3 percent inMarch of this year and remained at an elevated67.1 percent in the second quarter. Better employ-ment opportunities have drawn additional people intothe workforce. Although the recent welfare reform

1. More detail is provided in a paper by Lawrence Slifman andCarol Corrado, ‘‘Decomposition of Productivity and Unit Costs,’’Board of Governors of the Federal Reserve System, November 18,1996.

Change in Output per Hour,Nonfarm Business Sector

Percent, Q4 to Q4

1990 1992 1994 19962

0–

+

2

4

Q1

Note. Value for 1997:Q1 is the percent change from 1996:Q1to 1997:Q1.

16

legislation probably has not yet had a large effect onaggregate labor force dynamics, it may generate anadditional, albeit small, boost to labor force participa-tion rates over the next few years. Since the begin-ning of 1996, the increases in the labor force associ-ated with a higher participation rate have easedpressures on labor markets, as additional workershave stepped in to satisfy continuing strong demandfor labor. Nevertheless, hiring was sufficiently briskduring the first half of this year to pull the unemploy-ment rate down about one-quarter percentage pointbetween December and June.

Just as the low unemployment rate points to tight-ness in labor markets, anecdotal reports from many

regions and industries mention the difficulties firmsare having hiring workers, especially workers withspecialized skills. With this tightness, labor com-pensation costs have accelerated slightly. Althoughhourly labor costs, as measured by the employmentcost index (ECI), increased only 2.5 percent at anannual rate during the first three months of this year,they were up 3.0 percent over the twelve monthsended in March, compared with 2.7 percent overthe preceding twelve months. These increases aresmaller than might have been expected based onhistorical relationships, perhaps partly reflectingpersistent worker concerns about job security. Inaddition, modest increases in employer-paid benefitshave partly offset faster increases in wages andsalaries in the past couple of years. With smallerincreases in health care costs than earlier in thedecade, shifts of employees into managed care plans,and requirements that employees assume a greatershare of health care costs, employer costs for health-related benefits have been well contained. However,growth in employer health care costs may be in theprocess of bottoming out, as reports of risingpremiums for health insurance have become morecommon. Moreover, the wages and salaries com-ponent of the ECI has continued to accelerate, ris-ing 3.4 percent during the twelve months ending inMarch 1997, about one-quarter percentage pointfaster than during the previous twelve months androughly half a percentage point faster than in 1994and 1995.

Prices

The underlying trend of price inflation hasremained favorable this year. In particular, the CPIexcluding food and energy—often referred to asthe ‘‘core’’ CPI—increased at an annual rate of21⁄2 percent over the first two quarters of the year,about the same pace as in 1996. The overall CPIregistered a smaller increase than the core CPI dur-ing the first half of this year. Both the overall CPI andthe core CPI have been affected by a series of techni-cal changes implemented by the Bureau of LaborStatistics over the past two and one-half years toobtain a more accurate measure of price changes. Ifnot for these changes, increases in the CPI since 1994would be marginally larger.

Other measures of prices also suggest that favor-able inflation trends continued into 1997. Measuredfrom the first quarter of last year to the first quarter ofthis year, the chain price index for personal consump-tion expenditures excluding food and energy rose

Labor Force Participation RatePercent

1972 1977 1982 1987 1992 199757

60

63

66

Q2

Note. Data before 1994 have been adjusted for the redesign ofthe household survey.

Change in Employment Cost IndexPercent, Dec. to Dec.

1990 1992 1994 19960

2

4

Hourly compensation

Q1

Note. Data are for private industry, excluding farm and house-hold workers. The value for 1997:Q1 is measured from March1996 to March 1997.

17

2 percent, the same as in the four-quarter period ayear earlier.2 Similarly, the chain price index foroverall GDP—which covers prices of all goods andservices produced in the United States—and the chainmeasure for gross domestic purchases—which cov-ers prices of all goods purchased in the UnitedStates—increased the same amount over the year end-ing in the first quarter of 1997 as during the previ-ous four quarters.

