View PDF

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

Annual
'Report
x £ > 2001

•?*Mm?y

Board of Governors of the Federal Reserve System




This publication is available from the Board of Governors of the Federal Reserve System,
Publications Services, Mail Stop 127, Washington, DC 20551. It is also available at the
Board's World Wide Web site, at http://www.federalreserve.gov/




Letter of Transmittal

BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM

Washington, D.C., April 2002

THE SPEAKER OF
THE HOUSE OF REPRESENTATIVES

Pursuant to the requirements of section 10 of the Federal Reserve Act,
I am pleased to submit the eighty-eighth annual report of the Board of Governors
of the Federal Reserve System.
This report covers operations of the Board during calendar year 2001.

Sincerely,




Contents
Monetary Policy and Economic Developments
3
7
9

MONETARY POLICY AND THE ECONOMIC OUTLOOK
Monetary Policy, Financial Markets, and the Economy over 2001 and Early 2002
Economic Projections for 2002

11
12
14
20
22
25
27
29
35

ECONOMIC AND FINANCIAL DEVELOPMENTS IN 2001 AND EARLY 2002
The Household Sector
The Business Sector
The Government Sector
The External Sector
The Labor Market
Prices
U.S. Financial Markets
International Developments

41
41
71

MONETARY POLICY REPORTS TO THE CONGRESS
Report of February 13, 2001
Report of July 18, 2001

99
99
101
103
105

DOMESTIC OPEN MARKET OPERATIONS DURING 2001
Implementation of Monetary Policy in 2001
Banks' Demand for Fed Balances
Autonomous Factors Affecting the Supply of Fed Balances
Domestic Financial Assets on the Federal Reserve Balance Sheet
and Open Market Operations
111 The Federal Funds Rate and Discount Window Credit
113 The Conduct of Monetary Operations after September 11

Federal Reserve Operations
121
121
122
122
123
126

CONSUMER AND COMMUNITY AFFAIRS
Curbing Abusive Lending
Fostering Research
Preparing for the Community Reinvestment Act Review
Expanding Access to Consumer Information
Regulatory Matters




126
128
129
131
132
133
134
137

CONSUMER AND COMMUNITY AFFAIRS—Continued
CRA Bank Examinations and Activities
Community Affairs
Consumer Advisory Council
HMDA Data and Mortgage Lending Patterns
Economic Effects of the Electronic Fund Transfer Act
Compliance Activities
Agency Reports on Compliance with Consumer Protection Laws and Regulations
Consumer Complaints

141
142
143
151
162
163
165
169
172

BANKING SUPERVISION AND REGULATION
Scope of Responsibilities for Supervision and Regulation
Supervision for Safety and Soundness
Supervisory Policy
Supervisory Information Technology
Staff Training
Regulation of the U.S. Banking Structure
Enforcement of Other Laws and Regulations
Federal Reserve Membership

173
173
173
179
180
182
182
183
184
184
184
186

FEDERAL RESERVE BANKS
Major Initiatives
Developments in Federal Reserve Priced Services
Developments in Currency and Coin
Developments in Fiscal Agency and Government Depository Services
Information Technology
Examinations of Federal Reserve Banks
Income and Expenses
Holdings of Securities and Loans
Volume of Operations
Federal Reserve Bank Premises
Pro Forma Financial Statements for Federal Reserve Priced Services

191 THE BOARD OF GOVERNORS AND THE GOVERNMENT PERFORMANCE
AND RESULTS ACT
191 Strategic and Performance Plans
191 Mission
191 Goals and Obj ectives
192 Interagency Coordination



195 FEDERAL LEGISLATIVE DEVELOPMENTS
195 USA PATRIOT Act
196 Proposed Check Truncation Act

Records
199 RECORD OF POLICY ACTIONS OF THE BOARD OF GOVERNORS
199 Regulation B (Equal Credit Opportunity), Regulation E (Electronic Fund Transfers),
Regulation M (Consumer Leasing), Regulation Z (Truth in Lending), and
Regulation DD (Truth in Savings)
199 Regulation D (Reserve Requirements of Depository Institutions)
200 Regulation E
201 Regulation H (Membership of State Banking Institutions
in the Federal Reserve System)
202 Regulation H and Regulation Y (Bank Holding Companies
and Change in Bank Control)
203 Regulation K (International Banking Operations) and
Rules Regarding Delegation of Authority
204 Regulation Y
205 Regulation Z
205 Miscellanous Interpretations
206 Rules Regarding Equal Opportunity
207 Policy Statements and Other Actions
208 Discount Rates in 2001
215
215
217

MINUTES OF FEDERAL OPEN MARKET COMMITTEE MEETINGS
Authorization for Domestic Open Market Operations
Guidelines for the Conduct of System Open Market Operations
in Federal Agency Issues
217 Domestic Policy Directive
217 Authorization for Foreign Currency Operations
219 Foreign Currency Directive
219 Procedural Instructions with Respect to Foreign Currency Operations




220
236
246
255
264
273
282
290

MINUTES OF FEDERAL OPEN MARKET COMMITTEE MEETINGS—Continued
Meeting Held on January 30-31, 2001
Meeting Held on March 20, 2001
Meeting Held on May 15, 2001
Meeting Held on June 26-27, 2001
Meeting Held on August 21, 2001
Meeting Held on October 2, 2001
Meeting Held on November 6, 2001
Meeting Held on December 11, 2001

301 LITIGATION
301 Judicial Review of Board Orders under the Bank Holding Company Act
301 Litigation under the Financial Institutions Supervisory Act
301 Litigation under the Gramm-Leach-Bliley Act
301 Other Actions

Federal Reserve System Organization
305

BOARD OF GOVERNORS

307

FEDERAL OPEN MARKET COMMITTEE

308

ADVISORY COUNCILS TO THE BOARD OF GOVERNORS

308
309
310

Federal Advisory Council
Consumer Advisory Council
Thrift Institutions Advisory Council

311 FEDERAL RESERVE BANKS
311
313
313
313
313

Officers of Federal Reserve Banks and Branches
Conference of Chairmen
Conference of Presidents
Conference of First Vice Presidents
Directors of the Banks and Branches

334

HISTORICAL RECORDS: MEMBERSHIP OF THE BOARD OF GOVERNORS,
1913-2001




Statistical Tables
338
342
346
347
348
352
356
357
358
359
360
361
362
368

1. Statement of Condition of the Federal Reserve Banks, by Bank,
December 31, 2001 and 2000
2. Federal Reserve Open Market Transactions, 2001
3. Federal Reserve Bank Holdings of U.S. Treasury and Federal Agency Securities,
December 31, 1999-2001
4. Number and Annual Salaries of Officers and Employees of the Federal Reserve
Banks, December 31, 2001
5. Income and Expenses of the Federal Reserve Banks, by Bank, 2001
6. Income and Expenses of the Federal Reserve Banks, 1914-2001
7. Acquisition Costs and Net Book Value of Premises of the Federal Reserve
Banks and Branches, December 31, 2001
8. Operations in Principal Departments of the Federal Reserve Banks, 1998-2001
9. Federal Reserve Bank Interest Rates on Loans to Depository Institutions,
December 31, 2001
10. Reserve Requirements of Depository Institutions, December 31, 2001
11. Initial Margin Requirements under Regulations T, U, and X
12. Principal Assets and Liabilities and Number of Insured Commercial Banks
in the United States, by Class of Bank, June 30, 2001 and 2000
13. Reserves of Depository Institutions, Federal Reserve Bank Credit,
and Related Items, Year-End 1918-2001 and Month-End 2001
14. Banking Offices and Banks Affiliated with Bank Holding Companies
in the United States, December 31, 2000 and 2001

Financial Statements
371

BOARD OF GOVERNORS FINANCIAL STATEMENTS

381

FEDERAL RESERVE BANKS COMBINED FINANCIAL STATEMENTS

393 MAPS OF THE FEDERAL RESERVE SYSTEM
397

INDEX




Monetary Policy and
Economic Developments




Monetary Policy and the Economic Outlook
Last year was a difficult one for the
economy of the United States. The
slowdown in the growth of economic
activity that had become apparent in late
2000 intensified in the first half of the
year. Businesses slashed investment
spending—making especially deep
cuts in outlays for high-technology
equipment—in response to weakening
final demand, an oversupply of some
types of capital, and declining profits.
As actual and prospective sales deteriorated, many firms in the factory sector
struggled with uncomfortably high levels of inventories, and the accompanying declines in manufacturing output
steepened. At the same time, foreign
economies also slowed, further reducing
the demand for U.S. production. The
aggressive actions by the Federal
Reserve to ease the stance of monetary
policy in the first half of the year provided support to consumer spending and
the housing sector. Nevertheless, the
weakening in activity became more
widespread through the summer, job
losses mounted further, and the unemployment rate moved higher. With few
indications that economic conditions
were about to improve, with underlying
inflation moderate and edging lower,
and with inflation expectations well
contained, the Federal Reserve continued its efforts to counter the ongoing
weakness by cutting the federal funds
rate, bringing the cumulative reduction

NOTE. The discussions here and in the next
section ("Economic and Financial Developments
in 2001 and Early 2002") consist of the text,
tables, and selected charts from Monetary Policy
Report to the Congress (Board of Governors, February 2002).



in that rate to 3 percentage points by
August.
The devastating events of September 11 further set back an already fragile
economy. Heightened uncertainty and
badly shaken confidence caused a widespread pullback from economic activity
and from risk-taking in financial markets, where equity prices fell sharply for
several weeks and credit risk spreads
widened appreciably. The most pressing
concern of the Federal Reserve in the
first few days following the attacks was
to help shore up the infrastructure of
financial markets and to provide massive quantities of liquidity to limit potential disruptions to the functioning of
those markets. The economic fallout of
the events of September 11 led the Federal Open Market Committee (FOMC)
to cut the target federal funds rate after a
conference call early the following week
and again at each meeting through the
end of the year (see box "Monetary
Policy after the Terrorist Attacks").
Displaying the same swift response to
economic developments that appears
to have characterized much business
behavior in the current cyclical episode,
firms moved quickly to reduce payrolls
and cut production after mid-September.
Although these adjustments occurred
across a broad swath of the economy,
manufacturing and industries related to
travel, hospitality, and entertainment
bore the brunt of the downturn. Measures of consumer confidence fell
sharply in the first few weeks after the
attacks, but the deterioration was not
especially large by cyclical standards,
and improvement in some of these
indexes was evident in October. Similarly, equity prices started to rebound in

88th Annual Report, 2001

Monetary Policy after the Terrorist Attacks
The terrorist attacks on September 11
destroyed a portion of the infrastructure of
U.S. financial markets, disrupted communication networks, and forced some market
participants to retreat to contingency sites
in varying states of readiness. These developments, along with the tragic loss of life
among the employees of a few major financial firms, greatly complicated trading,
clearing, and settlement of many different
classes of financial instruments. Direct dislocations elevated uncertainties about payment flows, making it difficult for the
reserve market to channel funds where they
were needed most. Depositories that held
more reserve balances than they preferred
had considerable difficulty unloading the
excess in the market; by contrast, depositories awaiting funds had to scramble to
cover overdraft positions. As a result, the
effective demand for reserves ballooned.
The Federal Reserve accommodated the
increase in the demand for reserves through
a variety of means, the relative importance
of which shifted through the week. On
Tuesday morning, shortly after the attacks,
the Federal Reserve issued a press release
reassuring financial markets that the Federal Reserve System was functioning normally and stating that "the discount window is available to meet liquidity needs."

late September, and risk spreads began
to narrow somewhat by early November, when it became apparent that the
economic effects of the attacks were
proving less severe than many had
feared.
Consumer spending remained surprisingly solid over the final three
months of the year in the face of
enormous economic uncertainty, widespread job losses, and further deterioration of household balance sheets from
the sharp drop in equity prices immedi


Depository institutions took up the offer,
and borrowing surged to a record
$45 Vi billion by Wednesday. Discount
loans outstanding dropped off sharply on
Thursday and returned to very low levels
by Friday. Separately, overnight overdrafts
on Tuesday and Wednesday rose to several
billion dollars, as a handful of depository
and other institutions with accounts at the
Federal Reserve were forced into overdraft
on their reserve accounts. Overnight overdrafts returned to negligible levels by the
end of the week.
Like their U.S. counterparts, foreign
financial institutions operating in the
United States faced elevated dollar liquidity needs. In some cases, however, these
institutions encountered difficulties positioning the collateral at their U.S. branches
to secure Federal Reserve discount window
credit. To be in a position to help meet
those needs, three foreign central banks
established new or expanded arrangements
with the Federal Reserve to receive dollars
in exchange for their respective currencies.
These swap lines, which lasted for
thirty days, consisted of $50 billion for the
European Central Bank, $30 billion for the
Bank of England, and an increase of $8 billion (from $2 billion to $10 billion) for
the Bank of Canada. The European Central

ately following September 11. Several
factors were at work in support of
household spending during this period.
Low and declining interest rates provided a lift to outlays for durable goods
and to activity in housing markets.
Nowhere was the boost from low interest rates more apparent than in the sales
of new motor vehicles, which soared in
response to the financing incentives
offered by manufacturers. Low mortgage interest rates not only sustained
high levels of new home construction

Monetary Policy and the Economic Outlook

Bank drew on its line that week to channel
the funds to institutions with a need for
dollars.
By Thursday and Friday, the disruption
in air traffic caused the Federal Reserve to
extend record levels of credit to depository
institutions in the form of check float. Float
increased dramatically because the Federal
Reserve continued to credit the accounts of
banks for deposited checks even though the
grounding of airplanes meant that checks
normally shipped by air could not be presented to the checkwriters' banks on the
usual schedule. Float declined to normal
levels the following week once air traffic
was permitted to recommence. Lastly, over
the course of the week that included September 11, as the market for reserves began
to function more normally, the Federal
Reserve resumed the use of open market
operations to provide the bulk of reserves.
The open market Desk accommodated
all propositions down to the target federal
funds rate, operating exclusively through
overnight transactions for several days. The
injection of reserves through open market
operations peaked at $81 billion on Friday.
The combined infusion of liquidity from
the various sources pushed the level of
reserve balances at Federal Reserve Banks
to more than $100 billion on Wednesday,
September 12, about ten times the normal

but also allowed households to refinance mortgages and extract equity from
homes to pay down other debts or to
increase spending. Fiscal policy provided additional support to consumer
spending. The cuts in taxes enacted last
year, including the rebates paid out over
the summer, cushioned the loss of
income from the deterioration in labor
markets. And the purchasing power of
household income was further enhanced
by the sharp drop in energy prices during the autumn. With businesses having
positioned themselves to absorb a falloff



level. As anticipated by the FOMC, federal
funds traded somewhat below their new
target level for the rest of the week. By the
end of the month, bid-asked spreads and
trading volumes in the interbank and other
markets receded to more normal levels,
and federal funds consistently began to
trade around the intended rate.
The Federal Reserve took several steps
to facilitate market functioning in September in addition to accommodating the
heightened demand for reserves. The hours
of funds and securities transfer systems
operated by the Federal Reserve were
extended significantly for a week after the
attacks. The Federal Reserve Bank of New
York liberalized the terms under which it
would lend the securities in the System
portfolio, and the amount of securities lent
rose to record levels in the second half
of September. For the ten days following
the attacks, the Federal Reserve reduced
or eliminated the penalty charged on overnight overdrafts, largely because those
overdrafts were almost entirely the result
of extraordinary developments beyond the
control of the account holders. In addition,
the Federal Reserve helped restore communication between market participants and
in some cases processed bilateral loans of
reserves between account holders in lieu
of market intermediation.

of demand, the surprising strength in
household spending late in the year
resulted in a dramatic liquidation of
inventories. In the end, real gross
domestic product posted a much better
performance than had been anticipated
in the immediate aftermath of the
attacks.
More recently, there have been
encouraging signs that economic activity is beginning to firm. Job losses
diminished considerably in December
and January, and initial claims for unemployment insurance and the level of

88th Annual Report, 2001
insured unemployment have reversed
their earlier sharp increases. Although
motor vehicle purchases have declined
appreciably from their blistering fourthquarter pace, early readings suggest that
consumer spending overall has remained
very strong early this year. In the
business sector, new orders for capital
equipment have provided some tentative
indications that the deep retrenchment
in investment spending could be abating. Meanwhile, purchasing managers
in the manufacturing sector report that
orders have strengthened and that they
view the level of their customers' inventories as being in better balance. Indeed,
the increasingly rapid pace of inventory
runoff over the course of the last year
has left the level of production well
below that of sales, suggesting scope for
a recovery in output given the current
sales pace. Against this backdrop, the
FOMC left its target for the federal
funds rate unchanged in January. However, reflecting a concern that growth
could be weaker than the economy's
potential for a time, the FOMC retained
its assessment that the risks were
tilted unacceptably toward economic
weakness.
The extent and persistence of any
recovery in production will, of course,
depend critically on the trajectory of
final demand in the period ahead. Several factors are providing impetus to
such a recovery in the coming year.
With the real federal funds rate hovering
around zero, monetary policy should be
positioned to support growth in spending. Money and credit expanded fairly
rapidly through the end of the year, and
many households and businesses have
strengthened their finances by locking
in relatively low-cost long-term credit.
The second installment of personal
income tax cuts and scheduled increases
in government spending on homeland
security and national defense also will



provide some stimulus to activity this
year. Perhaps the most significant potential support to the economy could come
from farther gains in private-sector productivity. Despite the pronounced slowdown in real GDP growth last year, output per hour in the nonfarm business
sector increased impressively. Continued robust gains in productivity, stemming from likely advances in technology, should provide a considerable boost
to household and business incomes and
spending and contribute to a sustained,
noninflationary recovery.
Still, the economy faces considerable
risk of subpar economic performance
in the period ahead. Because outlays for
durable goods and for new homes have
been relatively well maintained in this
cycle, the scope for strong upward impetus from household spending seems
more limited than has often been the
case in past recoveries. Moreover, the
net decline in household net worth relative to income over the past two years is
likely to continue to restrain the growth
of spending in coming quarters. To be
sure, the contraction in business capital
spending appears to be waning. But
spending on some types of equipment,
most notably communications equipment, continues to decline, and there are
few signs yet of a broad-based upturn in
capital outlays. Activity abroad remains
subdued, and a rebound of foreign output is likely to follow, not lead, a
rebound in the United States. Furthermore, lenders and equity investors
remain quite cautious. Banks have continued to tighten terms and standards
on loans, and risk spreads have
increased a little this year. Stock prices
have retreated from recent highs as earnings continue to fall amid concerns
about the transparency of corporate
financial reports and uncertainty about
the pace at which profitability will
improve.

Monetary Policy and the Economic Outlook

Monetary Policy, Financial
Markets, and the Economy
over 2001 and Early 2002
As economic weakness spread and
intensified over the first half of 2001,
the FOMC aggressively lowered its target for the federal funds rate. Because
firms reacted unusually swiftly to indicators that inventories were uncomfortably high and capital was becoming
underutilized, the drop in production
and business capital spending was especially steep. Moreover, sharp downward
revisions in corporate profit expectations caused equity prices to plunge,
which, along with a decline in consumer
confidence, pointed to vulnerability in
household spending. Meanwhile, a significant deceleration in energy prices,
after a surge early in the year, began to
hold down overall inflation; the restraining effect of energy prices, combined
with the moderation of resource utilization, also promised to reduce core inflation. Responding to the rapid deterioration in economic conditions, the FOMC
cut its target for the federal funds rate

2Vi percentage points—in 5 half-point
steps—by the middle of May. Moreover,
the FOMC indicated throughout this
period that it judged the balance of risks
to the outlook as weighted toward economic weakness. The Board of Governors of the Federal Reserve System
approved reductions in the discount rate
that matched the Committee's cuts in
the target federal funds rate. As a result,
the discount rate declined from 6 percent to 3^2 percent over the period.
At its June and August meetings,
the FOMC noted information suggesting continued softening in the economy
and a lack of convincing evidence that
the end of the slide in activity was in
sight. Although consumer spending on
both housing and nonhousing items—
buoyed by the tax cuts and rebates, low
mortgage interest rates, declining energy
prices, and realized capital gains from
home sales—remained fairly resilient,
economic conditions in manufacturing
deteriorated further. Firms continued to
reduce payrolls, work off excess inventories, and cut back capital equipment
expenditures amid sluggish growth in

Selected Interest Rates

2/2

3/21

5/16

6/28

2000

8/22

10/3

11/15 12/19 1/3 1/31

3/20 4/18 5/15

6/27

8/219/17 10/2 11/6 12/1!

2001

NOTE. The data are daily and extend through February 25, 2002. The dates on the horizontal axis
are those of scheduled FOMC meetings and of any intermeeting policy actions.




1/30

2002

8

88th Annual Report, 2001

business sales, significantly lower corporate profits, and greater uncertainty
about future sales and earnings. With
energy prices in retreat, price inflation
remained subdued. In reaching its policy
decisions at its June and August meetings, the FOMC took into account the
substantial monetary policy stimulus
already implemented since the start of
the year—but not yet fully absorbed by
the economy—and the oncoming effects
of stimulative fiscal policy measures
recently enacted by the Congress. Consequently, the Committee opted for
smaller interest rate cuts of lA percentage point at both the June and August
meetings, which brought the target federal funds rate down to 3x/2 percent; as
earlier in the year, the FOMC continued
to indicate that it judged the balance of
risks to the outlook as weighted toward
economic weakness. After both meetings, the Board of Governors of the
Federal Reserve System also approved
similar reductions in the discount rate,
which moved down to 3 percent.
After the terrorist attacks on September 11, the available Committee members held a telephone conference on
September 13, during which they agreed
that the financial markets were too disrupted to allow for an immediate alteration in the stance of monetary policy.
However, the members were in agreement that the attacks' potential effects
on asset prices and on the performance
of the economy, and the resulting uncertainty, would likely warrant some policy
easing in the very near future. Accordingly, the FOMC, at a telephone conference on September 17, voted to reduce
its target for the federal funds rate
l
/i percentage point, to 3 percent, and
stated that it continued to judge the risks
to the outlook to be weighted toward
economic weakness.
Over subsequent weeks, heightened
aversion to risk, which caused investors



to flock from private to Treasury and
federal agency debt, boosted risk
spreads sharply, especially on lowerrated corporate debt. Increased demand
for safe and liquid assets contributed to
selling pressure in the stock market. At
its October 2 meeting, the FOMC had
little hard information available on economic developments since the attacks.
However, evidence gleaned from surveys, anecdotes, and market contacts
indicated that the events of September 11 had considerable adverse repercussions on an already weak economy:
Survey indicators of consumer confidence had fallen, and consumer spending had apparently declined. At the same
time, anecdotal information pointed to
additional deep cutbacks in capital
spending by many firms after an
already-significant contraction in business fixed investment over the summer
months.
When the FOMC met on November
6, scattered early data tended to confirm
the information that the decline in production, employment, and final demand
had steepened after the terrorist attacks.
Although an economic turnaround
beginning in the first half of 2002 was
a reasonable expectation according to
the Committee, concrete evidence that
the economy was stabilizing had yet
to emerge. Meanwhile, the marked
decrease in energy prices since the
spring had induced a decline in overall
price inflation, and inflation expectations had fallen. Accordingly, the
FOMC voted to lower its target for the
federal funds rate Vi percentage point
at both its October and November meetings and reiterated its view that the risks
to the outlook were weighted toward
economic weakness. The sizable adjustments in the stance of monetary policy
in part reflected concerns that insufficient policy stimulus posed an unacceptably high risk of a more extended cycli-

Monetary Policy and the Economic Outlook
cal retrenchment that could prove
progressively more difficult to counter,
given that the federal funds rate—at
2 percent—was already at such a low
level.
By the time of the December FOMC
meeting, the most recent data were suggesting that the rate of economic decline
might be moderating. After plunging
earlier in the year, orders and shipments
of nondefense capital goods had turned
up early in the fourth quarter, and the
most recent survey evidence for manufacturing also suggested that some
expansion in that sector's activity might
be in the offing. In the household sector, personal consumption expenditures
appeared to have been quite well maintained, an outcome that reflected the
continuation of zero-rate financing
packages offered by the automakers,
widespread price discounting, and low
interest rates. In an environment of very
low mortgage interest rates, household
demand for housing remained at a relatively high level, and financial resources
freed up by a rapid pace of mortgage
refinancing activity also supported consumer spending.
Nonetheless, the evidence of emerging stabilization in the economy was
quite tentative and limited, and the
Committee saw subpar economic performance as likely to persist over the near
term. Moreover, in the probable absence
of significant inflationary pressures for
some time, a modest easing action could
be reversed in a timely manner if it
turned out not to be needed. In view of
these considerations, the FOMC lowered its target for the federal funds rate
VA percentage point, to VA percent, on
December 11, 2001, and stated that it
continued to judge the risks to the outlook to be weighted mainly toward economic weakness. As had been the case
throughout the year, the Board of Governors approved reductions in the discount



rate that matched the FOMC's cuts in
the target federal funds rate, bringing
the discount rate to 1 lA percent, its lowest level since 1948.
Subsequent news on economic activity bolstered the view that the economy
was beginning to stabilize. The information reviewed at the January 29-30,
2002, FOMC meeting indicated that
consumer spending had held up remarkably well, investment orders had firmed
further, and the rate of decline in manufacturing production had lessened
toward the end of 2001. With weakness
in business activity abating, and monetary policy already having been eased
substantially, the FOMC left the federal
funds rate unchanged at the close of its
meeting, but it continued to see the risks
to the outlook as weighted mainly
toward economic weakness.

Economic Projections for 2002
Federal Reserve policymakers are
expecting the economy to begin to
recover this year from the mild downturn experienced in 2001, but the pace
of expansion is not projected to be sufficient to cut into the margin of underutilized resources. The central tendency of
the real GDP growth forecasts made by
the members of the Board of Governors
and the Federal Reserve Bank presidents is 2Vi percent to 3 percent, measured as the change between the final
quarter of 2001 and the final quarter of
this year. The pace of expansion is likely
to increase only gradually over the
course of the year, and the unemployment rate is expected to move higher for
a time. The FOMC members project the
civilian unemployment rate to stand at
about 6 percent to 6x/4 percent at the end
of 2002.
A diminution of the rate of inventory
liquidation is likely to be an important
factor helping to buoy production this

10

88th Annual Report, 2001

Economic Projections for 2002
Percent

Indicator

MEMO:

Federal Reserve Governors
and Reserve Bank presidents

2001 actual
Range

Central
tendency

4-41/2
2'/ 2 -3
About IV2

Change, fourth quarter to fourth quarter1
Nominal GDP
Real GDP
PCE chain-type price index

1.9
.1
1.3

3'/2-5i/2
2-31/2
1-2

Average level, fourth quarter
Civilian unemployment rate

5.6

53/4-6i/2

6-61/4

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

year. In 2001, businesses cut inventories
sharply so as to avoid carrying excessive stocks relative to the weaker pace
of sales, and although this process of
liquidation probably is not yet complete
in many industries, the overall pace of
reduction is likely to slow. Then, as
final demand strengthens, liquidation
should give way to some restocking later
in the year.
As noted above, the forces affecting
demand this year are mixed. On the
positive side are the stimulative effects
of both fiscal policy and the earlier
monetary policy actions. A gradual turnaround in employment and a strengthening of the economies of our major trading partners should provide some lift
to final demand, and spending by both
households and businesses ought to
be supported by robust productivity
growth. On the other hand, the problems
facing the high-tech sector have not yet
completely receded, and indications are
that spending on other types of capital
equipment remains lackluster. The surprising strength of household spending




through this period of economic weakness suggests a lack of pent-up consumer demand going forward. In addition, consumers likely will not benefit
from declining energy prices to the
extent they did last year, and the net
decline in equity values since mid-2000
will probably continue to weigh on consumption spending in the period ahead.
Federal Reserve policymakers believe
that consumer prices will increase
slightly more rapidly in 2002 than in
2001, as last year's sharp decline in
energy prices is unlikely to be repeated.
The central tendency of the FOMC
members' projections for increases in
the chain-type price index for personal
consumption expenditures (PCE) is
about W2 percent; last year's actual
increase was about \lA percent. Nevertheless, diminished levels of resource
utilization, the indirect effects of previous declines in energy prices on firms'
costs, and continued competitive pressures all ought to restrain the pace of
price increases outside of the energy
sector this year.
•

11

Economic and Financial Developments
in 2001 and Early 2002
In 2001, the economy turned in its
weakest performance in a decade. Real
GDP increased at an annual rate of
3
A percent in the first half of the year
and, according to the advance estimate
from the Commerce Department,
declined at a Vi percent annual rate in
the second half. Although the effects of
the weakening economy were broadly
felt, the factory sector was especially
hard hit. Faced with slumping demand
both here and abroad, manufacturers
cut production aggressively to limit
excessive buildups of inventories. Moreover, businesses sharply reduced their
investment spending, with particularly
dramatic cuts in outlays for hightechnology equipment. By contrast,
household spending was reasonably well
Change in Real GDP
Percent, annual rate

— 4

1995

1997

1999

Change in PCE Chain-Type Price Index

•
|

Total
Excluding food and energy

2001

NOTE. Here and in subsequent charts, except as
noted, annual changes are measured from Q4 to Q4,
and change for a half-year is measured between its
final quarter and the final quarter of the preceding
period.




maintained, buoyed by lower interest
rates and cuts in federal taxes. Firms
trimmed payrolls through most of the
year, and the unemployment rate moved
up nearly 2 percentage points to around
5% percent by year-end. Job losses were
especially large following the terrorist
attacks of September 11, which had
extremely adverse effects on certain sectors of the economy—most notably, airline transportation and hospitality industries. Nevertheless, by early this year
some signs appeared that the economy
was beginning to mend.
Inflation declined last year, pulled
down by a sharp drop in energy prices.
Excluding food and energy items, consumer price inflation leveled off and, by
some measures, moved lower last year.
Weakening economic activity, the indirect effects of declining energy prices on

1995

1997

1999

2001

NOTE. The data are for personal consumption
expenditures (PCE).

12

88th Annual Report, 2001

firms' costs, and continued strong competitive pressures helped keep a lid on
core consumer price inflation.

The Household Sector
Consumer Spending
Growth in consumer spending slowed
last year but remained sufficiently solid
to provide an important source of
support to overall final demand. Personal consumption expenditures (PCE)
increased 3 percent in real terms in 2001
after having advanced 4lA percent in
2000 and around 5 percent in both 1998
and 1999. The deceleration in consumer
spending was widespread among durable goods, nondurable goods, and services. However, motor vehicle expenditures remained strong through most
of the year and surged in the fall as
consumers responded enthusiastically to
automakers' aggressive expansion of
financing incentives. After September 11, spending declined in certain
travel- and tourism-related categories,
including air transportation, hotels and
motels, and recreation services such as
amusement parks; spending in these
categories has recovered only partially
since then.
Last year's downshift in consumption
growth reflected the weakening labor
market and associated deceleration of
income as well as the erosion in household wealth since the middle of 2000.
With employment declining over much
of last year, real personal income rose
only about \3A percent after a gain of
4Vi percent in 2000. The slowing of
income growth was even sharper in
nominal terms, but price declines for
gasoline and other energy items in the
latter half of the year substantially cushioned the blow to real incomes. A continued rise in house prices supported the



wealth position of many households;
in the aggregate, however, household
wealth deteriorated further as equity
prices moved lower, on net. The decline
in wealth since mid-2000 likely exerted
a notable restraining influence on household spending last year.
Both monetary and fiscal policy supported consumer spending over the past
year. Low interest rates helped enable
motor vehicle finance companies to
offer favorable financing on new vehicles. In addition, low mortgage rates led
to a spate of mortgage refinancing that
lasted most of the year, lowering payments and freeing cash to be used by
households for other spending needs.
Indeed, many households apparently
used these refinancings as an opportunity to extract equity from their homes,
a move that further accommodated consumer spending. Furthermore, the first
wave of tax reductions from the Economic Growth and Tax Relief Reconciliation Act of 2001—including the $300
and $600 rebate checks mailed last
summer—likely helped to boost spending in the latter part of the year. The
continued phase-in of the tax reductions
enacted last year should provide further
Change in Real Income and Consumption
Percent, annual rate

—

Q] Disposable personal income
| Personal consumption
expenditures

—

8

___ 4

I— 2

1995

1997

1999

2001

Economic and Financial Developments in 2001 and Early 2002
stimulus to income and consumption
this year.
The personal saving rate, which had
declined through 1999, leveled off in
2000 and in the first half of 2001. The
saving rate moved erratically in the second half of the year but rose on average.
It shot up in the summer as households
received their tax rebates; it then
declined later in the year as households
spent some of the rebates and as purchases of new motor vehicles soared in
response to the incentives.
Consumer sentiment, as measured by
both the University of Michigan Survey
Research Center (SRC) and the Conference Board, had been running at
extremely high levels through most of
2000 but fell considerably near the
beginning of last year as concerns about
the economy intensified. By the spring,
measures of sentiment leveled off near
their historical averages and well above
levels normally associated with recessions. Sentiment dropped in September.
The SRC measure recovered gradually
thereafter, while the Conference Board
index fell further before turning up later
in the year; by early 2002, both sentiment measures again stood near their
historical averages.
Residential Investment
As with consumer spending, real expenditures on housing were well maintained
last year, buoyed by favorable mortgage
interest rates. Interest rates on thirtyyear fixed-rate mortgages, which had
been as high as SV2 percent in the spring
of 2000, hovered around the low level
of 7 percent in the first half of 2001.
They moved down further to 61/2 percent by late October, before backing up
to 7 percent again by December as prospects for the economy improved. As
monetary policy eased, contract rates
on adjustable-rate mortgages moved



13

down sharply to very low levels in the
fourth quarter and into early 2002.
According to the Michigan SRC survey,
declining mortgage rates have helped
elevate consumers' assessments of
homebuying conditions substantially
since mid-2000.
In the single-family sector, 1.27 million new homes were started last year,
3x/2 percent more than in 2000, when
activity had been held down by higher
mortgage rates. The pace of starts
moved up further in January 2002, in
part because of unusually favorable
weather. Furthermore, sizable backlogs
of building permits early this year
suggest that construction activity will
remain solid. Sales of new homes were
elevated throughout 2001—indeed, for
the year, they were the highest on
record—and sales of existing homes
remained strong as well. Meanwhile, the
increase in home prices moderated last
year. The constant-quality price index of
new homes, which attempts to control
for the mix of homes sold, rose only
1Vi percent last year, down from a 6 percent gain in 2000.
In the multifamily sector, starts averaged 328,000 units last year, a rate close
to the solid pace of the past several
years. Conditions are still relatively
favorable for the construction of multifamily units. In particular, vacancy rates
have remained low, although rents and
property values increased at a slower
rate last year than in 2000.
Household Finance
Households continued to borrow at a
brisk pace last year, increasing their debt
outstanding an estimated 83/4 percent, a
rate about 1 percentage point faster than
the average growth over the previous
two years. The cumulative declines in
mortgage interest rates encouraged
households to take on large amounts of

14

88th Annual Report, 2001

mortgage debt, both by fostering homebuying and by making it attractive to
refinance existing mortgages and extract
some of the accumulated equity; indeed,
the Mortgage Bankers Association
(MBA) refinancing index in October
reached the highest level since its inception in January 1980. The frenzied pace
of refinancing activity tailed off some
later in the fourth quarter, when fixed
mortgage interest rates backed up. All
told, mortgage debt grew an estimated
9 percent last year. Strength in durable
goods outlays supported growth in consumer credit (debt not secured by real
estate) in the first quarter of 2001, but as
consumption spending decelerated over
the next two quarters, the expansion of
consumer credit slowed sharply. However, consumer credit growth surged in
the fourth quarter, in large part because
of the jump in motor vehicle sales. For
the year as a whole, the rate of expansion of consumer credit, at 6lA percent,
was well below the 1014 percent rate
posted in 2000.
Hefty household borrowing outstripped the growth of disposable personal income in 2001. As a result,
despite lower interest rates, the household debt-service burden—an estimate
of minimum scheduled payments on
mortgage and consumer debt as a share
of disposable income—finished the year
near the peak recorded at the end of
1986. Measures of household credit
quality deteriorated noticeably last year.
According to the MBA, delinquency
rates on home mortgages continued to
trend higher from their historic lows of
the late 1990s, and auto loan delinquencies at finance companies edged up,
although they too remained at a relatively subdued level. The economic
slowdown and the rise in unemployment
significantly eroded the quality of loans
to subprime borrowers, and delinquency
rates for both mortgages and consumer



credit in that segment of the market
moved sharply higher.

The Business Sector
Much of the weakness in activity last
year was concentrated in the business
sector. In late 2000, manufacturers had
begun to cut back production in an effort
to reduce an undesired build-up of
inventories, and sharp inventory liquidation continued throughout last year.
Moreover, the boom in capital outlays
that had helped drive the expansion
through the late 1990s gave way to a
softening of spending in late 2000 and
to sharp declines last year. Spending
dropped for most types of capital equipment and structures; cutbacks were
especially severe for high-tech equipment, some types of which may have
been over-bought. A sharp reduction in
corporate profits and cash flow contributed to last year's downturn in capital
spending, as did general uncertainty
about the economic outlook. Despite the
reduction in interest rates, which helped
restrain businesses' interest expenses,
financing conditions worsened somewhat, on balance, given weaker equity
values, higher borrowing costs for risky
firms, and some tightening of banks'
lending standards.
Fixed Investment
Real spending on equipment and software (E&S) declined 8V2 percent in
2001 after an increase of the same
amount in 2000 and double-digit rates
of increase for several preceding years.
Spending on high-tech equipment,
which has accounted for about 40 percent of E&S spending in recent years,
dropped especially sharply last year.
Outlays for computers and peripheral
equipment, which had risen more than
30 percent in each of the preceding

Economic and Financial Developments in 2001 and Early 2002
seven years, fell 9 percent in 2001.
Spending on communications equipment swung even more severely, moving from increases of more than 20 percent on average from 1998 to 2000 to a
decline of more than 30 percent last
year. Business spending on software
held up comparatively well, falling only
2Vi percent in 2001 after having risen
around 12 percent in 1999 and 2000.
A number of factors may have
weighed on outlays for high-tech equipment, including businesses' decisions to
lengthen the replacement cycle for computers in light of weak economic conChange in Real Business Fixed Investment
Percent, annual rate

Structures
Equipment and software

— 20

nih

— 10

— 20

Percent, annual rate

High-tech equipment
and software
Other equipment

—
—

40

—

n

50

30

_ _ 20
__

[j j!

—

- i•

10
0

1 1
1995

1997

1999

2001

NOTE. High-tech equipment includes computers and
peripheral equipment and communications equipment.




15

ditions and the absence of new applications requiring the most up-to-date
machines. But in addition, the magnitude by which these categories of expenditure had increased in preceding years,
together with the abruptness of their
downturn, suggests that firms may have
been too optimistic about the immediate
profitability of some types of high-tech
capital; as these expectations were
revised, businesses viewed their previous investment as more than sufficient
to meet anticipated demand. This possibility is especially likely in the case of
communications equipment, for which
expectations about prospects for growth
in demand appear to have been disappointed. Some of the cutbacks may have
reflected a general pulling back in an
environment of greater uncertainty. The
sharp rise and subsequent decline of
equity values in the high-tech sector
mirrors the pattern of rising and slowing
investment and provides some support
for the notion that earnings expectations
may have been overly upbeat in the
past.
Under the influence of ongoing weakness in the market for heavy trucks,
business spending on motor vehicles
declined through most of the year. But
spending stabilized in the fourth quarter,
as the generous incentives on motor
vehicles may have helped boost spending by small businesses as well as consumers. Domestic orders for new aircraft declined last year, especially after
the terrorist attacks last fall, but these
lower orders had not yet affected spending by year-end because of the very
long lags involved in producing planes.
Apart from spending on transportation
and high-tech equipment, real outlays
declined IVi percent last year after having increased 6 percent in 2000, with the
turnaround driven by a sharp swing in
spending on many types of industrial
machinery and on office furniture.

16

88th Annual Report, 2001

Late last year, conditions in some segments of the high-tech sector showed
signs of bottoming. Developments in the
semiconductor industry have improved,
with production increasing during the
fall. Some of the improvement is apparently coming from increased demand
for computers. In the advance estimate
from the Commerce Department for the
fourth quarter, real spending on computers and peripheral equipment was
reported to have surged at an annual rate
of 40 percent. However, spending on
communications equipment, for which
evidence of a capital overhang has been
most pronounced, continued to decline
sharply in the fourth quarter, and orders
for communications equipment have
yet to display any convincing signs of
turning around. As for other types of
capital equipment, spending continued
to decline in the fourth quarter, but
a moderate rebound in new orders
for many types of capital goods
from their autumn lows hinted that a
broader firming of demand may be
under way.
Real business spending for nonresidential structures also declined sharply
in 2001. Construction of office buildings
dropped last year after having increased
notably for several years; industrial
building remained fairly steady through
the first half of last year but plummeted
in the second half. Vacancy rates for
these two types of properties rose considerably, and by year-end the industrial vacancy rate had reached its highest level since mid-1993. Meanwhile,
spending on non-office commercial
buildings (a category that includes retail,
wholesale, and some warehouse space)
decreased moderately last year. Investment in public utilities moved down
as well, a decline reflecting, in part, a
cutback in spending for communications projects such as the installation



of fiber-optic networks. Investment in
the energy sector was a pocket of
strength last year. Construction of drilling structures surged in 2000 and much
of 2001, as the industry responded to
elevated prices of oil and natural gas.
However, with oil and natural gas prices
reversing their earlier increases, drilling
activity turned down in the latter part of
the year.
Inventory Investment
By late 2000, manufacturers were
already cutting production to slow the
pace of inventory accumulation as
inventories moved up relative to sales.
Production cuts intensified in early
2001, and producers and distributers
liquidated inventories at increasing rates
throughout the year. The runoff of
inventories was a major factor holding
down GDP growth last year. Indeed, the
arithmetic subtraction from real GDP
growth attributable to the decline in nonfarm inventory investment was Wi percentage points over the four quarters
of 2001. However, because sales also
were weakening, inventory-sales ratios
remained high in much of the manufacturing sector, and in some portions of
the wholesale sector as well, throughout
the year.
The motor vehicle sector accounted
for about one-quarter of last year's overall inventory drawdown. Late in 2000
and early last year, automakers cut production in an attempt to clear out excess
stocks held by dealers. By the spring,
vehicle assemblies had stabilized, and
the automakers instead dealt with heavy
stocks by further sweetening incentives
to boost sales. By the end of the year,
inventories of cars and light trucks stood
at a relatively lean 2lA million units,
nearly 1 million units fewer than were
held a year earlier.