All of these price measures indicate that inflationremains muted, despite high levels of resource utiliza-tion. Several factors have contributed to the recentfavorable performance of price inflation. Energyprices have declined this year. Non-oil import pricesalso have fallen significantly, reducing input costs forsome domestic companies and likely restraining theprices charged by domestic businesses that competewith foreign producers. Besides being restrainedby some price competition from imported materialsand supplies, prices of manufactured goods at earlierstages of processing have been held in check by anexpansion of industrial capacity that has been rapidenough to restrain increases in utilization rates overthe past year. Also, to the extent that firms have suc-ceeded in their efforts to realize large efficiency gains

and reduce unit costs, upward pressure on prices maybe reduced. Finally, an extended period of relativelylow and steady inflation has reinforced a beliefamong households and businesses that the trend ofinflation should remain muted, and consequentlyhelped to hold down inflation expectations.

Developments in the food and energy sectors werefavorable to consumers in the first half of 1997.Consumer energy prices declined in the first half ofthe year as the price of crude oil dropped back fol-lowing last year’s run-up. In 1996, the price of crudeoil was boosted by refinery disruptions, uncertaintyabout the timing of Iraqi oil sales, and unusualweather patterns that increased energy demand forheating and cooling. As these factors receded thisyear, crude oil prices fell. Although the downwardtrend was interrupted by some transitory spikes inprices—as in May when tensions in the Middle Eastflared up—the price of crude is now roughly back tothe range that prevailed before last year’s run-up.Since December, gasoline prices have tumbled morethan 16 percent at an annual rate, and heating oilprices have fallen significantly. Natural gas pricesalso fell as stocks, which had dwindled over thewinter, were replenished. Reflecting the declines infuel prices, the CPI for energy fell about 9 percent atan annual rate between December 1996 and June1997.

Consumer food prices increased at an annual rateof only about 1 percent in the first half of the year.

2. The price measure for personal consumption expenditures(PCE) is closely related to the CPI because components of the CPIare key inputs in the construction of the PCE price measure.Nevertheless, the PCE price measure has the advantage that byusing chain weighting rather than fixed weights it avoids some ofthe substitution bias that affects the CPI.

Change in Consumer Prices ExcludingFood and Energy

Percent, Q4 to Q4

1990 1992 1994 19960

2

4

6

H1

Note. Consumer price index for all urban consumers. Value for1997:H1 is the percent change from 1996:Q4 to 1997:Q2 at anannual rate.

Change in Consumer PricesPercent, Q4 to Q4

1990 1992 1994 19960

2

4

6

H1

Note. Consumer price index for all urban consumers. Value for1997:H1 is the percent change from 1996:Q4 to 1997:Q2 at anannual rate.

18

Although coffee prices jumped, the prices of manyother food items were flat or edged lower. Mostnotably, declines in grain prices that began in mid-1996 have been working their way to the retail leveland have held down prices for a variety of grain-dependent foods, such as beef, poultry, and dairyproducts. Prices of foods that depend more heavily onlabor costs have been rising modestly this year.

Consumer prices for goods other than food andenergy rose a restrained three-quarters percent at anannual rate between December and June of this year,a touch below last year’s pace. Declining prices fornon-oil imports helped contain prices of goods in theCPI in the first half of the year, in part by constrain-ing U.S. businesses in competition with importers.For example, prices of new and used passenger carsdeclined in the first six months of the year, and pricesof light trucks were essentially flat. Also, prices ofhouse furnishings were about unchanged, on bal-ance, in the first half of the year, although apparelprices moved up after declining in recent years.

The CPI for non-energy services rose about3 percent at an annual rate between December andJune, a touch below last year’s pace. After risingmarkedly last year, airfares declined, on net, in thefirst half of this year. Fares fell substantially early inthe year when the excise tax on tickets expired, andeven with the reimposition of the tax in March, ticket

prices were still lower in June than in December.Increases in prices of medical services also continuedto slow somewhat this year.3 In addition, the CPI forauto finance fell in May and June as automakerssweetened incentives. In contrast, price increases inthe first half of the year picked up in some otherareas; shelter prices rose a bit more rapidly thanlast year, as did tuition and prices for personal careservices.

Credit and the Monetary Aggregates

Credit and Depository Intermediation. Thetotal debt of domestic nonfinancial sectors increasedat an annual rate of about 43⁄4 percent from the fourthquarter of 1996 through May of this year, placing theaggregate near the middle of the range for 1997established by the FOMC. This pace is more than halfa percentage point below that for 1996, reflectingsignificantly slower growth of borrowing by the fed-eral government. The total debt of the other sectorshas risen at a roughly constant pace over the past fewyears, even though the growth rate of nominal outputhas been increasing.

3. In January 1997, the Bureau of Labor Statistics introduced anew measure of the prices of hospital services—which account forroughly one-third of the CPI for medical services—and this newmeasure should, over time, provide a more accurate gauge of pricemovements in this area.

Alternative Measures of Price ChangePercent

Price measure

1995:Q1to

1996:Q1

1996:Q1to

1997:Q1

Fixed weightConsumer price index 2.7 2.9

Excluding food and energy 2.9 2.5

Chain typePersonal consumption expenditures 2.0 2.5

Excluding food and energy 2.0 2.0Gross domestic purchases 2.2 2.2Gross domestic product 2.2 2.2

DeflatorGross domestic product 2.1 1.8

Note. Changes are based on quarterly averages.

19

Credit on the books of depository institutions rosemore rapidly than total debt in the first half of 1997,indicating that their share of total debt outstandingincreased. Credit growth at thrift institutions easedlate last year and early this year after increasingmoderately in the first three quarters of 1996. How-ever, commercial bank credit grew at a brisk pace inthe first half of the year, with both securities and loansincreasing more rapidly than they did last year. Realestate lending at banks rose about 9 percent at anannual rate between the fourth quarter of 1996 andJune of this year, compared with 4 percent in 1996. Incontrast, outstanding home mortgages at thrift institu-tions grew little in the first part of the year after alarge run-up in 1996. Home equity credit lines frombanks expanded especially rapidly in the spring, assome banks promoted these loans as a substitute forconsumer loans. The growth of consumer loans atbanks (including loans that were securitized as wellas loans still on banks’ books) fell from about11 percent in 1996 to 31⁄4 percent at an annual ratebetween the fourth quarter of 1996 and June of thisyear.

The Monetary Aggregates. Growth of themonetary aggregates during the first half of 1997 wassimilar to growth in 1996. Between the fourth quarterof last year and June, M2 expanded at an annual rateof almost 5 percent; as the Committee had antici-pated, the aggregate was running close to the upperbound of its growth cone, which had been chosen tobe consistent with price stability. The behavior of M2over this period can be reasonably well explained bychanges in nominal GDP and interest rates, usinghistorical velocity relationships. In the first quarter,

the velocity of M2 (defined as the ratio of nominalGDP to M2) increased a little more than might havebeen anticipated from its recent relationship to theopportunity cost of holding M2—the interest earn-ings forgone by owning M2 assets rather than marketinstruments such as Treasury bills. M2 may havebeen held down a bit by savers’ preferences for equitymarket funds, for which inflows were quite strong.Growth of M2 was much slower in the second quarterthan in the first quarter (41⁄4 percent compared with6 percent at an annual rate), consistent with the slow-ing of the economy and almost unchanged M2opportunity cost. The monthly pattern of M2 growthin the second quarter was heavily influenced byunusually high individual non-withheld tax pay-ments. M2 surged in April, as households appar-ently accumulated additional liquid balances in orderto make the larger tax payments, and was aboutunchanged on a seasonally adjusted basis in May aspayments cleared and balances returned to normal.