Economic and Financial Developments in 2001 and Early 2002
Corporate Profits and Business
Finance
The profitability of the U.S. nonfinancial corporate sector suffered a severe
blow in 2001. The profit slump had
begun in the fourth quarter of the previous year, when the economic profits of
nonfinancial corporations—that is, book
profits from current production with
inventory and capital consumption
adjustments compiled by the Commerce
Department—plummeted almost 45 percent at an annual rate. The first three
quarters of 2001 brought little respite,
and economic profits spiraled downward at an average annual rate of 25 percent. The ratio of the profits of nonfinancial corporations to the sector's gross
nominal output fell to IVi percent last
year, a level not seen since the early
1980s. Earnings reports for the fourth
quarter indicate that nonfinancial corporate profits continued to fall late in the
year.
Before-Tax Profits of Nonfinancial
Corporations as a Percent of Sector GDP

— 12

10

1981

1986

I I
1991

_L
1996

2001

NOTE. The data are quarterly and extend through
2001 :Q3. Profits are from domestic operations of
nonfinancial corporations, with inventory valuation
and capital consumption adjustments.




17

Business borrowing slowed markedly
last year because firms slashed investment in fixed capital and inventories
even more than the drop in profits and
other internally generated funds. Business debt expanded at a 6lA percent
annual rate in 2001, well below the
double-digit rates of the two previous
years, and its composition shifted decidedly toward longer-term sources of
funds. Early in the year, favorable conditions in the corporate bond market, combined with firms' desire to lock in low
interest rates, prompted investmentgrade firms to issue a high volume of
bonds. They used the proceeds to
strengthen their balance sheets by repaying short-term debt obligations, refinancing other longer-term debt, and
building up liquid assets. Junk bond
issuance was also strong early in 2001,
as speculative-grade yields fell in
response to monetary policy easings,
although investors shunned the riskiest
issues amid increasing economic uncertainty and rising defaults among belowinvestment-grade borrowers.
The heavy pace of bond issuance,
along with a reduced need to finance
capital investments, enabled firms to
decrease their business loans at banks
and their commercial paper outstanding.
The move out of commercial paper
also reflected elevated credit spreads
between high- and low-tier issuers
resulting from the defaults of California
utilities and several debt downgrades
among prominent firms early in the year.
Announcements of new equity share
repurchase programs thinned considerably in the first half of the year, as firms
sought to conserve their cash buffers
in response to plummeting profits. A
significant slowdown in cash-financed
merger activity further damped equity
retirements, although these retirements
still outpaced gross equity issuance,

18

88th Annual Report, 2001

which was restrained by falling share
prices. Over the summer, issuance of
investment-grade bonds dropped off
appreciably. Moreover, market sentiment toward speculative-grade issues
cooled, as further erosion in that sector's
credit quality took its toll. Business
loans and outstanding commercial paper
continued to contract, and with share
prices in the doldrums, nonfinancial
firms raised only a small amount of
funds in public equity markets in the
third quarter.
The terrorist attacks on September 11
constricted corporate financing flows for
a time. The stock market closed for that
week, and trading in corporate bonds
came to a virtual halt. After the shutdown of the stock market, the Securities
and Exchange Commission, in an effort
to ensure adequate liquidity, temporarily
lifted some restrictions on firms' repurchases of their own shares. According
to reports from dealers, this change
triggered a spate of repurchases in the
first few days after the stock markets
reopened on September 17. When
full-scale trading in corporate bonds
resumed on September 17, credit
spreads on corporate bonds widened
sharply: Risk spreads on speculativegrade private debt soared to levels not
seen since late 1991, and spreads on
investment-grade corporate bonds also
moved higher, although by a considerably smaller amount. Against this backdrop, junk bond issuance nearly dried up
for the rest of the month. Commercial
paper rates—even for top-tier issuers—
jumped immediately after the attacks,
as risk of payment delays increased. In
response to elevated rates, some issuers
tapped their backup lines at commercial
banks, and business loans spiked in the
weeks after the attacks. Risk spreads for
low-tier borrowers in the commercial
paper market remained elevated, even
after market operations had largely



recovered, because of ongoing concerns
about credit quality and ratings downgrades among some high-profile issuers
in the fall.
By early October, the investmentgrade corporate bond market had largely
recovered from the disruptions associated with the terrorist attacks, and bond
issuance in that segment of the market
picked up considerably. Firms capitalized on relatively low longer-term
interest rates to pay down short-term
obligations, to refinance existing highercoupon debt, and to boost their holdings
of liquid assets. With high-yield bond
risk spreads receding moderately, issuance in the speculative-grade segment
of the corporate bond market stirred
somewhat from its moribund state,
although investors remained highly
selective. Public equity issuance, after
stalling in September, also regained
some ground in the fourth quarter,
spurred by a rebound in stock prices. As
was the case for most of the year, initial

Spreads of Corporate Bond Yields over the
Ten-Year Swap Rate

2000

2001

2002

NOTE. The data are daily and extend through February 21, 2002. The spreads compare the yields on the
Merrill Lynch AA, BBB, and 175 indexes with the
ten-year swap rate.

Economic and Financial Developments in 2001 and Early 2002
public offerings and venture capital
financing remained at depressed levels.
Commercial paper issuance recovered
somewhat early in the fourth quarter as
firms repaid bank loans made in the
immediate aftermath of the terrorist
attacks and as credit spreads for lowerrated issuers started to narrow. However, the collapse of the Enron Corporation combined with typical year-end
pressures to widen quality spreads in
early December. All told, the volume of
domestic nonfinancial commercial paper
outstanding shrank by one-third over the
year as a whole. Business loans at banks
fell further in the fourth quarter; for the
year, business loans contracted AlA percent, their first annual decline since
1993.
The slowing of sales and the drop in
profits caused corporate credit quality
to deteriorate noticeably last year. In
part because of the decline in market
interest rates, the ratio of net interest
payments to cash flow in the nonfinancial corporate sector moved only modestly above the relatively low levels of

Default Rate on Outstanding Bonds

1991

1993

1995

1997

1999

2001

NOTE. The data are monthly; the series shown is a
twelve-month moving average.




19

recent years, and most firms did not
experience significant difficulties servicing their debt. However, many firms
were downgraded, and evidence of
financial distress mounted over the
course of the year. The twelve-month
trailing average of the default rate on
corporate bonds nearly tripled last year
and by December ran almost Vi percentage point higher than its peak in 1991.
Delinquency rates on business loans at
banks also rose, although not nearly as
dramatically. The amount of nonfinancial debt downgraded by Moody's
Investors Service last year was more
than five times the amount upgraded;
downgrades were especially pronounced
in the fourth quarter, when ratings agencies lowered debt ratings of firms in the
telecommunication, energy, and auto
sectors.
Commercial mortgage debt, supported by still-strong construction
spending, expanded at a brisk 10 percent
pace over the first half of 2001. The
growth of commercial mortgage debt
edged down only Vi percentage point
in the second half, despite a sharp
slowdown in business spending on
nonresidential structures. As a result,
the issuance of commercial-mortgagebacked securities (CMBS) maintained a
robust pace throughout the year. Available data indicate some deterioration
in the quality of commercial real estate
credit. Delinquency rates on commercial
real estate loans at banks rose steadily
in 2001 and have started to edge out
of their recent record-low range. In
addition, CMBS delinquency rates
increased, especially toward the end of
the year, amid the rise in office vacancy
rates. Despite the erosion in credit quality in commercial real estate and heavy
issuance of CMBS, yield spreads on
investment-grade CMBS over swap
rates were about unchanged over the
year, suggesting that investors view

20

88th Annual Report, 2001

credit problems in this sector as being
contained. Commercial banks, however,
stiffened their lending posture in
response to eroding prospects for the
commercial real estate sector; significant net fractions of loan officers
surveyed over the course of the year
reported that their institutions had
firmed standards on commercial real
estate loans.

The Government Sector
Federal Government
Deteriorating economic conditions and
new fiscal initiatives have led to smaller
federal budget surpluses than had been
anticipated earlier. The fiscal 2001 surplus on a unified basis was $127 billion,
or about VA percent of GDP—well
below both the record $236 billion surplus recorded in fiscal 2000 and the
$281 billion surplus that the Congressional Budget Office had anticipated
for fiscal 2001 at this time last year.
Receipts, which had increased at least
6 percent in each of the preceding seven
fiscal years, declined around 2 percent
in fiscal 2001; the rise in individual tax
receipts slowed dramatically and corporate receipts plunged 27 percent. The
lower receipts reflected both the weakening economy—specifically, slow
growth of personal income, the drop in
corporate profits, and a pattern of
declines in equity values that led to
lower net capital gains realizations—
and changes associated with the Economic Growth and Tax Relief Reconciliation Act of 2001. Some provisions of
the act went into effect immediately,
including the rebate checks that were
mailed last summer. In addition, the act
shifted some corporate tax payments
into fiscal 2002.
Meanwhile, outlays were up 4 percent in fiscal 2001; abstracting from a



decline in net interest payments, outlays
increased nearly 6 percent, a second
year of increases larger than had prevailed for some time. Outlays have
increased across all major categories of
expenditure, including defense, Medicare and Medicaid, and social security.
As for the part of federal spending that
is counted in GDP, real federal outlays
for consumption and gross investment
increased somewhat more rapidly than
in recent years through the first three
quarters of 2001 as defense expenditures picked up. Spending rose faster
still in the fourth quarter because of
increases for homeland security and the
additional costs associated with the war
in Afghanistan.
The existence of surpluses through
fiscal 2001 meant that the federal government continued to contribute to the
pool of national saving. Nevertheless,
gross saving by households, businesses,
and governments has been trending
down over the past few years from the
recent high of around 19 percent of GDP
in 1998.
The Treasury used federal budget
surpluses over the first half of the year
to pay down its outstanding marketable
debt. In the third quarter, however, the
cut in personal income taxes and a
weakening in receipts as the economy
contracted led the Treasury to reenter
the credit markets as a significant borrower of new funds. The Treasury's
budget position swung back into surplus
late in the year owing to somewhat
stronger-than-expected tax receipts,
which helped push fourth-quarter net
borrowing below its third-quarter level.
Despite the increase in the Treasury's
net borrowing over the second half of
the year, publicly held debt remained at
only about one-third of nominal GDP
last year, its lowest level since the mid1980s and well below the 1993 peak of
almost 50 percent.

Economic and Financial Developments in 2001 and Early 2002
Federal Government Debt
Held by the Public
Percent of nominal GDP

— 45

35

— 25

1 1 1 i 1 I i i 11
1 i
1961

1971

1981

11 Ml II1 Ml
1991
2001

NOTE. The data are as of the end of the fiscal year.
Excludes debt held in federal government accounts
and by the Federal Reserve System.

The terrorist attacks on September 11
and the associated disruptions to financial markets had some spillover effects
on Treasury financing. On the day of
the attacks, the Treasury cancelled its
scheduled bill auction; over the next
several days, it drew down nearly all of
its compensating balances with commercial banks—about $12V2 billion in
total—to meet its obligations. On Thursday of that week, the settlement of securities sold the day before the attacks
eased the Treasury's immediate cash
squeeze, and the incoming stream of
estimated quarterly personal income tax
payments provided additional funds.
Infrastructure problems involving the
trading and clearing of Treasury securities were largely resolved over the following week, and when the Treasury
resumed its regular bill issuance on
September 17, exceptionally strong
demand for bills pushed stop-out rates—
that is, the highest yield accepted during
the auction—to their lowest level since
1961. Although the Treasury cancelled



21

debt buybacks scheduled for late September to conserve cash, it later
announced that buyback operations
would begin again in October.
With its credit needs still limited, the
Treasury announced on October 31 that
it was suspending issuance of nominal
and inflation-indexed thirty-year securities. Subsequently, the thirty-year Treasury bond yield fell sharply, bid-asked
spreads on outstanding bonds widened,
and liquidity in the bond sector deteriorated. Although bid-asked spreads narrowed over the balance of the year,
market participants reported that liquidity in the bond sector remained below its
level before the Treasury's announcement. The announcement on October 31
also indicated that after the January
2002 buyback operations, the Treasury
would determine the amount and timing
of buybacks on a quarter-by-quarter
basis, thereby fueling speculation that
future buybacks might be scaled back in
light of the changed budget outlook.

State and Local Governments
Real expenditures for consumption and
gross investment by states and localities
rose 5 percent last year after an increase
of 2Vi percent in 2000. Much of the
acceleration reflected a burst of spending on construction of schools and other
infrastructure needs. In addition, outlays
at the end of last year were boosted
by the cleanup from the September 11
attacks in New York. As for employment, state and local governments added
jobs in 2001 at a more rapid pace than
they did over the previous year and
thereby helped to offset job losses in the
private sector.
The fiscal condition of state and local
governments has been strained by the
deterioration in economic performance.
State governments are considering a

22

88th Annual Report, 2001

variety of actions to achieve budget
balance in the current fiscal year. Most
states are intending to cut planned
expenditures, and many are considering
drawing down rainy-day funds, which
governments had built up in earlier
years. According to the National Conference of State Legislators, these rainyday funds stood at the relatively high
level of $23 billion at the end of fiscal
2001 (June 30). Moreover, some states
that had planned to fund capital expenditures with current receipts appear to be
shifting to debt financing. Finally, a few
states are considering actions such as
postponing tax cuts that were enacted
earlier.
Debt of the state and local government sector expanded rapidly last year
after slow growth in 2000. Gross issuance of long-term municipal bonds
accelerated over the first half of 2001 as
state and local governments took advantage of lower yields to refund outstanding debt. Spurred by falling interest rates
and declining tax revenues, these governments continued to issue long-term
bonds to finance new capital projects at
a rapid clip over the second half of the
year. Despite a deterioration in tax
receipts, credit quality in the municipal
market remained high in 2001. Late in
the year, however, signs of weakness
had emerged, as the pace of net creditratings upgrades slowed noticeably.
Especially significant problems continue
to plague California and New York, both
of which saw their debt ratings lowered
in November. In California, the problems were attributed to declining tax
revenues and difficulties related to the
state's electricity crisis earlier in the
year, while New York's slip in credit
quality resulted not only from deteriorating tax receipts but also from fears of
higher-than-expected costs related to
clean up and rebuilding after the terrorist attacks.



The External Sector
Trade and the Current Account
The U.S. current account deficit narrowed significantly during 2001, with
both imports and exports of goods and
services falling sharply in response to a
global weakening of economic activity.
The deficit in goods and services narrowed to $333 billion at an annual rate
in the fourth quarter of 2001 from
$401 billion at the end of the previous
year. In addition, the deficit was temporarily reduced further in the third quarter
because service import payments were
lowered by a large one-time estimated
insurance payment from foreign insurers (reported on an accrual basis)
related to the events of September II. 1
Excluding the estimated insurance
figure, the current account deficit was
$434 billion at an annual rate over
the first three quarters of the year,
or AlA percent of GDP, compared with
$445 billion and AV2 percent for the
year 2000. Net investment income
payments were about the same during
the first three quarters of 2001 as in
the corresponding period a year earlier; higher net payments on our growing net portfolio liability position were
offset by higher net direct investment
receipts.
U.S. real exports were hit by slower
growth abroad, continued appreciation
of the dollar, and plunging global

1. The "insurance payment" component of
imported services is calculated as the value of
premiums paid to foreign companies less the
amount of losses recovered from foreign companies. In the third quarter, the estimated size of
losses recovered far exceeded the amount paid for
insurance premiums, resulting in a negative
recorded insurance payment. According to NIPA
accounting, the entire amount of a recovery is
recorded in the quarter in which the incident
occurred.

Economic and Financial Developments in 2001 and Early 2002
demand for high-tech products. Real
exports of goods and services fell
11 percent over the four quarters of
2001, with double-digit declines beginning in the second quarter. Service
receipts decreased 7 percent; all of the
decline came after the events of September 11. Receipts from travel and
passenger fares, which plunged following the terrorist attacks, were about
one-fourth lower in the fourth quarter
than in the second quarter. Receipts
from foreigners for other services
changed little over the year. Exports
declined in almost all major goods
categories, with the largest drops by
far in high-tech capital goods and
other machinery. Two exceptions were
exports of automotive products, which
rose during the second and third quarters (largely parts to Canada and Mexico
destined ultimately for use in U.S.
markets, and vehicles to Canada), and
agricultural goods. About 45 percent
of U.S. exports of goods were capital
equipment; 20 percent were industrial
supplies; and 5 percent to 10 percent
each were agricultural, automotive, consumer, and other goods. The value of
exported goods declined at double-digit
rates for almost all major market destinations. Even exports to Canada and
Mexico declined sharply, despite support from two-way trade with the United
States in such sectors as automotive
products.
As growth of the U.S. economy
slowed noticeably, real imports of goods
and services turned down and declined
8 percent for 2001 as a whole. Service
payments dropped 15 percent last year.
The plunge in outlays for travel and
passenger fares after September 11 held
down total real service payments, bringing their level in the fourth quarter
15 percent below that in the second
quarter. Spending on services other than
travel and passenger fares changed little



23

during the year.2 Imported goods fell
6 percent last year, with much of the
decrease in capital goods (computers,
semiconductors, and other machinery).
In contrast, real imports of automotive
products, consumer goods, oil, and other
industrial supplies were little changed,
and imports of foods rose. The pattern
of import growth appears to have shifted
toward the end of the year. Imports of
real non-oil goods declined at about a
10 percent annual rate during the first
three quarters of the year but fell less
rapidly in the fourth quarter. The price
of imported non-oil goods, after rising
in the first quarter, declined at an annual
rate of about 6 percent from the second
quarter through the fourth quarter, led
by decreases in the price of imported
industrial supplies.
The value of imported oil fell more
than one-third over the four quarters of
2001, a drop resulting almost entirely
from a sharp decline in oil prices. The
spot price of West Texas intermediate
(WTI) crude decreased about $10 per
barrel during the year, with much of the
decline occurring after September 11.
During the first eight months of 2001,
the spot price of WTI averaged $28 per
barrel as weakened demand for oil
and increased non-OPEC supply were
largely offset by OPEC production
restraint. In the wake of the terrorist
attacks, oil prices dropped sharply in
response to a decline in jet fuel consumption, weaker economic activity,
and reassurance from Saudi Arabia that
supply would be forthcoming. Oil prices
continued to drift lower during the

2. According to NIPA accounting, the value of
the one-time insurance payments by foreign insurers is not reflected in NIPA real imports of
services. The deflator for service imports was
adjusted down for the third quarter to offset the
lower value of service imports; the deflator
returned to its usual value in the fourth quarter.

24

88th Annual Report, 2001

fourth quarter, reflecting OPEC's apparent unwillingness to continue to sacrifice market share in order to defend
higher oil prices. In late December, however, OPEC worked out an arrangement
in which it agreed to reduce its production targets an additional 1.5 million
barrels per day, contingent on the
pledges from several non-OPEC producers (Angola, Mexico, Norway, Oman,
and Russia) to reduce oil exports a total
of 462,500 barrels per day. Given the
uncertainty over the extent to which
these reductions will actually be implemented and the comfortable level of oil
inventories, the spot price of WTI
remained near $20 per barrel in early
2002.

Financial Account
The slowing of U.S. and foreign economic growth over the course of last
year had noticeable effects on the composition of U.S. capital flows, especially
when the slowing became more pronounced in the second half. On balance, net private capital flowed in at
a pace only slightly below the record
set in 2000, including unprecedented
net inflows through private securities
transactions.
During the first half of 2001, sagging
stock prices and signs of slower growth
brought a shift in the types of U.S. securities demanded by private foreigners
but did not reduce the overall demand
for them. Indeed, during the first half,
foreign private purchases of U.S. securities averaged $137 billion per quarter, a
rate well above the record $109 billion
pace set in 2000. A slowing of foreign
purchases of U.S. equities, relative to
2000, was more than offset by a pickup
in foreign purchases of corporate and
agency bonds. In addition, private for


eigners, who had sold a significant
quantity of Treasury securities during
2000, roughly halted their sales in the
first half of 2001. The increased capital inflows arising from larger foreign
purchases of U.S. securities in the
first half was only partly offset by an
increase in the pace at which U.S. residents acquired foreign securities, especially equities.
The pattern of private securities transactions changed significantly in the third
quarter: Foreign purchases of U.S. equities slowed markedly, and U.S. investors
shifted from net purchases of foreign
securities to net sales. However, the
reduced flows in the third quarter
seem to have reflected short-lived
reactions to events in the quarter. Preliminary data for the fourth quarter show
a significant bounceback in foreign purchases of U.S. securities and a return to
purchases of foreign securities by U.S.
residents.
The changing economic climate also
affected direct investment capital flows.
During 2000, foreign direct investment in the United States averaged
more than $70 billion per quarter.
These flows slowed to less than
$60 billion per quarter in the first
half and then dropped to only $26 billion in the third quarter (the last available data). The drop resulted in part
from a decline in the outlook for corporate profits and a significant reduction in general merger and acquisition
activity. By contrast, U.S. direct investment abroad picked up over the course
of 2001. The third quarter outflow of
$52 billion—a record—reflected both a
large merger and robust retained earnings by the foreign affiliates of U.S.
firms. Capital inflows from official
sources were relatively modest in 2001,
totaling only $15 billion, compared with
$36 billion in 2000.

Economic and Financial Developments in 2001 and Early 2002
The Labor Market
Employment and Unemployment
Last year's weakening in economic
activity took its toll on the labor market.
Payroll employment edged up early last
year and then dropped nearly Wi million by January 2002. Declines were
particularly large in manufacturing,
which has shed one in twelve jobs since
mid-2000. Job cuts accelerated in the
months following the terrorist attacks of
September 11, with declines occurring
in a wide variety of industries. The
unemployment rate moved up from
4 percent in late 2000 to 5.8 percent by
December 2001. In January 2002, the
unemployment rate edged down to
5.6 percent.

Measures of Labor Utilization

—

15

Augmented
unemployment

Civilian
unemployment
1 1 1 I I
1972

1982

1992

2002

NOTE. The data extend through January 2002. The
augmented umemployment rate is the number of
unemployed plus those who are not in the labor force
and want a job, divided by the civilian labor force
plus those who are not in the labor force and want a
job. In January 1994, a redesigned survey was introduced; data for the augmented rate from that point
on are not directly comparable with those of earlier
periods. For the augmented rate, the data are quarterly
through December 1993 and monthly thereafter; for
the civilian labor force rate, the data are monthly.




25

Early last year, employment in
manufacturing, which had been trending down for several years, began to
decline more rapidly. Job losses were
widespread within the manufacturing
sector but were most pronounced in
durable-goods industries, such as those
producing electrical and industrial
machinery and metals. Employment at
help supply firms and in wholesale
trade—industries that are directly
related to manufacturing—also began to
decline. Outside of manufacturing and
its related industries, private payrolls
continued to increase robustly in the first
quarter of last year, but hiring then
slowed, although it remained positive,
on net, in the second and third quarters.
Construction payrolls increased into
the spring but flattened out thereafter.
Employment at retail trade establishments also continued to increase moderately through the spring but began to
decline in the late summer. In services
industries other than help supply
firms—a broad group that accounted for
nearly half of the private payroll
increases over the preceding several
years—job gains slowed but remained
positive in the second and third quarters
of last year. In all, private payroll
employment declined about 115,000 per
month in the second and third quarters,
and the unemployment rate moved up
steadily to 4V2 percent by the spring and
to nearly 5 percent by August.
The labor market was especially hard
hit by the terrorist attacks. Although
labor demand was weak prior to the
attacks, the situation turned far worse
following the events of September 11,
and private payrolls plunged more than
400,000 per month on average in October and November. Employment fell
substantially not only in manufacturing
and in industries directly affected by
the attacks, such as air transportation,

26

88th Annual Report, 2001

hotels, and restaurants, but also in a
wide variety of other industries such as
construction and much of the retail
sector.
Employment continued to decline in
December and January but much less
than in the preceding two months.
Manufacturing and its related industries
lost jobs at a slower pace, and employment leveled off in other private industries. The unemployment rate moved up
to 5.8 percent in December but then
ticked down to 5.6 percent in January.
The recent reversal of the October and
November spikes in new claims for
unemployment insurance and in the
level of insured unemployment also
point to some improvement in labor
market conditions early this year.
Productivity and Labor Costs
Given economic conditions, growth of
labor productivity was impressive in
2001. Productivity growth typically
drops when the economy softens, partly
because businesses tend not to shed
workers in proportion to reduced
demand. Last year, however, output per
hour in the nonfarm business sector
increased a relatively solid 1 Vi percent,
according to the advance estimate, after
having risen 2Vi percent in 2000—a
mild deceleration by past cyclical standards. Indeed, productivity is estimated
to have increased at an annual rate of
more than 2 percent in the second half
of the year, an impressive performance
during a period when real GDP was, on
net, contracting. The buoyancy of productivity during 2001 provides further
support to the view that the underlying
trend of productivity growth has stepped
up notably in recent years.
Hourly labor compensation costs
increased more slowly last year than in
2000, although different compensation
measures paint different pictures of the



magnitude of that deceleration. The
slowing likely reflected the influence of
the soft labor market, energy-driven
declines in price inflation toward the
latter part of the year, and subdued inflation expectations. Compensation probably was also held down by a reduction
in variable pay, such as bonuses that are
tied to company performance and stockoption activity.
According to the employment cost
index, hourly compensation costs
increased 4V4 percent during 2001,
down from a AVi percent increase in
2000; both the wages and salaries and
benefits components recorded slightly
smaller increases. The deceleration in
the index for wages and salaries was
concentrated among sales workers,
whose wages often include a substantial
commission component and so are especially sensitive to cyclical developments. Although the increase in employers' cost of benefits slowed overall,
the cost of providing health insurance
increased more than 9 percent last year;
the rise continued this component's
accelerating contribution to labor costs
over the past few years after a period
Change in Output per Hour
Percent, annual rate

— 4
— 3
-

2

— 1
-

LL

J
1991

1993

_U

L
1995

1997

NOTE. Nonfarm business sector.

1999

2001

Economic and Financial Developments in 2001 and Early 2002
of restrained cost increases in the mid1990s.
An alternative measure of hourly
compensation is the BLS's measure of
compensation per hour in the nonfarm business sector, which is derived
from compensation information in
the national accounts; this measure
increased 4 percent last year, a very
large drop from the 13A percent increase
registered in 2000. One reason that
these two compensation measures may
diverge is that only nonfarm compensation per hour captures the cost of stock
options. Although the two compensation measures differ in numerous other
respects as well, the much sharper deceleration in nonfarm compensation per
hour may indicate that stock option
exercises leveled off or declined in 2001
in response to the fall in equity values.
However, because nonfarm compensation per hour can be revised substantially, one must be cautious in interpreting the most recent quarterly figures
from this series.
Unit labor costs, the ratio of hourly
compensation to output per hour in the
nonfarm business sector, increased about
2 percent last year. Although down from
a huge 5 percent increase in 2000 that
reflected that year's surge in nonfarm
compensation per hour, the figure for
2001 is still a little higher than the moderate increases seen over the preceding
several years. Last year's increase in
unit labor costs was held up by the
smaller productivity increases that
accompanied weak economic activity;
accordingly, subsequent increases in unit
labor costs would be held down if output per hour begins to increase more
rapidly as the economy strengthens.

Prices
Inflation declined in 2001 largely
because of a steep drop in energy prices.



27

The chain-type price index for personal
consumption
expenditures
(PCE)
increased 1.3 percent last year after having increased 2.6 percent in 2000; the
turnaround in consumer energy prices
accounted for almost all of that deceleration. Increases in PCE prices excluding
food and energy items also slowed a
little last year after having moved up in
2000. The chain-type price index for
gross domestic purchases—the broadest
price measure for domestically purchased goods and services—decelerated
considerably last year. The small
increase in this index reflected both the
drop in energy prices and a resumption
of rapid declines for prices of investment goods, especially computers, following a period of unusual firmness in
2000. The price index for GDP—the
broadest price measure for domestically
produced goods and services—posted a
smaller deceleration of about V2 percentage point between 2000 and 2001
because lower oil prices have a smaller
weight in U.S. production than in US.
purchases.
Consumer energy prices continued to
move higher through the early months
of 2001 before turning down sharply in
the second half of the year. Despite the
fact that crude oil prices were declining
Alternative Measures of Price Change
Percent
Price measure

2000

2001

Chain-type
Gross domestic product
Gross domestic purchases
Personal consumption
expenditures
Excluding food and energy ...

2.4
2.5

1.8
1.1

2.6
1.9

1.3
1.6

Fixed-weight
Consumer price index
Excluding food and energy ...

3.4
2.5

1.9
2.7

NOTE. Changes are based on quarterly averages and
are measured to the fourth quarter of the year indicated
from the fourth quarter of the preceding year.

28

88th Annual Report, 2001

over the first half of the year, retail
gasoline prices increased at an annual
rate of 8 percent during that period. The
sizable increase in margins on gasoline
reflected both refinery disruptions and
low inventory levels going into the summer driving season. But gasoline prices
fell sharply thereafter as refineries came
back on line, imports of gasoline picked
up, and crude oil prices moved considerably lower over the latter half of the
year. In all, gasoline prices were down
19 percent over the year as a whole.
Heating oil prices reflected crude oil
developments more directly and
declined sharply through most of the
year. Meanwhile, spot prices of natural
gas peaked in January 2001 at the
extraordinarily high level of nearly $10
per million BTUs, and prices at the consumer level continued to surge in the
first few months of the year. These
increases reflected the pressure from
ongoing strength in demand coupled
with unusually cold weather early last
winter that left stocks at very low levels.
But the situation improved as expanded
supply allowed stocks to be replenished:
Spot prices reversed those earlier
increases, and prices of consumer natural gas declined substantially through
the rest of the year.
In contrast, electricity prices rose
through most of last year. The increases
reflected the effects of the earlier rises in
the prices of natural gas and coal on fuel
costs of utilities as well as problems
with electricity generation in California.
California was able to avoid serious
power disruptions last summer because
high electricity prices, weak economic
activity, and moderate weather all
helped keep demand in check.
Consumer food prices increased more
rapidly last year, rising about 3 percent
after having risen only 21/2 percent in
2000. Early in the year, strong demand,
both domestic and foreign, led to



large increases in livestock prices—
especially beef. But these prices softened later in the year under the influence of higher supplies, lower domestic
demand, and foreign outbreaks of mad
cow disease, which apparently damped
demand for beef no matter where
produced.
Excluding food and energy items,
PCE prices rose 1.6 percent last year, a
small deceleration from its 1.9 percent
increase over 2000. That deceleration
was concentrated in prices of goods,
with prices especially soft for motor
vehicles and apparel. By contrast, prices
of many services continued to accelerate
last year. In particular, shelter costs—
which include residential rent, the
imputed rent of owner-occupied housing, and hotel and motel prices—
increased 4!/4 percent last year after having risen 3Vi percent in 2000.
Standing somewhat in contrast to the
small deceleration in core PCE prices,
the core consumer price index (CPI)
increased 23A percent last year, about
the same rate as in 2000. Although components of the CPI are key inputs of the
PCE price index, the two price measures
differ in a variety of ways. One important difference is that the PCE measure
is broader in scope; it includes expenditures made by nonprofit institutions and
consumption of items such as checking
services that banks provide without
explicit charge. Prices for the PCE categories that are outside the scope of the
CPI decelerated notably in 2001 and
accounted for much of the differential
movements of inflation measured by the
two price indexes. Another difference is
that the CPI places a larger weight on
housing than does the PCE price index,
and last year's acceleration of housing
prices therefore boosted the CPI relative
to the PCE measure.
The leveling off or decline in core
consumer price inflation reflects a vari-

Economic and Financial Developments in 2001 and Early 2002
ety of factors, including the weakening
of economic activity and the accompanying slackening of resource utilization;
the decline in energy prices that reduced
firms' costs; and continuing intense
competitive pressures in product markets. These factors also likely helped
to reduce inflation expectations late last
year, and this reduction itself may be
contributing to lower inflation. According to the Michigan SRC, median oneyear inflation expectations, which had
held near 3 percent through 2000 and
into last summer, moved down to
23/4 percent in the third quarter and
plummeted to 1 percent or lower in
October and November. Falling energy
prices and widespread reports of discounting following the September 11
attacks likely played a role in causing
this sharp break in expectations. Part of
this drop was reversed in December, and
since then, inflation expectations have
remained around 2 percent—a rate still
well below the levels that had prevailed
earlier. Meanwhile, the Michigan SRC's
measure of longer-term inflation expectations, which had also remained close
to 3 percent through 2000 and the first
half of 2001, ticked down to 23A percent
in October and stood at that level early
this year.

U.S. Financial Markets
As a consequence of the Federal
Reserve's aggressive easing of the
stance of monetary policy in 2001, interest rates on short- and intermediate-term
Treasury securities fell substantially
over the course of the year. Longer-term
Treasury bond yields, however, ended
the year about unchanged, on balance.
These rates had already fallen appreciably in late 2000 in anticipation of
monetary policy easing. They may also
have been held up last year by an



29

increased likelihood of federal budget
deficits and, except in the immediate
aftermath of the terrorist attacks, by
investors' optimism about future economic prospects. Despite this optimism, the slowdown in final demand, a
slump in corporate earnings, and a
marked deterioration in credit quality
of businesses in a number of sectors
made investors more wary about risk.
Although interest rates on higher-rated
investment- grade corporate bonds generally moved in line with those on
comparably dated government securities, lower-rated firms found credit to
be considerably more expensive, as
risk spreads on speculative-grade debt
soared for most of the year before narrowing somewhat over the last few
months. Interest rates on commercial
paper and business loans fell last year
by about as much as the federal funds
rate, but risk spreads generally remained
in the elevated range. In addition, commercial banks tightened standards and
terms for business borrowers throughout
the year. Equity prices were exceptionally volatile and fell further, on balance,
in 2001.
Increased caution on the part of lenders did not appear to materially damp
aggregate credit flows. Private borrowing was robust last year, especially when
compared with the marked slowing in
nominal spending. Relatively low longterm interest rates encouraged both businesses and households to concentrate
borrowing in longer-term instruments,
thereby locking in lower debt-service
obligations. The proceeds of long-term
borrowing were also used to strengthen
balance sheets by building stocks of liquid assets. A shift toward safer and more
liquid asset holdings showed through in
rapid growth of M2, which was spurred
further by reduced short-term market
interest rates and elevated stock market
volatility.

30

88th Annual Report, 2001

Interest Rates
Short-term market interest rates moved
down with the FOMC's cumulative cut
in the target federal funds rate of
43/4 percentage points, and yields on
intermediate-term Treasury securities
declined almost 2 percentage points.
Longer-term interest rates had already
fallen in the latter part of 2000, when
investors began to anticipate significant
policy easing in response to weakening
economic growth. As the FOMC aggressively eased the stance of monetary policy during the winter and spring, investors' expectations of a prompt revival in
economic activity took hold and were
manifested in a sharp upward tilt of
money market futures rates and an
appreciable rise in longer-term interest
rates over the second quarter. However, signs of the anticipated economic
turnaround failed to materialize as
the summer progressed. Indeed, the
weakening in economic activity was
becoming more widespread, which
prompted expectations of further monetary policy easing over the near term,
Rates on Selected Treasury Securities

Three-month

2000

2001

\V_~ ^

2002

NOTE. The data are daily and extend through February 21, 2002.




and longer-term interest rates turned
down again.
The terrorist attacks of September 11
dramatically redrew the picture of the
nation's near-term economic prospects.
Market participants lowered markedly
their expected trajectory for the path of
the federal funds rate in the immediate
aftermath of the attacks, and revisions to
policy expectations, combined with considerable flight-to-safety demands, cut
short- and intermediate-term Treasury
yields substantially over subsequent
days. The FOMC, confronted with evidence of additional weakness in final
demand and prices, eased policy further
over the balance of the year, and shortterm market interest rates continued to
decline. In early November, however,
intermediate- and long-term interest
rates turned up, as it became apparent
that the economic fallout from the
attacks would be more limited than
some had originally feared, and as military success in Afghanistan bolstered
investors' confidence and moderated
safe-haven demands. By the end of the
year, yields on intermediate-term Treasury securities had reversed about half
of their post-September 11 decline,
while yields on longer-term Treasury
securities had risen enough to top their
pre-attack levels. In early 2002, however, yields on intermediate- and longerterm Treasuries edged down again, as
market participants trimmed their expectations for the strength of the economic
rebound, and the Congress failed to
move forward with additional fiscal
stimulus.
Yields on higher quality investmentgrade corporate bonds generally followed those on comparably dated Treasury securities last year, although risk
spreads widened moderately before
narrowing over the last few months. In
contrast, interest rates on speculativegrade corporate debt increased steadily

Economic and Financial Developments in 2001 and Early 2002
in 2001, as risk spreads ballooned
in response to mounting signs of financial distress among weaker firms. Even
with a considerable narrowing over
the final two months of the year, risk
spreads on below-investment-grade
bonds remained quite wide. Spreads for
high-yield bonds edged down further in
2002 after rising sharply in early January, when several important technology
and telecommunications companies
revised down their earnings forecasts or
released corrections to past earnings
statements. Interest rates on commercial
and industrial (C&I) loans at banks fell
last year by about as much as the federal
funds rate. According to the Federal
Reserve's quarterly Survey of Terms of
Business Lending, the spread over the
target federal funds rate of the average
interest rate on C&I loans varied somewhat over the year, falling for a while
then rising sharply between August and
November; nonetheless, it has generally
remained in the elevated range that has
persisted since late 1998. The same survey also indicated that over the course
of last year commercial banks, like other
lenders, have become especially cautious about lending to marginal credits,
as indicated by the average spread on
riskier C&I loans not made under a previous commitment, which soared in
2001.

31

came to a halt at the end of the first
quarter, with the Wilshire 5000—a very
broad index of stock prices—down
about 13 percent, while the tech-heavy
Nasdaq ended the first quarter at its
lowest level since 1998 and more than
60 percent below its record high reached
in March of 2000.
Companies, especially in the technology sector, reported weak profits for the
first quarter, but their announcements
generally surpassed analysts' sharply
lowered expectations. With the 1 percentage point reduction in the federal
funds rate over March and April, investors became more confident that an
improvement in economic conditions
was in train, and equity prices rallied;
the rebound was particularly strong for
technology companies—the Nasdaq
rose almost 40 percent between April
and the end of May. The forward
momentum in equity markets was
checked in June, however, in part
because analysts slashed their estimates
for near-term corporate earnings growth.
Although the stock market initially
proved resilient in the face of the bleak
Major Stock Price Indexes
January 3, 2000 = 100

Equity Markets
The exceptional volatility of equity
prices in 2001 likely reflected the dramatic fluctuations in investors' assessment of the outlook for the economy
and corporate earnings. Share prices
tumbled early last year, as pessimism
and uncertainty about the direction of
the economy were intensified by a spate
of negative earnings announcements and
profit warnings in February and March.
The pronounced sell-off of equities



75

50
Nasdaq

1 . , i,

• ,1

2000

2001

2002

NOTE. The data are daily and extend through February 21, 2002.

32

88th Annual Report, 2001

profit news, suggesting that weak earnings had been largely anticipated by
investors, the steady barrage of dismal
economic news—particularly in the
technology and telecommunications
sectors—started to exert downward
pressure on share prices by early
August. The slide in stock prices intensified in early September, with technology
stocks taking an exceptional drubbing.
By September 10, the Wilshire 5000
was down almost 10 percent from the
end of July, while the Nasdaq had lost
more than 16 percent.
The attacks on September 11, a Tuesday, caused stock markets to shut down
and to remain closed for the rest of that
week. Trading resumed in an orderly
fashion on Monday, September 17, but
the day ended with the market as a
whole down about 5 percent—with airline and hotel stocks pounded most—
and trading volume on the New York
Stock Exchange hitting a record high.
Major stock price indexes, which sagged
further in subsequent days and weeks,
were weighed down by investors' more
pessimistic evaluation of the near-term
economic outlook and by sizable downward revisions to analysts' earnings
projections for the rest of 2001. By the
third week of the month, broad stock
price indexes had fallen a total of
12 percent from their levels on September 10.
In late September, stock prices staged
a comeback that lasted through the
fourth quarter, as incoming information
suggested that the economy had proven
remarkably resilient and economic prospects were improving. On the perception that the worst for the technology
sector would soon pass, share prices of
firms in technology industries jumped
sharply, lifting the Nasdaq more than
35 percent from its September nadir. On
balance, last year's gyrations in stock
prices left the Wilshire 5000 down about



10 percent, while the Nasdaq fell 20 percent. The widespread decline in equity
prices through the first three quarters of
2001 is estimated to have wiped out
nearly $3!/2 trillion in household wealth,
translating into 8V4 percent of total
household net worth. Of this total, however, about $1V4 trillion was restored by
the stock market rally in the fourth quarter. Moreover, the level of household net
worth at the end of last year was still
almost 50 percent higher than it was at
the end of 1995, when stepped-up productivity gains had begun to induce
investors to boost significantly their
expectations of long-term earnings
growth. In January and early February
of 2002, investors reacted to generally
disappointing news about expected earnings, especially in the telecommunications sector, and to concerns about corporate accounting practices by erasing
some of the fourth-quarter gain in equity
prices. Despite this decline, the priceearnings ratio for the S&P 500 index
(calculated using operating earnings
expected over the next year) remained
close to its level at the beginning of
2001. The relatively elevated ratio
reflected lower market interest rates as
well as investor anticipation of a return
to robust earnings growth.
Debt and Depository Intermediation
The growth of the debt of nonfederal
sectors was strong over the first half of
the year, as the decline in longer-term
interest rates during the final months of
2000 prompted some opportunistic tapping of bond markets by businesses and
helped keep the expansion of household
credit brisk. However, the combination
of a stepdown in the growth of consumer durables purchases, a further drop
in capital expenditures, and a substantial
inventory liquidation over the second
half of the year resulted in a signifi-

Economic and Financial Developments in 2001 and Early 2002
cantly slower pace of private borrowing.
On balance, growth of nonfederal debt
retreated about 1 percentage point in
2001, to IVi percent. Federal debt continued to contract early last year; it then
turned up as the budget fell into a deficit
reflecting the implementation of the tax
cut, the effect of the weaker economy
on tax receipts, and emergency spending
in the wake of the terrorist attacks. As
a result, the federal government paid
down only 11A percent of its debt, on
net, over 2001, compared with 63A percent in the previous year. With nominal
GDP decelerating sharply, the ratio of
nonfinancial debt to GDP moved up
notably in 2001, more than reversing its
decrease in the previous year.
The economic slowdown and the
decline in market interest rates last year
left a noticeable imprint on the composition of financial flows, with borrowing
by businesses and households migrating
toward longer-term bond and mortgage
markets. As a consequence, credit at
depository institutions expanded sluggishly over the year. Growth of loans at
commercial banks dropped off sharply,
from 12 percent in 2000 to 2VA percent in 2001. The slowdown in total
bank credit—after adjustments for
mark-to-market accounting rules—was
less severe, because banks acquired
securities, largely mortgage-backed
securities, at a brisk pace throughout the
year. A healthy banking sector served as
an important safety valve for several
weeks after September 11, as businesses
tapped backup lines of credit to overcome problems associated with the
repayment of maturing commercial
paper and issuance of new paper. Moreover, with payment flows temporarily
interrupted by the terrorist attacks, a
substantial volume of overdrafts was
created, causing a spike in the "other"
loan category that includes loans to
depository institutions. By the end of



33

October, however, the disruptions to
business financing patterns and payment
systems that bloated bank balance sheets
had largely dissipated, and loans contracted sharply.
Commercial banks reported a marked
deterioration in loan performance last
year. Delinquency and charge-off rates
on C&I loans trended up appreciably,
although they remained well below rates
recorded during the 1990-91 recession.
Delinquency rates on credit card
accounts increased for the second year
in a row, reaching 5 percent for the first
time since early 1992. Banks responded
to the deteriorating business and household balance sheets by tightening credit
standards and terms for both types of
loan, according to the Federal Reserve's
Senior Loan Officer Opinion Survey on
Bank Lending Practices. Banks indicated that they had tightened business
lending policies in response to greater
uncertainty about the economic outlook
and their reduced tolerance for risk.
Similarly, the net fractions of banks
reporting that they had tightened standards for both credit card and other consumer loans rose markedly over the first
half of last year. As household financial
conditions continued to slip, the net proportion of banks that tightened standards on consumer loans remained at an
elevated level in the second half of the
year.
In response to rising levels of delinquent and charged-off loans, commercial banks significantly boosted the rate
of provisioning for loan losses last year,
which, along with reduced income from
capital market activities, cut into the
banking sector's profits. Nonetheless,
through the third quarter of 2001—
the latest period for which Call Report
data are available—measures of industry profitability remained near the
elevated range recorded for the past several years, and banks continued to hold

34

88th Annual Report, 2001

substantial capital to absorb losses.
Indeed, virtually all assets were at wellcapitalized banks at the end of the third
quarter, and the substitution of securities
for loans on banks' balance sheets also
helped edge up risk-based capital ratios.
In the fourth quarter, a number of large
banks saw their profits decline further
because of their exposure to Enron and,
to a lesser extent, Argentina. On the
positive side, wider net interest margins
helped support profits throughout 2001.
The Monetary Aggregates
The broad monetary aggregates grew
very rapidly in 2001. Over the four quarters of the year, M2 increased 1014 percent, a rate significantly above the pace
of the past several years. Because the
rates of return provided by many components of M2 move sluggishly, the
swift decline in short-term market interest rates last year significantly lowered
the opportunity cost of holding M2
M2 Growth Rate
Percent

8
—

1991

1993

1995

1997

1999

6

2001

NOTE. M2 consists of currency, travelers checks,
demand deposits, other checkable deposits, savings
deposits (including money market deposit accounts),
small-denomination time deposits, and balances in
retail money market funds. Annual growth rates are
computed from fourth-quarter averages.




assets, especially for its liquid deposits
(the sum of checking and savings
accounts) and retail money funds components. Moreover, negative returns and
elevated volatility in equity markets
likely raised household demand for M2
assets through the fall. An unprecedented level of mortgage refinancing
activity (which results in prepayments
that temporarily accumulate in deposit
accounts before being distributed to
investors in mortgage-backed securities), as well as increased foreign
demand for U.S. currency, also bolstered
the growth of M2 over the course of the
year.
Involuntary accumulation of liquid
deposits resulting from payment system
disruptions after the terrorist attacks,
combined with elevated safe-haven
demands, caused M2 to surge temporarily in the weeks following September 11. At the same time, plunging
equity prices led to a sharp step-up
in the growth of retail money market mutual funds. After a substantial
unwinding of distortions to money flows
in October, M2 growth over the balance
of the year was spurred by further
declines in its opportunity cost resulting
from additional monetary policy easings
and by heightened volatility in equity
markets. The hefty advance in M2 last
year outpaced the anemic expansion of
nominal income, and M2 velocity—the
ratio of nominal GDP to M2—posted a
record decline.
M3—the
broadest
monetary
aggregate—grew 13 percent over 2001.
In addition to the surge in its M2 component, huge inflows into institutional
money funds boosted M3 growth. Investors' appetite for these instruments was
enormous last year because their returns
were unusually attractive as they lagged
the steep decline in market interest rates.
The slow-down in the growth of bank
credit over the summer, which resulted

Economic and Financial Developments in 2001 and Early 2002
in a contraction in managed liabilities,
damped the rise in M3 somewhat. The
velocity of M3 dropped for the seventh
year in the row, to a record low.

International Developments
Economic activity in foreign economies
weakened substantially in 2001. Early in
the year, activity abroad was depressed
by high oil prices, the global slump in
the high-tech sector, and spillover from
the U.S. economic slowdown. The September terrorist attacks further heightened economic uncertainty. On average,
foreign economic activity was about flat
over the year. The weakest performer
among industrial economies was Japan,
where output declined. The euro area
eked out a slight increase in its real
GDP. Activity in most emerging market
economies in both Asia and Latin
America declined. Asian developing
economies were particularly hard hit by
the falloff in demand for their high-tech
exports. In Latin America, the output
decline in Mexico largely reflected
sharply reduced export demand from the
United States; Argentina's financial
crisis precipitated a further sharp drop
in output in that country. An easing of
average foreign inflation reflected the
weakness of activity as well as a net
decline in global oil prices over the
course of the year.
In response to the pronounced weakness in economic activity, monetary
authorities in the major industrial countries eased policy throughout the year.
Nevertheless, interest rates on long-term
government securities showed little net
change from the beginning to the end of
the year in most major industrial countries. Weak economic conditions tended
to put downward pressure on long-term
rates, but moves toward more stimulative macroeconomic policies appeared
to encourage market participants to



35

expect economic recovery, thereby supporting long-term interest rates. Following the terrorist attacks in September,
interest rates declined around the globe
as expected economic activity weakened and demand shifted away from
equities and toward the relative safety of
bonds. However, toward year-end, as the
period of crisis passed, long-term interest rates rebounded strongly.
Overall stock indexes in foreign
industrial economies declined for the
second consecutive year as activity faltered and actual and projected corporate
earnings fell sharply. Technologyoriented stock indexes again fell more
than the overall indexes. Among emerging market economies, the performance
of stocks was mixed; stock indexes in
several Asian emerging market economies rebounded strongly late in the year,
a move possibly reflecting market participants' hopes for a revival in global
demand for the high technology products that feature prominently in these
countries' exports. Argentine financial
markets came under increasing pressure
Foreign Equity Indexes
January 1999 = 100

A Latin America

—
/

1

200

A

— 1
hxJ

175
150

in

—

Developing Asia

i

I

1999

i

1

i

i

2000

f

!

i

v""^
V—
Japan
i

2001

4^_
_

125
100
75

i

2002

NOTE. The data are monthly. The last observations
are the average of trading days through February 21,
2002.

36

88th Annual Report, 2001

throughout the year because of growing
fears of a debt default and the end of the
peso's peg to the dollar. Near year-end,
Argentine authorities in fact suspended
debt payments to the private sector and,
early in 2002, ended the one-to-one peg
to the dollar. There was limited negative
spillover to other emerging financial
markets from the sharp deterioration in
Argentina's economic and financial condition, in contrast to the situation that
prevailed during other emerging market
financial crises of recent years.
The dollar's average foreign exchange value remained strong through
most of 2001. The dollar continued to
rise despite mounting evidence of weakening U.S. economic activity and the
significant easing of monetary policy
by the FOMC. Market participants may
have felt that the falloff in economic
growth in foreign economies and expectations that the United States offered
stronger prospects for economic growth
in the future outweighed disappointNominal U.S. Dollar Exchange Rate Indexes
January 1999= 100

Major currencies
—

—

1999

2000

110

—

Broad

115

105

-— 100

2001

2002

NOTE. The data are monthly. Indexes are tradeweighted averages of the exchange value of the dollar
against major currencies and against the currencies of
a broader group of important U.S. trading partners.
Last observations are the average of trading days
through February 21, 2002.




ing U.S. economic performance in the
near term. The dollar's average foreign
exchange value against the currencies of
other major industrial countries recorded
a net increase of 8 percent over 2001 as
a whole. The dollar also strengthened,
but by a lesser amount, against the currencies of our most important developing country trading partners. So far this
year, the dollar's average value has risen
further on balance.
Industrial Economies
The dollar showed particular strength
against the Japanese yen last year,
appreciating nearly 15 percent. The
weakness of the yen reflected serious
ongoing structural problems and the
relapse of the Japanese economy back
into recession. Early in the year, in
response to signs of renewed weakening
of the economy, the Bank of Japan
announced that it was easing policy by
shifting its operating target from the
overnight rate—already not far above
zero—to balances held by financial
institutions at the Bank of Japan. Policy
was eased further and more liquidity
was injected into the banking system
when the balances target was raised
three times later in the year. The yen
received a temporary boost when
Junichiro Koizumi, widely seen as more
likely to introduce economic reforms,
became prime minister in April. The yen
again strengthened in the immediate
wake of the September terrorist attacks,
prompting the Bank of Japan to make
substantial intervention sales of yen.
However, later in the year, amid signs of
a renewed deterioration of economic
conditions, the yen again started to
weaken significantly.
For the year as a whole, Japanese real
GDP is estimated to have declined more
than 1 percent, a reversal of the rebound
recorded the previous year. Private

Economic and Financial Developments in 2001 and Early 2002
investment declined and private consumption moved lower, as households
curtailed spending in the face of rising
unemployment and falling real income.
The winding-down of the large-scale
public works programs of recent years
more than offset the effect on growth
from the additional spending contained
in several supplemental budgets. Last
year marked the third consecutive year
of deflation, with the prices of both consumer goods and real estate continuing
to move lower.
The dollar's movements against the
euro in 2001 appear to have been mainly
influenced by market perceptions of the
strength of economic activity in the
United States relative to that in the euro
area. In the early part of the year, the
euro weakened as evidence mounted
that the economic slowdown that was
already apparent in the United States as
the year began was also taking hold in
Europe. During the summer, the euro
rose against the dollar as market partici-

U.S. Dollar Exchange Rate against the Euro
and the Japanese Yen
January 1999= 100

—

110

—

100

—

90

Japanese yen

i

1999

i

i

1

2000

2001

2002

NOTE. The data are monthly. Exchange rates are in
foreign currency units per dollar. Last observations
are the average of trading days through February 21,
2002.




37

pants appeared to revise downward their
expectation of an early U.S. recovery.
Then, later in the year, with more signs
of a further weakening of activity in
Europe, the euro again declined. On balance, the dollar appreciated more than
5 percent relative to the euro over the
course of the year. Real GDP in the euro
area is estimated to have increased at
less than a 1 percent rate in 2001, a
sharp slowing from the nearly 3 percent
growth rate of the previous year. Fixed
investment and inventory investment
both are estimated to have made negative contributions to the growth of real
GDP, whereas consumption growth
remained near the rate of the previous
year. The slowing of growth in the euro
area was not uniform across countries,
with weakness being more pronounced
in Germany and less so in France.
The European Central Bank (ECB)
held off easing monetary policy in the
early months of the year, restrained by
the euro's weakness, growth of M3 that
remained in excess of the ECB's reference value, and a euro-area inflation rate
above its 2 percent target ceiling. In
May, evidence of slowing activity
prompted the ECB to reduce its key
policy rate 25 basis points. Three additional reductions followed later in the
year, as activity weakened further and
the inflation rate receded toward its target ceiling. The total reduction in the
ECB's key policy rate over the course of
the year was 150 basis points. The
beginning of 2002 saw the introduction
of euro notes and coins, a process that
proceeded smoothly.
The dollar appreciated 6 percent
against the Canadian dollar in 2001 as
the Canadian economy slowed abruptly.
Real GDP in Canada is estimated to
have been about flat last year after
growing more than 3 percent in 2000. A
key factor in this slowing was the sharp
drop-off in Canadian exports to the

38

88th Annual Report, 2001

United States. An inventory correction
also depressed output. Earlier in the
year, consumption was buoyed by continued employment growth, tax cuts, and
a housing boom. However, later in the
year, growth of consumption faltered as
employment prospects worsened and
asset prices weakened. The Bank of
Canada has moved aggressively to
counter the slowing of economic activity by lowering its key policy interest
rate nine times in 2001 and once in
January 2002 for a cumulative total of
375 basis points.3 When the Bank of
Canada initiated easing moves early in
2001, inflation was slightly above the
Bank's target range of 1 percent to
3 percent; but by the end of the year,
slack activity and falling energy prices
had pushed the inflation rate down to
near the bottom of the range.

Emerging Market Economies
Argentina was a main focus of attention
among emerging market economies in
2001. In the first part of the year,
worse-than-expected data on the fiscal
situation and concerns that the government would be unable to implement
announced fiscal measures heightened
doubts about whether Argentina would
be able to avoid a default on its debt.
Argentine financial markets received
only temporary support from a largescale debt exchange completed in June
and an enhancement of IMF support
approved in September. With financial
market confidence eroding, conditions
took a dramatic turn for the worse late

3. Among these reductions was one on September 17, when the Bank of Canada (along with the
ECB) announced a reduction of its policy rate by
50 basis points, following the 50 basis point reduction in the federal funds rate announced by the
FOMC earlier in the day.



in the year; financial asset prices fell
sharply, and funds moved out of the
banking system as the government
moved to restructure its debt and the
one-to-one peg to the dollar looked
increasingly precarious. In early December, the government imposed capital
controls, including limits on bank
account withdrawals. These restrictions
led to widespread protests, which triggered the resignation of President de la
Rua and an interval of political turmoil.
After the resignation of President de la
Rua, the government announced it
would suspend debt payments to the private sector. The government of the new
president, Eduardo Duhalde, suspended
Argentina's currency board arrangement
and established a temporary dual
exchange rate system. In early February,
the dual exchange rate system was abandoned, and the peso's floating rate
moved to about 2 pesos per dollar amid
continuing economic uncertainty. For
2001 as a whole, Argentine real GDP is
estimated to have fallen at well over a
5 percent rate, and prices declined
further.
To date, the negative spillover from
events in Argentina to other emerging
financial markets has been limited, possibly because market participants had
been well aware of Argentina's problems for some time and viewed them as
largely confined to that country. Brazil
was probably most heavily affected by
events in Argentina, and the bond spread
on Brazilian debt showed a net increase
of about 110 basis points over the course
of last year while the spread on Argentina debt exploded upward. Other
important factors weighing on Brazilian
economic activity last year likely were
weak growth in the United States—
Brazil's most important export market—
and the emergence of an energy shortage as drought limited hydroelectric
output. For the year as a whole, Brazil-

Economic and Financial Developments in 2001 and Early 2002
ian real GDP is estimated to have risen
at less than a 1 percent rate after growing at a 4 percent rate the previous two
years. The Brazilian currency registered
a net depreciation against the dollar of
about 16 percent over the course of last
year, while stock prices declined more
than 10 percent. The Brazilian central
bank tightened policy last year in an
effort to hold down the inflationary
impact of currency depreciation.
Real GDP in Mexico declined about
1 percent in 2001, a sharp reversal from
the 5 percent growth rates recorded in
the previous two years. The falloff in
activity was mainly a reflection of the
negative effects on direct trade and confidence in Mexico arising from the slowdown of the U.S. economy. In light of
the marked weakening of activity,
declining inflation, and a strong peso,
the Bank of Mexico started to loosen the
stance of monetary policy in May, and
short-term interest rates continued to
decline over the rest of the year. In
February 2002, the Bank of Mexico
moved to tighten monetary conditions,
citing concerns that an increase in
administered prices would raise inflation. Mexican financial markets fared
quite well last year, with the peso appreciating 5 percent against the dollar and
stock prices rising nearly 15 percent.
The effect on Mexican financial markets
from Argentina's difficulties appeared
to have been quite limited, as indicated
by the net decline of the Mexican debt
spread by 80 basis points over the
course of the year.
Economic growth in the Asian emerging market economies turned negative
last year. On average, real GDP in
developing Asia is estimated to have
declined about 1 percent in 2001, compared with average growth of 6 percent
in the previous year. A key factor in this
slowing was the sharp falloff in global
demand for the high-tech products that



39

had fueled rapid export growth in the
region in recent years.
The economies of Taiwan, Singapore,
and Malaysia are highly dependent on
exports of semiconductors and other
high-tech products, and as global
demand for these goods was cut back
sharply, real GDP in these countries
declined by an estimated 5 percent on
average last year. Indonesia and Thailand, both relatively less dependent on
high-tech exports and experiencing
some reduction in political tension over
the course of the year, managed to
record small positive real GDP growth
rates last year, albeit well below rates of
the previous year.
Korean real GDP is estimated to have
increased about 2 percent in 2001.
While in an absolute sense Korea is an
important exporter of high-tech products such as semiconductors, it has a
relatively more diversified economy
than most of its Asian neighbors, and
thus the magnitude of its slowdown last
year was somewhat muted. Government
moves toward monetary and fiscal policy stimulus over the course of the year
helped support domestic demand in
Korea.
In China, recorded growth of real
GDP remained robust last year. China's
lesser dependency on exports in general,
and high-tech exports in particular,
cushioned it from last year's global
slowdown, and the government stepped
up the pace of fiscal stimulus to offset
weakening private demand. Hong Kong,
with exports not heavily concentrated
in high-tech goods and an economy
closely integrated with a rapidly growing Chinese economy, is nevertheless
estimated to have experienced a decline
in real GDP last year. The peg of Hong
Kong's currency to a strengthening U.S.
dollar put pressure on its competitive
position, and domestic price deflation
continued.

40

88th Annual Report, 2001

Conditions in financial markets in
emerging Asia were, for the most part,
not particularly volatile last year. Debt
spreads were little changed on average




for the region as a whole, exchange rates
against the dollar generally moved
lower, and stock indexes declined somewhat on average.

41

Monetary Policy Reports to the Congress
Report submitted to the Congress on
February 13, 2001, pursuant to section 2B of the Federal Reserve Act

Report of February 13, 2001
Monetary Policy and the
Economic Outlook
When the Federal Reserve submitted its
previous Monetary Policy Report to the
Congress, in July of 2000, tentative
signs of a moderation in the growth
of economic activity were emerging
following several quarters of extraordinarily rapid expansion. After having
increased the interest rate on federal
funds through the spring to bring the
growth of aggregate demand and potential supply into better alignment and
thus contain inflationary pressures, the
Federal Reserve had stopped tightening
as evidence of an easing of economic
growth began to appear.
Indications that the expansion had
moderated from its earlier rapid pace
gradually accumulated during the summer and into the autumn. For a time, this
downshifting of growth seemed likely to
leave the economy expanding at a pace
roughly in line with that of its potential.
Over the last few months of the year,
however, elements of economic restraint
emerged from several directions to slow
growth even more. Energy prices, rather
than turning down as had been anticipated, kept climbing, raising costs
throughout the economy, squeezing
business profits, and eroding the income
available for discretionary expenditures. Equity prices, after coming off



their highs earlier in the year, slumped
sharply starting in September, slicing
away a portion of household net worth
and discouraging the initial offering
of new shares by firms. Many businesses encountered tightening credit
conditions, including a widening of risk
spreads on corporate debt issuance and
bank loans. Foreign economic activity
decelerated noticeably in the latter part
of the year, contributing to a weakening
of the demand for U.S. exports, which
also was being restrained by an earlier
appreciation in the exchange value of
the U.S. dollar.
The dimensions of the economic
slowdown were obscured for a time by
the usual lags in the receipt of economic
data, but the situation began to come
into sharper focus late in the year as
the deceleration steepened. Spending on
business capital, which had been rising rapidly for several years, elevating
stocks of these assets, flattened abruptly
in the fourth quarter. Consumers
clamped down on their outlays for motor
vehicles and other durables, the stocks
of which also had climbed to high
levels. As the demand for goods softened, manufacturers adjusted production quickly to counter a buildup
in inventories. Rising concern about
slower growth and worker layoffs contributed to a sharp deterioration of consumer confidence. In response to the
accumulating weakness, the Federal
Open Market Committee (FOMC) lowered the intended interest rate on federal
funds Vi percentage point on January 3
of this year. Another rate reduction of
that same size was implemented at the
close of the most recent meeting of the
FOMC at the end of last month.

42

88th Annual Report, 2001

As weak economic data induced
investors to revise down their expectations of future short-term interest rates
in recent months and as the Federal
Reserve eased policy, financial market
conditions became more accommodative. Since the November FOMC meeting, yields on many long-term corporate
bonds have dropped on the order of a
full percentage point, with the largest
declines taking place on riskier bonds as
the yield spreads on those securities narrowed considerably from their elevated
levels. In response, borrowing in longterm credit markets has strengthened
appreciably so far in 2001. The less
restrictive conditions in financial markets should help lay the groundwork for
a rebound in economic growth.
That rebound should also be encouraged by underlying strengths of the
economy that still appear to be present
despite the sluggishness encountered of
late. The most notable of these strengths
is the remarkable step-up in structural
productivity growth since the mid1990s, which seems to be closely related
to the spread of new technologies. Even
as the economy slowed in 2000, evidence of ongoing efficiency gains were
apparent in the form of another year of
rapid advance in output per worker hour
in the nonfarm business sector. With
households and businesses still in the
process of putting recent innovations
in place and with technological breakthroughs still occurring, an end to profitable investment opportunities in the
technology area does not yet seem to
be in sight. Should investors continue
to seek out emerging opportunities, the
ongoing transformation and expansion
of the capital stock will be maintained,
thereby laying the groundwork for further gains in productivity and ongoing
advances in real income and spending.
The impressive performance of productivity and the accompanying environ


ment of low and stable underlying inflation suggest that the longer-run outlook
for the economy is still quite favorable,
even though downside risks may remain
prominent in the period immediately
ahead.

Monetary Policy, Financial
Markets, and the Economy
over the Second Half of 2000
and Early 2001
As described in the preceding Monetary
Policy Report to the Congress, the very
rapid pace of economic growth over
the first half of 2000 was threatening
to place additional strains on the economy's resources, which already appeared
to be stretched thin. Private long-term
interest rates had risen considerably in
response to the strong economy, and, in
an effort to slow the growth of aggregate
demand and thereby prevent a buildup
of inflationary pressures, the Federal
Reserve had tightened its policy settings
substantially through its meeting in
May 2000. Over subsequent weeks, preliminary signs began to emerge suggesting that growth in aggregate demand
might be slowing, and at its June meeting the FOMC left the federal funds rate
unchanged.
Further evidence accumulated over
the summer to indicate that demand
growth was moderating. The rise in
mortgage interest rates over the previous year seemed to be damping activity in the housing sector. Moreover,
the growth of consumer spending had
slowed from the exceptional pace of earlier in the year; the impetus to spending
from outsized equity price gains in 1999
and early 2000 appeared to be partly
wearing off, and rising energy prices
were continuing to erode the purchasing
power of households. By contrast, business fixed investment still was increas-

42

88th Annual Report, 2001

As weak economic data induced
investors to revise down their expectations of future short-term interest rates
in recent months and as the Federal
Reserve eased policy, financial market
conditions became more accommodative. Since the November FOMC meeting, yields on many long-term corporate
bonds have dropped on the order of a
full percentage point, with the largest
declines taking place on riskier bonds as
the yield spreads on those securities narrowed considerably from their elevated
levels. In response, borrowing in longterm credit markets has strengthened
appreciably so far in 2001. The less
restrictive conditions in financial markets should help lay the groundwork for
a rebound in economic growth.
That rebound should also be encouraged by underlying strengths of the
economy that still appear to be present
despite the sluggishness encountered of
late. The most notable of these strengths
is the remarkable step-up in structural
productivity growth since the mid1990s, which seems to be closely related
to the spread of new technologies. Even
as the economy slowed in 2000, evidence of ongoing efficiency gains were
apparent in the form of another year of
rapid advance in output per worker hour
in the nonfarm business sector. With
households and businesses still in the
process of putting recent innovations
in place and with technological breakthroughs still occurring, an end to profitable investment opportunities in the
technology area does not yet seem to
be in sight. Should investors continue
to seek out emerging opportunities, the
ongoing transformation and expansion
of the capital stock will be maintained,
thereby laying the groundwork for further gains in productivity and ongoing
advances in real income and spending.
The impressive performance of productivity and the accompanying environ


ment of low and stable underlying inflation suggest that the longer-run outlook
for the economy is still quite favorable,
even though downside risks may remain
prominent in the period immediately
ahead.

Monetary Policy, Financial
Markets, and the Economy
over the Second Half of 2000
and Early 2001
As described in the preceding Monetary
Policy Report to the Congress, the very
rapid pace of economic growth over
the first half of 2000 was threatening
to place additional strains on the economy's resources, which already appeared
to be stretched thin. Private long-term
interest rates had risen considerably in
response to the strong economy, and, in
an effort to slow the growth of aggregate
demand and thereby prevent a buildup
of inflationary pressures, the Federal
Reserve had tightened its policy settings
substantially through its meeting in
May 2000. Over subsequent weeks, preliminary signs began to emerge suggesting that growth in aggregate demand
might be slowing, and at its June meeting the FOMC left the federal funds rate
unchanged.
Further evidence accumulated over
the summer to indicate that demand
growth was moderating. The rise in
mortgage interest rates over the previous year seemed to be damping activity in the housing sector. Moreover,
the growth of consumer spending had
slowed from the exceptional pace of earlier in the year; the impetus to spending
from outsized equity price gains in 1999
and early 2000 appeared to be partly
wearing off, and rising energy prices
were continuing to erode the purchasing
power of households. By contrast, business fixed investment still was increas-

Monetary Policy Reports, February
ing very rapidly, and strong growth of
foreign economies was fostering greater
demand for U.S. exports. Weighing this
evidence and recognizing that the effects
of previous tightenings had not yet been
fully felt, the FOMC decided at its
meeting in August to hold the federal
funds rate unchanged. The Committee
remained concerned that demand could
continue to grow faster than potential
supply at a time when the labor market
was already taut, and it saw the balance
of risks still tilted toward heightened
inflation pressures.
The FOMC faced fairly similar circumstances at its October meeting. By
then, it had become more apparent
that the growth in demand had fallen
to a pace around that of potential supply. Although consumer spending had
picked up again for a time, it did not
regain the vigor it had displayed earlier
in the year, and capital spending, while
still growing briskly, had decelerated
from its first-half pace. With increases
in demand moderating, private employment gains slowed from the rates seen
earlier in the year. However, labor markets remained exceptionally tight, and
the hourly compensation of workers had
accelerated to a point at which unit labor
costs were edging up despite strong
gains in productivity. In addition, sizable increases in energy prices were
pushing broad inflation measures above
the levels of recent years. Although core
inflation measures were at most only
creeping up, the Committee felt that
there was some risk that the increase in
energy prices, which was lasting longer
than had seemed likely earlier in the
year, would start to leave an imprint on
business costs and longer-run inflation
expectations, posing the risk that core
inflation rates could rise more substantially. Weighing these considerations,
the FOMC decided to hold the federal
funds rate unchanged at its October



43

meeting. While recognizing that the
risks in the outlook were shifting, the
FOMC believed that the tautness of
labor markets and the rise in energy
prices meant that the balance of those
risks still was weighted toward heightened inflation pressures, and this assessment was noted in the balance-of-risks
statement.
By the time of the November FOMC
meeting, conditions in the financial markets were becoming less accommodative in some ways, even as the Federal
Reserve held the federal funds rate
steady. Equity prices had declined
considerably over the previous several
months, resulting in an erosion of
household wealth that seemed likely to
restrain consumer spending going forward. Those price declines, along with
the elevated volatility of equity prices,
also hampered the ability of firms to
raise funds in equity markets and were
likely discouraging business investment.
Some firms faced more restrictive conditions in credit markets as well, as risk
spreads in the corporate bond market
widened significantly for firms with
lower credit ratings and as banks tightened the standards and terms on their
business loans. Meanwhile, incoming
data indicated that the pace of economic
activity had softened a bit further. Still,
the growth of aggregate demand apparently had moved only modestly below
that of potential supply. Moreover, while
crude oil prices appeared to be topping
out, additional inflationary pressures
were arising in the energy sector in the
form of surging prices for natural gas,
and there had been no easing of the
tightness in the labor market. In assessing the evidence, the members of the
Committee felt that the risks to the outlook were coming into closer balance
but had not yet shifted decisively. At the
close of the meeting, the FOMC left the
funds rate unchanged once again, and it

44

88th Annual Report, 2001

stated that the balance of risks continued
to point toward increased inflation.
However, in the statement released after
the meeting, the FOMC noted the possibility of subpar growth in the economy
in the period ahead.
Toward the end of the year, the moderation of economic growth gave way,
fairly abruptly, to more sluggish conditions. By the time of the December
FOMC meeting, manufacturing activity
had softened considerably, especially in
motor vehicles and related industries,
and a number of industries had accumulated excessive stocks of inventories.
Across a broader set of firms, forecasts
for corporate sales and profits in the
fourth quarter and in 2001 were being
slashed, contributing to a continued
decline in equity prices and a further
widening of risk spreads on lower-rated
corporate bonds. In this environment,
growth in business fixed investment
appeared to be slowing appreciably.
Consumer spending showed signs of
decelerating further, as falling stock
prices eroded household wealth and consumer confidence weakened. Moreover,
growth in foreign economies seemed to
be slowing, on balance, and U.S. export
performance began to deteriorate. Market interest rates had declined sharply in
response to these developments. Against
this backdrop, the FOMC at its December meeting decided that the risks to the
outlook had swung considerably and
now were weighted toward economic
weakness, although it decided to wait
for additional evidence on the extent
and persistence of the slowdown before
moving to an easier policy stance. Recognizing that the current position of
the economy was difficult to discern
because of lags in the data and that
prospects for the near term were particularly uncertain, the Committee agreed at
the meeting that it would be especially
attentive over coming weeks to signs



that an intermeeting policy action was
called for.
Additional evidence that economic
activity was slowing significantly
emerged not long after the December
meeting. New data indicated a marked
weakening in business investment, and
retail sales over the holiday season
were appreciably lower than businesses
had expected. To contain the resulting
buildup in inventories, activity in the
manufacturing sector continued to drop.
In addition, forecasts of near-term corporate profits were being marked down
further, resulting in additional declines
in equity prices and in business confidence. Market interest rates continued to
fall, as investors became more pessimistic about the economic outlook. Based
on these developments, the Committee
held a telephone conference call on
January 3, 2001, and decided to cut
the intended federal funds rate Vi percentage point. Equity prices surged on
the announcement, and the Treasury
yield curve steepened considerably,
apparently because market participants
became more confident that a prolonged
downturn in economic growth would
likely be forestalled. Following the policy easing, the Board of Governors
approved a decrease in the discount rate
of a total of Vi percentage point.
The Committee's action improved
financial conditions to a degree. Over
the next few weeks, equity prices rose,
on net. Investors seemed to become less
wary of credit risk, and yield spreads
narrowed across most corporate bonds
even as the issuance of these securities
picked up sharply. But in some other
respects, investors remained cautious, as
evidenced by widening spreads in commercial paper markets. Incoming data
pointed to further weakness in the manufacturing sector and a sharp decline in
consumer confidence. Moreover, slower
U.S. growth appeared to be spilling over

Monetary Policy Reports, February

ployment rate in the fourth quarter of
this year will be about 4!/2 percent, still
quite low by historical standards.
The rate of economic expansion over
the near term will depend importantly
on the speed at which inventory overhangs that developed over the latter
part of 2000 are worked off. Gains in
information technology have no doubt
enabled businesses to respond more
quickly to a softening of sales, which
has steepened the recent production cuts
but should also damp the buildup in
inventories and facilitate a turnaround.
The motor vehicle industry made some
progress toward reducing excess stocks
in January owing to a combination of
stronger sales and a further sharp cutback in assemblies. In other parts of
manufacturing, the sizable reductions
in production late last year suggest that
producers in general were moving
quickly to get output into better alignment with sales. Nevertheless, stocks at
year-end were above desired levels in a
number of industries.
Once inventory imbalances are
worked off, production should become
more closely linked to the prospects for
sales. Household and business expenditures have decelerated markedly in
recent months, and uncertainties about

to several important trading partners. In
late January, the FOMC cut the intended
federal funds rate V2 percentage point
while the Board of Governors approved
a decrease in the discount rate of an
equal amount. Because of the significant
erosion of consumer and business confidence and the need for additional
adjustments to production to work off
elevated inventory levels, the FOMC
indicated that the risks to the outlook
continued to be weighted toward economic weakness.
Economic Projections for 2001
Although the economy appears likely to
be sluggish over the near term, the members of the Board of Governors and the
Reserve Bank presidents expect stronger
conditions to emerge as the year
progresses. For 2001 overall, the central
tendency of their forecasts of real GDP
growth is 2 percent to IVi percent, measured as the change from the fourth
quarter of 2000 to the fourth quarter of
2001. With growth falling short of its
potential rate, especially in the first half
of this year, unemployment is expected
to move up a little further. Most of the
governors and Reserve Bank presidents
are forecasting that the average unemEconomic Projections for 2001
Percent

Indicator

Memo:
2000 actual

Federal Reserve governors
and Reserve Bank presidents
Range

Central
tendency

4-5
2-2'/2
VA-2V4

Change, fourth quarter to fourth quarter1
Nominal GDP
Real GDP 2
PCE chain-type price index

5.9
3.5
2.4

3-y4-5'/4
2-2-Y4
PA-2V2

Average level, fourth quarter
Civilian unemployment rate

4.0

4'/ 2 -5

1. Change from average for fourth quarter of 2000 to
average for fourth quarter of 2001.




45

2. Chain-weighted.

About 4Vi

46

88th Annual Report, 2001

how events might unfold are considerable. But, responding in part to the easing of monetary policy, financial markets are shifting away from restraint,
and this shift should create a more
favorable underpinning to the expected
pickup in the economy as the year
progresses. The sharp drop in mortgage
interest rates since May of last year
appears to have stemmed the decline
in housing activity; it also has enabled
many households to refinance existing
mortgages at lower rates, an action that
should free up cash for added spending.
Conditions of business finance also have
eased to some degree. Interest rates on
investment-grade corporate bonds have
recently fallen to their lowest levels in
about IV2 years. Moreover, the premiums required of bond issuers that are
perceived to be at greater risk have
dropped back in recent weeks from the
elevated levels of late 2000. As credit
conditions have eased, firms have issued
large amounts of corporate bonds so far
in 2001. However, considerable caution
is evident in the commercial paper market and among banks, whose loan officers have reported a further tightening
of lending conditions since last fall. In
equity markets, prices have recently
dropped in response to negative reports
on corporate earnings, reversing the
gains that took place in January.
The restraint on domestic demand
from high energy prices is expected to
ease in coming quarters. Natural gas
prices have dropped back somewhat in
recent weeks as the weather has turned
milder, and crude oil prices also are
down from their peaks. Although these
prices could run up again in conjunction
with either a renewed surge in demand
or disruptions in supply, participants in
futures markets are anticipating that
prices will be trending gradually lower
over time. A fall in energy prices would
relieve cost pressures on businesses to



some degree and would leave more
discretionary income in the hands of
households.
How quickly investment spending
starts to pick up again will depend not
only on the cost of finance but also on
the prospective rates of return to capital.
This past year, expectations regarding
the prospects of some high-tech companies clearly declined, and capital spending seems unlikely to soon regain the
exceptional strength that was evident
in the latter part of the 1990s and for
a portion of last year. From all indications, however, technological advance
still is going forward at a rapid pace,
and investment will likely pick up again
if, as expected, the expansion of the
economy gets back on more solid footing. Private analysts are still anticipating
high rates of growth in corporate earnings over the long-run, suggesting that
the current sluggishness of the economy
has not undermined perceptions of
favorable long-run fundamentals.
The degree to which increases in
exports might help to support Ithe U.S.
economy through a stretch of sluggishness has become subject to greater
uncertainty recently because foreign
economies also seem to have decelerated toward the end of last year. However, the expansion of imports has
slowed sharply, responding in part to the
softening of domestic demand growth.
In effect, some of the slowdown in
demand in this country is being shifted
to foreign suppliers, implying that the
adjustments required of domestic producers are not as great as they otherwise
would have been.
In adjusting labor input to the slowing
of the economy, businesses are facing
conflicting pressures. Speedy adjustment of production and ongoing gains
in efficiency argue for cutbacks in labor
input, but companies are also reluctant
to lay off workers that have been diffi-

Monetary Policy Reports, February
cult to attract and retain in the tight
labor market conditions of the past few
years. In the aggregate, the balance that
has been struck in recent months has
led, on net, to slower growth of employment, cutbacks in the length of the average workweek, and, in January of this
year, a small increase in the unemployment rate.
Inflation is not expected to be a pressing concern over the coming year. Most
of the governors and Reserve Bank
presidents are forecasting that the rise
in the chain-type price index for personal consumption expenditures will be
smaller than the price rise in 2000. The
central tendency of the range of forecasts is l3/4 percent to 2lA percent. Inflation should be restrained this coming
year by an expected downturn in energy
prices. In addition, the reduced pressure
on resources that is associated with the
slowing of the economy should help
damp increases in labor costs and prices.