The correspondence between changes in M2 veloc-ity and in opportunity cost during recent years mayrepresent a return to the roughly stable relationshipobserved for several decades until 1990—albeit ata higher level of velocity. The relationship wasdisturbed in the early 1990s by households’ appar-ent decisions to shift funds out of lower-yieldingdeposits into higher-yielding stock and bond mutualfunds. On one hand, the ‘‘credit crunch’’ at banks andthe resolution of troubled thrifts curbed the eager-ness of these institutions to attract retail deposits,holding down the rates of return offered on brokereddeposits and similar accounts relative to the average

Debt: Annual Range and Actual LevelBillions of dollars

O N D J F M A M J

1996 1997

14,400

14,600

14,800

15,000

15,200

Domestic nonfinancial sectors

7%

3%

M2: Annual Range and Actual LevelBillions of dollars

O N D J F M A M J

1996 1997

3,750

3,800

3,850

3,900

3,9505%

1%

20

deposit rates used in constructing measures ofopportunity cost. At the same time, the appeal oflonger-term assets was enhanced temporarily by thesteeply sloped yield curve and more permanently bythe greater variety and lower cost of mutual fundproducts available to investors. More recently, robustinflows into stock funds apparently have substitutedto only a limited extent for holdings of M2 assets, andM2 velocity and opportunity cost have again beenmoving roughly together since mid-1994, althoughvelocity has continued to drift up slightly. However,the period of renewed stability in the behavior ofM2—three years—is still fairly short, and whetherthe stability will persist is unclear. Variations inopportunity cost and income growth during thisperiod have been rather small, leaving considerabledoubt about how M2 would respond to moresignificant changes in the financial and economicenvironment.

M3 rose about 7 percent at an annual rate betweenthe fourth quarter of 1996 and June of this year. Thispace is a little faster than last year’s and again left M3above the upper end of its growth cone, which, likethe growth cone for M2, was set to be consistent withprice stability. Large time deposits, which are notincluded in M2, continued to increase much morerapidly than other deposits. Banks have been fund-ing their asset growth disproportionately throughwholesale deposits, leaving interest rates on retaildeposits further below market rates than they have

been historically. Growth of institution-only moneymarket funds eased just a little from last year’s torridpace, as the role of these funds in corporate cashmanagement continued to increase.

M1 contracted at a 21⁄2 percent annual rate betweenthe fourth quarter of 1996 and June of this year.Growth of this aggregate was again depressed by thespread of so-called sweep programs, whereby bal-ances in transactions accounts, which are subjectto reserve requirements, are ‘‘swept’’ into savingsaccounts, which are not. Sweep programs benefitdepositories by reducing their required holdings ofreserves, which earn no interest. At the same time,they do not restrict depositors’ access to their fundsfor transactions purposes, because the funds are sweptback into transactions accounts when needed. Untillate last year, most retail sweep programs werelimited to NOW accounts, but demand-depositsweeps have expanded markedly since then. Adjustedfor the estimated total of balances swept owing to theintroduction of new sweep programs, M1 expanded ata 43⁄4 percent annual rate between the fourth quarterof 1996 and June 1997, a little below its sweep-adjusted growth rate in 1996.

The drop in the amount of deposits held in transac-tions accounts in the first half of 1997 caused requiredreserves to fall about 10 percent at an annual rate,close to the rate of decline last year. Nonetheless, themonetary base has expanded at a moderate pace so farin 1997, because the runoff in required reserves hasbeen more than offset—as it was also last year—byan increase in the demand for currency. Currencygrowth has been a little higher this year than last, asthe effects of strong domestic spending more than

M3: Annual Range and Actual LevelBillions of dollars

O N D J F M A M J

1996 1997

4,800

4,900

5,000

5,100

6%

2%

M2 Velocity and the Opportunity Costof Holding M2Ratio Percentage points, ratio scale

1978 1982 1986 1990 1994

1

234

10

25

1.6

1.7

1.8

1.9

2.0

Quarterly

M2velocity

M2opportunitycost

Q1

Q1

Note. M2 opportunity cost is a two-quarter moving average ofthe three-month Treasury bill rate less the weighted average ratepaid on M2 components.