Economic and Financial
Developments in 2000
and Early 2001
The combination of exceptionally strong
growth in the first half of 2000 and
subdued growth in the second half
resulted in a rise in real GDP of about
3!/2 percent for the year overall. Domestic demand started out the year with
incredible vigor but decelerated thereafter and was sluggish by year-end.
Exports surged for three quarters and
then faltered. In the labor market,
growth of employment slowed over the
year but was sufficient to keep the
unemployment rate around the lowest
sustained level in more than thirty years.
Core inflation remained low in 2000
in the face of sharp increases in energy
prices. Although the chain-type price
index for personal consumption expenditures (PCE) moved up faster than in



47

1999, it showed only a slight step-up in
the rate of increase after excluding the
prices of food and energy. Unit labor
costs picked up moderately, adding to
the cost pressures from energy, but the
ability of businesses to raise prices was
restrained by the slowing of the economy and the persistence of competitive
pricing conditions.
The Household Sector
Personal consumption expenditures
increased AV2 percent in real terms in
2000 after having advanced 5 percent in
1998 and 5Vi percent in 1999. A large
portion of last year's gain came in the
first quarter, when consumption moved
ahead at an unusually rapid pace. The
increase in consumer spending over the
remainder of the year was moderate,
averaging about 3J/2 percent at an annual
rate. Consumer outlays for motor vehicles and parts surged to a record high
early in 2000 but reversed that gain
over the remainder of the year; sales of
vehicles tailed off especially sharply as
the year drew to a close. Real consumer
purchases of gasoline fell during the
year in response to the steep run-up in
gasoline prices. Most other broad categories of goods and services posted sizable gains over the year as a whole, but
results late in the year were mixed: Real
outlays for goods other than motor
vehicles eked out only a small gain in
the fourth quarter, while real outlays for
consumer services rose very rapidly, not
only because of higher outlays for home
heating fuels during a spell of colderthan-usual weather but also because of
continued strength in real outlays for
other types of services.
Changes in income and wealth provided less support to consumption in
2000 than in other recent years. Real
disposable personal income rose about
2!/4 percent last year after a gain of

48

88th Annual Report, 2001

slightly more than 3 percent in 1999.
Disposable income did not rise quite as
much in nominal terms as it had in 1999,
and rising prices eroded a larger portion
of the nominal gain. Meanwhile, the net
worth of households turned down in
2000 after having climbed rapidly for
several years, as the effect of a decline
in the stock market was only partially
offset by a sizable increase in the value
of residential real estate. With the peak
in stock prices not coming until the year
was well under way, and with valuations
having previously been on a sharp
upward course for an extended period,
stock market wealth may well have
continued to exert a strong positive
effect on consumer spending for several
months after share values had topped
out. As time passed, however, the impetus to consumption from this source
most likely diminished. The personal
saving rate, which had dropped sharply
during the stock market surge of previous years, fell further in 2000, but the
rate of decline slowed, on average, after
the first quarter.
Even with real income growth slowing and the stock market turning down,
consumers maintained a high degree
of optimism through most of 2000
regarding the state of the economy and
the economic outlook. Indexes of sentiment from both the University of Michigan Survey Research Center and the
Conference Board rose to new peaks
in the first quarter of the year, and the
indexes remained close to those levels
for several more months. Survey readings on personal finances, general business conditions, and the state of the
labor market remained generally favorable through most of the year. As of
late autumn, only mild softness could
be detected. Toward year-end, however,
confidence in the economy dropped
sharply. Both of the indexes of confidence showed huge declines over the



two months ended in January. The
marked shift in attitudes toward yearend probably was brought on by a combination of developments, including the
weakness in the stock market over the
latter part of the year and more frequent
reports of layoffs.
Real outlays for residential investment declined about 2lA percent, on net,
over the course of 2000, as construction
of new housing dropped back from the
elevated level of the previous year.
Investment in housing was influenced
by a sizable swing in mortgage interest
rates as well as by slower growth of
employment and income and the downturn in the stock market. After having
moved up appreciably in 1999, mortgage rates continued to advance through
the first few months of 2000. By midMay, the average commitment rate on
conventional fixed-rate mortgages was
above 8V2 percent, up roughly Wi percentage points from the level of a year
earlier. New construction held up even
as rates were rising in 1999 and early
2000, but it softened in the spring of last
year. Starts and permits for singlefamily houses declined from the first
quarter to the third quarter.
But even as homebuilding activity
was turning down, conditions in mortgage markets were moving back in a
direction more favorable to housing.
From the peak in May, mortgage interest
rates fell substantially over the remainder of the year and into the early part of
2001, reversing the earlier increases.
Sales of new homes firmed as rates
turned down, and prices of new houses
continued to trend up faster than the
general rate of inflation. Inventories of
unsold new homes held fairly steady
over the year and were up only moderately from the lows of 1997 and 1998.
With demand well-maintained and
inventories under control, activity stabilized. Starts and permits for single-

Monetary Policy Reports, February
family houses in the fourth quarter of
2000 were up from the average for the
third quarter.
Households continued to borrow at a
brisk pace last year, with household debt
expanding an estimated &3A percent,
well above the growth rate of disposable personal income. Consumer credit
increased rapidly early in the year,
boosted by strong outlays on durable
goods; but as consumer spending cooled
later in the year, the expansion of consumer credit slowed. For the year as a
whole, consumer credit is estimated to
have advanced more than iVi percent,
up from the 7 percent pace of 1999.
Households also took on large amounts
of mortgage debt, which grew an estimated 9 percent last year, reflecting the
solid pace of home sales.
With the rapid expansion of household debt in recent years, the household
debt service burden has increased to levels not seen since the late 1980s. Even
so, with unemployment low and household net worth high, the credit quality of
the household sector appears to have
deteriorated little last year. Personal
bankruptcy filings held relatively steady
and remain well below their peak from
several years ago. Delinquency rates on
home mortgages, credit cards, and auto
loans have edged up in recent quarters
but are at most only slightly above their
levels of the fourth quarter of 1999.
Lenders did not appear to be significantly concerned about the credit quality of the household sector for most of
last year, although some lenders have
become more cautious of late. According to surveys of banks conducted by
the Federal Reserve, few commercial
banks tightened lending conditions on
consumer installment loans and mortgage loans to households over the first
three quarters of 2000. However, the
most recent survey indicates that a
number of banks tightened standards



49

and terms on consumer loans, particularly non-credit-card loans, over the
past several months, perhaps because
of some uneasiness about how the financial position of households will hold up
as the pace of economic activity slows.
The Business Sector
Real business fixed investment rose
10 percent in 2000 according to the
advance estimate from the Commerce
Department. Investment spending shot
ahead at an annual rate of 21 percent in
the first quarter of the year; its strength
in that period came, in part, from hightech purchases that had been delayed
from 1999 by companies that did not
want their operating systems to be in a
state of change at the onset of the new
millennium. Expansion of investment
was slower but still relatively brisk in
the second and third quarters, at annual
rates of about 15 percent and 8 percent respectively. In the fourth quarter,
however, capital spending downshifted
abruptly in response to the slowing
economy, tightening financial conditions, and rising concern about the prospects for profits; the current estimate
shows real investment outlays having
fallen at an annual rate of 1 Vi percent in
that period.
Fixed investment in equipment and
software was up 9Vi percent in 2000,
with the bulk of the gain coming in the
first half of the year. Spending slowed to
a rate of growth of about 5lA percent in
the third quarter and then declined in the
fourth quarter. Business investment in
motor vehicles fell roughly 15 percent,
on net, during 2000, with the largest
portion of the drop coming in the fourth
quarter; the declines in real outlays on
larger types of trucks were particularly
sizable. Investment in industrial equipment, tracking the changing conditions
in manufacturing, also fell in the fourth

50

88th Annual Report, 2001

quarter but was up appreciably for the
year overall. Investment in high-tech
equipment decelerated over the year but
was still expanding in the fourth quarter:
Real outlays for telecommunications
equipment posted exceptionally large
gains in the first half of the year, flattened out temporarily in the third quarter, and expanded again in the fourth.
Spending on computers and peripherals
increased, in real terms, at an average
rate of about 45 percent over the first
three quarters of the year but slowed
abruptly to a 6 percent rate of expansion
in the year's final quarter, the smallest
quarterly advance in several years.
Investment in nonresidential structures rose substantially in 2000, about
12x/2 percent in all, after having declined
1% percent in 1999. Investment in factory buildings, which had fallen more
than 20 percent in 1999 in an apparent
reaction to the economic disruptions
abroad and the associated softness in
demand for U.S. exports, more than
recouped that decline over the course of
2000. Real outlays for office construction, which had edged down in 1999
after several years of strong advance,
got back on track in 2000, posting a gain
of about 13V2 percent. Real investment
in commercial buildings other than
offices was little changed after moderate
gains in the two previous years. Spending on structures used in drilling for
energy strengthened in response to the
surge in energy prices.
Business inventory investment was
subdued early in the year when final
sales were surging; aggregate inventorysales ratios, which have trended lower in
recent years as companies became more
efficient at managing stocks, edged
down further. As sales moderated in
subsequent months, production growth
did not decelerate quite as quickly, and
inventories began to rise more rapidly.
Incoming information through the sum


mer suggested that some firms might be
encountering a bit of backup in stocks
but that the problems were not severe
overall. In the latter part of the year,
however, inventory-sales ratios turned
up, indicating that more serious overhangs were developing. Responding to
the slowing of demand and the increases
in stocks, manufacturers reduced output
in each of the last three months of the
year by successively larger amounts.
Businesses also began to clamp down
on the flow of imports. Despite those
adjustments, stocks in a number of
domestic industries were likely well
above desired levels as the year drew to
a close.
The Commerce Department's compilation of business profits currently
extends only through the third quarter
of 2000, but these data show an evolving pattern much like that of other economic data. After having risen at an
annual rate of more than 16 percent in
the first half of the year, U.S. corporations' economic profits—that is, book
profits with inventory and capital consumption adjustments—slowed to less
than a 3 percent rate of growth in the
third quarter. Profits from operations
outside the United States continued to
increase rapidly in the third quarter.
However, economic profits from domestic operations edged down in that period,
as solid gains for financial corporations
were more than offset by a 4 percent rate
of decline in the profits of nonfinancial
corporations. Profits of nonfinancial
corporations as a share of their gross
nominal output rose about Vi percentage point in the first half of 2000 but
reversed part of that gain in the third
quarter. Earnings reports for the fourth
quarter indicate that corporate profits
fell sharply in that period.
Business debt expanded strongly over
the first half of 2000, propelled by
robust capital spending as well as by

Monetary Policy Reports, February
share repurchases and cash-financed
merger activity. The high level of capital
expenditures outstripped internally generated funds by a considerable margin
despite continued impressive profits.
To meet their borrowing needs, firms
tapped commercial paper, bank loans,
and corporate bonds in volume in the
first quarter. The rapid pace of borrowing continued in the second quarter,
although borrowers relied more heavily
on bank loans and commercial paper to
meet their financing needs in response
to a rise in longer-term interest rates.
Business borrowing slowed appreciably in the second half of the year. As
economic growth moderated and profits
weakened, capital spending decelerated
sharply. In addition, firms held down
their borrowing needs by curbing their
buildup of liquid assets, which had been
accumulating quite rapidly in previous
quarters. Borrowing may have been
deterred by a tightening of financial conditions for firms with lower credit ratings, as investors and lenders apparently
became more concerned about credit
risk. Those concerns likely were exacerbated by indications that credit quality
had deteriorated at some businesses. The
default rate on high-yield bonds continued to climb last year, reaching its highest level since 1991. Some broader measures of credit quality also slipped. The
amount of nonfinancial debt downgraded by Moody's Investor Services
in 2000 was more than twice as large
as the amount upgraded, and the delinquency rate on business loans at commercial banks continued to rise over the
year. But while some firms were clearly
having financial difficulties, many other
firms remained soundly positioned to
service their debt. Indeed, the ratio of
net interest payments to cash flow for all
nonfinancial firms moved only modestly above the relatively low levels of
recent years.



51

As concerns about risk mounted,
lenders became more cautious about
extending credit to some borrowers. An
increasingly large proportion of banks
reported firming terms and standards
on business loans over the course of the
year. In the corporate bond market, yield
spreads on high-yield and lower-rated
investment-grade bonds, measured relative to the ten-year swap rate, began
climbing sharply in September and by
year-end were at levels well above those
seen in the fall of 1998. Lower-rated
commercial paper issuers also had to
pay unusually large premiums late in
the year, particularly on paper spanning
the year-end. As financial conditions
became more stringent, issuance of
high-yield debt was cut back sharply in
the fourth quarter, although investmentgrade bond issuance remained strong.
Bank lending to businesses was also
light at that time, and net issuance of
commercial paper came to a standstill.
In total, the debt of nonfinancial businesses expanded at an estimated 5Vz percent rate in the fourth quarter, less than
half the pace of the first half of the year.
The slowdown in borrowing in the latter
part of the year damped the growth of
nonfinancial business debt over 2000,
although it still expanded an estimated
83/4 percent.
In early 2001, borrowing appears to
have picked up from its sluggish fourthquarter pace. Following the easing of
monetary policy in early January, yield
spreads on corporate bonds reversed a
considerable portion of their rise over
the latter part of 2000, with spreads on
high-yield bonds narrowing more than a
percentage point. As yields declined,
corporate bond issuance picked up, and
even some below-investment grade
issues were brought to the market. In
contrast, investors in the commercial
paper market apparently became more
concerned about credit risk, partly in

52

88th Annual Report, 2001

response to the defaults of two California utilities on some bonds and commercial paper in mid-January related
to the difficulties in the electricity market in that state. After those defaults,
spreads between top-tier and second-tier
commercial paper widened further, and
investors became more discriminating
even within the top rating tier. Some
businesses facing resistance in the commercial paper market reportedly met
their financing needs by tapping backup
credit lines at banks.
Growth in commercial mortgage
debt slowed last year to an estimated
rate of 9lA percent, and issuance of
commercial-mortgage-backed securities
in 2000 fell back from its 1999 pace.
Spreads on lower-rated commercialmortgage-backed securities over swap
rates widened by a small amount late in
the year, and banks on net reported tightening their standards on commercial real
estate credit over the year. Nevertheless,
fundamentals in the commercial real
estate market remain solid, and delinquency rates on commercial mortgages
stayed around their historic lows.
The Government Sector
Real consumption and investment expenditures of federal, state, and local
governments, the part of government
spending that is included in GDP, rose
only 1 lA percent in the aggregate during
2000. The increase was small partly
because the consumption and investment expenditures of the federal government had closed out 1999 with a
large increase in advance of the century
date change. Federal purchases in the
fourth quarter of 2000 were about 1 percent below the elevated level at yearend 1999. Abstracting from the bumps
in the spending data, the underlying
trend in real federal consumption and
investment outlays appears to have been



mildly positive over the past couple of
years. The consumption and investment
expenditures of state and local governments rose about 2x/2 percent in 2000
after an unusually large increase of
4x/4 percent in 1999. The slowdown in
spending was mainly a reflection of a
downshift in government investment in
structures, which can be volatile from
year to year and had posted a large gain
in 1999.
Total federal spending, as reported in
the unified budget, rose 5 percent in
fiscal year 2000, the largest increase
in several years. A portion of the rise
stemmed from shifts in the timing of
some outlays in a way that tended to
boost the tally for fiscal 2000. But even
allowing for those shifts, the rise in
spending would have exceeded the
increases of other recent years. Outlays
accelerated for most major functions,
including defense, health, social security, and income security. Of these,
spending on health—about threefourths of which consists of outlays
for Medicaid—recorded the biggest
increase. Medicaid grants to the states
were affected last fiscal year by
increased funding for the child health
insurance initiative that was passed in
1997 and by a rise in the portion of
Medicaid expenses picked up by the federal government. Spending on agriculture rose very sharply for a third year
but not as rapidly as in fiscal 1999. The
ongoing paydown of debt by the federal
government led to a decline of nearly
3 percent in net interest payments in
fiscal 2000 after a somewhat larger drop
in these payments in fiscal 1999.
Federal receipts increased 103/4 percent in fiscal year 2000, the largest
advance in more than a decade. The
increase in receipts from taxes on the
income of individuals amounted to more
than 14 percent. In most recent years,
these receipts have grown much faster

Monetary Policy Reports, February
than nominal personal income as measured in the national income and product accounts. One important factor in
the difference is that rising levels of
income and a changing distribution have
shifted more taxpayers into higher tax
brackets; another is an increase in revenues from taxes on capital gains and
other items that are not included in personal income. Receipts from the taxation of corporate profits also moved up
sharply in fiscal 2000, rebounding from
a small decline the previous fiscal year.
With federal receipts rising much faster
than spending, the surplus in the unified
budget rose to $236 billion in fiscal
2000, nearly double that of fiscal 1999.
The on-budget surplus, which excludes
surpluses accumulating in the social
security trust fund, rose from essentially
zero in fiscal 1999 to $86 billion in
fiscal 2000. Excluding net interest payments, a charge resulting from past deficits, the surplus in fiscal 2000 was about
$460 billion.
Federal saving, which is basically
the federal budget surplus adjusted to
conform to the accounting practices followed in the national income and product accounts, amounted to about 3Vi percent of nominal GDP over the first three
quarters of 2000. This figure has been
rising roughly 1 percentage point a year
over the past several years. Mainly
because of that rise in federal saving,
the national saving rate has been running at a higher level in recent years
than was observed through most of the
1980s and the first half of the 1990s,
even as the personal saving rate has
plunged. The rise in federal saving has
kept interest rates lower than they otherwise would have been and has contributed, in turn, to the rapid growth of
capital investment and the faster growth
of the economy's productive potential.
The burgeoning federal budget surplus allowed the Treasury to pay down



53

its debt last year at an even faster pace
than in recent years. As of the end of
fiscal 2000, the stock of marketable
Treasury debt outstanding had fallen
about $500 billion from its peak in 1997.
The existing fiscal situation and the
anticipation that budget surpluses would
continue led the Treasury to implement
a number of debt management changes
during 2000, many designed to preserve
the liquidity of its securities. In particular, the Treasury sought to maintain
large and regular offerings of new securities at some key maturities, because
such attributes are thought to importantly contribute to market liquidity.
In part to make room for continued
sizable auctions of new securities, the
Treasury initiated a debt buyback program through which it can purchase
debt that it previously issued. In total,
the Treasury conducted twenty buyback
operations in 2000, repurchasing a total
of $30 billion par value of securities
with maturities ranging from twelve to
twenty-seven years. Those operations
were generally well received and caused
little disruption to the market. Going
forward, the Treasury intends to conduct
two buyback operations per month and
expects to repurchase about $9 billion
par value of outstanding securities in
each of the first two quarters of 2001.
Despite conducting buybacks on that
scale, the Treasury had to cut back considerably its issuance of new securities.
To still achieve large sizes of individual
issues at some maturities, the Treasury
implemented a schedule of regular
reopenings—in which it auctions additional amounts of a previously issued
security instead of issuing a new one—
for its five-, ten-, and thirty-year instruments. Under that schedule, every other
auction of each of those securities is a
smaller reopening of the previously auctioned security. At other maturities, the
Treasury reduced the sizes of its two-

54

88th Annual Report, 2001

year notes and inflation-indexed securities and eliminated the April auction
of the thirty-year inflation-indexed
bond. In addition, the Treasury recently
announced that it would stop issuing
one-year bills following the February
auction, after having cut back the frequency of new offerings of that security
last year.
These reductions in the issuance of
Treasury securities have caused the
Federal Reserve to modify some of
its procedures for obtaining securities at
Treasury auctions, as described in detail
below. In addition, the Treasury made
changes in the rules for auction participation by foreign and international
monetary authority (FIMA) accounts,
which primarily include foreign central
banks and governmental monetary entities. The new rules, which went into
effect on February 1, 2001, impose limits on the size of non-competitive bids
from individual FIMA accounts and on
the total amount of such bids that will
be awarded at each auction. These limits will leave a larger pool of securities
available for competitive bidding at the
auctions, helping to maintain the liquidity and efficiency of the market. Moreover, FIMA purchases will be subtracted
from the total amount of securities
offered, rather than being added on as
they were in some previous instances,
making the amount of funds raised at
the auction more predictable.
State and local government debt
increased little in 2000. Gross issuance
of long-term municipal bonds was well
below the robust pace of the past two
years. Refunding offerings were held
down by higher interest rates through
much of the year, and the need to raise
new capital was diminished by strong
tax revenues. Net issuance was also
damped by an increase in the retirement of bonds from previous refunding
activity. Credit quality in the munici


pal market improved considerably last
year, with credit upgrades outnumbering
downgrades by a substantial margin.
The only notable exception was in the
not-for-profit health care sector, where
downgrades predominated.
The External Sector
Trade and Current Account
The current account deficit reached
$452 billion (annual rate) in the third
quarter of 2000, or 4.5 percent of GDP,
compared with $331 billion and 3.6 percent for 1999. Most of the expansion
in the current account deficit occurred
in the balance of trade in goods and
services. The deficit on trade in goods
and services widened to $383 billion
(annual rate) in the third quarter from
$347 billion in the first half of the year.
Data for trade in October and November suggest that the deficit may have
increased further in the fourth quarter.
Net payments on investments were a bit
less during the first three quarters of
2000 than in the second half of 1999
owing to a sizable increase in income
receipts from direct investment abroad.
U.S. exports of goods and services
rose an estimated 7 percent in real terms
during 2000. Exports surged during the
first three quarters, supported by a
pickup in economic activity abroad that
began in 1999. By market destination,
U.S. exports were strongest to Mexico
and countries in Asia. About 45 percent
of U.S. goods exports were capital
equipment, 20 percent were industrial
supplies, and roughly 10 percent each
were agricultural, automotive, consumer, and other goods. Based on data
for October and November, real exports
are estimated to have declined in the
fourth quarter, reflecting in part a slowing of economic growth abroad. This
decrease was particularly evident in

Monetary Policy Reports, February
exports of capital goods, automotive
products, consumer goods, and agricultural products.
The quantity of imported goods and
services expanded rapidly during the
first three quarters of 2000, reflecting
the continuing strength of U.S. domestic
demand and the effects of past dollar
appreciation on price competitiveness.
Increases were widespread among trade
categories. Based on data for October
and November, real imports of goods
and services are estimated to have risen
only slightly in the fourth quarter. Moderate increases in imported consumer
and capital goods were partly offset by
declines in other categories of imports,
particularly industrial supplies and automotive products, for which domestic
demand had softened. The price of
non-oil imports is estimated to have
increased by less than 1 percent during
2000.
The price of imported oil rose nearly
$7 per barrel over the four quarters of
2000. During the year, oil prices generally remained high and volatile, with the
spot price of West Texas intermediate
(WTI) crude fluctuating between a low
of $24 per barrel in April and a high
above $37 per barrel in September.
Strong demand—driven by robust world
economic growth—kept upward pressure on oil prices even as world supply
increased considerably. Over the course
of 2000, OPEC raised its official production targets by 3.7 million barrels per
day, reversing the production cuts made
in the previous two years. Oil production from non-OPEC sources rebounded
as well. During the last several weeks of
2000, oil prices fell sharply as market
participants became convinced that the
U.S. economy was slowing. In early
2001, however, oil prices moved back
up when OPEC announced a planned
production cut of 1.5 million barrels per
day.



55

Financial Account
The counterpart to the increased U.S.
current account deficit in 2000 was
an increase in net capital inflows. As
in 1999, U.S. capital flows in 2000
reflected the relatively strong cyclical
position of the U.S. economy for most of
the year and the global wave of corporate mergers. Foreign private purchases
of U.S. securities were exceptionally
robust—well in excess of the record set
in 1999. The composition of U.S. securities purchased by foreigners continued
the shift away from Treasuries as the
U.S. budget surplus, and the attendant
decline in the supply of Treasuries, lowered their yield relative to other debt.
Last year private foreigners sold, on net,
about $50 billion in Treasury securities,
compared with net sales of $20 billion
in 1999. Although sizable, these sales
were slightly less than what would have
occurred had foreigners reduced their
holdings in proportion to the reduction
in Treasuries outstanding. The increased
sale of Treasuries was fully offset by
larger foreign purchases of U.S. securities issued by government-sponsored
agencies. Net purchases of agency securities topped $110 billion, compared
with the previous record of $72 billion
set in 1999. In contrast to the shrinking supply of Treasury securities, U.S.
government-sponsored agencies accelerated the pace of their debt issuance.
Private foreign purchases of U.S. corporate debt grew to $180 billion, while net
purchases of U.S. equities ballooned to
$170 billion compared with $108 billion
in 1999.
The pace of foreign direct investment
inflows in the first three quarters of 2000
also accelerated from the record pace
of 1999. As in the previous two years,
direct investment inflows were driven
by foreign acquisition of U.S. firms,
reflecting the global strength in merger

56

88th Annual Report, 2001

and acquisition activity. Of the roughly
$200 billion in direct investment
inflows in the first three quarters, about
$100 billion was directly attributable to
merger activity. Many of these mergers
were financed, at least in part, by an
exchange of equity, in which shares in
the U.S. firm were swapped for equity
in the acquiring firm. Although U.S.
residents generally appear to have sold a
portion of the equity acquired through
these swaps, the swaps likely contributed significantly to the $97 billion capital outflow attributed to U.S. acquisition
of foreign securities. U.S. direct investment abroad was also boosted by merger
activity and totaled $117 billion in the
first three quarters of 2000, a slightly
faster pace than that of 1999.
Capital inflows from foreign official
sources totaled $38 billion in 2000—a
slight increase from 1999. Nearly all
of the official inflows were attributable
to reinvested interest earnings. Modest
official sales of dollar assets associated
with foreign exchange intervention were
offset by larger inflows from some nonOPEC oil exporting countries, which
benefited from the elevated price of oil.
The Labor Market
Nonfarm payroll employment increased
about \xh percent in 2000, measured on
a December-to-December basis. The job
count had risen slightly more than 2 percent in 1999 and roughly 2Vi percent a
year over the 1996-98 period. Over the
first few months of 2000, the expansion
of jobs proceeded at a faster pace than in
1999, boosted both by the federal government's hiring for the decennial Census and by a somewhat faster rate of job
creation in the private sector. Indications
of a moderation in private hiring started
to emerge toward mid-year, but because
of volatility of the incoming data a slowdown could not be identified with some



confidence until late summer. Over the
remainder of the year monthly increases
in private employment stepped down
further. Job growth came almost to a
stop in December, when severe weather
added to the restraint from a slowing economy. In January of this year,
employment picked up, but the return of
milder weather apparently accounted for
a sizable portion of the gain.
Employment rose moderately in the
private service-producing sector of the
economy in 2000, about 2 percent overall after an increase of about 3 percent
in 1999. In the fourth quarter, however,
hiring in the services-producing sector was relatively slow, in large part
because of a sizable decline in the number of jobs in personnel supply—a
category that includes temporary help
agencies. Employment in construction
increased about 2Vi percent in 2000
after several years of gains that were
considerably larger. The number of jobs
in manufacturing was down for a third
year, owing to reductions in factory
employment in the second half of the
year, when manufacturers were adjusting to the slowing of demand. Those
adjustments in manufacturing may also
have involved some cutbacks in the
employment of temporary hires, which
would help to account for the sharp job
losses in personnel supply. The average
length of the workweek in manufacturing was scaled back as well over the
second half of the year.
The slowing of the economy did not
lead to any meaningful easing in the
tightness of the labor market in 2000.
The household survey's measure of the
number of persons employed rose 1 percent, about in line with the expansion of
labor supply. On net, the unemployment
rate changed little; its fourth-quarter
average of 4.0 percent was down just
a tenth of a percentage point from the
average unemployment rate in the fourth

Monetary Policy Reports, February
quarter of 1999. The flatness of the rate
through the latter half of 2000, when the
economy was slowing, may have partly
reflected a desire of companies to hold
on to labor resources that had been difficult to attract and retain in the tight
labor market of recent years. January of
this year brought a small increase in the
rate, to 4.2 percent.
Productivity continued to rise rapidly
in 2000. Output per hour in the nonfarm
business sector was up about 3Vi percent over the year as a whole. Sizable
gains in efficiency continued to be evident even as the economy was slowing
in the second half of the year. Except for
1999, when output per hour rose about
33A percent, the past year's increase was
the largest since 1992, a year in which
the economy was in cyclical recovery
from the 1990-91 recession. Cutting
through the year-to-year variations in
measured productivity, the underlying
trend still appears to have traced out a
pattern of strong acceleration since the
middle part of the 1990s. Support for
a step-up in the trend has come from
increases in the amount of capital per
worker—especially high-tech capital—
and from organizational efficiencies that
have resulted in output rising faster
than the combined inputs of labor and
capital.
Alternative measures of the hourly
compensation of workers, while differing in their coverage and methods of
construction, were consistent in showing some acceleration this past year. The
employment cost index for private
industry (ECI), which attempts to measure changes in the labor costs of nonfarm businesses in a way that is free
from the effects of employment shifts
among occupations and industries, rose
nearly 4Vi percent during 2000 after
having increased about 3Vi percent in
1999. Compensation per hour in the
nonfarm business sector, a measure that



57

picks up some forms of employee compensation that the ECI omits but that
also is more subject to eventual revision
than the ECI, showed hourly compensation advancing 53A percent this past
year, up from a 1999 increase of about
4Vz percent. Tightness of the labor market was likely one factor underlying
the acceleration of hourly compensation
in 2000, with employers relying both
on larger wage increases and more
attractive benefit packages to attract
and retain workers. Compensation gains
may also have been influenced to some
degree by the pickup of consumer price
inflation since 1998. Rapid increases in
the cost of health insurance contributed
importantly to a sharp step-up in benefit
costs.
Unit labor costs, the ratio of hourly
compensation to output per hour,
increased about 2lA percent in the nonfarm business sector in 2000 after having risen slightly more than Vi percent
in 1999. Roughly three-fourths of the
acceleration was attributable to the
faster rate of increase in compensation
per hour noted above. The remainder
stemmed from the small deceleration
of measured productivity. The labor cost
rise for the latest year was toward the
high end of the range of the small to
moderate increases that have prevailed
over the past decade.
Prices
Led by the surge in energy prices, the
aggregate price indexes showed some
acceleration in 2000. The chain-type
price index for real GDP, the broadest
measure of goods and services produced
domestically, rose 2lA percent in 2000,
roughly 3A percentage point more than
in 1999. The price index for gross
domestic purchases, the broadest measure of prices for goods and services
purchased by domestic buyers, posted a

58

88th Annual Report, 2001

rise of almost 2V2 percent in 2000 after
having increased slightly less than 2 percent the previous year. Prices paid by
consumers, as measured by the chaintype price index for personal consumption expenditures, picked up as well,
about as much as the gross purchases
index. The consumer price index (CPI)
continued to move up at a faster pace
than the PCE index this past year, and it
exhibited slightly more acceleration—an
increase of nearly 3Vi percent in 2000
was % percentage point larger than the
1999 rise. Price indexes for fixed investment and government purchases also
accelerated this past year.
The prices of energy products purchased directly by consumers increased
about 15 percent in 2000, a few percentage points more than in 1999. In
response to the rise in world oil prices,
consumer prices of motor fuels rose
nearly 20 percent in 2000, bringing the
cumulative price hike for those products
over the past two years to roughly
45 percent. Prices also rose rapidly for
home heating oil. Natural gas prices
increased 30 percent, as demand for that
fuel outpaced the growth of supply, pulling stocks down to low levels. Prices of
natural gas this winter have been exceptionally high because of the added
Alternative Measures of Price Change
Percent
Price measure

1999

2000

Chain-type
Gross domestic product
Gross domestic purchases
Personal consumption
expenditures
Excluding food and energy ...

1.6
1.9

2.3
2.4

2.0
1.5

2.4
1.7

Fixed-weight
Consumer price index
Excluding food and energy . . .

2.6
2.1

3.4
2.6

NOTE. Changes are based on quarterly averages and
are measured to the fourth quarter of the year indicated
from the fourth quarter of the preceding year.




demand for heating that resulted from
unusually cold weather in November
and December. Electricity costs jumped
for some users, and prices nationally
rose faster than in other recent years,
about 2x/4 percent at the consumer level.
Businesses had to cope with rising
costs of energy in production, transportation, and temperature control. In
some industries that depend particularly heavily on energy inputs, the rise
in costs had a large effect on product
prices. Producer prices of goods such
as industrial chemicals posted increases
that were well above the average rates
of inflation last year, and rising prices
for natural gas sparked especially steep
price advances for nitrogen fertilizers
used in farming. Prices of some services
also exhibited apparent energy impacts:
Producers paid sharply higher prices for
transportation services via air and water,
and consumer airfares moved up rapidly
for a second year, although not nearly
as much as in 1999. Late in 2000 and
early this year, high prices for energy
inputs prompted shutdowns in production at some companies, including those
producing fertilizers and aluminum.
Despite the spillover of energy effects
into other markets, inflation outside the
energy sector remained moderate overall. The ongoing rise in labor productivity helped to contain the step-up in labor
costs, and the slow rate of rise in the
prices of non-oil imports meant that
domestic businesses had to remain cautious about raising their prices because
of the potential loss of market share.
Rapid expansion of capacity in manufacturing prevented bottlenecks from
developing in the goods-producing
sector of the economy when domestic
demand was surging early in the year;
later on, an easing of capacity utilization
was accompanied by a softening of
prices in a number of industries. Inflation expectations, which at times in the

Monetary Policy Reports, February
past have added to the momentum of
rising inflation, remained fairly quiescent in 2000.
Against this backdrop, core inflation
remained low in 2000. Producer prices
of intermediate materials excluding food
and energy, after having accelerated
through the first few months of 2000,
slowed thereafter, and their four-quarter
rise of PA percent was only a bit larger
than the increase during 1999. Prices
of crude materials excluding food and
energy fell moderately this past year
after having risen about 10 percent a
year earlier. At the consumer level, the
CPI excluding food and energy moved
up 2l/i percent in 2000, an acceleration
of slightly less than Vi percentage point
from 1999 when put on a basis that
maintains consistency of measurement.
The rise in the chain-type price index
for personal consumption expenditures
excluding food and energy was PA percent, just a bit above the increases
recorded in each of the two previous
years.
Consumer food prices rose 2Vi percent in 2000 after an increase of about
2 percent in 1999. In large part, the
moderate step-up in these prices probably reflected cost and price considerations similar to those at work elsewhere in the economy. Also, farm
commodity prices moved up, on net,
during 2000, after three years of sharp
declines, and this turnabout likely
showed through to the retail level to
some extent. Meat prices, which are
linked more closely to farm prices than
is the case with many other foods,
recorded increases that were appreciably larger than the increases for food
prices overall.
The chain-type price index for private
fixed investment rose about PA percent in 2000, but that small increase
amounted to a fairly sharp acceleration
from the pace of the preceding few



59

years, several of which had brought
small declines in investment prices.
Although the price index for investment
in residential structures slowed a little,
to about a 3Vi percent rise, the index for
nonresidential structures sped up from a
23/4 percent increase in 1999 to one of
AVi percent in 2000. Moreover, the price
index for equipment and software ticked
up slightly, after having declined 2 percent or more in each of the four preceding years. To a large extent, that
turnabout was a reflection of a smaller
rate of price decline for computers; they
had dropped at an average rate of more
than 20 percent through the second
half of the 1990s but fell at roughly half
that rate in 2000. Excluding computers,
equipment prices increased slightly in
2000 after having declined a touch in
1999.
U.S. Financial Markets
Financial markets in 2000 were influenced by the changing outlook for the
U.S. economy and monetary policy and
by shifts in investors' perceptions of and
attitudes toward risk. Private longerterm interest rates generally firmed in
the early part of the year as growth
remained unsustainably strong and as
market participants anticipated a further
tightening of monetary policy by the
Federal Reserve. Later in the year, as it
became apparent that the pace of economic growth was slowing, market participants began to incorporate expectations of significant policy easing into
asset prices, and most longer-term interest rates fell sharply over the last several
months of 2000 and into 2001. Over the
course of the year, investors became
more concerned about credit risk and
demanded larger yield spreads to hold
lower-rated corporate bonds, especially
once the growth of the economy slowed
in the second half. Banks, apparently

60

88th Annual Report, 2001

having similar concerns, reported widening credit spreads on business loans
and tightening standards for lending
to businesses. Weakening economic
growth and tighter financial conditions
in some sectors led to a slowing in the
pace of debt growth over the course of
the year.
Stock markets had another volatile
year in 2000. After touching record
highs in March, stock prices turned
lower, declining considerably over the
last four months of the year. Valuations
in some sectors fell precipitously from
high levels, and near-term earnings forecasts were revised down sharply late in
the year. On balance, the broadest stock
indexes fell more than 10 percent last
year, and the tech-heavy Nasdaq was
down nearly 40 percent.
Interest Rates
The economy continued to expand at an
exceptionally strong and unsustainable
pace in the early part of 2000, prompting the Federal Reserve to tighten its
policy stance in several steps ending at
its May meeting. Private interest rates
and shorter-term Treasury yields rose
considerably over that period, reaching
a peak just after the May FOMC meeting. Investors apparently became more
concerned about credit risk as well;
spreads between rates on lower-rated
corporate bonds and swaps widened in
the spring, adding to the upward pressure on private interest rates. Long-term
Treasury yields, in contrast, remained
below their levels from earlier in the
year, as market participants became
increasingly convinced that the supply
of those securities would shrink considerably in coming years and incorporated
a "scarcity premium" into their prices.
By mid-May, with the rapid expansion
of economic activity showing few signs
of letting up, rates on federal funds and



eurodollar futures, which can be used as
a rough gauge of policy expectations,
were indicating that market participants
expected additional policy tightening
going forward.
Signs of a slowdown in the growth
of aggregate demand began to appear
in the incoming data soon after the
May FOMC meeting and continued to
gradually accumulate over subsequent
months. In response, market participants
became increasingly convinced that
the FOMC would not have to tighten
its policy stance further, which was
reflected in a flattening of the term
structure of rates on federal funds and
eurodollar futures. Interest rates on most
corporate bonds declined gradually on
the shifting outlook for the economy,
and by the end of August had fallen
more than Vi percentage point from their
peaks in May.
Most market interest rates continued
to edge lower into the fall, as the growth
of the economy seemed to moderate
further. Over the last couple months of
2000 and into early 2001, as it became
apparent that economic growth was
slowing more abruptly, market participants sharply revised down their expectations for future short-term interest
rates. Treasury yields plummeted over
that period, particularly at shorter maturities: The two-year Treasury yield
dropped more than a full percentage
point from mid-November to early January, moving below the thirty-year yield
for the first time since early 2000.
Yields on inflation-indexed securities
also fell considerably, but by less than
their nominal counterparts, suggesting
that the weakening of economic growth
lowered expectations of both real interest rates and inflation.
Although market participants had
come to expect considerable policy easing over the first part of this year, the
timing and magnitude of the intermeet-

Monetary Policy Reports, February
ing cut in the federal funds rate in early
January was a surprise. In response,
investors built into asset prices anticipations of a more rapid policy easing over
the near-term. Indeed, the further substantial reduction in the federal funds
rate implemented at the FOMC meeting
later that month was largely expected
and elicited little response in financial
markets. Even with a full percentage
point reduction in the federal funds rate
in place, futures rates have recently
pointed to expectations of additional
policy easing over coming months.
Investors appear to be uncertain about
this outlook, however, judging from the
recent rise in the implied volatilities of
interest rates derived from option prices.
On balance since the beginning of 2000,
the progressive easing in the economic
outlook, in combination with the effects
of actual and prospective reductions in
the supply of Treasury securities, has
resulted in a sizable downward shift in
the Treasury yield curve.
The prospect of a weakening in economic growth, along with sizable
declines in equity prices and downward
revisions to profit forecasts, apparently
caused investors to reassess credit risks
in the latter part of last year. Spreads
between rates on high-yield corporate
bonds and swaps soared beginning in
September, pushing the yields on those
bonds substantially higher. Concerns
about credit risk also spilled over into
the investment-grade sector, where yield
spreads widened considerably for lowerrated securities. For most investmentgrade issuers, though, the effects of the
revised policy outlook more than offset
any widening in risk spreads, resulting
in a decline in private interest rates in
the fourth quarter. Since the first policy
easing in early January, yield spreads on
corporate bonds have narrowed considerably, including a particularly large
drop in the spread on high-yield bonds.



61

Overall, yields on most investmentgrade corporate bonds have reached
their lowest levels since the first half of
1999, while rates on most high-yield
bonds have fallen about 2 percentage
points from their peaks and have
reached levels similar to those of mid2000.
Although investors at times in recent
months appeared more concerned about
credit risk than they were in the fall of
1998, the recent financial environment,
by most accounts, did not resemble
the market turbulence and disruption of
that time. The Treasury and investmentgrade corporate bond markets remained
relatively liquid, and the investmentgrade market easily absorbed the high
volume of bond issuance over 2000.
Investors continued to show a heightened preference for larger, more liquid
corporate issues, but they did not exhibit
the extreme desire for liquidity that was
apparent in the fall of 1998. For example, the liquidity premium for the onthe-run ten-year Treasury note this year
remained well below the level of that
fall.
Nonetheless, the Treasury market has
become somewhat less liquid than it was
several years ago. Moreover, in 2000,
particular segments of the Treasury market occasionally experienced bouts of
unusually low liquidity that appeared
related to actual or potential reductions
in the supply of individual securities.
Given the possibility that liquidity could
deteriorate further as the Treasury
continues to pay down its debt, market
participants reportedly increased their
reliance on alternative instruments—
including interest rate swaps and
debt securities issued by governmentsponsored housing agencies and other
corporations—for some of the hedging
and pricing functions historically provided by Treasury securities. Fannie
Mae and Freddie Mac continued to issue

62

88th Annual Report, 2001

large amounts of debt under their
Benchmark and Reference debt programs, which are designed to mimic
characteristics of Treasury securities—
such as large issue sizes and a regular
calendar of issuance—that are believed
to contribute to their liquidity. By the
end of 2000, the two firms together had
more than $300 billion of notes and
bonds and more than $200 billion of
bills outstanding under those programs.
Trading volume and dealer positions
in agency securities have risen considerably since 1998, and the market for
repurchase agreements in those securities has reportedly become more active.
Also, several exchanges listed options
and futures on agency debt securities.
Open interest on some of those futures
contracts has picked up significantly,
although it remains small compared to
that on futures contracts on Treasury
securities.
The shrinking supply of Treasury
securities and the possibility of a consequent decline in market liquidity also
pose challenges for the Federal Reserve.
For many years, Treasury securities
have provided the Federal Reserve with
an effective asset for System portfolio
holdings and the conduct of monetary
policy. The remarkable liquidity of
Treasury securities has allowed the System to conduct sizable policy operations
quickly and with little disruption to markets, while the safety of Treasury securities has allowed the System to avoid
credit risk in its portfolio. However,
if Treasury debt continues to be paid
down, at some point the amount outstanding will be insufficient to meet
the Federal Reserve's portfolio needs.
Well before that time, the proportion
of Treasury securities held by the System could reach levels that would significantly disrupt the Treasury market
and make monetary policy operations
increasingly difficult or costly. Rec


ognizing this possibility, last year the
FOMC initiated a study to consider
alternative approaches to managing the
Federal Reserve's portfolio, including
expanding the use of the discount
window and broadening the types of
assets acquired in the open market. As it
continues to study various alternatives,
the FOMC will take into consideration the effect that such approaches
might have on the liquidity and safety of
its portfolio and the potential for distorting the allocation of credit to private
entities.
Meanwhile, some measures have
been taken to prevent the System's holdings of individual Treasury securities
from reaching possibly disruptive levels
and to help curtail any further lengthening of the average maturity of the System's holdings. On July 5, 2000, the
Federal Reserve Bank of New York
announced guidelines limiting the System's holdings of individual Treasury
securities to specified percentages of
their outstanding amounts, depending
on the remaining maturity of the issue.
Those limits range from 35 percent for
Treasury bills to 15 percent for longerterm bonds. As a result, the System
has redeemed some of its holdings of
Treasury securities on occasions when
the amount of maturing holdings has
exceeded the amount that could be
rolled over into newly issued Treasury
securities under these limits. Redemptions of Treasury holdings in 2000
exceeded $28 billion, with more than
$24 billion of the redemptions in
Treasury bills. In addition, the Federal
Reserve accommodated a portion of
the demand for reserves last year by
increasing its use of longer-term repurchase agreements rather than by purchasing Treasury securities outright.
The System maintained an average of
more than $15 billion of longer-term
repurchase agreements over 2000, typi-

Monetary Policy Reports, February
cally with maturities of twenty-eight
days.
Equity Prices
After having moved higher in the first
quarter of 2000, equity prices reversed
course and finished the year with considerable declines. Early in the year,
the rapid pace of economic activity
lifted corporate profits, and stock analysts became even more optimistic about
future earnings growth. In response,
most major equity indexes reached
record highs in March, with the Wilshire 5000 rising 63A percent above its
1999 year-end level and the Nasdaq
soaring 24 percent, continuing its rapid
run-up from the second half of 1999.
Equity prices fell from these highs during the spring, with a particularly steep
drop in the Nasdaq, as investors grew
more concerned about the lofty valuations of some sectors and the prospect of
higher interest rates.
Broader equity indexes recovered
much of those losses through August,
supported by the decline in market interest rates and the continued strength of
earnings growth in the second quarter.
But from early September through the
end of the year, stock prices fell considerably in response to the downshift in
economic growth, a reassessment of the
prospects for some high-tech industries,
and disappointments in corporate earnings. In December and January, equity
analysts significantly reduced their forecasts for year-ahead earnings for the
S&P 500. However, analysts apparently
view the slowdown in earnings as shortlived, as long-run earnings forecasts did
not fall much and remain at very high
levels, particularly for the technology
sector.
On balance, the Wilshire 5000 index
fell 12 percent over 2000—its first
annual decline since 1994. The Nasdaq



63

composite plunged 39 percent, leaving it
at year-end more than 50 percent below
its record high and erasing nearly all of
its gains since the beginning of 1999.
The broad decline in equity prices last
year is estimated to have lopped more
than $P/4 trillion from household
wealth, or more than 4 percent of the
total net worth of households. Nevertheless, the level of household net worth is
still quite high—about 50 percent above
its level at the end of 1995. Investors
continued to accumulate considerable
amounts of equity mutual funds over
2000, although they may have become
increasingly discouraged by losses on
their equity holdings toward the end
of the year, when flows into equity
funds slumped. At that time, money
market mutual funds expanded sharply,
as investors apparently sought a refuge
for financial assets amid the heightened volatility and significant drops
in equity prices. So far in 2001, major
equity indexes are little changed, on
balance, as the boost from lower interest rates has been countered by continued disappointments over corporate
earnings.
Some of the most dramatic plunges in
share prices in 2000 took place among
technology, telecommunications, and
Internet shares. While these declines
partly stemmed from downward revisions to near-term earnings estimates,
which were particularly severe in some
cases, they were also driven by a reassessment of the elevated valuations of
many companies in these sectors. The
price-earnings ratio (calculated using
operating earnings expected over the
next year) for the technology component of the S&P 500 index fell substantially from its peak in early 2000,
although it remains well above the ratio
for the S&P 500 index as a whole. For
the entire S&P 500 index, share prices
fell a bit more in percentage terms than

64

88th Annual Report, 2001

the downward revisions to year-ahead
earnings forecasts, leaving the priceearnings ratio modestly below its historical high.
The volatility of equity price movements during 2000 was at the high end
of the elevated levels observed in recent
years. In the technology sector, the
magnitudes of daily share price changes
were at times remarkable. There were
twenty-seven days during 2000 in which
the Nasdaq composite index moved up
or down by at least 5 percent; by comparison, such outsized movements were
observed on a total of only seven days
from 1990 to 1999.
Despite the volatility of share price
movements and the large declines on
balance over 2000, equity market conditions were fairly orderly, with few
reports of difficulties meeting margin
requirements or of large losses creating
problems that might pose broader systemic concerns. The fall in share prices
reined in some of the margin debt of
equity investors. After having run up
sharply through March, the amount of
outstanding margin debt fell by about
30 percent over the remainder of the
year. At year-end, the ratio of margin
debt to total equity market capitalization was slightly below its level a year
earlier.
The considerable drop in valuations
in some sectors and the elevated volatility of equity price movements caused
the pace of initial public offerings to
slow markedly over the year, despite a
large number of companies waiting to
go public. The slowdown was particularly pronounced for technology companies, which had been issuing new
shares at a frantic pace early in the
year. In total, the dollar amount of initial
public offerings by domestic nonfinancial companies tapered off in the fourth
quarter to its lowest level in two years



and has remained subdued so far in
2001.

Debt and the Monetary Aggregates
Debt and Depository Intermediation
Aggregate debt of domestic nonfinancial sectors increased an estimated
5!/4 percent over 2000, a considerable
slowdown from the gains of almost
7 percent posted in 1998 and 1999. The
expansion of nonfederal debt moderated
to SVi percent in 2000 from 9l/z percent
in 1999; the slowing owed primarily to a
weakening of consumer and business
borrowing in the second half of the year,
as the growth of durables consumption
and capital expenditures fell off and
financial conditions tightened for some
firms. Some of the slowdown in total
nonfinancial debt was also attributable
to the federal government, which paid
down 63/4 percent of its debt last year,
compared with 2x/2 percent in 1999. In
1998 and 1999, domestic nonfinancial
debt increased faster than nominal GDP,
despite the reduction in federal debt over
those years. The ratio of nonfinancial
debt to GDP edged down in 2000,
however, as the federal debt paydown
accelerated and nonfederal borrowing
slowed.
Depository institutions continued to
play an important role in meeting the
demand for credit by businesses and
households. Credit extended by
commercial banks, after adjustment
for mark-to-market accounting rules,
increased 10 percent over 2000, well
above the pace for total nonfinancial
debt. Bank credit expanded at a particularly brisk rate through late summer,
when banks, given their ample capital
base and solid profits, were willing to
meet strong loan demand by households
and businesses. Over the remainder of

Monetary Policy Reports, February
the year, the growth of bank credit
declined appreciably, as banks became
more cautious lenders and as several
banks shed large amounts of government securities.
Banks reported a deterioration of the
quality of their business loan portfolios
last year. Delinquency and charge-off
rates on C&I loans, while low by historical standards, rose steadily, partly
reflecting some repayment difficulties
in banks' syndicated loan portfolios.
Several large banks have stated that the
uptrend in delinquencies is expected to
continue in 2001. Higher levels of provisioning for loan losses and some narrowing of net interest margins contributed to a fallback of bank profits from
the record levels of 1999. In addition,
capitalization measures slipped a bit last
year. Nevertheless, by historical standards banks remained quite profitable
overall and appeared to have ample
capital. In the aggregate, total capital
(the sum of tier 1 and tier 2 capital)
remained above 12 percent of riskweighted assets over the first three quarters of last year, more than two percentage points above the minimum
level required to be considered wellcapitalized.
In response to greater uncertainty
about the economic outlook and a
reduced tolerance for risk, increasing
proportions of banks reported tightening
standards and terms on business loans
during 2000 and into 2001, with the
share recently reaching the highest level
since 1990. The tightening became
widespread for loans to large and
middle-market firms. A considerable
portion of banks reported firming standards and terms on loans to small businesses as well, consistent with surveys
of small businesses indicating that a
larger share of those firms had difficulty
obtaining credit in 2000 than in pre


65

vious years. With delinquency rates for
consumer and real estate loans having
changed little, on net, last year, banks
did not tighten credit conditions significantly for loans to households over the
first three quarters of 2000. More
recently, however, an increasing portion
of banks increased standards and terms
for consumer loans other than credit
cards, and some of the banks surveyed
anticipated a further tightening of conditions on consumer loans during 2001.
The Monetary Aggregates
The monetary aggregates grew rather
briskly last year. The expansion of the
broadest monetary aggregate, M3, was
particularly strong over the first three
quarters of 2000, as the robust growth
in depository credit was partly funded
through issuance of the managed liabilities included in this aggregate, such as
large time deposits. M3 growth eased
somewhat in the fourth quarter because
the slowing of bank credit led depository institutions to reduce their reliance on managed liabilities. Institutional
money funds increased rapidly throughout 2000, despite the tightening of policy early in the year, in part owing
to continued growth in their provision
of cash management services for businesses. For the year as a whole, M3
expanded 9VA percent, well above the
VA percent pace in 1999. This advance
again outpaced that of nominal income,
and M3 velocity—the ratio of nominal
income to M3—declined for the sixth
year in a row.
M2 increased 6XA percent in 2000,
about unchanged from its pace in 1999.
Some slowing in M2 growth would have
been expected based on the rise in shortterm interest rates over the early part of
the year, which pushed up the "opportunity cost" of holding M2, given that the

66

88th Annual Report, 2001

Growth of Money and Debt
Percent

Period

Domestic
nonfinancial
debt

Ml

M2

M3

Annual1
1990
1991
1992
1993
1994

4.2
7.9
14.4
10.6
2.5

4.2
3.1
1.8
1.3
.6

1.9
1.2
.6
1.0
1.7

6.7
4.5
4.5
4.9
4.8

1995
1996
1997
1998
1999

-1.5
-4.5
-1.2
2.2
1.8

3.8
4.5
5.6
8.4
6.2

6.1
6.8
8.9
10.9
7.7

5.4
5.3
5.4
6.9
6.8

2000

-1.5

6.3

9.2

5.3

Quarterly
(annual rate) 2
2000:Ql
Q2
Q3
Q4

2.0
-1.8
-3.7
-2.7

5.8
6.4
5.8
6.6

10.6
9.0
8.9
7.1

5.6
6.2
4.7
4.1

NOTE. Ml consists of currency, travelers checks,
demand deposits, and other checkable deposits. M2 consists of Ml plus savings deposits (including money market deposit accounts), small-denomination time deposits,
and balances in retail money market funds. M3 consists
of M2 plus large-denomination time deposits, balances in
institutional money market funds, RP liabilities (overnight and term), and eurodollars (overnight and term).
Debt consists of the outstanding credit market debt of the
U.S. government, state and local governments, households and nonprofit organizations, nonfinancial businesses, and farms.
1. From average for fourth quarter of preceding year to
average for fourth quarter of year indicated.
2. From average for preceding quarter to average for
quarter indicated.

interest rates on many components of
M2 do not increase by the same amount
or as quickly as market rates. However,
with the level of long-term rates close to
that of short-term rates, investors had
much less incentive to shift funds out of
M2 assets and into assets with longer
maturities, which helped support M2
growth. M2 was also boosted at times
by households' increased preference for
safe and liquid assets during periods of
heightened volatility in equity markets.
On balance over the year, the growth of



M2 slightly exceeded that of nominal
income, and M2 velocity edged down.
The behavior of the components of
M2 was influenced importantly by interest rate spreads. The depressing effect of
higher short-term market interest rates
was most apparent in the liquid deposit
components, including checkable deposits and savings accounts, whose rates
respond very sluggishly to movements
in market rates. Small time deposits and
retail money market mutual funds,
whose rates do not lag market rates as
much, expanded considerably faster than
liquid deposits. Currency growth was
held down early in the year by a runoff
of the stockpile accumulated in advance
of the century date change. In addition,
it was surprisingly sluggish over the balance of the year given the rapid pace
of income growth, with weakness apparently in both domestic and foreign
demands.

International Developments
In 2000, overall economic activity in
foreign economies continued its strong
performance of the previous year. However, in both industrial and developing
countries, growth was strongest early,
and clear signs of a general slowing
emerged later in the year. Among industrial countries, growth in Japan last year
moved up to an estimated 2 percent, and
growth in the euro area slowed slightly
to 3 percent. Emerging market economies in both Asia and Latin America
grew about 6 percent on average in
2000. For Asian developing economies,
this represented a slowing from the
torrid pace of the previous year, while
growth in Latin America, especially
Mexico, picked up from 1999. Average
foreign inflation edged up slightly to
3 percent, mainly reflecting higher oil
prices. Over the first part of the year,
monetary authorities moved to tighten

Monetary Policy Reports, February
conditions in many industrial countries,
in reaction to continued strong growth
in economic activity that was starting to
impinge on capacity constraints, as well
as some upward pressures on prices.
Interest rates on long-term government
securities declined on balance in most
industrial countries, especially toward
year-end when evidence of a slowdown
in global economic growth started to
emerge.
Conditions in foreign financial markets were somewhat more unsettled than
in the previous year. Overall stock
indexes in the foreign industrial countries generally declined, most notably
in Japan. As in the United States,
technology-oriented stock indexes were
extremely volatile during the year. After
reaching peaks in the first quarter, they
started down while experiencing great
swings toward mid-year, then fell
sharply in the final quarter, resulting in
net declines for the year of one-third or
more. Stock prices in emerging market
economies were generally quite weak,
especially in developing Asia, where
growth in recent years has depended
heavily on exports of high-tech goods.
Although there was no major default or
devaluation among emerging market
economies, average risk spreads on
developing country debt still moved
higher on balance over the course of the
year, as the threat of potential crises in
several countries, most notably Argentina and Turkey, heightened investor
concerns.
The dollar's average foreign exchange value increased over most of
the year, supported by continued robust
growth of U.S. activity, rising interest
rates on dollar assets, and market perceptions that longer-term prospects for
U.S. growth and rates of return were
more favorable than in other industrial
countries. Part of the rise in the dollar's
average value was reversed late in the



67

year when evidence emerged that the
pace of U.S. activity was slowing much
more sharply than had been expected.
Despite this decline, the dollar's average
foreign exchange value against the currencies of other major foreign industrial
countries recorded a net increase of over
7 percent for the year as a whole. The
dollar also strengthened nearly as much
on balance against the currencies of the
most important developing country trading partners of the United States. So far
this year, the dollar's average value has
remained fairly stable.
Industrial Economies
The dollar showed particular strength
last year against the euro, the common
currency of much of Europe. During the
first three quarters of the year, the euro
continued to weaken, and by late October had fallen to a low of just above
82 cents, nearly one-third below its
value when it was introduced in January
1999. The euro's decline against the dollar through most of last year appeared to
be due mainly to the vigorous growth of
real GDP and productivity in the United
States contrasted with steady but less
impressive improvements in Europe. In
addition, investors may have perceived
that Europe was slower to adopt "new
economy" technologies, making it a
relatively less attractive investment climate. In September, a concerted intervention operation by the monetary
authorities of the G-7 countries, including the United States, was undertaken at
the request of European authorities to
provide support for the euro. The European Central Bank also made intervention purchases of euros on several occasions acting on its own. Late in the year,
the euro abruptly changed course and
started to move up strongly, reversing
over half of its decline of earlier in the
year. This recovery of the euro against

68

88th Annual Report, 2001

the dollar appeared to reflect mainly a
market perception that, while growth
was slowing in both Europe and the
United States, the slowdown was much
sharper for the United States. For the
year as a whole, the dollar appreciated,
on net, about 7 percent against the
euro.
The European Central Bank raised its
policy interest rate target six times by a
total of 175 basis points over the first
ten months of the year. These increases
reflected concerns that the euro's
depreciation, tightening capacity constraints and higher oil prices would put
upward pressure on inflation. While
core inflation—inflation excluding food
and energy—remained well below the
2 percent inflation target ceiling, higher
oil prices pushed the headline rate above
the ceiling for most of the year. Real
GDP in the euro area is estimated to
have increased about 3 percent for 2000
as a whole, only slightly below the rate
of the previous year, although activity
slowed toward the end of the year.
Growth was supported by continued
strong increases in investment spending.
Net exports made only a modest contribution to growth, as rapid increases in
exports were nearly matched by robust
imports. Overall activity was sufficiently
strong to lead to a further decline in the
average euro-area unemployment rate to
below 9 percent, a nearly 1 percentage
point reduction for the year.
The dollar rose about 12 percent
against the Japanese yen over the course
of 2000, roughly reversing the decline
of the previous year. Early in the year,
the yen experienced periods of upward
pressure on evidence of a revival of
activity in Japan. On several of these
occasions, the Bank of Japan made
substantial intervention sales of yen. By
August, signs of recovery were strong
enough to convince the Bank of Japan to
end the zero interest rate policy that it



had maintained for nearly a year and a
half, and its target for the overnight rate
was raised to 25 basis points. Later in
the year, evidence emerged suggesting
that the nascent recovery in economic
activity was losing steam, and in
response the yen started to depreciate
sharply against the dollar.
For the year as a whole, Japanese real
GDP is estimated to have increased
about 2 percent, a substantial improvement from the very small increase of the
previous year and the decline recorded
in 1998. Growth, which was concentrated in the first part of the year, was
led by private nonresidential investment. In contrast, residential investment
slackened as the effect of tax incentives
waned. Consumption rebounded early in
the year from a sharp decline at the end
of 1999 but then stagnated, depressed in
part by record-high unemployment and
concerns that ongoing corporate restructuring could lead to further job losses.
Public investment, which gave a major
boost to the economy in 1999, remained
strong through the first half of last year
but then fell off sharply, and for the year
as a whole the fiscal stance is estimated
to have been somewhat contractionary.
Inflation was negative for the second
consecutive year, with the prices of both
consumer goods and real estate continuing to move lower.
The dollar appreciated 4 percent relative to the Canadian dollar last year.
Among the factors that apparently
contributed to the Canadian currency's
weakness were declines in the prices of
commodities that Canada exports, such
as metals and lumber, and a perception
by market participants of unfavorable
differentials in rates of return and economic growth prospects in Canada relative to the United States. For the year as
a whole, real GDP growth in Canada
is estimated to have been only slightly
below the strong 5 percent rate of 1999,

Monetary Policy Reports, February
although, as in most industrial countries,
there were signs that the pace of growth
was tailing off toward the end of the
year. Domestic demand continued to be
robust, led by surging business investment and solid personal consumption
increases. In the first part of the year, the
sustained rapid growth of the economy
led Canadian monetary authorities to
become increasingly concerned with a
buildup of inflationary pressures, and
the Bank of Canada matched all of the
Federal Reserve's interest rate increases
in 2000, raising its policy rate by a total
of 100 basis points. By the end of the
year, the core inflation rate had risen to
near the middle of the Bank of Canada's
1 percent to 3 percent target range,
while higher oil prices pushed the
overall rate above the top of the range.
So far this year, the Bank of Canada
has only partially followed the Federal
Reserve in lowering interest rates, and
the Canadian dollar has remained little
changed.
Emerging Market Economies
In emerging market economies, the
average growth rate of economic activity in 2000 remained near the very
strong 6 percent rate of the previous
year. However, there was a notable and
widespread slowing near the end of the
year, and results in a few individual
countries were much less favorable.
Growth in developing Asian economies
slowed on average from the torrid pace
of the previous year, while average
growth in Latin America picked up
somewhat. No major developing country experienced default or devaluation in
2000, but nonetheless, financial markets
did undergo several periods of heightened unrest during the year. In the
spring, exchange rates and equity prices
weakened and risk spreads widened in
many emerging market economies at a



69

time of a general heightening of financial market volatility and rising interest
rates in industrial countries, as well as
increased political uncertainty in several
developing countries. After narrowing
at mid-year, risk spreads on emerging
market economy debt again widened
later in the year, reflecting a general
movement on financial markets away
from riskier assets, as well as concerns
that Argentina and Turkey might be facing financial crises that could spread to
other emerging market economies. Risk
spreads generally narrowed in the early
part of 2001.
Among Latin American countries,
Mexico's performance was noteworthy.
Real GDP rose an estimated 7 percent,
an acceleration from the already strong
result of the previous year. Growth was
boosted by booming exports, especially
to the United States, favorable world
oil prices, and a rebound in domestic
demand. In order to keep inflation on a
downward path in the face of surging
domestic demand, the Bank of Mexico
tightened monetary conditions six times
last year, pushing up short-term interest
rates, and by the end of the year the rate
of consumer price inflation had moved
below the 10 percent inflation target.
The run-up to the July presidential election generated some sporadic financial
market pressures, but these subsided
in reaction to the smooth transition to
the new administration. Over the course
of the year, the risk spread on Mexican debt declined on balance, probably
reflecting a favorable assessment by
market participants of macroeconomic
developments and government policies,
reinforced by rating upgrades of Mexican debt. During 2000, the peso depreciated slightly against the dollar, but by
less than the excess of Mexican over
U.S. inflation.
Argentina encountered considerable
financial distress last year. Low tax

70

88th Annual Report, 2001

revenues due to continued weak activity
along with elevated political uncertainty
greatly heightened market concerns
about the ability of the country to fund
its debt. Starting in October, domestic
interest rates and debt risk spreads
soared amid market speculation that
the government might lose access to
credit markets and be forced to abandon
the exchange rate peg to the dollar.
Financial markets began to recover after
an announcement in mid-November
that an IMF-led international financial support package was to be put
in place. Further improvement came
in the wake of an official announcement
in December of a $40 billion support
package. The fall in U.S. short-term
interest rates in January eased pressure
on Argentina's dollar-linked economy
as well.
Late in the year, Brazilian financial
markets received some negative spillover from the financial unrest in Argentina, but conditions did not approach
those prevailing during Brazil's financial crisis of early 1999. For 2000 as a
whole, the Brazilian economy showed
several favorable economic trends. Real
GDP growth increased to an estimated
4 percent after being less than 1 percent
the previous two years, inflation continued to move lower, and short-term interest rates declined.
Growth in Asian developing countries in 2000 slowed from the previous
year, when they had still been experiencing an exceptionally rapid bounceback
from the 1997-1998 financial crises
experienced by several countries in the
region. In Korea, real GDP growth last
year is estimated to have been less than
half of the blistering 14 percent rate
of 1999. Korean exports, especially
of high-tech products, started to fade
toward the end of 2000. Rapid export
growth had been a prominent feature of
the recovery of Korea and other Asian



developing economies following their
financial crises. In addition, a sharp fall
in Korean equity prices over the course
of the year, as well as continued difficulties with the process of financial and
corporate sector restructuring, tended
to depress consumer and business confidence. These developments contributed
to the downward pressure on the won
seen near the end of the year. Elsewhere
in Asia, market concerns over heightened political instability were a major
factor behind financial pressures last
year in Indonesia, Thailand, and the
Philippines. In China, output continued
to expand rapidly in 2000, driven by a
combination of surging exports early in
the year, sustained fiscal stimulus, and
some recovery in private consumption.
In contrast, growth in both Hong Kong
and Taiwan slowed, especially in the
latter part of the year. In Taiwan, the
exchange rate and stock prices both
came under downward pressure as a
result of the slowdown in global electronics demand and apparent market
concerns over revelations of possible
weaknesses in the banking and corporate sectors.
Turkey's financial markets came
under severe strain in late November as
international investors withdrew capital
amid market worries about the health of
Turkey's banks, the viability of the government's reform program and its crawling peg exchange rate regime, and the
widening current account deficit. The
resulting liquidity shortage caused shortterm interest rates to spike up and led to
a substantial decline in foreign exchange
reserves held by the central bank. Markets stabilized somewhat after it was
announced in December that Turkey had
been able to reach loan agreements with
the IMF, major international banks, and
the World Bank in an effort to provide
liquidity and restore confidence in the
banking system.

Monetary Policy Reports, July
Report submitted to the Congress on
July 18, 2001, pursuant to section 2B of
the Federal Reserve Act

Report of July 18, 2001
Monetary Policy and the
Economic Outlook
When the Federal Reserve submitted
its report on monetary policy in midFebruary, the Federal Open Market
Committee (FOMC) had already reduced its target for the federal funds rate
twice to counter emerging weakness in
the economy. As the year has unfolded,
the weakness has become more persistent and widespread than had seemed
likely last autumn. The shakeout in the
high-technology sector has been especially severe, and with overall sales and
profits continuing to disappoint, businesses are curtailing purchases of other
types of capital equipment as well. The
slump in demand for capital goods has
also worked against businesses' efforts
to correct the inventory imbalances that
emerged in the second half of last year
and has contributed to sizable declines
in manufacturing output this year. At
the same time, foreign economies have
slowed, limiting the demand for U.S.
exports.
To foster financial conditions that will
support strengthening economic growth,
the FOMC has lowered its target for the
federal funds rate four times since February, bringing the cumulative decline
this year to 23/4 percentage points. A
number of factors spurred this unusually
steep reduction in the federal funds rate.
In particular, the slowdown in growth
was rapid and substantial and carried
considerable risks that the sluggish performance of the economy in the first
half of this year would persist. Among
other things, the abruptness of the slowing, by jarring consumer and business



71

confidence, raised the possibility of
becoming increasingly self-reinforcing
were households and businesses to postpone spending while reassessing their
situations. In addition, other financial
developments, including a higher foreign exchange value of the dollar, lower
equity prices, and tighter lending terms
and standards at banks, were tending
to restrain aggregate demand and thus
were offsetting some of the influence
of the lower federal funds rate. Finally,
despite some worrisome readings early
in the year, price increases remained
fairly well contained, and prospects
for inflation have become less of a concern as rates of resource utilization have
declined and energy prices have shown
signs of turning down.
The information available at midyear
for the recent performance of both the
U.S. economy and some of our key trading partners remains somewhat downbeat, on balance. Moreover, with inventories still excessive in some sectors,
orders for capital goods very soft, and
the effects of lower stock prices and
the weaker job market weighing on
consumers, the economy may expand
only slowly, if at all, for a while longer.
Nonetheless, a number of factors are
in place that should set the stage for
stronger growth later this year and in
2002. In particular, interest rates have
declined since last fall; the lower rates
have helped businesses and households strengthen their financial positions and should show through to aggregate demand in coming quarters. The
recently enacted tax cuts and the apparent cresting of energy prices should also
bolster aggregate demand fairly soon. In
addition, as firms at some point become
more satisfied with their inventory holdings, the cessation of liquidation will
boost production and, in turn, provide
a lift to employment and incomes; a
subsequent shift to inventory accumula-

72

88th Annual Report, 2001

tion in association with the projected
strengthening in demand should provide additional impetus to production.
Moreover, with no apparent sign of
abatement in the rapid pace of technological innovation, the outlook for
productivity growth over the longer
run remains favorable. The efficiency
gains made possible by these innovations should spur demand for the capital equipment that embodies the new
technologies once the overall economic
situation starts to improve and should
support consumption by leading to solid
increases in real incomes over time.
Even though an appreciable recovery
in the growth of economic activity by
early next year seems the most likely
outcome, there is as yet no hard evidence that this improvement is in train,
and the situation remains very uncertain. In these circumstances, the FOMC
continues to believe that the risks are
weighted toward conditions that may
generate economic weakness in the
foreseeable future. At the same time,
the FOMC recognizes the importance
of sustaining the environment of low
inflation and well-anchored inflation
expectations that enabled the Federal
Reserve to react rapidly and forcefully
to the slowing in real GDP growth over
the past several quarters. When, as the
FOMC expects, activity begins to firm,
the Committee will continue to ensure
that financial conditions remain consistent with holding inflation in check, a
key requirement for maximum sustainable growth.
Monetary Policy, Financial
Markets, and the Economy
over the First Half of 2001
By the time of the FOMC meeting on
December 19, 2000, it had become evident that economic growth had downshifted considerably, but the extent of



that slowing was only beginning to
come into focus. At that meeting, the
FOMC concluded that the risks to the
economy in the foreseeable future had
shifted to being weighted mainly toward
conditions that may generate economic
weakness and that economic and financial developments could warrant further
close review of the stance of policy well
before the next scheduled meeting. Subsequent data indicated that holiday retail
sales had come in below expectations
and that conditions in the manufacturing
sector had deteriorated. Corporate profit
forecasts had also been marked down,
and it seemed possible that the resulting
decline in equity values, along with the
expense of higher energy costs, could
damp future business investment and
household spending. In response, the
FOMC held a telephone conference on
January 3, 2001, and decided to reduce
the target federal funds rate Vi percentage point, to 6 percent, and indicated
that the risks to the outlook remained
weighted toward economic weakness.
The timing and size of the cut in the
target rate seemed to ease somewhat the
concerns of financial market participants
about the longer-term outlook for the
economy. Equity prices generally rose
in January, risk spreads on lower-rated
corporate bonds narrowed significantly,
and the yield curve steepened. However,
incoming data over the month revealed
that the slowing in consumer and business spending late last year had been
sizable. Furthermore, a sharp erosion
in survey measures of consumer confidence, a backup of inventories, and
a steep decline in capacity utilization
posed the risk that spending could
remain depressed for some time. In light
of these developments, the FOMC at its
scheduled meeting on January 30 and 31
cut its target for the federal funds rate
another lh percentage point, to 5x/2 percent, and stated that it continued to

Monetary Policy Reports, July
judge the risks to be weighted mainly
toward economic weakness.
The information reviewed by the
FOMC at its meeting on March 20 suggested that economic activity continued
to expand, but slowly. Although consumer spending seemed to be rising
moderately and housing had remained
relatively firm, stock prices had declined
substantially in February and early
March, and reduced equity wealth and
lower consumer confidence had the
potential to damp household spending
going forward. Moreover, manufacturing output had contracted further,
as businesses continued to work down
their excess inventories and cut back on
capital equipment expenditures. In addition, economic softness abroad raised
the likelihood of a weakening in U.S.
exports. Core inflation had picked up a
bit in January, but some of the increase
reflected the pass-through of a rise in
energy prices that was unlikely to continue, and the FOMC judged that the
slowdown in the growth of aggregate
demand would ease inflationary pressures on labor and other resources.
Accordingly, the FOMC on March 20
lowered its target for the federal funds
rate another Vi percentage point, to
5 percent. The members also continued
to see the risks to the outlook as remaining weighted mainly toward economic
weakness. Furthermore, the FOMC
recognized that in a rapidly evolving
economic situation, it would need to
be alert to the possibility that a conference call would be desirable during the relatively long interval before
the next scheduled meeting to discuss
the possible need for a further policy
adjustment.
Capital markets continued to soften
in late March and early April, in part
because corporate profits and economic
activity remained quite weak. Although
equity prices and bond yields began to



73

rise in mid-April as financial market
investors became more confident that a
cumulative downward spiral in activity
could be avoided, reports continued to
suggest flagging economic performance
and risks of extended weakness ahead.
In particular, spending by consumers
had leveled out and their confidence had
fallen further. The FOMC discussed
economic developments in conference
calls on April 11 and April 18, deciding
on the latter occasion to reduce its target
for the federal funds rate another Vi percentage point, to 4x/2 percent. The Committee again indicated that it judged
the balance of risks to the outlook as
weighted toward economic weakness.
When the FOMC met on May 15,
economic conditions remained quite
sluggish, especially in manufacturing,
where production and employment had
declined further. Although members
were concerned that some indicators of
core inflation had moved up in the early
months of the year and that part of the
recent backup in longer-term interest
rates may have owed to increased inflation expectations, most saw underlying price increases as likely to remain
damped as continued subpar growth
relieved pressures on resources. In light
of the prospect of continued weakness
in the economy and the significant risks
to the economic expansion, the FOMC
reduced its target for the federal funds
rate an additional Vi percentage point, to
4 percent. With the softening in aggregate demand still of unknown persistence and dimension, the FOMC continued to view the risks to the outlook
as weighted toward economic weakness.
Still, the FOMC recognized that it had
eased policy substantially this year and
that, in the absence of further sizable
adverse shocks to the economy, at future
meetings it might need to consider
adopting a more cautious approach to
further policy actions.

74

88th Annual Report, 2001

Subsequent news on economic activity and corporate profits failed to point
to a rebound. In June, interest rates on
longer-term Treasuries and on higherquality private securities declined, some
risk spreads widened, and stock prices
fell as financial market participants
trimmed their expectations for economic activity and profits. When the
FOMC met on June 26 and 27, conditions in manufacturing appeared to
have worsened still more. It also seemed
likely that slower growth abroad would
restrain demand for exports and that
weakening labor markets would hold
down growth in consumer spending. In
light of these developments, but also
taking into account the cumulative
250 basis points of easing already undertaken and the other forces likely to be
stimulating spending in the future, the
FOMC lowered its target for the federal funds rate VA percentage point, to
33/4 percent, and continued to view the
risks to the outlook as weighted toward
economic weakness.
The Board of Governors of the Federal Reserve System approved cuts in
the discount rate in the first half of the
year that matched the FOMC's cuts in
the target federal funds rate. As a result,
the discount rate declined from 6 percent to 3VA percent over the period.

Economic Projections
for 2001 and 2002
The members of the Board of Governors
and the Federal Reserve Bank presidents, all of whom participate in the
deliberations of the FOMC, expect economic growth to remain slow in the near
term, though most anticipate that it will
pick up later this year at least a little.
The central tendency of the forecasts
for the increase in real GDP over the
four quarters of 2001 spans a range of
WA percent to 2 percent, and the central



tendency of the forecasts for real GDP
growth in 2002 is 3 percent to 3J/4 percent. The civilian unemployment rate,
which averaged 4Vi percent in the second quarter of 2001, is expected to move
up to the area of 43/4 percent to 5 percent
by the end of this year. In 2002, with the
economy projected to expand at closer
to its trend rate, the unemployment rate
is expected to hold steady or perhaps to
edge higher. With pressures in labor and
product markets abating and with energy
prices no longer soaring, inflation is
expected to be well contained over the
next year and a half.
Despite the projected increase in real
GDP growth, the uncertainty about the
near-term outlook remains considerable.
Economic Projections for 2001 and 2002
Percent

Indicator

Board of Governors
and
Reserve Bank presidents
Central
tendency

Range
2001
Change, fourth quarter
to fourth quarter1
Nominal GDP
Real GDP 2
PCE prices

314-5
1-2
2-23/4

3Vfe-41/4
1 i/4-2
2-2V2

Average level,
fourth quarter
Civilian unemployment
rate

43/4-5

43/4-5
2002

Change, fourth quarter
to fourth quarter^
Nominal GDP
Real GDP 2
PCE prices

43/4_6
3-31/2
11/2-3

3-3V4
i /4-2y2

Average level,
fourth quarter
Civilian unemployment
rate

43/4-51/2

43/4-51/4

5_5i/2
3

1. Change from average for fourth quarter of previous
year to average for fourth quarter of year indicated.
2. Chain-weighted.

Monetary Policy Reports, July
This uncertainty arises not only from the
difficulty of assessing when businesses
will feel that conditions are sufficiently
favorable to warrant a pickup in capital spending but also from the difficulty
of gauging where businesses stand in
the inventory cycle. Nonetheless, all the
FOMC participants foresee a return to
solid growth by 2002. By then, the
inventory correction should have run its
course, and the monetary policy actions
taken this year, as well as the recently
enacted tax reductions, should be providing appreciable support to final
demand.
In part because of lower interest rates,
many firms have been able to shore up
their balance sheets. And although some
lower-rated firms, especially in telecommunications and other sectors with
gloomy near-term prospects, may continue to find it difficult to obtain financing, businesses generally are fairly well
positioned to step up their capital spending once the outlook for sales and profits improves. By all accounts, technological innovation is still proceeding
rapidly, and these advances should eventually revive high-tech investment, especially with the price of computing power
continuing to drop sharply.
In addition, consumer spending is
expected to get a boost from the tax
cuts and from falling energy prices,
which should help offset the effects of
the weaker job market and the decline
over the past year in stock market
wealth. Housing activity, which has
been buoyed in recent quarters by low
mortgage interest rates, is likely to
remain firm into 2002. Significant
concerns remain about the foreign economic outlook and the prospects for U.S.
exports. Nevertheless, economic activity
abroad is expected to benefit from a
strengthening of the U.S. economy, a
stabilization of the global high-tech
sector, an easing of oil prices, and stimu


75

lative macroeconomic policies in some
countries.
The chain-type price index for personal consumption expenditures rose
2lA percent over the four quarters of
2000, and most FOMC participants
expect inflation to remain around that
rate through next year; indeed, the central tendency of their forecasts for the
increase in this price measure is 2 percent to 2V2 percent in 2001 and PA percent to 2Vi percent in 2002. One favorable factor in the inflation outlook is the
behavior of energy prices. Those prices
have declined recently after having
increased rapidly in the past couple of
years, and prospects are good that they
could stabilize or even fall further
in coming quarters. In addition to their
direct effects, lower energy prices
should tend to limit increases in other
prices by reducing input costs for a wide
range of energy-intensive goods and services and by helping damp inflation
expectations. More broadly, the competitive conditions that have restricted
businesses' ability to raise prices in
recent years are likely to persist. And
although labor costs could come under
upward pressure as wages tend to catch
up to previous increases in productivity, the slackening in resource utilization this year is expected to contribute
to reduced inflation pressures going
forward.

Economic and Financial
Developments in 2001
Economic growth remained very slow
in the first half of 2001 after having
downshifted in the second half of 2000.
Real gross domestic product rose at an
annual rate of just VA percent in the
first quarter, about the same as in the
fourth quarter, and appears to have
posted at best a meager gain in the
second quarter. Businesses have been

76

88th Annual Report, 2001

working to correct the inventory imbalances that emerged in the second half
of last year, which has led to sizable
declines in manufacturing output, and
capital spending has weakened appreciably. In contrast, household spending—
especially for motor vehicles and
houses—has held up well. Employment
increased only modestly over the first
three months of the year and turned
down in the spring; the unemployment
rate in June stood at 4Vi percent, Vi percentage point higher than in the fourth
quarter of last year.
The inflation news early this year was
not very favorable, as energy prices
continued to soar and as measures of
core inflation—which exclude food and
energy—registered some pickup. More
recently, however, energy prices have
moved lower, and the monthly readings
on core inflation have returned to more
moderate rates. Moreover, apart from
energy, prices at earlier stages of processing have been quiescent this year.