21

offset a slight drop in net shipments of U.S. cur-rency abroad in the first four months of the year.

Further reductions in required reserves have thepotential to diminish the Federal Reserve’s ability tocontrol the federal funds rate closely on a day-to-day basis. Traditionally, the daily demand for bal-ances at the Federal Reserve largely reflected banks’needs for required reserves, which are fairly predict-able. As a result, the Federal Reserve has generallybeen able to supply the quantity of balances that satis-fies this demand at the intended funds rate. Moreover,reserve requirements are specified in terms of anaverage level of balances over a two-week period, soif the funds rate on a particular day moves above thelevel expected to prevail on ensuing days, banks cantrim their balances and thereby relieve some of theupward pressure on the funds rate. If requiredreserves were to fall quite low, the demand for bal-

ances would become more linked to banks’ desire toavoid overnight overdrafts when conducting trans-actions through their accounts at Reserve Banks.Demand from this source is more variable than isrequirement-related demand, and it also cannot besubstituted across days; both factors would tend, allelse equal, to increase the volatility of the federalfunds rate.

The decline in required reserves over the pastseveral years has not created serious problems in thefederal funds market, but funds-rate volatility hasrisen a little, and the risk of much greater volatilitywould increase if required reserves were to fallsubstantially further. One factor mitigating anincrease in funds-rate volatility has been an increasein required clearing balances. These balances, whichbanks can precommit to hold on a two-week aver-age basis, earn credits that banks use to pay for Fed-

Growth of Money and DebtPercent

Period M1 M2 M3Domestic

nonfinancialdebt

Annual1

1987 6.3 4.2 5.8 10.01988 4.3 5.7 6.3 9.01989 0.5 5.2 4.0 7.9

1990 4.1 4.1 1.8 6.91991 7.9 3.1 1.2 4.61992 14.4 1.8 0.6 4.71993 10.6 1.3 1.1 5.21994 2.5 0.6 1.7 5.2

1995 −1.6 4.0 6.2 5.51996 −4.6 4.7 6.8 5.4

Quarterly(annual rate)2

1997 Q1 −0.7 6.1 8.2 4.5Q2 −5.4 4.3 6.8 n.a.

Year-to-date3

1997 −2.6 4.9 7.1 4.8

1. From average for fourth quarter of preceding year toaverage for fourth quarter of year indicated.

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

3. From average for fourth quarter of 1996 to average forJune (May in the case of domestic nonfinancial debt).

22

eral Reserve priced services. Like required reservebalances, required clearing balances are predictableby the Federal Reserve and can be substituted acrossdays within the two-week maintenance period. Funds-rate volatility has also been damped by banks’improved management of their balances at ReserveBanks, which in part reflects the improved real-timeaccess to account information now provided bythe Federal Reserve. Whether these factors couldcontinue to restrain funds-rate volatility if requiredreserve balances were to become much smaller is asyet unclear. Also unclear is whether a moderateincrease in funds-rate volatility would have any seri-ous adverse consequences for interest rates farther outon the yield curve or for the macroeconomy. The Fed-eral Reserve continues to monitor the situationclosely.

Interest Rates, Equity Prices, andExchange Rates

Interest Rates. Interest rates on Treasury securi-ties were little changed or declined a bit, on bal-ance, between the end of 1996 and mid-July. Yieldsrose substantially in the first quarter as evidencemounted that the robust economic activity observedin the closing months of 1996 had continued into1997. By the time of the March FOMC meeting, mostparticipants in financial markets were anticipatingsome tightening of monetary policy, and rates movedlittle when the increase in the intended federal fundsrate was announced. Beginning in late April, key datapointed to continued low inflation and a slowing of

economic growth in the second quarter, and interestrates retraced their earlier advance.