The Household Sector
Growth in household spending has
slowed noticeably from the rapid pace
of the past few years. Still, it was fairly
well maintained in the first half of 2001
despite the weaker tenor of income,
wealth, and consumer confidence, and
the personal saving rate declined a bit
further. A greater number of households
encountered problems servicing debt,
but widespread difficulties or restrictions on the availability of credit did not
emerge.
Consumer Spending
Real consumer spending grew at an
annual rate of 3Vi percent in the first
quarter. Some of the increase reflected
a rebound in purchases of light motor
vehicles, which were boosted by a sub


stantial expansion of incentives and rose
to just a tad below the record pace of
2000 as a whole. In addition, outlays
for non-auto goods posted a solid gain,
and spending on services rose modestly
despite a weather-related drop in outlays
for energy services. In the second quarter, however, the rise in consumer spending seems to have lessened as sales of
light motor vehicles dropped a bit, on
average, and purchases of other goods
apparently did not grow as fast in real
terms as they had in the first quarter.
The rise in real consumption so far
this year has been considerably smaller
than the outsized gains in the second
half of the 1990s and into 2000. But the
increase in spending still outstripped
the growth in real disposable personal
income (DPI), which has been restrained
this year by further big increases in consumer energy prices and by the deterioration in the job market; between the
fourth quarter of 2000 and May, real
DPI increased just about 2 percent at an
annual rate, well below the average pace
of the preceding few years. In addition,
the net worth of households fell again
in the first quarter, to a level 8 percent
below the high reached in the first quarter of 2000. On net, the ratio of household net worth to DPI has returned to
about the level reached in 1997, significantly below the recent peak but still
high by historical standards. In addition,
consumer sentiment indexes, which had
risen to extraordinary levels in the late
1990s and remained there through last
fall, fell sharply around the turn of the
year. However, these indexes have not
deteriorated further, on net, since the
winter and are still at reasonably favorable levels when compared with the
readings for the pre-1997 period.
Rising household wealth almost certainly was a key factor behind the surge
in consumer spending between the mid1990s and last year, and thus helps to

Monetary Policy Reports, July
explain the sharp fall in the personal
saving rate over that period. The saving
rate has continued to fall this year—
from -0.7 percent in the fourth quarter
of 2000 to -1.1 percent in May—even
though the boost to spending growth
from the earlier run-up in stock prices
has likely run its course and the effects
of lower wealth should be starting to
feed through to spending. The apparent
decline in the saving rate may simply
reflect noisiness in the data or a slower
response of spending to wealth than
average historical experience might suggest. In addition, consumers probably
base their spending decisions on income
prospects over a longer time span than
just a few quarters. Thus, to the extent
that consumers do not expect the current
sluggishness in real income growth to
persist, the tendency to maintain spending for a time by dipping into savings or
by borrowing may have offset the effect
of the decline in wealth on the saving
rate.
Residential Investment
Housing activity remained buoyant in
the first half of this year as lower mortgage interest rates appear to have offset
the restraint from smaller gains in
employment and income and from lower
levels of wealth. In the single-family
sector, starts averaged an annual rate
of 1.28 million units over the first five
months of the year—4 percent greater
than the hefty pace for 2000 as a whole.
Sales of new and existing homes
strengthened noticeably around the turn
of the year and were near record levels
in March; they fell back in April but
reversed some of that drop in May.
Inventories of new homes for sale are
exceptionally low; builders' backlogs
are sizable; and, according to the Michigan survey, consumers' assessments of
homebuying conditions remain favor


11

able, mainly because of perceptions that
mortgage rates are low.
Likely because of the sustained
strength of housing demand, home
prices have continued to rise faster than
overall inflation, although the various
measures that attempt to control for
shifts in the regional composition of
sales and in the characteristics of houses
sold provide differing signals on the
magnitude of the price increases. Notably, over the year ending in the first
quarter, the constant-quality price index
for new homes rose 4 percent, while
the repeat-sales price index for existing
homes was up nearly 9 percent. Despite
the higher prices, the share of income
required to finance a home purchase—
one measure of affordability—has fallen
in recent quarters as mortgage rates have
dropped back after last year's bulge, and
that share currently is about as low as it
has been at any time in the past decade.
Rates on thirty-year conventional fixedrate loans now stand around 11A percent,
and ARM rates are at their lowest levels
in a couple of years.
In the multifamily sector, housing
starts averaged 343,000 units at an
annual rate over the first five months of
the year, matching the robust pace that
has been evident since 1997. Moreover,
conditions in the market for multifamily
housing continue to be conducive to
new construction. The vacancy rate for
multifamily rental units in the first quarter held near its low year-earlier level,
and rents and property values continued
to rise rapidly.
Household Finance
The growth of household debt is estimated to have slowed somewhat in the
first half of this year to a still fairly hefty
IV2 percent annual rate—about a percentage point below its average pace
over the previous two years. Households

78

88th Annual Report, 2001

have increased both their home mortgage debt and their consumer credit
(debt not secured by real estate) substantially this year, although in both cases
the growth has moderated a bit recently.
The relatively low mortgage interest
rates have boosted mortgage borrowing
both by stimulating home purchases
and by making it attractive to refinance
existing mortgages and extract some of
the buildup in home equity. The rapid
growth in consumer credit has been concentrated in credit card debt, perhaps
reflecting households' efforts to sustain
their consumption in the face of weaker
income growth.
The household debt service burden—
the ratio of minimum scheduled payments on mortgage and consumer debt
to disposable personal income—rose
to more than 14 percent at the end of
the first quarter, a twenty-year high, and
available data suggest a similar reading
for the second quarter. In part because
of the elevated debt burden, some measures of household loan performance
have deteriorated a bit in recent quarters. The delinquency rate on home
mortgage loans has edged up but
remains low, while the delinquency rate
on credit card loans has risen noticeably
and is in the middle part of its range
over the past decade. Personal bankruptcies jumped to record levels in the
spring, but some of the spurt was probably the result of a rush to file before
Congress passed bankruptcy reform
legislation.
Lenders have tightened up somewhat
in response to the deterioration of household financial conditions. In the May
Senior Loan Officer Opinion Survey on
Bank Lending Practices, about a fifth of
the banks indicated that they had tightened the standards for approving applications for consumer loans over the preceding three months, and about a fourth
said that they had tightened the terms on



loans they are willing to make, substantial increases from the November survey. Of those that had tightened, most
cited actual or anticipated increases in
delinquency rates as a reason.
The Business Sector
The boom in capital spending that has
helped fuel the economic expansion
came to a halt late last year. After having risen at double-digit rates over the
preceding five years, real business fixed
investment flattened out in the fourth
quarter of 2000 and rose only a little in
the first quarter of 2001. Demand for
capital equipment has slackened appreciably, reflecting the sluggish economy,
sharply lower corporate profits and cash
flow, earlier overinvestment in some
sectors, and tight financing conditions
facing some firms. In addition, inventory investment fell substantially in the
first quarter as businesses moved to
address the overhangs that began to
develop late last year. With investment
spending weakening, businesses have
cut back on new borrowing. Following
the drop in longer-term interest rates
in the last few months of 2000, credit
demands have been concentrated in
longer-term markets, though cautious
investors have required high spreads
from marginal borrowers.
Fixed Investment
Real spending on equipment and software (E&S) began to soften in the second half of last year, and it posted small
declines in both the fourth quarter of
2000 and the first quarter of 2001. Much
of the weakness in the first quarter was
in spending on high-tech equipment and
software; such spending, which now
accounts for about half of E&S outlays when measured in nominal terms,
declined at an annual rate of about

Monetary Policy Reports, July
12 percent in real terms—the first real
quarterly drop since the 1990 recession.
An especially sharp decrease in outlays
for communications equipment reflected
the excess capacity that had emerged as
a result of the earlier surge in spending,
the subsequent re-evaluation of profitability, and the accompanying financing
difficulties faced by some firms. In addition, real spending on computers and
peripheral equipment, which rose more
than 40 percent per year in the second
half of the 1990s, showed little growth,
on net, between the third quarter of 2000
and the first quarter of 2001. The leveling in real computer spending reportedly reflects some stretching out of businesses' replacement cycles for personal
computers as well as a reduced demand
for servers. Outside the high-tech area,
spending rose in the first quarter as purchases of motor vehicles reversed some
of the decline recorded over the second
half of 2000 and as outlays for industrial
equipment picked up after having been
flat in the fourth quarter.
Real E&S spending likely dropped
further in the second quarter. In addition
to the ongoing contraction in outlays
on high-tech equipment, the incoming
data for orders and shipments point to a
decline in investment in non-high-tech
equipment, largely reflecting the weakness in the manufacturing sector this
year.
Outlays on nonresidential construction posted another sizable advance in
early 2001 after having expanded nearly
13 percent in real terms in 2000, but
the incoming monthly construction data
imply a sharp retrenchment in the second quarter. The downturn in spending
comes on the heels of an increase in
vacancy rates for office and industrial
space in many cities. Moreover, while
financing generally remains available
for projects with viable tenants, lenders
are now showing greater caution. Not



79

surprisingly, one bright spot is the
energy sector, where expenditures for
drilling and mining have been on a
steep uptrend since early 1999 (mainly
because of increased exploration for
natural gas) and the construction of
facilities for electric power generation
remains very strong.
Inventory Investment
A sharp reduction in the pace of inventory investment was a major damping
influence on real GDP growth in the
first quarter of 2001. The swing in real
nonfarm inventory investment from an
accumulation of $51 billion at an annual
rate in the fourth quarter of 2000 to a
liquidation of $25 billion in the first
quarter of 2001 subtracted 3 percentage
points from the growth in real GDP in
the first quarter. Nearly half of the negative contribution to GDP growth came
from the motor vehicle sector, where a
sizable cut in assemblies (added to the
reduction already in place in the fourth
quarter) brought the overall days' supply down to comfortable levels by the
end of the first quarter. A rise in truck
assemblies early in the second quarter
led to some backup of inventories in
that segment of the market, but truck
stocks were back in an acceptable range
by June; automobile assemblies were up
only a little in the second quarter, and
stocks remained lean.
Firms outside the motor vehicles
industry also moved aggressively to
address inventory imbalances in the first
half of the year, and this showed through
to manufacturing output, which, excluding motor vehicles, fell at an annual rate
of IVi percent over this period. These
production adjustments—along with a
sharp reduction in the flow of imports—
contributed to a small decline in real
non-auto stocks in the first quarter, and
book-value data for the manufactur-

80

88th Annual Report, 2001

ing and trade sector point to a further
decrease, on net, in April and May. As
of May, stocks generally seemed in line
with sales at retail trade establishments,
but there were still some notable overhangs in wholesale trade and especially
in manufacturing, where inventoryshipments ratios for producers of computers and electronic products, primary
and fabricated metals, and chemicals
remained very high.
Business Finance
The economic profits of U.S. corporations fell at a 19 percent annual rate in
the first quarter after a similar decline
in the fourth quarter of 2000. As a result,
the ratio of profits to GDP declined
1 percentage point over the two quarters, to 8.5 percent; the ratio of the profits of nonfinancial corporations to sector
output fell 2 percentage points over
the interval, to 10 percent. Investment
spending has declined by more than
profits, however, reducing somewhat the
still-elevated need of nonfinancial corporations for external funds to finance
capital expenditures. Corporations have
husbanded their increasingly scarce
internal funds by cutting back on cashfinanced mergers and equity repurchases. While equity retirements have
therefore fallen, so has gross equity issuance, though by less. Inflows of venture
equity capital, in particular, have been
reduced substantially. Businesses have
met their financing needs by borrowing
heavily in the bond market while paying
down both commercial and industrial
(C&I) loans at banks and commercial
paper. In total, after having increased
9V2 percent last year, the debt of nonfinancial businesses rose at a 5 percent
annual rate in the first quarter of this
year and is estimated to have risen at
about the same pace in the second
quarter.



The decline in C&I loans and commercial paper owes, in part, to less
hospitable conditions in shorter-term
funding markets. The commercial paper
market was rattled in mid-January by
the defaults of two large California utilities. Commercial paper is issued only by
highly rated corporations, and default is
extremely rare. The defaults, along with
some downgrades, led investors in commercial paper to pull back and reevaluate the riskiness of issuers. For a while,
issuance by all but top-rated names
became very difficult and quality
spreads widened significantly, pushing
some issuers into the shortest maturities
and inducing others to exit the market
entirely. As a consequence, the amount
of commercial paper outstanding plummeted. In the second quarter, risk
spreads returned to more typical levels
and the runoff moderated. By the end
of June, the amount of nonfinancial
commercial paper outstanding was
nearly 30 percent below its level at the
end of 2000, with many firms still not
having returned to the market.
Even though banks' C&I loans were
boosted in January and February by borrowers substituting away from the commercial paper market, loans declined, on
net, over the first half of the year, in part
because borrowers paid down their bank
loans with proceeds from bond issues.
Many banks reported on the Federal
Reserve's Bank Lending Practices surveys this year that they had tightened
standards and terms—including the premiums charged on riskier loans, the cost
of credit lines, and loan covenants—
on C&I loans. Loan officers cited a
worsened economic outlook, industryspecific problems, and a reduced tolerance for risk as the reasons for having
tightened. Despite these adjustments to
banks' lending stance, credit appears to
remain amply available for sound borrowers, and recent surveys of small

Monetary Policy Reports, July
businesses indicate that they have not
found credit significantly more difficult
to obtain.
Meanwhile, the issuance of corporate
bonds this year has proceeded at about
double the pace of the preceding two
years. With the yields on high-grade
bonds back down to their levels in the
first half of 1999 and with futures
quotes suggesting interest rates will be
rising next year, corporations apparently
judged it to be a relatively opportune
time to issue. Although investors remain
somewhat selective, they have been
willing to absorb the large volume of
issuance as they have become more confident that the economy would recover
and a prolonged disruption to earnings
would be avoided. The heavy pace of
issuance has been supported, in part, by
inflows into bond mutual funds, which
may have come at the expense of equity
funds.
The flows are forthcoming at relatively high risk spreads, however.
Spreads of most grades of corporate debt
relative to rates on swaps have fallen
a little this year, but spreads remain
unusually high for lower investmentgrade and speculative-grade credits. The
elevated spreads reflect the deterioration in business credit quality that has
occurred as the economy has slowed.
While declines in interest rates have
held aggregate interest expense at a
relatively low percentage of cash flow,
many individual firms are feeling the
pinch of decreases in earnings. Over the
twelve months ending in May, 11 percent of speculative-grade bonds, by dollar volume, have defaulted—the highest
percentage since 1991 and a substantial jump from 1998, when less than
2 percent defaulted. This deterioration
reflects not only the unusually large
defaults by the California utilities, but
also stress in the telecommunications
sector and elsewhere. However, some



81

other measures of credit performance
have shown a more moderate worsening. The ratio of the liabilities of failed
businesses to those of all nonfinancial
businesses and the delinquency rate on
C&I loans at banks have risen noticeably from their lows in 1998, but both
remain well below levels posted in the
early 1990s.
Commercial mortgage debt increased
at about an S3A percent annual rate in
the first half of this year, and the issuance of commercial-mortgage-backed
securities (CMBS) maintained its robust
pace of the past several years. While
spreads of the yields on investment- and
speculative-grade CMBS over swap
rates have changed little this year, significant fractions of banks reported
on the Bank Lending Practices survey
that they have tightened terms and
standards on commercial real estate
loans. Although the delinquency rates
on CMBS and commercial real estate
loans at banks edged up in the first
quarter, they remained near record lows.
Nevertheless, those commercial banks
that reported taking a more cautious
approach toward commercial real estate
lending stated that they are doing so, in
part, because of a less favorable economic outlook in general and a worsening of the outlook for commercial real
estate.
The Government Sector
The fiscal 2001 surplus in the federal
unified budget is likely to be smaller
than the surplus in fiscal 2000 because
of the slower growth in the economy
and the recently enacted tax legislation.
Nonetheless, the unified surplus will
remain large, and the paydown of the
federal debt is continuing at a rapid
clip. As a consequence, the Treasury has
taken a number of steps to preserve
liquidity in a shrinking market. The

82

88th Annual Report, 2001

weaker economy is also reducing revenues at the state and local level, but
these governments remain in reasonably
good fiscal shape overall and are taking
advantage of historically low interest
rates to refund existing debt and to issue
new debt.

technology-driven boom in domestic
investment in recent years.
Federal receipts in the first eight
months of the current fiscal year were
just AXA percent higher than during the
first eight months of fiscal 2000—a
much smaller gain than those posted,
on average, over the preceding several
years. Much of the slowing was in corFederal Government
porate receipts, which dropped below
The fiscal 2001 surplus in the federal year-earlier levels, reflecting the recent
government's unified budget is likely to deterioration in profits. In addition, indicome in below the fiscal 2000 surplus of vidual income tax payments rose less
$236 billion. Over the first eight months rapidly than over the preceding few
of the fiscal year—October to May—the years, mainly because of slower growth
unified budget recorded a surplus of in withheld tax payments. This spring's
$137 billion, $16 billion higher than nonwithheld payments of individual
during the comparable period last year. taxes, which are largely payments on the
But over the balance of the fiscal year, previous year's liability, were relatively
receipts will continue to be restrained strong. Indeed, although there was no
by this year's slow pace of economic appreciable "April surprise" this year—
growth and the associated decline in that is, these payments were about in
corporate profits. Receipts will also be line with expectations—liabilities again
reduced significantly over the next few appear to have risen faster than the
months by the payout of tax rebates and NIPA tax base in 2000. One factor that
the shift of some corporate payments has lifted liabilities relative to income
into fiscal 2002, provisions included in in recent years is that rising levels of
the Economic Growth and Tax Relief income and a changing distribution have
shifted more taxpayers into higher tax
Reconciliation Act of 2001.
Federal saving, which is basically brackets. Higher capital gains realizathe unified budget surplus adjusted to tions also have helped raise liabilities
conform to the accounting practices fol- relative to the NIPA tax base over this
lowed in the national income and prod- period. (Capital gains are not included
uct accounts (NIPA), has risen dramati- in the NIPA income measure, which, by
cally since hitting a low of —3V2 percent design, includes only income from curof GDP in 1992 and stood at 33/4 percent rent production.)
of GDP in the first quarter—a swing of
The faster growth in outlays that
more than 7 percentage points. Reflect- emerged in fiscal 2000 has extended
ing the high level of federal saving, into fiscal 2001. Smoothing through
national saving, which comprises saving some timing anomalies at the start of the
by households, businesses, and govern- fiscal year, nominal spending during the
ments, has been running at a higher rate first eight months of fiscal 2001 was
since the late 1990s than it did over more than 4 percent higher than during
most of the preceding decade, even as the same period last year; excluding the
the personal saving rate has plummeted. sizable drop in net interest outlays that
The deeper pool of national saving, has accompanied the paydown of the
along with large inflows of foreign federal debt, the increase in spending
capital, has provided resources for the so far this year was nearly 6 percent.



Monetary Policy Reports, July
Spending in the past couple of years
has been boosted by sizable increases
in discretionary appropriations as well
as by faster growth in outlays for the
major health programs. The especially
rapid increase in Medicaid outlays
reflects the higher cost and utilization
of medical care (including prescription
drugs), growing enrollments, and a rise
in the share of expenses picked up
by the federal government. Outlays for
Medicare have been lifted, in part, by
the higher reimbursements to providers
that were enacted last year.
Real federal expenditures for consumption and gross investment, the part
of government spending that is included
in GDP, rose at a 5 percent annual rate
in the first quarter. Over the past couple
of years, real nondefense purchases have
remained on the moderate uptrend that
has been evident since the mid-1990s,
while real defense purchases have
started to rise slowly after having bottomed out in the late 1990s.
The Treasury has used the substantial
federal budget surpluses to pay down
its debt further. At the end of June, the
outstanding Treasury debt held by the
public had fallen nearly $600 billion, or
15 percent, from its peak in 1997. Relative to nominal GDP, publicly held debt
has dropped from nearly 50 percent in
the mid-1990s to below 33 percent in
the first quarter, the lowest it has been
since 1984.
Declines in outstanding federal debt
and the associated reductions in the sizes
and frequency of auctions of new issues
have diminished the liquidity of the
Treasury market over the past few years.
Bid-asked spreads are somewhat wider,
quote sizes are smaller, and the difference between yields on seasoned versus
most-recently issued securities has
increased. In part, however, these developments may also reflect a more cautious attitude among securities dealers



83

following the market turmoil in the fall
of 1998.
The Treasury has taken a number of
steps to limit the deterioration in the
liquidity of its securities. In recent years,
it has concentrated its issuance into
fewer securities, so that the auction sizes
of the remaining securities are larger.
Last year, in order to enable issuance of
a larger volume of new securities, the
Treasury began buying back less-liquid
older securities, and it also made every
second auction of its 5- and 10-year
notes and 30-year bond a reopening of
the previously issued security. In February, the Treasury put limits on the noncompetitive bids that foreign central
banks and governmental monetary entities may make, so as to leave a larger
and more predictable pool of securities
available for competitive bidding, helping to maintain the liquidity and efficiency of the market. In May, the Treasury announced that it would begin
issuing Treasury bills with a four-week
maturity to provide it with greater flexibility and cost efficiency in managing its cash balances, which, in part
because new securities are now issued
less frequently, have become more volatile. Finally, also in May, the Treasury
announced it would in the next few
months seek public comment on a plan
to ease the "35 percent rule," which
limits the bidding at auctions by those
holding claims on large amounts of an
issue. With reopenings increasingly
being used to maintain liquidity in individual issues, this rule was constraining
many potential bidders. As discussed
below, the reduced issuance of Treasury securities has also led the Federal
Reserve to modify its procedures for
acquiring such securities and to study
possible future steps for its portfolio.
In early 2000, as investors focused
on the possibility that Treasury securities were going to become increasingly

84

88th Annual Report, 2001

scarce, they became willing to pay a
premium for longer-dated securities,
pushing down their yields. However,
these premiums appear to have largely
unwound later in the year as market
participants made adjustments to the
new environment. These adjustments
include the substitution of alternative
instruments for hedging and pricing,
such as interest rate swaps, prominent
high-grade corporate bonds, and securities issued by government-sponsored
enterprises (GSEs). To benefit from
adjustments by market participants, in
1998, Fannie Mae and Freddie Mac initiated programs to issue securities that
share some characteristics with Treasury securities, such as regular issuance
calendars and large issue sizes; in the
first half of this year they issued $88 billion of coupon securities and $502 billion of bills under these programs. The
GSEs have also this year begun buying back older securities to boost the
size of their new issues. Nevertheless,
the market for Treasury securities
remains considerably more liquid than
markets for GSE and other fixed-income
securities.
State and Local Governments
State and local governments saw an
enormous improvement in their budget
positions between the mid-1990s and
last year as revenues soared and spending generally was held in check; accordingly, these governments were able both
to lower taxes and to make substantial allocations to reserve funds. More
recently, however, revenue growth has
slowed in many states, and reports of
fiscal strains have increased. Nonetheless, the sector remains in relatively
good fiscal shape overall, and most governments facing revenue shortfalls have




managed to adopt balanced budgets for
fiscal 2002 with only minor adjustments
to taxes and spending.
Real consumption and investment
spending by state and local governments
rose at nearly a 5 percent annual rate
in the first quarter and apparently posted
a sizable increase in the second quarter
as well. Much of the strength this year
has been in construction spending,
which has rebounded sharply after a
reported decline in 2000 that was hard
to reconcile with the sector's ongoing
infrastructure needs and the good financial condition of most governments.
Hiring also remained fairly brisk during
the first half of the year; on average,
employment rose 30,000 per month,
about the same as the average monthly
increase over the preceding three
years.
Although interest rates on municipal debt have edged up this year, they
remain low by historical standards.
State and local governments have taken
advantage of the low interest rates to
refund existing debt and to raise new
capital. Credit quality has remained
quite high in the municipal sector
even as tax receipts have softened, with
credit upgrades outpacing downgrades
in the first half of this year. Most
notable among the downgrades was that
of California's general obligation bonds.
Standard and Poor's lowered California's debt two notches from AA to A+,
citing the financial pressures from the
electricity crisis and the likely adverse
effects of the crisis on the state's
economy.
The External Sector
The deficits in U.S. external balances
narrowed sharply in the first quarter of
this year, largely because of a smaller

Monetary Policy Reports, July
deficit in trade in goods and services.
Most of the financial flows into the
United States continued to come from
private foreign sources.
Trade and Current Account
After widening continuously during the
past four years, the deficits in U.S. external balances narrowed in the first quarter of 2001. The current account deficit
in the first quarter was $438 billion at an
annual rate, or 4.3 percent of GDP, compared with $465 billion in the fourth
quarter of 2000. Most of the reduction
of the current account deficit can be
traced to changes in U.S. trade in goods
and services; the trade deficit narrowed
from an annual rate of $401 billion in
the fourth quarter of 2000 to $380 billion in the first quarter of this year. The
trade deficit in April continued at about
the same pace. Net investment income
payments were a bit less in the first
quarter than the average for last year
primarily because of a sizable decrease
in earnings by U.S. affiliates of foreign
firms.
As US. economic growth slowed in
the second half of last year and early
this year, real imports of goods and
services, which had grown very rapidly
in the first three quarters of 2000,
expanded more slowly in the fourth
quarter and then contracted 5 percent
at an annual rate in the first quarter.
The largest declines were in high-tech
products (computers, semiconductors,
and telecommunications equipment)
and automotive products. In contrast,
imports of petroleum and petroleum
products increased moderately. A temporary surge in the price of imported
natural gas pushed the increase of the
average price of non-oil imports above
an annual rate of 1 percent in the first



85

quarter, slightly higher than the rate of
increase recorded in 2000.
U.S. real exports were hit by slower
growth abroad, the strength of the
dollar, and plunging global demand
for high-tech products. Real exports of
goods and services, which had grown
strongly in the first three quarters of
2000, fell 6V2 percent at an annual rate
in the fourth quarter of last year and
declined another 1 percent in the first
quarter of this year. The largest declines
in both quarters were in high-tech capital goods and automotive products (primarily in intrafirm trade with Canada).
By market destination, the largest
increases in U.S. goods exports during
the first three quarters of 2000 had been
to Mexico and countries in Asia; the
recent declines were mainly in exports
to Asia and Latin America. In contrast,
goods exports to Western Europe
increased steadily throughout the entire
period. About 45 percent of U.S. goods
exports in the first quarter of 2001 were
capital equipment; 20 percent were
industrial supplies; and 5 to 10 percent
each were agricultural, automotive, consumer, and other goods.
After increasing through much of
2000, the spot price of West Texas intermediate (WTI) crude oil reached a peak
above $37 per barrel in September, the
highest level since the Gulf War. As
world economic growth slowed in the
latter part of 2000, oil price declines
reversed much of the year's price gain.
In response, OPEC reduced its official
production targets in January of this year
and again in March. As a result, oil
prices have remained relatively high in
2001 despite weaker global economic
growth and a substantial increase in
U.S. oil inventories. Oil prices have also
been elevated by the volatility of Iraqi
oil exports arising from tense relations

86

8 8 * Annual Report, 2001

between Iraq and the United Nations.
During the first six months of this year,
the spot price of WTI has fluctuated,
with only brief exceptions, between $27
and $30 per barrel.

ing, and the unemployment rate rose.
Increases in hourly compensation have
continued to trend up in recent quarters,
while measured labor productivity has
been depressed by the slower growth of
output.

Financial Account
In the first quarter of 2001, as was the
case in 2000 as a whole, nearly all of the
net financial flows into the United States
came from private foreign sources. Foreign official inflows were less than
$5 billion and were composed primarily of the reinvestment of accumulated
interest earnings. Reported foreign
exchange intervention purchases of dollars were modest.
Inflows arising from private foreign
purchases of U.S. securities accelerated
further in the first quarter and are on a
pace to exceed last year's record. All of
the pickup is attributable to larger net
foreign purchases of U.S. bonds, as foreign purchases of both corporate and
agency bonds accelerated and private
foreign sales of Treasuries paused. Foreign purchases of U.S. equities are only
slightly below their 2000 pace despite
the apparent decline in expected returns
to holding US. equities.
The pace at which U.S. residents
acquired foreign securities changed little
between the second half of last year and
the first quarter of this year. As in previous years, most of the foreign securities
acquired were equities.
Net financial inflows associated with
direct investment slowed a good bit in
the first quarter, as there were significantly fewer large foreign takeovers of
U.S. firms and US. direct investment
abroad remained robust.
The Labor Market
Labor demand weakened in the first
half of 2001, especially in manufactur


Employment and Unemployment
After having risen an average of
149,000 per month in 2000, private payroll employment increased an average
of only 63,000 per month in the first
quarter of 2001, and it declined an average of 117,000 per month in the second
quarter. The unemployment rate moved
up over the first half of the year and in
June stood at 4Vi percent, V2 percentage
point higher than in the fourth quarter of
last year.
Much of the weakness in employment
in the first half of the year was in the
manufacturing sector, where job losses
averaged 78,000 per month in the first
quarter and 116,000 per month in the
second quarter. Since last July, manufacturing employment has fallen nearly
800,000. Factory job losses were widespread in the first half of the year, with
some of the biggest cutbacks at industries struggling with sizable inventory
overhangs, including metals and industrial and electronic equipment. The
weakness in manufacturing also cut into
employment at help-supply firms and at
wholesale trade establishments.
Apart from manufacturing and the
closely related help-supply and wholesale trade industries, employment
growth held up fairly well in the first
quarter but began to slip noticeably in
the second quarter. Some of the slowing
in the second quarter reflected a drop in
construction employment after a strong
first quarter that likely absorbed a portion of the hiring that normally takes
place in the spring; on average, construction employment rose a fairly brisk

Monetary Policy Reports, July
15,000 per month over the first half,
about the same as in 2000. Hiring in the
services industry (other than help-supply
firms) also slowed markedly in the second quarter. Employment in retail trade
remained on a moderate uptrend over
the first half of the year, and employment in finance, insurance, and real
estate increased modestly after having
been unchanged, on net, last year.
Labor Costs and Productivity
Through the first quarter, compensation
growth remained quite strong—indeed,
trending higher by some measures.
These gains likely reflected the influence of earlier tight labor markets,
higher consumer price inflation—
largely due to soaring energy prices—
and the greater real wage gains made
possible by faster structural productivity
growth. The upward pressures on labor
costs could abate in coming quarters if
pressures in labor markets ease and
energy prices fall back.
Hourly compensation, as measured by
the employment cost index (ECI) for
private nonfarm businesses, moved up
in the first quarter to a level about
AlA percent above its level of a year
earlier; this compares with increases of
about 4Vi percent over the preceding
year and 3 percent over the year before
that. The slight deceleration in the most
recent twelve-month change in the ECI
is accounted for by a slowdown in the
growth of compensation for sales workers relative to the elevated rates that had
prevailed in early 2000; these workers'
pay includes a substantial commission
component and thus is especially sensitive to cyclical developments. Compensation per hour in the nonfarm business
sector—a measure that picks up some
forms of compensation that the ECI
omits but that sometimes has been
revised substantially once the data go



87

through the annual revision process—
shows a steady uptrend over the past
couple of years; it rose 6 percent over
the year ending in the first quarter after
having risen AVi percent over the preceding year.
According to the ECI, wages and
salaries rose at an annual rate of about
AV2 percent in the first quarter. Excluding sales workers, wages rose 5 percent
(annual rate) in the first quarter and
4V4 percent over the year ending in
March; this compares with an increase
of 3% percent over the year ending in
March 2000. Separate data on average
hourly earnings of production or nonsupervisory workers also show a discernible acceleration of wages: The
twelve-month change in this series was
AXA percent in June, V2 percentage point
above the reading for the preceding
twelve months.
Benefit costs as measured in the ECI
have risen faster than wages over the
past year, with the increase over the
twelve months ending in March totaling
5 percent. Much of the pressure on benefits is coming from health insurance,
where employer payments have accelerated steadily since bottoming out in the
mid-1990s and are now going up about
8 percent per year. The surge in spending on prescription drugs accounts for
some of the rise in health insurance
costs, but demand for other types of
medical care is increasing rapidly as
well. Moreover, although there has
been some revamping of drug coverage
to counter the pressures of soaring
demand, many employers have been
reluctant to adjust other features of the
health benefits package in view of the
need to retain workers in a labor market
that has been very tight in recent years.
Measured labor productivity in the
nonfarm business sector has been
bounced around in recent quarters by
erratic swings in hours worked by self-

88

88th Annual Report, 2001

employed individuals, but on balance, it
has barely risen since the third quarter
of last year after having increased about
3 percent per year, on average, over the
preceding three years. This deceleration
coincides with a marked slowing in output growth and seems broadly in line
with the experience of past business
cycles; these readings remain consistent
with a noticeable acceleration in structural productivity having occurred in the
second half of the 1990s. Reflecting the
movements in hourly compensation and
in actual productivity, unit labor costs in
the nonfarm business sector jumped in
the first quarter and have risen 3Vi percent over the past year.
Looking ahead, prospects for favorable productivity performance will
hinge on a continuation of the rapid
technological advances of recent years
and on the willingness of businesses to
expand and update their capital stocks
to take advantage of the new efficiencyenhancing capital that is becoming
available at declining cost in many
cases. To be sure, the current weakness
in business investment will likely damp
the growth of the capital stock relative
to the pace of the past couple of years.
But once the cyclical weakness in the
economy dissipates, continued advances
in technology should provide impetus to
renewed capital spending and a return to
solid increases in productivity.
Prices
Inflation moved higher in early 2001 but
has moderated some in recent months.
After having risen 2VA percent in 2000,
the chain price index for personal consumption expenditures (PCE) increased
about 3V4 percent in the first quarter of
2001 as energy prices soared and as core
consumer prices—which exclude food
and energy—picked up. Energy prices
continued to rise rapidly in April and



May but eased in June and early July. In
addition, core PCE price inflation has
dropped back after the first-quarter
spurt, and the twelve-month change in
this series, which is a useful indicator of
the underlying inflation trend, stood at
\xh percent in May, about the same as
the change over the preceding twelve
months. The core consumer price index
(CPI) continued to move up at a faster
pace than the core PCE measure over
the past year, rising 2Vi percent over the
twelve months ending in May, also the
same rate as over the preceding year.
PCE energy prices rose at an annual
rate of about 11 percent in the first quarter and, given the big increases in April
and May, apparently posted another
sizable advance in the second quarter.
Unlike the surges in energy prices in
1999 and 2000, the increases in the first
half of 2001 were not driven by developments in crude oil markets. Indeed,
natural gas prices were the major factor
boosting overall energy prices early this
year as tight inventories and concerns
about potential stock-outs pushed spot
prices to extremely high levels; natural gas prices have since receded as
additional supplies have come on line
and inventories have been rebuilt. In
the spring, gasoline prices soared in
response to strong demand, refinery
disruptions, and concerns about lean
inventories; with refineries back on line,
imports up, and inventories restored,
gasoline prices have since fallen noticeably below their mid-May peaks. Electricity prices also rose substantially
in the first half of the year, reflecting
higher natural gas prices as well as the
problems in California. Capacity problems in California and the hydropower
shortages in the Northwest persist,
though California's electricity consumption has declined recently and wholesale prices have dropped. In contrast,
capacity in the rest of the country

Monetary Policy Reports, July
has expanded appreciably over the past
year and, on the whole, appears adequate to meet the normal seasonal rise in
demand.
Core PCE prices rose at a 2J/2 percent
annual rate in the first quarter—a hefty
increase by the standards of recent
years. But the data are volatile, and the
first-quarter increase, no doubt, exaggerates any pickup. Based on monthly data
for April and May, core PCE inflation
appears to have slowed considerably in
the second quarter; the slowing was concentrated in the goods categories and
seems consistent with reports that retailers have been cutting prices to spur sales
in an environment of soft demand.
Core consumer price inflation—
whether measured by the PCE index or
by the CPI—in recent quarters almost
certainly has been boosted by the effects
of higher energy prices on the costs of
producing other goods and services.
Additional pressure has come from the
step-up in labor costs. That said, firms
appear to have absorbed much of these
cost increases in lower profit margins.
Meanwhile, non-oil import prices have
remained subdued, thus continuing to
restrain input costs for many domestic
industries and to limit the ability of

89

firms facing foreign competition to
raise prices for fear of losing market
share. In addition, apart from energy,
price pressures at earlier stages of
processing have been minimal. Indeed,
excluding food and energy, the producer
price index (PPI) for intermediate materials has been flat over the past year, and
the PPI for crude materials has fallen
11 percent. Moreover, inflation expectations, on balance, seem to have
remained quiescent: According to the
Michigan survey, the median expectation for inflation over the upcoming year
generally has been running about 3 percent this year, similar to the readings in
2000.
In contrast to the step-up in consumer
prices, prices for private investment
goods in the NIPA were up only a little
in the first quarter after having risen
about 2 percent last year. In large part,
this pattern was driven by movements in
the price index for computers, which fell
at an annual rate of nearly 30 percent in
the first quarter as demand for high-tech
equipment plunged. This drop in computer prices was considerably greater
than the average decrease of roughly
20 percent per year in the second half
of the 1990s and the unusually small

Alternative Measures of Price Change
Percent, Ql to Ql
1998
to
1999

1999
to
2000

2000
to
2001

Chain-type
Gross domestic product
Gross domestic purchases
Personal consumption expenditures
Excluding food and energy

1.5
1.2
1.5
1.8

1.8
2.3
2.5
1.6

2.3
2.2
2.2
1.7

Fixed-weight
Consumer price index
Excluding food and energy

1.7
2.2

3.3
2.2

3.4
2.7

Price measure

NOTE. A fixed-weight index uses quantity weights
from a base year to aggregate prices from each distinct
item category. A chain-type index is the geometric average of two fixed-weight indexes and allows the weights




to change each year. The consumer price indexes are for
all urban consumers. Changes are based on quarterly
averages.

90

88th Annual Report, 2001

11 percent decrease in 2000. Monthly
PPI data suggest that computer prices
were down again in the second quarter,
though much less than in the first
quarter.
All told, the GDP chain-type price
index rose at an annual rate of 3Vi percent in the first quarter and has risen
2VA percent over the past four quarters,
an acceleration of Vi percentage point
from the comparable year-earlier period.
The price index for gross domestic
purchases—which is defined as the
prices paid for consumption, investment,
and government purchases—also accelerated in the first quarter—to an increase
of about 23/4 percent; the increase in this
measure over the past year was 2lA percent, about the same as over the preceding year. Excluding food and energy, the
latest four-quarter changes in both GDP
and gross domestic purchases prices
were roughly the same as over the preceding year.

U.S. Financial Markets
Longer-term interest rates and equity
prices have shown remarkably small net
changes this year, given the considerable shifts in economic prospects and
major changes in monetary policy. To
some extent, the expectations of the economic and policy developments in 2001
had already become embedded in financial asset prices as last year came to a
close; from the end of August through
year-end, the broadest equity price
indexes fell 15 percent and investmentgrade bond yields declined 40 to
70 basis points. In addition, however,
equity prices and long-term interest rates
were influenced importantly by growing
optimism in financial markets over the
second quarter of 2001 that the economy and profits would rebound strongly
toward the end of 2001 and in 2002. On
net, equity prices fell 6 percent in the



first half of this year as near-term corporate earnings were revised down substantially. Rates on longer-term Treasury issues rose a little, but those on
corporate bonds were about unchanged,
with the narrowing spread reflecting
greater investor confidence in the outlook. But risk spreads remained wide
by historical standards for businesses
whose debt was rated as marginally
investment grade or below; many of
these firms had been especially hard
hit by the slowdown and the near-term
oversupply of high-tech equipment and
services, and defaults by these firms
became more frequent. Nevertheless, for
most borrowers the environment for
long-term financing was seen to be quite
favorable, and firms and households
tended to tap long-term sources of credit
in size to bolster their financial conditions and lock in more favorable costs.
Interest Rates
In response to the abrupt deceleration
in economic growth and prospects for
continued weakness in the economy, the
FOMC lowered the target federal funds
rate 23A percentage points in six steps
in the first half of this year, an unusually
steep decline relative to many past easing cycles. Through March, the policy
easings combined with declining equity
prices and accumulating evidence that
the slowdown in economic growth was
more pronounced than had been initially thought led to declines in yields
on intermediate- and longer-term Treasury securities. Over the second quarter, despite the continued decrease in
short-term rates and further indications
of a weakening economy, yields on
intermediate-term Treasury securities
were about unchanged, while those on
longer-term securities rose appreciably.
On net, yields on intermediate-term
Treasury securities fell about 3A per-

Monetary Policy Reports, July
centage point in the first half of this
year, while those on longer-term Treasury securities rose about lA percentage
point.
The increase in longer-term Treasury
yields in the second quarter appears to
have been the result of a number of
factors. The main influence seems to
have been increased investor confidence
that the economy would soon pick up.
That confidence likely arose in part from
the aggressive easing of monetary policy and also in part from the improving
prospects for, and passage of, a sizable
tax cut. The tax cut and the growing
support for certain spending initiatives
implied stronger aggregate demand and
less federal saving than previously
anticipated. The prospect that the federal debt might be paid down less rapidly may also have reduced slightly
the scarcity premiums investors were
willing to pay for Treasury securities.
Finally, a portion of the rise may have
been the result of increased inflation
expectations. Inflation compensation as
measured by the difference between
nominal Treasury rates and the rates
on inflation-indexed Treasury securities
rose about lA percentage point in the
second quarter. Despite this increase,
there is little evidence that inflation is
expected to go up from its current level.
At the end of last year, inflation compensation had declined to levels suggesting investors expected inflation to fall,
and the rise in inflation compensation in
the second quarter largely reversed those
declines. Moreover, survey measures of
longer-term inflation expectations have
changed little since the middle of last
year.
Yields on longer-maturity corporate
bonds were about unchanged, on net,
over the first half of this year. Yields on
investment-grade bonds are near their
lows for the past ten years, but those
on speculative-grade bonds are ele


91

vated. Spreads of corporate bond yields
relative to swap rates narrowed a bit,
although they still remain high. Amidst
signs of deteriorating credit quality and
a worsening outlook for corporate earnings, risk spreads on speculative-grade
bonds had risen by about 2 percentage
points late last year, reaching levels not
seen since 1991. Much of this widening
was reversed early in the year, as investors became more confident that corporate balance sheets would not deteriorate substantially, but speculative-grade
bond spreads widened again recently in
response to negative news about secondquarter earnings and declines in share
prices, leaving these spreads at the end
of the second quarter only slightly
below where they began the year. Nonetheless, investors, while somewhat
selective, appear to remain receptive
to new issues with speculative-grade
ratings.
Interest rates on commercial paper
and C&I loans have fallen this year by
about as much as the federal funds rate,
although some risk spreads widened.
The average yield spread on second-tier
commercial paper over top-tier paper
widened to about 100 basis points in
late January, about four times its typical level, following defaults by a few
prominent issuers. As the year progressed, investors became less concerned about the remaining commercial paper borrowers, and this spread
has returned to a more normal level.
According to preliminary data from the
Federal Reserve's quarterly Survey of
Terms of Business Lending, the spread
over the target federal funds rate of
the average interest rate on commercial
bank C&I loans edged up between
November and May and remains in the
elevated range it shifted to in late 1998.
Judging from the widening since 1998
of the average spread between rates on
riskier and less-risky loans, banks have

92

88th Annual Report, 2001

become especially cautious about lending to marginal credits.
Equity Markets
After rising in January in response to the
initial easing of monetary policy, stock
prices declined in February and March
in reaction to profit warnings and weak
economic data, with the Wilshire 5000,
the broadest major stock price index,
ending the first quarter down 13 percent.
Stock prices retraced some of those
losses in the second quarter, rising 7 percent, as first-quarter earnings releases
came in a little above sharply reduced
expectations and as investors became
more confident that economic growth
and corporate profits would soon pick
up. On net, the Wilshire 5000 ended the
half down 6 percent, the DJIA declined
3 percent, and the tech-heavy Nasdaq
fell 13 percent. Earnings per share of the
S&P 500 in the first quarter decreased
10 percent from a year earlier. A disproportionate share of the decline in S&P
earnings—more than half—was attributable to a plunge in the technology sector, where first-quarter earnings were
down nearly 50 percent from their peak
in the third quarter of last year.
The decline in stock prices has left
the Wilshire 5000 down by about
20 percent, and the Nasdaq down by
about 60 percent, from their peaks in
March 2000. Both of these indexes are
near their levels at the end of 1998,
having erased the sharp run-up in
prices in 1999 and early 2000. But both
indexes remain more than two and onehalf times their levels at the end of
1994, when the bull market shifted into
a higher gear. The ratio of expected oneyear-ahead earnings to equity prices
began to fall in 1995 when, as productivity growth picked up, investors began
to build in expectations that increases
in earnings would remain rapid for some



time. This measure of the earningsprice ratio remains near the levels
reached in 1999, suggesting that investors still anticipate robust long-term
earnings growth, likely reflecting expectations for continued strong gains in
productivity.
Despite the substantial variation in
share prices over the first half of this
year, trading has been orderly, and
financial institutions appear to have
encountered no difficulties that could
pose broader systemic concerns. Market
volatility and a less ebullient outlook
have led investors to buy a much smaller
share of stock on margin. At the end of
May, margin debt was 1.15 percent of
total market capitalization, equal to its
level at the beginning of 1999 and well
below its high of 1.63 percent in March
of last year.
Federal Reserve Open Market
Operations
As noted earlier, the Federal Reserve
has responded to the diminished size of
the auctions of Treasury securities by
modifying its procedures for acquiring
such securities. To help maintain supply
in private hands adequate for liquid markets, since July of last year the System
has limited its holdings of individual
securities to specified percentages, ranging from 15 percent to 35 percent, of
outstanding amounts. To stay within
these limits, the System has at times not
rolled over all of its holdings of maturing securities, generally investing the
difference by purchasing other Treasury
securities on the open market. The Federal Reserve also has increased its holdings of longer-term repurchase agreements (RPs), including RPs backed by
agency securities and mortgage-backed
securities, as a substitute for outright
purchases of Treasury securities. In the
first half of the year, longer-term RPs,

Monetary Policy Reports, July
typically with maturities of twenty-eight
days, averaged $13 billion.
As reported in the previous Monetary
Policy Report, the FOMC also initiated
a study to evaluate assets to hold on its
balance sheet as alternatives to Treasury
securities. That study identified several
options for further consideration. In the
near term, the Federal Reserve is considering purchasing and holding Ginnie
Mae mortgage-backed securities, which
are explicitly backed by the full faith
and credit of the U.S. government,
and engaging in repurchase operations
against foreign sovereign debt. For possible implementation later, the Federal
Reserve is studying whether to auction
longer-term discount window credit, and
it will over time take a closer look at
a broader array of assets for repurchase
and for holding outright, transactions
that would require additional legal
authority.
Debt and the Monetary Aggregates
The growth of domestic nonfinancial
debt in the first half of 2001 is estimated
to have remained moderate, slowing
slightly from the pace in 2000 as a
reduction in the rate of increase in nonfederal debt more than offset the effects
of smaller net repayments of federal
debt. In contrast, the monetary aggregates have grown rapidly so far this
year, in large part because the sharp
decline in short-term market interest
rates has reduced the opportunity cost of
holding the deposits and other assets
included in the aggregates.
Debt and Depository Intermediation
The debt of the domestic nonfinancial
sectors is estimated to have expanded at
a 43A percent annual rate over the first
half of 2001, a touch below the 5lA percent growth recorded in 2000. Changes



93

in the growth of nonfederal and federal
debt this year have mostly offset each
other. The growth of nonfederal debt
moderated from SV2 percent in 2000 to a
still-robust 11A percent pace in the first
half of this year. Households' borrowing
slowed some but was still substantial,
buoyed by continued sizable home and
durable goods purchases. Similarly,
business borrowing moderated even as
bond issuance surged, as a good portion
of the funds raised was used to pay
down commercial paper and bank loans.
Tending to boost debt growth was a
slowing in the decline in federal debt to
a 6lA percent rate in the first half of this
year from 63A percent last year, largely
because of a decline in tax receipts on
corporate profits.
The share of credit to nonfinancial
sectors held at banks and other depository institutions edged down in the first
half of the year. Bank credit, which
accounts for about three-fourths of
depository credit, increased at a 31/2 percent annual rate in the first half of the
year, well off the 9Vi percent growth
registered in 2000. Banks' loans to businesses and households decelerated even
more, in part because borrowers preferred to lock in the lower rates available from longer-term sources of funds
such as bond and mortgage markets and
perhaps also in part because banks
firmed up their lending stance in reaction to concerns about loan performance. Loan delinquency and chargeoff rates have trended up in recent
quarters, and higher loan-loss provisions
have weighed on profits. Nevertheless,
through the first quarter, bank profits
remained in the high range recorded for
the past several years, and virtually all
banks—98 percent by assets—were well
capitalized. With banks' financial condition still quite sound, they remain well
positioned to meet future increases in
the demand for credit.

94

88th Annual Report, 2001

The Monetary Aggregates
The monetary aggregates have expanded
rapidly so far this year, although growth
rates have moderated somewhat
recently. M2 rose \0xA percent at an
annual rate in the first half of this year
after having grown 6lA percent in 2000.
The interest rates on many of the components of M2 do not adjust quickly or
fully to changes in market interest rates.
As a consequence, the steep declines in
short-term market rates this year have
left investments in M2 assets relatively
more attractive, contributing importantly
to the acceleration in the aggregate. M2
has also probably been buoyed by the
volatility in the stock market this year,
and perhaps by lower expected returns
on equity investments, leading investors
to seek the safety and liquidity of M2
assets.
M3, the broadest monetary aggregate, rose at a 13VA percent annual rate
through June, following 9lA percent
growth in 2000. All of the increase in
M3, apart from that accounted for by
M2, resulted from a ballooning of institutional money market funds, which
expanded by nearly a third. Yields on
these funds lag market yields somewhat,
and so the returns to the funds, like
those on many M2 assets, became relatively attractive as interest rates on
short-term market instruments declined.

International Developments
So far this year, average foreign growth
has weakened further and is well below
its pace of a year ago. Activity abroad
was restrained by the continued high
level of oil prices, the global slump
of the high-technology sector, and
spillover effects from the U.S. economic slowdown, but in some countries
domestic demand softened as well in
reaction to local factors. High oil prices



kept headline inflation rates somewhat
elevated, but even though core rates of
inflation have edged up in countries
where economic slack has diminished,
inflationary pressures appear to be well
under control.
Monetary authorities in most cases
reacted to signs of slowdown by lowering official rates, but by less than in the
United States. Partly in response to these
actions, yield curves have steepened
noticeably so far in 2001. Although
long-term interest rates moved down
during the first quarter, they more than
reversed those declines in most cases
as markets reacted to a combination of
the anticipation of stronger real growth
and the risk of increased inflationary
pressure. Foreign equity markets—
especially for high-tech stocks—were
buffeted early this year by many of
the same factors that affected U.S.
share prices: negative earnings reports,
weaker economic activity, buildups of
inventories of high-tech goods, and
uncertainties regarding the timing and
extent of policy responses. In recent
months, the major foreign equity
indexes moved up along with U.S. stock
prices, but they have edged off lately
and in most cases are down, on balance,
for the year so far.
Slower U.S. growth, monetary easing
by the Federal Reserve, fluctuations
in U.S. stock prices, and the large U.S.
external deficit have not undermined
dollar strength. After the December
2000 FOMC meeting, the dollar lost
ground against the major currencies; but
shortly after the FOMC's surprise rate
cut on January 3, the dollar reversed all
of that decline as market participants
evidently reassessed the prospects for
recovery in the United States versus that
in our major trading partners. The dollar
as measured by a trade-weighted index
against the currencies of major industrial countries gained in value steadily

Monetary Policy Reports, July
in the first three months of 2001, reaching a fifteen-year high in late March.
Continued flows of foreign funds into
U.S. assets appeared to be contributing importantly to the dollar's increase.
Market reaction to indications that the
U.S. economy might be headed toward
a more prolonged slowdown undercut
the dollar's strength somewhat in early
April, and the dollar eased further after
the unexpected April 18 rate cut by the
FOMC. However, the dollar has more
than made up that loss in recent months
as signs of weakness abroad have
emerged more clearly. On balance, the
dollar is up about 7 percent against the
major currencies so far this year; against
a broader index that includes currencies
of other important trading partners, the
dollar has appreciated 5 percent.
The dollar has gained about 9 percent
against the yen, on balance, as the Japanese economy has remained troubled
by structural problems, stagnant growth,
and continuing deflation. Industrial production has been falling, and real GDP
declined slightly in the first quarter, with
both private consumption and investment contracting. Japanese exports also
have sagged because of slower demand
from many key trading partners. Early
in the year, under increasing pressure to
respond to signs that their economy was
weakening further, the Bank of Japan
(BOJ) slightly reduced the uncollateralized overnight call rate, its key policy
interest rate. By March, the low level
of equity prices, which had been declining since early 2000, was provoking
renewed concerns about the solvency of
Japanese banks. In mid-March, the BOJ
announced that it was shifting from aiming at a particular overnight rate to targeting balances that private financial
institutions hold at the Bank, effectively
returning the overnight rate to zero;
the BOJ also announced that it would
continue this easy monetary stance until



95

inflation moves up to zero or above.
After the yen had moved near the end of
March to its weakest level relative to the
dollar in more than four years, Japanese
financial markets were buoyed by the
surprise election in May of Junichiro
Koizumi to party leadership and thereby
to prime minister. The yen firmed
slightly for several weeks thereafter, but
continued weak economic fundamentals
and increased market focus on the
daunting challenges facing the new government helped push the yen back down
and beyond its previous low level.
At the start of 2001, economic activity in the euro area had slowed noticeably from the more rapid rates seen
early last year but still was fairly robust.
Average GDP growth of near 2 percent was only slightly below estimated
rates of potential growth, although some
key countries (notably Germany) were
showing signs of faltering further.
Although high prices for oil and food
had raised headline inflation, the rate of
change of core prices was below the
2 percent ceiling for overall inflation set
by the European Central Bank (ECB).
The euro also was showing some signs
of strength, having moved well off the
low it had reached in October. However,
negative spillovers from the global
slowdown started to become more evident in weaker export performance in
the first quarter, and leading indicators
such as business confidence slumped.
Nevertheless, the ECB held policy
steady through April, as further weakening of the euro against the dollar (following a trend seen since the FOMC's
rate cut in early January), growth of M3
in excess of the ECB's reference rate,
and signs of an edging up of euro-area
core inflation were seen as militating
against an easing of policy.
In early May, the ECB surprised markets with a 25 basis point reduction of
its minimum bid rate and parallel reduc-

96

88th Annual Report, 2001

tions of its marginal lending and deposit
rates. In explaining the step, the ECB
noted that monetary developments no
longer posed a threat to price stability
and projected that moderation of GDP
growth would damp upward price pressure. The euro has continued to fall
since then and, on balance, has declined
9 percent against the dollar since the
beginning of the year. Faced with a similar slowdown in the U.K. economy that
was exacerbated by the outbreak of footand-mouth disease, the Bank of England
also cut its official call rate three times
(by a total of 75 basis points) during the
first half of the year. The Labor Party's
victory in parliamentary elections in
early June seemed to raise market
expectations of an early U.K. euro referendum and put additional downward
pressure on sterling, but that was partly
offset by signs of stronger inflationary
pressure. On balance, the pound has lost
about 6 percent against the dollar this
year, while it has strengthened against
the euro.
The exchange value of the Canadian
dollar has swung over a wide range in
2001. In the first quarter, the Canadian
dollar fell about 5 percent against the
U.S. dollar as the Canadian economy
showed signs of continuing a deceleration of growth that had started in late
2000. Exports—especially autos, auto
equipment, and electronic equipment—
suffered from weaker U.S. demand.
Softer global prices for non-oil commodities also appeared to put downward
pressure on the Canadian currency. With
inflation well within its target range, the
Bank of Canada cut its policy rate several times by a total of 125 basis points.
So far this year, industries outside of
manufacturing and primary resources
appear to have been much less affected
by external shocks, and domestic
demand has maintained a fairly healthy
pace. Since the end of March, the Cana


dian dollar has regained much of the
ground it had lost earlier and is down
about 2 percent on balance since the
beginning of the year.
Global financial markets were rattled
in February by serious problems in the
Turkish banking sector. Turkish interest
rates soared and, after market pressures
led authorities to allow the Turkish lira
to float, it experienced a sharp depreciation of more than 30 percent. An IMF
program announced in mid-May that
will bring $8 billion in support this year
and require a number of banking and
other reforms helped steady the situation temporarily, but market sentiment
started to deteriorate again in early July.
In Argentina, the weak economy and
the government's large and growing
debt burden stoked market fears that
the government would default on its
debt and alter its one-for-one peg of the
peso to the dollar. In April, spreads
on Argentina's internationally traded
bonds moved up sharply, and interest
rates spiked. In June, the government
completed a nearly $30 billion debt
exchange with its major domestic and
international creditors aimed at alleviating the government's cash flow squeeze,
improving its debt amortization profile,
and giving it time to enact fiscal reforms
and revive the economy. Argentine
financial conditions improved somewhat
following agreement on the debt swap.
However, this improvement proved temporary, and an apparent intensification
of market concerns about the possibility
of a debt default triggered a sharp fall in
Argentine financial asset prices at midJuly. This financial turbulence in Argentina negatively affected financial markets in several other emerging market
economies. The turmoil in Argentina
took a particular toll on Brazil, where an
energy crisis added to other problems
that have kept growth very slow since
late last year. Intervention purchases of

Monetary Policy Reports, July
the real by the Brazilian central bank
and a 300 basis point increase in its
main policy interest rate helped take
some pressure off the currency, but the
real has declined about 24 percent so far
this year.
The weak performance of the Mexican economy at the end of last year
caused largely by a fall in exports to
the United States (notably including a
sharp drop in exports of automotive
products) and tight monetary policy carried over into early 2001. With inflation
declining, the Bank of Mexico loosened
monetary policy in May for the first
time in three years. Problems with
Mexican growth did not spill over to
financial markets, however. The peso
has remained strong and is up about
3 percent so far this year, and stock
prices have risen.
Average growth in emerging Asia
slowed significantly in the first half;
GDP grew more slowly or even declined
in economies that were more exposed to
the effects of the global drop in demand
for high-tech products. Average growth
of industrial production in Malaysia,




97

Singapore, and Hong Kong, for example, fell from a 15 percent annual rate in
late 2000 to close to zero in mid-2001.
The turnaround of the high-tech component of industrial production in those
countries was even more abrupt—from
more than a 30 percent rate of increase
to a slight decline by midyear. In the
Philippines and Indonesia, economic
difficulties were compounded by serious
political tensions. Currencies in many
of these countries moved down versus
the dollar, and stock prices declined.
In Korea, the sharp slump in activity
that began late last year continued into
2001, as weakness in the external sector
spread to domestic consumption and
investment. The Bank of Korea lowered
its target interest rate a total of 50 basis
points over the first half of the year in
response to the weakening in activity.
The Chinese economy, which is less
dependent on technology exports than
many other countries in the region, continued to expand at a brisk pace in the
first half of this year, as somewhat softer
export demand was offset by increased
government spending.
•

99

Domestic Open Market Operations during 2001
Implementation of
Monetary Policy in 2001
The directives pertinent to the implementation of domestic open market
operations issued by the Federal Open
Market Committee (FOMC) instruct the
Trading Desk at the Federal Reserve
Bank of New York (FRBNY) to foster
conditions in the market for reserves
consistent with maintaining the federal
funds rate at an average around a specified rate. This indicated rate is commonly referred to as the federal funds
rate target. The Desk arranges open market operations to target the funds rate,
while at the same time achieving certain other objectives that may affect the
structure of the Federal Reserve balance
sheet.
This report reviews the conduct of
open market operations in 2001. It
begins with a description of the operating procedures that are used to control
the funds rate and a summary of the key
new developments in the policy implementation framework. The demand for
balances at the Federal Reserve and the
behavior of autonomous factors outside
the control of the Desk that affect the
supply of these balances are described
in the following sections. Next, the different domestic financial assets held
by the Federal Reserve, and the various
types of open market operations used to
adjust them, are reviewed. The behavior
of the federal funds rate in 2001 and use
of the discount window are discussed
NOTE. This chapter is adapted from the annual

report of the Manager of the System Open Market
Account to the Federal Open Market Committee. The original report is available at http://
www.ny.frb.org/pihome/Omo/omo2001 .pdf.



in the following section. The conduct of
open market operations in the aftermath
of the terrorist attacks on the World
Trade Center and Pentagon on September 11 is reviewed in the final section.

Overview of Operating Procedures
to Control the Federal Funds Rate
The FOMC lowered the federal funds
rate target on eleven different occasions
during 2001, reducing it by a cumulative 43/4 percentage points to end the
year at a level of 13A percent (table).
Three of these rate changes were made
between regularly scheduled FOMC
meetings. Associated with each FOMC
policy move, the Board of Governors
approved an equal-sized reduction in the
basic discount rate, which preserved a
50 basis point spread of the target funds
rate over the discount rate.
To target the federal funds rate, the
Desk uses open market operations to
Changes in the Federal Funds Rate
Specified in FOMC Directives
Percent
Date of change

Target federal
funds rate

May 16, 2000

6'/2

January 3, 2001' . . .

6

January 31
March 20
April 181
May 15
June 27

5«/2
5
4'/2
4
3-y4

August 21
September 17]
October 2
November 6
December 11

3'/ 2
3
21/2
2
iy 4

Associated
discount rate
6
53/4
(5'/2onJan.4)
5
41/2
4
31/2
3'/4
3
2'/2
2
1 !/2
11/4

1. Policy change came between regularly scheduled
meetings.

100 88th Annual Report, 2001
align the supply of balances held by
depository institutions at the Federal
Reserve—or Fed balances—with banks'
demand for holding balances at the target rate. Each morning, the Desk considers whether open market operations are
needed based on estimates of the supply
of and demand for balances, taking
account of possible forecast errors and
minimal levels of aggregate Fed balances that in practice are needed to
facilitate settlement of wholesale financial payments by banks. When the funds
rate is already near its target, the Desk
aims to supply a level of balances in line
with its best estimate of demand. And
when the funds rate deviates from the
target, the Desk may adjust the level of
Fed balances it aims to supply accordingly, to nudge the rate in the appropriate direction. Operations designed
to alter the supply of Fed balances that
same day, most commonly of a shortterm temporary nature, are typically
arranged around 9:30 a.m. eastern time
each morning, shortly after a complete
set of estimates is available. Open market operations that are designed primarily to meet other objectives that
influence the size or composition of
the Fed's balance sheet can generally be
arranged at other times of the day, but
their use must be coordinated with those
operations geared toward achieving a
particular level of Fed balances on each
day.
The average level of balances banks
demand over two-week reserve maintenance periods is in large measure determined by certain requirements to hold
balances, with only a small level of
additional, or excess, balances typically
demanded. Levels of requirements and
period-average demands for excess are
relatively insensitive to changes in the
target level of the federal funds rate or
only respond with some lag. The ability
of depository institutions to average



their holdings of balances over the days
within a maintenance period to meet
their requirements gives them considerable leeway in managing their accounts
from day to day. This flexibility limits
the volatility in rates that can develop
when the Desk mis-estimates either the
supply of or demand for balances. Nonetheless, the funds rate will firm if the
level of balances falls so low that some
banks have difficulty finding sufficient
funds to cover late-day deficits in their
Fed accounts; the rate will soften if
balances are so high that some banks
risk ending a period holding undesired

excess balances.
New Developments in 2001
There were no changes made to the
FOMC's Authorization for Domestic
Open Market Operations in 2001
(appendix A). At its January meeting,
the FOMC once again extended temporarily, through its first regularly scheduled meeting in 2002, its authorization
for an expanded pool of eligible collateral for the Desk's repurchase agreements (RPs). The principal effect was
to continue the inclusion of pass-through
mortgage securities of the Government
National Mortgage Association, Freddie
Mac, and Fannie Mae, and of stripped
securities of government agencies. To
implement this decision, the FOMC
voted to extend temporarily its suspension of several provisions of its "Guidelines for the Conduct of System Open
Market Operations in Federal Agency
Issues," which impose restrictions on
transactions in federal agency securities
(appendix B). Late in 2001, the Desk
began to accept permanently the direct
debt obligations of the Student Loan
Marketing Association as collateral on
its repurchase transactions.
The Desk continued to operate under
the guidelines first articulated in July

Domestic Open Market Operations during 2001 101
2000 that limit the permanent holdings
of single Treasury securities in the
System Open Market Account (SOMA)
to a given share of the total outstanding amount.1 These guidelines were
prompted by the prospect of paydowns
of marketable debt associated with
projected budget surpluses. Meanwhile,
Federal Reserve staff continued work
begun in 2000 on various studies of
alternative assets the Federal Reserve
might hold in its portfolio.

Banks' Demand for Fed Balances
The Desk aims to satisfy banks' demand
for holding Fed balances. Total demand
may be viewed as the sum of two components: the portion needed to meet all
requirements, and the portion held in
excess of requirements.
Total Balance Requirements
A bank's total balance requirement measures the level of balances it must hold
at the Federal Reserve on average over
a two-week maintenance period to meet
various regulatory obligations. Total
balance requirements may be decomposed into two basic parts: reserve balance requirements (the level of reserve
requirements not met with applied vault
cash) and clearing balance requirements.
In addition, various as-of accounting
adjustments may be applied that affect
the actual level of Fed balances a bank
must hold to meet all these requirements.2 Clearing balance requirements
1. A detailed description of these guidelines
and their motivation can be found on the web
site of the Federal Reserve Bank of New York
at http://www.ny.frb.org/pihome/news/announce/
2000/an000705.html. They were also discussed in
more detail in the Domestic Open Market Operations report for 2000.
2. Clearing balance requirements, applied vault
cash, and as-of adjustments affect the level of a



and, under lagged reserve accounting
rules in effect since August 1998,
reserve balance requirements are determined prior to the start of each maintenance period, which facilitates estimation of the demand for Fed balances.
But not all as-of adjustments are known
when a period starts. Most problematically, when large as-of adjustments are
applied or reported to the Desk on the
settlement day, it affords the Desk little
or no opportunity to adjust its estimates
of demand and its operations.
Decreases in short-term interest rates
contributed to an increase in the underlying level of requirements, particularly
over the second half of the year (chart).
Falling interest rates spurred growth
in reservable deposits over the year.3
As a consequence, aggregate reserve
requirements rose above the level of
banks' applied vault cash, lifting the
level of reserve balance requirements
in a sustained fashion for the first time
since the wholesale adoption of sweep
programs in 1995. The reduction in
interest rates also contributed to a rise
in clearing balance requirements, which
registered their first significant increase
in several years. With the Fed using
lower interest rates linked to the target
funds rate to compute earning credits
on clearing balance requirements, banks
that wish to have the maximum useful
bank's total balance requirements, and hence its
demand for Fed balances. In published data on
reserves, these three variables are treated as
sources of reserve supply.
3. At the same time, there was little further
growth in new sweep account programs, which in
the past had been a major source of decline in
reserve requirements. The estimated amount of
demand deposits swept by commercial banks
through the introduction of new sweep programs
during 2001 was about $40 billion, somewhat
down from recent years and well below the peak
level. A reduction in interest rates also reduces the
incentive banks have to expand sweeps to reduce
the level of their requirements.

102 88th Annual Report, 2001
Total Balance Requirements
and Components

1998

1999

2000

Excess Demands and
Actual Excess Levels

2001

NOTE. Maintenance period averages through January 9, 2002.
1. Reserve requirements minus applied vault cash, and
less all as-of adjustments.

level of clearing balance requirements,
that is, the level that generates just
enough income credits to pay for all
covered Fed services, had room to
increase these requirements. Over the
twelve months ending in December,
the underlying level of total balance
requirements rose about $5 billion, with
somewhat more than half coming from
the higher reserve balance requirements.
This aggregate increase is not large
when measured against the size of the
Fed's balance sheet, but it is significant
as a portion of total requirements.
Total balance requirements increased
dramatically, but temporarily, in the two
maintenance periods ended October 17
and October 31, as a byproduct of disruptions following the September 11
attacks. Reservable deposits soared at
a handful of key money center banks
that were not able to transfer out funds
on behalf of their customers, and under
lagged reserve accounting rules, these
institutions faced much higher reserve
requirements in October. These banks
were able to restore their operational
capabilities within days, and the higher
levels of reserve requirements were
transitory.



Period-average and daily levels of Fed
balances are measured relative to the
period-average level of requirements,
to obtain measures of excess balances.
Demands for excess balances display
fairly stable and predictable patterns that
are insensitive to the level of requirements, and the Desk must estimate these
excess demand patterns as part of estimating total demand for Fed balances.4
The reasons for the severe distortions
to excess levels in the aftermath of the
September 11 attacks are described in
the final section of this report.
Over the last two months of the year,
period-average levels of excess balances
became more elevated, most notably at
smaller banking institutions where positive excess levels historically are concentrated (chart). To some degree, typi-

4. In this section, actual levels of excess balances on average over time are used as an approximation of excess demand, even though a number
of factors can cause actual excess levels to deviate
from demand on any day or for any period.

Excess Balances
Billions of dollars

—

1

1

—

— 3.0
— 2.5
— 2.0

It All institutions

A A/
i Large banks

1999

2000

»

Yv

pF 15
/—

1.0

2001

NOTE. Maintenance period averages through January 9, 2002.
Period ended September 19, 2001, not shown (total
excess, $38 billion).

Domestic Open Market Operations during 2001 103
Median Levels of Excess Balances,
by Day in a Maintenance Period
Millions of dollars
1998-2000

2001

Weekl
Thursday
Friday
Monday
Tuesday
Wednesday

725
-400
975
675
725

775
-1,000
200
0
0

Week 2
Thursday
Friday
Monday
Tuesday
Wednesday

675
-175
3,450
2,925
6,075

-475
-625
2,550
4,250
8,150

Day of period

cal seasonal factors, the size of which
can vary from year to year, may account
for this late-year increase. But anecdotal evidence also suggests that the low
absolute level to which interest rates
have dropped, thereby lowering the opportunity cost of holding excess balances, may have contributed to the
increase. No evidence suggests that
excess demand at larger banks has been
increasing.
The daily intraperiod distribution of
excess balances in 2001 continued to
reflect banks' strong preference for concentrating their accumulation of Fed balances late in a maintenance period, after
the second weekend (table).5 The degree
of skew was more pronounced over this
past year, with banks typically holding
somewhat lower levels of excess on
most days ahead of the second weekend
and larger excess balances on the settlement day. This greater concentration of
excess accumulated on the final day was
encouraged by strongly held market
expectations that the FOMC would
5. Median values are shown in table 2 because
they are less influenced than average values by the
extreme and unrepresentative deviations from normal levels of daily excess that arise from time to
time.



adopt a lower target rate at its meetings
during the year, most of which happened
to fall on the second Tuesday of a maintenance period, which pushed demands
for balances toward the end of these
periods.

Autonomous Factors Affecting
the Supply of Fed Balances
Autonomous factors are the assets and
liabilities on the Federal Reserve balance sheet that are outside the direct
control of the Trading Desk.6 They
exclude the domestic financial assets
controlled through open market operations, discount window loans, and the
deposit balances held by depository
institutions at the Fed. Federal Reserve
note liabilities represent the largest
single autonomous factor on the Fed's
balance sheet by far, and for this reason
the net value (assets minus liabilities) of
all autonomous factors has a large negative value; the net value of all other
factors is close to zero. Net movements
in autonomous factors affect the supply
of Fed balances, and thereby create a
need for open market operations to
change the levels of the various domestic financial assets on the Fed's balance
sheet to offset the effects of these factors.7 The behavior of key factors in the
aftermath of the September 11 attacks
is discussed in the final section of this
report.

6. Autonomous factors are defined to include
liabilities arising from matched sale-purchase
agreements arranged with foreign official institutions as part of the foreign RP pool. The foreign RP pool is not reported directly on the Fed's
balance sheet, but it is a factor that affects the
supply of Fed balances.
7. In fact, the Desk retains a small degree of
discretionary influence over the levels of some
autonomous factors, which may be used to shape
the need for open market operations on some days.

104 88th Annual Report, 2001
Federal Reserve Notes
Federal Reserve notes expanded by
nearly $50 billion over the year and
were once again the largest source of
exogenous change on the Fed's balance
sheet (chart).8 Federal Reserve notes
outstanding increased at an 8 percent
pace over the twelve-month period ending in December, somewhat faster than
their 63A percent average annual rate of
expansion over the preceding five-year
interval. Lower interest rates likely
spurred demand for Federal Reserve
notes in 2001 by reducing the economic
cost of holding non-interest-bearing
notes. Foreign demand also contributed
to faster growth late in the year, compounding the seasonal increase in
Federal Reserve notes that occurred
ahead of the holidays. Unsettled economic conditions in Argentina seemed
to stimulate demand throughout much
of the second half of the year.
8. The unusual decline in Federal Reserve notes
over the twelve months ended in December 2000
was a byproduct of the temporary bulge in Federal
Reserve notes outstanding around the century date
change.

Net Value of All Autonomous Factors and
Value of Federal Reserve Notes
Billions of dollars

-450
All autonomous factors

-475
-500

Federal
Reserve
notes

—

1999

Volatility and Predictability of
Key Autonomous Factors
Excluding the roughly two-week period
following the September 11 attacks, the
average of the daily absolute changes
in the net value of autonomous factors
was down from the previous year, and
same-day predictability showed a slight
improvement (table). Reduced volatility
in currency in circulation, which is used
as a proxy for Federal Reserve notes
in putting together daily forecasts of
autonomous factors, mostly reflected the
impact of the huge swings in this factor
around the century date change, which
elevated volatility in each of the two
previous years.9 Although the foreign
RP pool was somewhat more volatile

-575

i

1
1998

By comparison, the change in the net
value of all other autonomous factors
was small over the year. Some huge
temporary changes in the foreign RP
pool, Federal Reserve float, and foreign
exchange holdings followed the September 11 attacks, but most quickly returned
to their pre-attack values. The greatest
exception was the level of the foreign
RP pool, which remained elevated
throughout the fourth quarter of the year.
Primarily as a consequence of these
higher pool levels, the net value of
autonomous factors other than Federal
Reserve notes fell a bit, by roughly
$2 billion, over 2001.

-550

y
1

-525

Changes in
Other Autonomous Factors

\

2000

-600

2001

NOTE. Net value equals assets minus liabilities. Maintenance period averages through January 9, 2002.




9. Currency in circulation consists mostly of
Federal Reserve notes, but it also includes about
$30 billion of coins, which are liabilities of the
Treasury. In absolute terms, changes in currency
in circulation almost entirely reflected movements
in Federal Reserve notes.

Domestic Open Market Operations during 2001 105
Daily Changes and Forecast Misses in Key Autonomous Factors:
Average and Maximum of Absolute Values
Millions of dollars

1999

2001
excluding
Sept. 11-28

2000

Item

2001,
Sept. 11-28

Average
Daily change
Currency in
circulation
Treasury balance
Foreign RP pool
Float
Net value
Daily forecast miss
Currency in
circulation
Treasury balance
Foreign RP pool
Float
Net value

Maximum

Average

Maximum

Average

Maximum

Average

Maximum

918
911
588
712
1,709

5,379
7,446
6,050
6,217
17,653

970
1,460
485
887
2,058

8,087
23,434
4,015
9,677
23,896

851
823
586
894
1,828

2,696
7,413
3,273
4,923
7,918

919
2,297
3,699
6,888
7,028

2,537
5,671
7,812
32,099
30,770

233
599
224
394
811

1,361
3,284
1,817
4,274
5,443

238
615
129
392
787

1,648
6,866
976
2,742
7,218

210
534
81
447
762

1,043
2,975
1,127
2,084
3,503

502
608
2,070
2,312
2,568

1,135
1,821
4,966
10,398
12,723

NOTE. Forecast misses are based on New York staff
estimates. Currency in circulation is used as a proxy for
Federal Reserve notes.

during 2001, forecasting errors were
down.
The Treasury's Fed balance was
much less volatile during 2001 than it
was during 2000, and somewhat more
predictable. Over the past few years, the
ability of the staff to forecast the Treasury's Fed balance on a same-day basis
has benefited from improved methods
for collecting tax payment information
early each morning from around the
financial system. In 2001, predictability
was also enhanced by a new cash
management technique adopted by the
Treasury, called dynamic investing, that
enabled it to move some portion of
unexpected flows arriving in its Fed
account into its Treasury tax and loan
(TT&L) accounts at commercial banks
on a same-day basis. Throughout the
year, TT&L capacity remained high
relative to the level of Treasury's total



cash balances. This helped moderate
volatility in the Treasury's Fed balance
by reducing the number of days on
which the Fed balance jumped because
of insufficient TT&L capacity, and it
also may have improved indirectly the
ability to forecast the Treasury's Fed
balance.10

Domestic Financial Assets on the
Federal Reserve Balance Sheet
and Open Market Operations
The total value of all domestic financial
assets (less any matched sale-purchase
10. In 2001, the Treasury's general cash balance exceeded TT&L capacity, including Special
Direct Investment capacity, by more than the normal level of balances placed at the Fed (usually
$5 billion) on only two days, compared with six
days in 2000. The number of such occasions was
seven in 1999 and sixteen in 1998.

106 88th Annual Report, 2001
agreements arranged in the market)
held by the Federal Reserve mirrors
the net level of autonomous factors
and of Fed balances.11 More substantively, the behavior of various autonomous factors and of sources of demand
for Fed balances will influence the
choice of open market operations used
to adjust the Fed's domestic financial
portfolio.12

Permanent Holdings in the
System Open Market Account
and Outright Open Market Activity
The domestic SOMA includes all the
domestic securities held on an outright
basis. By and large, changes in the level
of the SOMA have been used to accommodate net changes in autonomous
factors and in demands for Fed balances
that are expected to endure. For this
reason, these holdings are often characterized as being "permanent," although
their net value cam be reduced whenever
needed. The par value of the SOMA
stood at $575 billion at year-end, consisting almost entirely of Treasury securities, about $42 billion higher than
one year earlier.13 The expansion in
the SOMA in 2001, as in many years,
11. In this report, the securities sold under temporary matched sale-purchase agreements (MSPs)
as part of the foreign RP pool or in the market are
considered financial assets held by the Fed,
although they are not officially recorded as such
on the Fed's balance sheet. See footnote 6 for the
treatment of the foreign RP pool as an autonomous
factor liability. In keeping with this treatment, in
this report MSPs arranged in the market are considered a financial liability arranged at the discretion of the Desk.
12. Discount window activity is discussed in
the section "The Federal Funds Rate and Discount
Window Credit."
13. The increase reflects almost entirely new
purchases in excess of redemptions but also
includes a $529 million increase in the inflation
compensation component of inflation-indexed
securities, bringing its level to $961 million.



roughly corresponded to the increase in
Federal Reserve note liabilities.14
The distribution of SOMA holdings
by remaining maturity and across individual issues is intended to achieve various objectives associated with having
a liquid portfolio without distorting the
yield curve or impairing the liquidity
of the market for individual Treasury
securities. In pursuit of these objectives,
the Desk continued to adhere to the
per-issue guideline limits on SOMA
holdings of individual Treasury issues,
articulated in July 2000. It also continued to limit SOMA purchases of newly
issued Treasury securities, as it has no
particular portfolio need for some of the
liquidity characteristics that can add to
the value of these issues in the market.
Auction Participation
and Redemptions
Typically, any needed expansion of the
SOMA is achieved by making outright
purchases of Treasury securities in the
secondary market, which are then sustained by replacing maturing holdings
with newly issued debt at Treasury auctions. At Treasury auctions of coupons
and bills in 2001, the FRBNY continued
to place add-on bids for the SOMA
equal to the lesser of (1) its maturing
holdings on the issue date of a new
security or (2) the amount that would
bring SOMA holdings as a percentage
of the issue to the percentage guideline
limits.15 There were no issues maturing
14. By comparison, the slight increase in net
balance sheet liabilities from movements in other
autonomous factors and the rise in total balance
requirements added only modestly to any need for
a "permanent" increase in the value of financial
assets in the Fed's portfolio.
15. Foreign add-ons, which are not known at
the time the Desk determines its level of participation at auctions, were assumed to be zero in this
calculation.

Domestic Open Market Operations during 2001 107
budget situation and Treasury issuance
patterns. Also during the year, $120 million of holdings of Federal agency securities were called, which left a mere
$10 million of agency holdings in the
SOMA at year-end.

on dates when newly auctioned Treasury Inflation Indexed Securities (TIIS)
settled. In cases where maturing holdings were to be rolled into more than
one new issue of different maturities,
the Desk allocated the maturing amount
in such a way as to leave the same gap,
measured in percentage points, between
the per-issue cap and the actual percentage holding of each new issue. A
slightly different approach was taken for
the weekly bill auctions after the introduction of the new twenty-eight-day
bill because of the potential volatility in
amounts of twenty-eight-day bills auctioned from week to week. The Desk
determined the amount of maturing bills
to be rolled over and its allocation on
the basis of the smallest twenty-eightday bill auction size experienced to date,
rather than the actual auction size.
Remaining within the per-issue percentage caps while the Treasury continued to cut back on auction sizes through
the first half of the year forced another
$27 billion of redemptions of maturing Treasury holdings in 2001, roughly
equal to the previous year's total; this
includes about $1.5 billion of maturing
holdings that were redeemed because
of the cancellation of a twenty-eight-day
bill auction on September 11. Redemptions tapered off over the year, largely as
a consequence of the changed federal

Secondary Market Purchases and
Operational Techniques
With redemptions again so large over
the year as a whole and growth in Federal Reserve notes strong, the necessary
expansion of the SOMA required a
record value of outright purchases of
Treasury securities by the Trading Desk,
amounting to $68.5 billion (table). There
were no sales of securities.
About $15 billion of bills were purchased, and bill holdings increased by a
significant amount for the first time in
several years. Altogether, the Desk purchased $8 billion of bills in the market
in four operations. Another $7 billion
were purchased directly from foreign
central banks, in small daily increments
on days when sell orders from these
accounts were available and consistent
with SOMA portfolio guidelines.16

16. The Desk sets a $250 million limit on total
daily purchases, from foreign accounts, subject
to review if reserve needs or orders warrant an
exception.

Purchases and Redemptions of Treasury Bills and Coupons
Billions of dollars
Item
Treasury bills
Purchased outright
Purchased from internal
foreign accounts
Redemptions
Treasury coupons
Purchased outright
Redemptions




1997

1998

1999

2000

2001

5.5

0

0

6.2

8.4

3.6
0

3.6
-2.0

0
0

2.5
-23.8

7.1
-10.1

35.0
-2.0

26.4
-.6

45.4
-1.4

35.7
-4.1

53.2
-16.8

108 88th Annual Report, 2001
The Desk also purchased $53 billion
of coupon securities in the market,
arranging a record sixty-four coupon
operations.17 These operations continued to be segmented into separate
tranches across different portions of the
yield curve to facilitate rapid execution.
Given the frequent need for secondary
market purchases, the Desk sought to
distribute its purchases evenly over time
as much as possible and did not attempt
to concentrate operations in periods
when Federal Reserve note growth was
fastest.
The selection of specific issues in
each operation was based on the relative attractiveness of propositions and
portfolio considerations. In addition to
remaining within the per-issue-guideline
limits and avoiding on-the-run issues,
the Desk avoided purchases that would
be expected to cause a sizable redemption on any day in the foreseeable future,
and it bought no issues in the secondary
market that had less than four weeks
remaining to maturity.
General Characteristics of
Domestic Permanent SOMA Holdings
at Year-End
The average maturity of the entire
SOMA portfolio of Treasury securities
was 53.5 months at year-end, up slightly
from 52.9 months one year earlier.
The share of all outstanding marketable
Treasury securities held in the SOMA
was 19 percent, about a percentage point
higher than a year earlier. The SOMA
held 25 percent of all bills (compared
with 31 percent a year ago), and 17 percent of all coupons including TIIS (compared with 14 percent a year earlier).
At the end of the year, approximately
17. This total includes five TIIS operations,
totaling $3.3 billion. On one day, two separate
coupon operations were arranged.



$228 billion of marketable Treasury
securities remained purchasable under
the Desk's guidelines for percentage
holdings—compared with $260 billion
at the end of the previous year. The
gross remaining purchasable amount
was $183 billion if account is taken
of the practices of avoiding purchases
of recently issued debt, purchases that
would contribute to sizable redemptions,
and purchases of issues that mature
within four weeks.
Temporary Holdings and
Open Market Operations
Long-Term Repurchase Agreements
Over the past two years, long-term RPs,
defined as operations with an original
maturity of more than fifteen days,
have been a standard asset in the Fed's
domestic financial portfolio.18 Temporarily increasing the total size of outstanding long-term RPs has proved to be
an effective way of addressing significant increases in the net value of autonomous factor liabilities or increases in
demands for Fed balances that are
expected to last for a number of weeks
or months, but not permanently. Longterm RPs can also be adjusted readily
to accommodate an extended mismatch
between changes in the permanent
SOMA and in levels of autonomous factors and total balance requirements.
During the year, the Desk adhered to
the practice of arranging an RP with a
18. The choice of any maturity to distinguish
long-term from short-term RPs is somewhat arbitrary. Fifteen days had been the maximum allowable maturity under the FOMC's Authorization for
many years until 1998, and it approximates the
length of a reserve maintenance period. Fifteen
days is designated to be the longest "short-term"
maturity because, as noted in this section, the RPs
the Desk used that carried a fifteen-day maturity
had a clear short-term operational focus.