The yield on the inflation-indexed ten-yearTreasury note was little changed between mid-Apriland mid-July, suggesting that at least part of theroughly 60-basis-point drop in the nominal ten-yearyield over that period reflected a reduction inexpected inflation or in uncertainty about future infla-tion, or both. Yet, relative movements in these twoyields should be interpreted carefully, as the market’sexperience in trading indexed debt is relatively brief,making its prices potentially vulnerable to small shiftsin market sentiment. Moreover, the Treasury an-nounced this spring a reduction in the frequency ofnominal ten-year note auctions, perhaps putting down-ward pressure on their nominal yields, and some inves-tors may have paid renewed attention to upcomingtechnical adjustments to the CPI, which will reducemeasured inflation. Survey-based measures of expectedinflation showed little change in the second quarter.

The interest rate on the three-month Treasury billwas held down in recent months by the reduced sup-ply of bills associated with the smaller federal deficit.Between mid-March and mid-July, the spreadbetween the federal funds rate and the three-monthyield averaged about 15 basis points above the aver-age spread in 1996. Interest rates on private short-term instruments increased a little in the secondquarter after the small System tightening in March.

Equity Prices. Equity markets have advanceddramatically again this year. Through mid-July, mostbroad measures of U.S. stock prices had climbedbetween 20 percent and 25 percent since year-end.Stocks began the year strongly, with the majorindexes reaching then-record levels in late Janu-ary or February. Significant selloffs ensued, partlyoccasioned by the backup in interest rates, and byearly April the NASDAQ index was well below itsyear-end mark and the S&P 500 composite index wasbarely above its. Equity prices began rebounding inlate April, however, soon pushing these indexes tonew highs. Stock prices have been somewhat morevolatile this year than last.

The run-up in stock prices in the spring wasbolstered by unexpectedly strong corporate profits forthe first quarter. Still, the ratio of prices in theS&P 500 to consensus estimates of earnings over thecoming twelve months has risen further from levelsthat were already unusually high. Changes in thisratio have often been inversely related to changes inlong-term Treasury yields, but this year’s stock price

Selected Treasury RatesPercent

1965 1975 1985 19950

5

10

15

Quarterly

Thirty-yearbond

Five-yearnote

Three-monthbill

Q2

Note. The twenty-year Treasury bond rate is shown until thefirst issuance of the thirty-year Treasury bond, in the first quarterof 1977.

23

gains were not matched by a significant net decline ininterest rates. As a result, the yield on ten-yearTreasury notes now exceeds the ratio of twelve-month-ahead earnings to prices by the largest amountsince 1991, when earnings were depressed by theeconomic slowdown. One important factor behind theincrease in stock prices this year appears to be afurther rise in analysts’ reported expectations of earn-ings growth over the next three to five years. Theaverage of these expectations has risen fairly steadilysince early 1995 and currently stands at a level notseen since the steep recession of the early 1980s,when earnings were expected to bounce back fromlevels that were quite low.

Exchange Rates. The weighted average for-eign exchange value of the dollar in terms of the otherG-10 currencies rose sharply in the first quarter fromits level in December and has moved up somewhatfurther since then. On balance, the nominal dollaris more than 10 percent above its level at the endof December. A broader measure of the dollarthat includes currencies from additional U.S. tradingpartners and adjusts for changes in relative consumerprices shows appreciation of about 7 percent. Afterrising nearly 10 percent in terms of the Japanese yento a recent peak in late April, the dollar retreated; it iscurrently about unchanged from its value in terms ofyen at the end of December. In contrast, the dollar hasrisen about 17 percent in terms of the German marksince the end of last year.

Early in the year, data showing continuedstrengthening of U.S. economic activity surprisedmarket participants, raised their expectations of sometightening of U.S. monetary policy, and contributed toupward pressure on the dollar. In light of the FOMCaction in late March and the tendency for subsequenteconomic indicators to suggest a slowing of thegrowth of U.S. real output, pressure for dollar appre-ciation abated. While robust economic activity in theUnited States generated a rise in U.S. long-term inter-est rates through April, market uncertainty about thestrength of output growth in several foreign indus-trial countries led to little change, on balance, in aver-

Major Stock Price IndexesIndex (December 31, 1996=100)

J F M A M J J A S O N D J F M A M J J

1996 1997

75

85

95

105

115

125Daily

NASDAQ

S&P 500

Note. Last observations are for July 18, 1997.

Equity Valuation and Long-Term Interest RatePercent

1982 1987 1992 19972

6

10

14

Monthly

Ten-year Treasury note yield

S&P 500 earnings–price ratioJuly

Note. Earnings–price ratio is based on the I/B/E/S Inter-national, Inc., consensus estimate of earnings over the comingtwelve months. All observations reflect prices at mid-month.

Weighted Average Exchange Valueof the U.S. Dollar

Index, March 1973 = 100

1992 1993 1994 1995 1996 199775

85

95

Monthly

June

Note. Nominal value in terms of the currencies of the otherG-10 countries. Weights are based on the 1972–76 global tradeof each of the ten countries.

24

age long-term (ten-year) rates in other G-10 countries.Since then, U.S. rates have returned to near year-end levels, while rates abroad have moved down.Accordingly, the long-term interest differential, onbalance, has shifted further in favor of dollar assetssince December, consistent with the net appreciationof the dollar this year.

Despite indications of further recovery of output inJapan, the dollar rose against the yen early in the yearas planned fiscal policy in Japan appeared to be morerestrictive than had been expected, and Japaneselong-term interest rates declined in response. State-ments by G-7 officials at their meeting in Berlinin February and on subsequent occasions suggestedsome concern that the dollar’s strength and the yen’sweakness not become excessive. The dollar movedback down in terms of the yen in May and has sincefluctuated narrowly. The yen has been supportedby data showing a widening of Japanese externalsurpluses and by a partial retracing by Japanese long-term rates of their earlier decline, as indicators havesuggested that the fiscal measures may not be ascontractionary as previously expected.

The dollar also rose sharply early in the year interms of the German mark and other continentalEuropean currencies. Market participants have beendisappointed that the pace of economic activity hasnot strengthened further in continental Europeancountries. In addition, uncertainties about the pros-pects for European Monetary Union, including thepossibility of delay and the question of whichcountries will be in the first group proceeding toStage Three, have resulted in fluctuations in the markand, on balance, appear to have strengthened the dol-lar. German long-term interest rates have declinedsomewhat on balance this year.

Short-term market interest rates in most of themajor foreign industrial countries have changed littleon average since the end of last year. Rates in theUnited Kingdom have risen somewhat as the newgovernment increased the official lending rate one-quarter percentage point in May and the Bank ofEngland raised it by the same amount in June andagain in July. Short-term rates in Italy and Switzer-land have eased. Stock prices have risen sharply sofar this year in the major foreign industrial countries,particularly in continental Europe.

The dollar has changed little on balance in terms ofthe Mexican peso since December, as improvedinvestor sentiment toward Mexico, reflected in nar-rowing yield spreads between Mexican and U.S.dollar-denominated bonds, has supported the peso.

The trend in Mexican inflation has declined this year;nevertheless, the excess of Mexican inflation overU.S. inflation implies about a 7 percent real appre-ciation of the peso since December.

Since mid-May, financial pressures in Thailand,which caused authorities there to raise interest ratesand have led to depreciation of the currency, havespilled over to influence financial markets in some ofour Asian trading partners, particularly the Philip-pines and Malaysia. Interest rates in both of thesecountries rose sharply. Philippine officials relaxedtheir informal peg of the peso in terms of the dollar,and the currency declined significantly; the Malaysianringgit and Indonesian rupiah have also depreciated.

U.S. and Foreign Interest Rates

Three-monthPercent

2

4

6

8

Monthly

Monthly

Average foreign

U.S. large CD

Ten-yearPercent

Average foreign

U.S. Treasury

June

June

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

1992 1993 1994 1995 1996 19974

6

8

25