Domestic Open Market Operations during 2001 109
twenty-eight-day maturity on the Monday or Thursday (or both) of each
week.19 These operations are typically
arranged early in the morning, before
final daily reserve estimates are available, as their use is not geared toward
addressing daily volatility in autonomous factors and excess demands. In
other respects, these RPs are operationally just like those for short-term
maturities. Dealer participation in these
long-term RPs has consistently been
very strong, measured by the size of
propositions.
The sizes of the twenty-eight-day RPs
arranged over the year ranged from
$2 billion to $5 billion. Over most of the
first half of 2001, their total outstanding
value stood at $12 billion, which was
also the lowest outstanding total for
the year (chart). In the third quarter, the
Desk built up their underlying level
modestly, but in the immediate aftermath of the September 11 attacks the
Desk allowed two long-term RPs to
mature without replacement, to simplify
its market involvement at the time. As
reserve deficiencies deepened late in the
year, at first when requirements bulged
in October and then as Federal Reserve
notes began to grow from seasonal
factors, long-term RPs were gradually
increased, peaking at a level of $31 billion in the year-end maintenance period.
Short-term RPs and MSPs
Short-term temporary operations, RPs
and matched sale-purchases (MSPs), are
the primary tool used to address day-to19. This practice was first begun in March
2000. In January 2002, the Desk began to arrange
these twenty-eight-day RPs just once per week, on
each Thursday, adjusting the size of each operation to achieve the same desired total outstanding
amount. This weekly schedule will continue to
provide the desired flexibility to the portfolio at
even lower operational cost.



Temporary Operations Outstanding
Billions of dollars

1999

2000

2001

NOTE. Maintenance period averages through January 9, 2002.

day volatility in autonomous factors and
in demands for Fed balances. These
operations are also used to fill temporarily the gaps left by more-enduring
changes in autonomous factors and Fed
balance demands that are not immediately met by changes in the permanent
SOMA or long-term RPs outstanding.
Daily volatility in short-term temporary operations outstanding (RPs less
MSPs), measured by the average of
absolute daily changes in short-term
agreements outstanding, has been
around $31/2 billion in each of the past
two years. Daily levels of net shortterm operations outstanding ranged
from -$4 billion to +$81 billion; excluding the days immediately following
the September 11 attacks, the peak
was +$31 billion. On a period-average
basis, short-term operations outstanding
ranged from $4 billion to $38 billion;
excluding the two exceptionally high
period-average levels that covered late
September, the period-average peak was
$14 billion. For the year as a whole,
short-term temporary operations outstanding averaged $10 billion. The average was closer to $8 billion excluding
the September 19 maintenance period,
which was somewhat above the $5 billion average outstanding level in 2000.

110 88th Annual Report, 2001
Number of Temporary Operations, by Maturity and Type
Item
One business day
Term RPs up to fifteen days
Term RPs over fifteen days
One-business-day MSPs
Term MSPs

1998

1999

2000

2001

144
62
3
21
1

147
83
14
13

142
46
61
16
3

133
85
88
10
0

Volatility in autonomous factors and
in demand for Fed balances requires the
Desk to be prepared to arrange these
operations each day, and often an overlapping structure of short-term operations is constructed. By far the most
common operation was an overnight RP
(which includes all RPs that cover just
one business day), of which 133 were
arranged in 2001 (table). As usual, the
Fed's portfolio continued to be structured in such a way as to keep reliance
on MSPs relatively low.20
In general, propositions were sufficient to cover the intended size of the
short-term operations the Desk wished
to arrange. However, ahead of days on
which propositions were expected to
run low, the Desk sometimes layeredin term agreements of short duration
to ensure this outcome. For example,
dealer participation on overnight RPs
was relatively low on quarter-end dates,
when high excess needs usually required
a large amount of short-term RPs to be
outstanding. Propositions on RPs on
FOMC meeting dates in 2001 also
tended to be low, as a byproduct of
expected imminent rate cuts. On these
20. One reason the Desk avoids heavy reliance
on MSPs is that propositions on these operations
in general are low compared with RPs, reflecting
dealers' net borrowing needs. Also, given the
structure of the Fed's balance sheet, routine reliance on MSPs would require expanding the Fed's
holdings of financial assets above the level that is
needed to meet its net autonomous factor liabilities and demands for Fed balances.



0

dates, by the time the Desk was prepared to arrange its short-term operations, dealers had already met a greaterthan-normal share of their total overnight borrowing needs, in response to
heightened demand from their institutional customers. These cash investors
had greater amounts to invest on an
overnight basis with the dealers because
the borrowers with whom they normally
placed cash on a term basis were issuing
less term debt on days of expected rate
cuts.
Also in 2001, the Desk arranged two
short-term RPs, an overnight operation
and a term agreement of up to fifteen
days, on seven different maintenance
period settlement dates, usually out of
concern that propositions on the overnight RP alone might not be adequate to
address all of the remaining period need.
Given banks' usual preference for holding higher excess levels on settlement
dates, which was even more pronounced
in 2001, the Desk sometimes faced a
larger remaining "add need" on these
days than it was comfortable addressing
with a single, overnight operation. The
term agreements arranged on these occasions were used to help meet needs in
the following maintenance period.
Collateral Distribution
The Desk solicited propositions across
the entire pool of eligible collateral on
all RPs arranged in 2001. But with the
exception of nine RPs arranged on the

Domestic Open Market Operations during 2001 111
Average Annual RPs Outstanding, by Collateral Tranche
Billions of dollars
2001

2000

Item
Short-term RPs

Long-term RPs

Short-term RPs

Long-term RPs

Treasury
Agency
Mortgage-backed

2.3
1.3
1.5

7.1
3.7
5.3

4.1
2.2
3.4

8.0
4.1
4.5

Total

5.1

16.1

9.7

16.6

days immediately following the September 11 attacks, all RPs were arranged as
three separate simultaneous operations
differentiated by type of collateral eligible. In the first of these, only Treasury
debt was accepted; in the second, direct
federal agency obligations (in addition
to Treasury debt) were eligible; and in
the third, mortgage-backed agency debt
was eligible (in addition to the other two
categories of debt). For the purposes of
this report, these separate operations are
counted as different tranches of a single
RR In order to simplify the structure of
its operations, for several days after September 11 the Desk arranged only RPs
with a single tranche, under which dealers had the option to deliver Treasury,
agency, or mortgage-backed collateral.
All RPs arranged in 2001 settled under
the triparty agreements established with
two clearing banks in 1999. Under
these agreements, dealers have flexibility to choose, and to change from day to
day, the specific securities they deliver
within each tranche.
The distribution of accepted propositions across collateral categories on
multi-tranche RPs was determined by
the relative attractiveness of rates in
each tranche benchmarked against current market financing rates for that class
of collateral. Distributions of collateral
by tranche on outstanding RPs tend
to be reasonably stable, but they can
be very volatile from one operation to



the next. In 2001, tranches in which
mortgage-backed securities were eligible tended to account for a somewhat
smaller share of total outstanding RPs.
Their share on short-term RPs in 2001
was about the same as in the previous
year, but only because of the large,
single-tranche RPs arranged in the aftermath of September 11 (table).21
The Federal Funds Rate and
Discount Window Credit
The Federal Funds Rate
Daily volatility in the federal funds rate
and deviations of effective rates from
target in 2001 were slightly higher than
in the preceding year, but still to the low
side of recent norms (table). Deviations
of morning funds rates from target, often
a measure of market expectations for
likely rate behavior later in the day, continued to show the kinds of recurring
patterns associated with certain calendar events seen in previous years. The
deviations of the morning rate from target on high-payment-flow days and on
Fridays were a touch smaller than in
past years. However, morning premiums
21. These tranches reflect options that dealers
have for delivering different categories of collateral on outstanding RPs where, for example, a
dealer has the option to deliver Treasury debt on
agency RPs but not vice versa.

112 88th Annual Report, 2001
Federal Funds Rate Behaviors: Medians and Averages of Daily Values
Basis points
Item

1999

1998

Deviations of effective rate from target
Median
Average

2000

-1
-1

Absolute deviations of effective rate from target
Median
Average

8
13

Intraday standard deviations
Median

25
-6
13

0
-1

12

Medians of morning rates less target rate on
High-payment-flow days (excluding quarter-ends)
Fridays
Maintenance period settlement days

2001

on maintenance period settlement days,
which had been common in the past
but which had largely disappeared over
the preceding couple of years, were
again evident in 2001, averaging around
6 basis points. The higher levels of
excess reserves that had to be accumulated on the final day to meet requirements in 2001 may have contributed
to funding anxieties of bank reserve
managers.
Discount Window Credit
Discount window credit makes up a
relatively small portion of the total
domestic financial assets held by the
Federal Reserve (table). Much of this

7
11

19
-6
0

19
-6
0

16
-3
6

credit is seasonal borrowing, which
behaviorally is more akin to an autonomous factor in terms of its implications
for open market operations.22 Adjustment credit is typically quite small, but
the existence of the adjustment credit
facility is an important part of the monetary policy implementation framework.
It acts as a stabilizer, moderating the
upward movements in the federal funds
rate in the event a shortage of Fed balances leaves a bank overdrawn on its
Fed account at the end of any day or
deficient in meeting its requirements on
a maintenance period settlement day.
22. There were no instances of extended credit
borrowing at the discount window.

Discount Window Borrowing Activity
1998

1999

2000

2001

2001
excluding
Sept. 11-13

Average daily amount outstanding
(millions of dollars)
Seasonal credit
Adjustment credit

96
66

127
95

258
108

73
319

73
77

Number of days on which total
adjustment borrowing by large banks
More than $100 million-$500 million
More than $500 million

23
10

17
13

12
14

10
11

10
8

Item




Domestic Open Market Operations during 2001 113
The critical role of the adjustment credit
facility during times of severe stress in
financing markets is highlighted by the
discussion in the following section of its
use immediately following the September 11 attacks. For meeting more-routine
reserve shortfalls and payments difficulties, even levels of adjustment borrowing that are small relative to the total
supply of Fed balances can help alleviate the degree of upward rate pressure
that can develop in the market.
Large banks as a group borrowed an
amount in excess of $500 million on
eleven different days in 2001, including
three occasions coming in the immediate aftermath of the September 11
attacks. This total is in line with the
number of occasions banks borrowed
at least that much in the preceding
three years. Large banks borrowed a
somewhat smaller but still significant
amount, in excess of $100 million, on
another ten occasions in 2001, but this
number was somewhat below the frequency in most other recent years.

night basis. Communications disruptions
prevented many borrowers from having
normal access to their investor base for
the first few days after September 11,
even among those not directly affected
by the attacks, and the impaired ability
of a major clearing bank to process
funds and securities transfers for itself
and on behalf of its customers created
additional uncertainties. Banks and dealers, uncertain about their general cash
position or the availability of financing,
tended to refrain from making cash outlays until later than normal in the day.
In the federal funds market, several of
the major brokers ceased operations for
a time, and many large banks resorted
to arranging trades directly with one
another. Although not fully back to normal levels of operating efficiency, the
payments and communications infrastructure most critical to the functioning
of the financing market had recovered
considerably by Monday, September 17,
and participation levels were much
improved.

The Conduct of Monetary
Operations after September 11

Behavior of Autonomous Factors

This section presents an overview of the
context and conduct of open market
operations in the aftermath of the terrorist attacks on the World Trade Center and Pentagon on Tuesday, September 11.
General Financing Market
Conditions
Immediately following the attacks,
many financial markets effectively
ceased operations. But with Fedwire
and other wholesale payments networks
remaining open, securities dealers and
banks faced a continuing need to obtain
funding for large pre-existing positions
that they typically finance on an over


Levels of several of the autonomous factors on the Fed's balance sheet were
dramatically affected by some of the
responses to the World Trade Center
and Pentagon attacks. Over the threeday interval September 12 through
September 14 (Wednesday through Friday), net autonomous factor movements
increased the supply of Fed balances
dramatically, and then net factor movements began to drain large quantities.
The level of float in the banking system,
normally around $1 billion, peaked at
$47 billion on that Thursday as a result
of the temporary curtailment of air traffic nationwide. Another $20 billion of
Fed balances was created that day when
the European Central Bank drew on a
temporary foreign currency swap line

114 88th Annual Report, 2001
that had just been established. Meanwhile, investments in the foreign RP
pool jumped between $15 billion and
$20 billion above recent norms, reducing the supply of Fed balances. The
factors that were adding to the supply
of Fed balances returned to something
like normal levels by Monday, September 17, but persistent high levels of the
pool began to leave large underlying
deficiencies.

Federal Reserve Monetary
Operations, and the Level and
Distribution of Fed Balances
On the morning of September 11, the
Federal Reserve issued a public release
stating, "The Federal Reserve System
is open and operating. The discount
window is available to meet liquidity
needs," to encourage banks to view the
discount window as a source of liquidity. September 11 fell in the middle of
the maintenance period ended September 19; for the remainder of that period,
the Desk arranged only overnight RPs
for same-day settlement because of the
high degree of volatility in the needed
level of RPs outstanding from one day
to the next.
From Wednesday through the following Monday, the sizes of open market
operations were aimed at satisfying all
the financing that dealers wished to
arrange with the Desk, in order to mitigate to the extent possible the disruptions to normal trading and settlement
arrangements.23 On these four days, all
propositions with rates at or above the
prevailing target were accepted, which
was the vast majority. Dealers' total
23. The RP on September 12 was arranged
from the FRBNY's Main Building. Subsequent
operations were arranged out of the contingency
site at the Bank's East Rutherford Operations
Center.



demands for financing far surpassed any
need to arrange operations simply to
provide an aggregate level of Fed balances that would help banks meet their
requirements or their desired end-of-day
holdings of balances at the Fed. To more
effectively serve as a source of financing of last resort and to help encourage
dealers to continue to intermediate on
behalf of some of their own customers,
the Desk operated relatively late in the
day, after dealers had a good opportunity to assess their full financing needs
and to secure all available financing in
the market.
The size of the overnight RPs,
which typically may be around $3 billion, peaked on Thursday and Friday at
$70 billion and $81 billion, respectively,
the same days that autonomous factors
also added the most to the supply of Fed
balances. Before discount window borrowing, Fed balances on both those days
topped $110 billion, and, in general, Fed
balances before borrowing were extraordinarily elevated from Wednesday
through Monday (chart). But even with
such high levels of Fed balances, severe
dislocations that interfered with their
distribution in the first few days after

Total Federal Reserve Balances
around September 11
Billions ofdi liars

r

_

\

—

/

Borrowed
balances
—-

1

y

Nonborrowed
balances — 100
80

60
:

_w^V
9/5

// I
9/11

V
9/179/19

40
20

10/3

NOTE. Vertical dashed lines separate reserve maintenance periods.

Domestic Open Market Operations during 2001 115
the attacks caused many banks to borrow at the discount window to cover
overdraft positions. As a result, levels of
adjustment borrowing soared to record
levels on Tuesday and Wednesday.
By the final days of the maintenance
period, after financing markets began to
function more normally, the Desk aimed
its operations at maintaining a more
traditional balance between the supply
of and demand for Fed balances, consistent with the federal funds rate trading
around the target level, lowered to 3 percent on September 17. With cumulative excess positions so high and with
financing rates generally quite low,
reflecting the weight of these excess
positions, the Desk was aiming to leave
relatively low levels of Fed balances
in place each day. The size of the RPs
needed to provide even these relatively
low levels of balances remained large
for a time, reflecting the impact of
autonomous factors that were now
reducing the supply of Fed balances
below normal levels. As dealers increasingly were able to communicate with
and obtain financing from their usual
customers, the Desk had to move up
its operating time to ensure a sufficient level of participation for the
large RPs that were still needed, and
it had to accept the vast majority of
propositions—even those offered at
rates well below the new 3 percent target level—in order to arrange RPs of
sufficient size.
Even with the low levels of excess
provided late in the maintenance period,
the average level of excess balances
for the period ended September 19 was
$38 billion. This excess was highly concentrated at a small number of institutions that accumulated high balances as
a result of an inability to make payments
or to sell funds in the first days after the
attacks, and it did not reflect any desire
to hold huge excess balances.



In part to simplify the nature of our
direct market involvement under exigent circumstances, from September 11
through the remainder of the maintenance period under way, the Desk did
not replace any of its maturing longterm RPs, and it arranged no outright
operations. On the settlement day,
the Desk arranged three term RPs that
settled on a forward basis on the first
day of the following maintenance
period, totaling $23 billion, in order to
reduce the level of intervention that
would be needed in financing markets in upcoming days. Other changes
were also made to simplify operations.
Instead of differentiating between collateral types, each RP was arranged as a
single tranche where dealers had the
option to deliver any of the three categories of collateral. Because some dealers
lacked connectivity at their contingency
sites, the Desk operated in a semimanual mode, inputting propositions for
many dealers (although the automated
trade processing system continued to
operate uninterrupted). Because of the
time required to establish voice communications with dealers lacking electronic
connections and the time needed to
receive bids by phone, the time between
when an operation was first announced
and when it was closed was lengthened,
and the Desk often pre-announced its
time frame for operating.
Financing Rate Behavior
From Tuesday, September 11, through
most of Thursday, September 13, market participants in both the government
securities RP markets and in the federal
funds market simply priced their trades
at the target funds rate, a response to the
attacks that likely helped maintain some
order in these markets. The high levels
of excess balances provided through the
Desk's RPs first began to weigh heavily

116 88th Annual Report, 2001
Federal Funds Rates around September 11

zation in effect at the end of 2001 is
reprinted below.

Percentage points

Target rate

Authorization for Domestic
Open Market Operations
1. The Federal Open Market Committee
authorizes and directs the Federal Reserve
Bank of New York, to the extent necessary to carry out the most recent domestic
policy directive adopted at a meeting of the
Committee:

Effective \
rate
V

—

\i
•:

9/5
NOTE.

Vertical

9/11

9/17 9/19

10/3

dashed lines separate reserve mainte-

nance periods.

on the funds rate during late trading on
Thursday and again on Friday, although
through Monday, September 17, morning rates generally reverted back to
the target (chart). Thereafter, extremely
low rates prevailed in the funds and RP
markets for several days, falling even
below 1 percent. These low rates in
large measure reflected misperceptions
that the Desk was continuing to provide
high levels of balances, a view reinforced by the continuing large sizes
of the RPs and widespread reports that
were crediting the Desk with providing
abundant liquidity to the market. Several episodes of rates being pushed
higher in late-day trading, induced by
the relatively low levels of Fed balances
the Desk was leaving in place, were
needed to nullify these perceptions and
to bring the funds rate back up closer to
the target.

Appendix A:
Authorization for Domestic
Open Market Operations
Open market operations were conducted
under the Authorization for Domestic
Open Market Operations. The Authori


(a) To buy or sell U.S. Government
securities, including securities of the Federal
Financing Bank, and securities that are direct
obligations of, or fully guaranteed as to
principal and interest by, any agency of the
United States in the open market, from or
to securities dealers and foreign and international accounts maintained at the Federal
Reserve Bank of New York, on a cash, regular, or deferred delivery basis, for the System
Open Market Account at market prices, and,
for such Account, to exchange maturing U.S.
Government and Federal agency securities
with the Treasury or the individual agencies
or to allow them to mature without replacement; provided that the aggregate amount of
U.S. Government and Federal agency securities held in such Account (including forward
commitments) at the close of business on the
day of a meeting of the Committee at which
action is taken with respect to a domestic
policy directive shall not be increased or
decreased by more than $12.0 billion during
the period commencing with the opening of
business on the day following such meeting
and ending with the close of business on the
day of the next such meeting;
(b) To buy U.S. Government securities,
obligations that are direct obligations of, or
fully guaranteed as to principal and interest
by, any agency of the United States, from
dealers for the account of the Federal
Reserve Bank of New York under agreements for repurchase of such securities or
obligations in 65 business days or less, at
rates that, unless otherwise expressly authorized by the Committee, shall be determined
by competitive bidding, after applying reasonable limitations on the volume of agreements with individual dealers; provided that
in the event Government securities or agency

Domestic Open Market Operations during 2001 111
issues covered by any such agreement are
not repurchased by the dealer pursuant to the
agreement or a renewal thereof, they shall be
sold in the market or transferred to the System Open Market Account.
(c) To sell U.S. Government securities
that are direct obligations of, or fully guaranteed as to principal and interest by, any
agency of the United States to dealers for
System Open Market Account under agreements for the resale by dealers of such securities or obligations in 65 business days or
less, at rates that, unless otherwise expressly
authorized by the Committee, shall be determined by competitive bidding, after applying reasonable limitations on the volume of
agreements with individuals dealers.
2. In order to ensure the effective conduct
of open market operations, the Federal Open
Market Committee authorizes the Federal
Reserve Bank of New York to lend on an
overnight basis U.S. Government securities
held in the System Open Market Account to
dealers at rates that shall be determined by
competitive bidding but that in no event shall
be less than 1.0 percent per annum of the
market value of the securities lent. The Federal Reserve Bank of New York shall apply
reasonable limitations on the total amount of
a specific issue that may be auctioned and on
the amount of securities that each dealer may
borrow. The Federal Reserve Bank of New
York may reject bids which could facilitate
a dealer's ability to control a single issue
as determined solely by the Federal Reserve
Bank of New York.
3. In order to ensure the effective conduct
of open market operations, while assisting
in the provision of short-term investments
for foreign and international accounts maintained at the Federal Reserve Bank of New
York, the Federal Open Market Committee
authorizes and directs the Federal Reserve
Bank of New York (a) for System Open
Market Account, to sell U.S. Government
securities to such foreign and international
accounts on the bases set forth in paragraph l(a) under agreements providing for
the resale by such accounts of those securities in 65 business days or less on terms
comparable to those available on such transactions in the market; and (b) for New York
Bank account, when appropriate, to undertake with dealers, subject to the conditions



imposed on purchases and sales of securities
in paragraph l(b), repurchase agreements in
U.S. Government and agency securities, and
to arrange corresponding sale and repurchase
agreements between its own account and
foreign and international accounts maintained at the Bank. Transactions undertaken
with such accounts under the provisions of
this paragraph may provide for a service fee
when appropriate.
4. In the execution of the Committee's
decision regarding policy during any intermeeting period, the Committee authorizes
and directs the Federal Reserve Bank of
New York, upon the instruction of the Chairman of the Committee, to adjust somewhat
in exceptional circumstances the degree of
pressure on reserve positions and hence the
intended federal funds rate. Any such adjustment shall be made in the context of the
Committee's discussion and decision at its
most recent meeting and the Committee's
long-run objectives for price stability and
sustainable economic growth, and shall be
based on economic, financial, and monetary developments during the intermeeting
period. Consistent with Committee practice, the Chairman, if feasible, will consult
with the Committee before making any
adjustment.

Appendix B:
Guidelines for the Conduct of
System Open Market Operations
in Federal Agency Issues
The FOMC has established specific
guidelines for operations in agency
securities to ensure that Federal Reserve
operations do not have undue market
effects and do not serve to support
individual issuers. Provisions 3-6 of
the guidelines were first temporarily
suspended in August 1999, in order to
expand the types of agency securities
the Desk could accept in its operations
around the century date change. This
suspension was extended in March
2000, in light of anticipated paydowns
of federal debt, and it was reaffirmed in
January 2001 until the FOMC's first
meeting in 2002.

118 88th Annual Report, 2001

Guidelines for the Conduct of
System Open Market Operations
in Federal Agency Issues
1. System open market operations in Federal agency issues are an integral part of total
System open market operations designed to
influence bank reserves, money market conditions, and monetary aggregates.
2. System open market operations in Federal agency issues are not designed to support individual sectors of the market or
to channel funds into issues of particular
agencies.
3. System holdings of agency issues shall
be modest relative to holdings of U.S. Government securities, and the amount and timing of System transactions in agency issues
shall be determined with due regard for the
desirability of avoiding undue market effects.




4. Purchases will be limited to fully taxable issues not eligible for purchase by the
Federal Financing Bank, for which there is
an active secondary market. Purchases will
also be limited to issues outstanding in
amounts of $300 million or over in cases
where the obligations have maturity of five
years or less at the time of issuance, and to
issues outstanding in amounts of $200 million or over in cases where the securities
have a maturity of more than five years at
the time of issuance.
5. System holdings of any one issue at
any one time will not exceed 30 percent of
the amount of the issue outstanding. Aggregate holdings of the issues of any one agency
will not exceed 15 percent of the amount of
outstanding issues of that agency.
6. All outright purchases, sales, and holdings of agency issues will be for the System
Open Market Account.
•

Federal Reserve Operations




121

Consumer and Community Affairs
In 2001, the Division of Consumer
and Community Affairs of the Federal
Reserve Board was active in several
important areas:
• Curbing abusive lending practices
• Fostering research in community development and consumer economics
• Preparing for a review of the regulations that implement the Community
Reinvestment Act
• Expanding access to consumer information.
In addition, the division continued
its work in drafting regulations that
govern providers of consumer financial services; reviewing applications for
mergers and acquisitions; monitoring
fair lending activities and compliance
with the Community Reinvestment Act;
supporting community development
activities throughout the System; analyzing data gathered under the Home
Mortgage Disclosure Act; monitoring
compliance with consumer protection
regulations; and addressing consumer
complaints.

Curbing Abusive Lending
In December, the Board of Governors
revised the provisions of Regulation Z
(Truth in Lending) that implement the
Home Ownership and Equity Protection
Act (HOEPA). Enacted in 1994 in
response to evidence of abusive lending
practices in the home-equity-lending
markets, the act imposes substantive



limitations on, and additional disclosure
requirements in connection with, home
equity loans that have interest rates
above a certain level or fees above a
certain amount. It also authorizes the
Board to expand HOEPA s coverage to
more loans and to prohibit certain acts
and practices in mortgage lending. The
Board had published proposed revisions
to Regulation Z in December 2000.
The final revisions broaden the scope
of loans subject to HOEPA s protections
by adjusting the price triggers that determine coverage under the act. The ratebased trigger was lowered two percentage points for first-lien loans (from
10 to 8 percentage points) but was kept
at 10 percentage points for subordinatelien loans. The fee-based trigger was
revised to count as fees any amounts
paid at closing for optional credit insurance and similar debt-protection products obtained in connection with the
mortgage.
The revisions also restrict certain
acts and practices in home-secured
transactions. For example, creditors may
not refinance their HOEPA loans within
one year of extension if the refinancing is not in the borrower's interest.
To strengthen the existing prohibition
against extending credit on the basis
of homeowner equity without regard to
ability to repay, creditors must verify
and document the homeowner's repayment ability. The disclosures that must
be given three days before closing to
borrowers obtaining HOEPA-covered
loans must state the total amount borrowed and must indicate whether that
amount includes payment for optional
credit insurance or similar products.

122 88th Annual Report, 2001

Fostering Research
The Federal Reserve continues to foster
research in community development
and consumer economics. In April, the
System's Community Affairs Offices
held a second biennial research conference, "Changing Financial Markets and
Community Development." The conference featured the work of economists
and other scholars on the delivery
of financial services to lower-income
populations and small businesses; presentations were made on the Community Reinvestment Act, predatory lending, credit scoring, wealth creation,
and alternative financial services. The
importance of financial literacy and
consumer education was discussed by
Board Chairman Alan Greenspan in
his keynote address. The proceedings
of the conference, including speeches,
papers, and discussant statements, are
available on the web site of the
Federal Reserve Bank of Chicago, at
http://www.chicagofed.org/cedric/2001/
sessionone.cfm. Members of the Board's
Community Affairs staff, in partnership
with research colleagues at the Board
and the Reserve Banks, are now planning for the 2003 research conference,
which will focus on "Sustainable Community Development: What Works,
What Doesn't, and Why."
Also during the year, the Reserve
Banks sponsored programs focused on
emerging issues in community development to encourage research and facilitate discussion among academics and
practitioners. Topics included
• "Smart Growth and Community
Development: Working Together
Smartly" (Philadelphia, Richmond,
and Atlanta Reserve Banks)
• "Smart Codes: A Local Perspective
on Planning and Growth" (St. Louis
Reserve Bank)



• "Making Small Cities and Towns
Work" (Philadelphia and Richmond
Reserve Banks)
• "New Roads and e-Roads: Market
Innovations in Community Development" (Dallas Reserve Bank).
On the consumer economics side,
members of the Board's Consumer Policies staff conducted research on a wide
range of subjects. Studies on households
with high-cost home-secured loans and
consumers' choice of financial institutions for home-secured loans were
conducted in support of the division's
efforts to address concerns about abusive lending practices. Studies on lowincome and underserved consumers,
including research on reasons consumers do not have checking accounts and
on changes in account ownership over
time, supported Federal Reserve initiatives regarding financial access for the
unbanked. Other research focused on
electronic banking, consumers' complaints about credit card problems, consumers' satisfaction with the Federal
Reserve's complaint process, and financial literacy. The division staff received
an award from the Association for
Financial Planning and Counseling Education for research on the ability of lowincome households to save.

Preparing for the Community
Reinvestment Act Review
The current regulations implementing the Community Reinvestment Act
(CRA) were adopted in 1995 by the
supervisory agencies that have CRA
responsibilities—the Federal Reserve,
the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), and the
Office of Thrift Supervision (OTS). The
regulations reflect the agencies' efforts

Consumer and Community Affairs

123

to (1) emphasize an institution's actual publishing an advance notice of properformance in addressing its CRA posed rulemaking.
responsibilities rather than the process,
By the end of 2001, the agencies
(2) promote consistency in evaluations, had received approximately 400 comand (3) eliminate unnecessary burden on ments in response to the notice. These
institutions. To this end, CRA examina- comments will be taken into account in
tions focus on the quantitative aspects the agencies' analysis for determining
of an institution's performance, such as whether regulatory changes are needed
the number and dollar amount of loans to increase the CRA regulations'
and investments made; they also include effectiveness.
a review of qualitative aspects, such as
whether the bank is innovative in meetExpanding Access to
ing the credit needs of the community.
Consumer Information
The regulations require large institutions to collect, report, and disclose data The Board substantially expanded the
on small-business, small-farm, and com- Spanish-language offerings of its conmunity development loans and, for insti- sumer education program in 2001:
tutions already reporting Home Mort- Spanish-language versions of material
gage Disclosure Act data, data on home on three subjects—mortgages, vehicle
mortgage lending outside metropolitan leasing, and consumer complaints—
areas.1 Large retail institutions are were launched on the Board's public
evaluated on their record of providing web site, and Spanish-language versions
loans, investments, and services to their of two consumer brochures—Looking
communities. Small institutions, in con- for the Best Mortgage and How to File
trast, are evaluated under a streamlined a Consumer Complaint—were released.
approach that focuses on their lending; The materials can be found at http://
some small institutions elect to have www.federalreserve.gov/consumers.htm.
their investment and service activities
In 2001, the Board also completed a
reviewed as well in order to be consid- major revision of its consumer brochure
ered for an "outstanding" CRA rating. on credit cards, Shop—The Credit Card
The regulations also include a commu- You Pick Can Save You Money, incornity development test for limited- porating information on new disclosure
purpose and wholesale banks and an requirements under Regulation Z and
option for any bank to be examined information from the re-instituted Surunder a strategic plan.
vey of Credit Card Plans conducted by
When they adopted the regulations, the Board. A design review of all the
the supervisory agencies committed to Board's consumer education publicaconducting a full review in 2002 to tions is under way to ensure that the
determine whether their stated goals are materials are meeting consumers' needs.
being achieved. The agencies began In addition to enhancing its own conthe review process in July 2001 by sumer education program, the Board
also worked with other agencies on
resources to help consumers make deci1. A large institution is an institution that as of sions on financial privacy (see box) and
December 31 of the previous two calendar years
avoid abusive lending practices.
either had total assets of $250 million or more or
In recognition of the importance
was affiliated with a holding company that had
of financial education in increasing
total banking and thrift assets of $1 billion or
more.
economic opportunity, the Community



124 88th Annual Report, 2001

Financial Information and Consumers' Rights to Privacy
Gramm-Leach-Bliley also contains very important and far-reaching privacy
provisions. . . . Our objective is to devise disclosure requirements and consumer
"opt-out" procedures that protect consumer privacy without overwhelmingly
burdening financial institutions or consumers.
Laurence H. Meyer, Member, Board of Governors

July 1, 2001, marked the deadline for
financial companies—banks, brokers, and
insurance companies, among others—to
provide privacy notices to their existing
customers. Companies were required to tell
their customers
• What kinds of personal information the
company collects (for example, income,
assets, and account balances)
• How the company uses the information,
and whether it intends to make the information available to nonaffiliated third
parties (such as mortgage brokers, direct
marketers, or nonprofit organizations)
• What customers can do to limit some of
that information sharing
• How the company safeguards personal
nonpublic information against fraudulent
access.
Consumers must now be given a privacy
notice at the time they enter into a customer relationship with the company—
for instance, when they open a checking
account. And consumers, whether or not
they have actually become "customers"
(for example, consumers who have simply
filled out an application), must be given a
notice before their personal financial infor-

Affairs Offices at the Board and the
Reserve Banks offer resources and programs to promote personal financial
literacy skills. In 2001, the Community
Affairs staff at the Board organized
workshops for Board employees on



mation is shared with a third party. In addition to this initial notice, customers, as
long as they remain customers, must be
given an annual notice describing the company's privacy policies and practices.
Consumers must be given an opportunity to tell the company not to share the
information—that is, they must be allowed
to "opt out." Opting out must be reasonably convenient—accomplished by checking a box on an application, returning a
preaddressed reply form, or calling a tollfree telephone number, for example. And
consumers must be allowed a "reasonable" length of time to respond (generally
thirty days).
The opt-out right does not apply to all
types of personal information. For example, it does not apply to a consumer's telephone number if that number is published
in a telephone directory. The right also
does not apply in certain situations—for
example, consumers may not stop their
banks from sharing information needed to
process their credit card or check transactions, to comply with a court order, or to
prevent fraud. A financial company may
also disclose personal financial information to comply with federal, state, or local
requirements—such as a local law requiring mortgage documents to be recorded
in public records—without providing consumers an opt-out right.

preparation for home ownership and
on the effective use of credit. The Dallas
Reserve Bank launched an interactive
web-based version of Building Wealth:
A Beginner's Guide to Securing Your
Financial Future, a program to help

Consumer and Community Affairs

125

Origins of the New Rights
to Financial Privacy

Compliance with the
Privacy Provisions

Financial companies share information
about customers for a variety of reasons. In
some instances, they may do so simply in
the course of providing basic services to
their customers—when they process credit
card payments or arrange for the printing
of personalized checks, for example. They
may also use the information in offering additional services or introducing new
banking products. Some consumers want
to take advantage of these opportunities
and are willing to have their personal
financial information shared with third
parties. Others prefer to limit the promotional materials they receive and do not
want marketers and others to have such
information.
Concern about consumer privacy led
to passage of federal legislation governing the protection and disclosure of nonpublic personal information by financial
companies as part of the Gramm-LeaehBliley Act. Regulations implementing the
act's privacy provisions were issued in
June 2000 and became effective the following November. Eight federal agencies have
responsibilities for enforcing the privacy
provisions: the Board of Governors of the
Federal Reserve System, the Office of the
Comptroller of the Currency, the Federal
Deposit Insurance Corporation, the Office
of Thrift Supervision, and the National
Credit Union Administration (which collectively make up the Federal Financial Institutions Examination Council, or
FFIEC); the Securities and Exchange
Commission; the Federal Trade Commission; and the Commodity Futures Trading
Commission.

Financial companies supervised by the
FFIEC agencies are subject to examination
to ensure that they are complying with the
provisions of the Gramm-Leach-Bliley
Act. Examination procedures were developed by the FFIEC, and examinations
began in July 2001 as part of regular
consumer compliance examinations. As
of the end of 2001, few violations had
been found. Of those that were found,
many concerned not giving notices on time
or giving notices that did not contain all of
the necessary information.
To help financial institutions in their
efforts, the Board, working with the other
agencies, has issued a set of frequently
asked questions for financial institutions
(available at http://www.federalreserve.gov/
boarddocs/press/general/2001 /200112122/
attachment.pdf).
The eight federal agencies hosted a daylong workshop, "Get Noticed: Effective
Financial Privacy Notices/' in December
2001 to discuss how financial institutions
can provide consumers with more effective
notice of their privacy policies and practices. Information on the workshop is available at http://www.ftc.gov/bcp/workshops/
glb/index.html.

consumers develop a plan for building
personal wealth that includes setting
financial goals, budgeting, saving and
investing, and managing debt (http://
www.dallasfed.org / htm / wealth / index,
html). The Cleveland Reserve Bank



Consumer Education
The Board and the other agencies have
prepared information for consumers
explaining their financial privacy rights
under Gramm-Leach-Bliley. The information is available at http://www.
federalreserve.gov/pubs/privacy.

continues to support the Consumer Federation of America's "Cleveland Saves"
program to help low- and moderateincome families create personal savings
plans. The New York and San Francisco
Reserve Banks, in cooperation with a

126 88th Annual Report, 2001
national nonprofit organization dedicated to the economic self-sufficiency of
inner-city residents, are developing programs focused on enhancing economic
as well as computer literacy.

Regulatory Matters
In March 2001, the Board revised Regulation E to implement amendments to
the Electronic Fund Transfer Act concerning ATM fees. Under the amendments, ATM operators that impose a fee
on consumers for providing electronic
fund transfer (EFT) services must post a
notice to that effect in a prominent location on or at the ATM where the transfer
is initiated. Before a consumer commits to completing the transaction, the
operator must disclose that a fee will
be imposed and the amount of the fee.
When a consumer contracts with a
financial institution for an EFT service,
such as obtaining an ATM or debit card,
the institution's initial disclosures must
include notice that a fee may be charged
for transfers initiated at an ATM operated by another entity.
Also in March, the Board published
interim rules establishing standards for
the electronic delivery of federally mandated disclosures under five consumer
protection regulations: Regulation B
(Equal Credit Opportunity), Regulation E (Electronic Fund Transfers),
Regulation M (Consumer Leasing),
Regulation Z (Truth in Lending), and
Regulation DD (Truth in Savings). In
keeping with the Electronic Signatures
in Global and National Commerce Act
(the "E-Sign Act"), which was enacted
in June 2000, financial institutions,
creditors, and others may, under the
Board's interim rules, deliver disclosures electronically if they obtain the
consumer's consent. The interim rules
are not final; they serve as guidance
until final rules are adopted.



In addition to these rulemaking activities, the Board took the following regulatory and interpretive actions during the
year:
• Raised from $465 to $480 the total
dollar amount of points and fees that
trigger additional requirements for
certain mortgage loans under HOEPA,
to reflect changes in the consumer
price index (CPI), effective in January
2002
• Increased from $31 million to
$32 million the exemption threshold
for depository institutions required to
collect data in the year 2002 under the
Home Mortgage Disclosure Act, to
reflect changes in the consumer price
index for urban wage earners and
clerical workers (CPI-W), as prescribed by the statute
• Revised the official staff commentary
for Regulation E to provide guidance
on transactions that involve electronic
check conversion, whereby a consumer authorizes a merchant's use
of a check to capture encoded information that is then used to initiate
an electronic debit from the consumer's account. The commentary
revisions also provide guidance on
computer-initiated bill payments, the
authorization of recurring debits from
a consumer's account, and telephoneinitiated transfers.

CRA Bank Examinations
and Activities
The Community Reinvestment Act
requires the Board and other banking
agencies to encourage financial institutions to help meet the credit needs of
the local communities in which they do
business, consistent with safe and sound
business practices. To carry out this

Consumer and Community Affairs
mandate, the Federal Reserve has a
three-faceted program that includes
• Examining institutions to assess compliance with the CRA
• Analyzing applications for mergers
and acquisitions from state member
banks and bank holding companies in
relation to CRA performance
• Disseminating information on community development techniques to
bankers and the public through Community Affairs Offices at the Reserve
Banks.

Examinations for
Compliance with the CRA
The Federal Reserve assesses the CRA
performance of state member banks during regularly scheduled examinations
for compliance with consumer protection regulations. By law, small banks
(banks with assets of less then $250 million) that are rated "satisfactory" for
CRA performance are examined not
more than once every forty-eight
months, and those that are rated "outstanding" for CRA purposes are examined not more than once every sixty
months. During the 2001 reporting
period, the Federal Reserve conducted
183 CRA examinations.2 Of the banks
examined, 29 were rated "outstanding"
in meeting community credit needs, 151
were rated "satisfactory," 1 was rated
"needs to improve," and 2 were rated as
being in "substantial noncompliance."
Also during 2001, the Federal
Reserve worked with the other agencies
that have CRA responsibilities (the
FDIC, OCC, and OTS) and issued the
Board's Regulation G (Disclosure and
Reporting of CRA-Related Agree2. The 2001 reporting period was from July 1,
2000, through June 30, 2001.



111

ments), the implementing regulation
for the CRA Sunshine provisions of
the Gramm-Leach-Bliley Act. The act
requires insured depository institutions
and nongovernmental entities or persons who are parties to CRA-related
agreements to make certain of those
agreements public and to file annual
reports about their activities under the
agreements.
Analysis of Applications in
Relation to CRA Performance
Actions on bank and bank holding company applications during 2001 included
the following:
• In February, the Board approved an
application by FleetBoston Corp.
(Boston, Mass.) to acquire Summit
Bancorp (Princeton, N.J.).
• Also in February, the Board approved
an application by MetLife, Inc. (New
York, N. Y.), to become a bank holding
company by acquiring Grand Bank,
N.A. (Kingston, N.J.). This was the
first application by an insurance
company to become simultaneously a
bank holding company and a financial
holding company under the GrammLeach-Bliley Act.
• In April, the Board approved an
application by Countrywide Credit
Industries, Inc. (Calabasas, Calif.), to
acquire Treasury Bank, Ltd. (Washington, D.C.). This was the first application by a nonbanking financial company engaged primarily in mortgage
banking activities to become simultaneously a bank holding company and
a financial holding company under the
Gramm-Leach-Bliley Act.
In July, the Board approved an application by Citigroup, Inc. (New York,

128 88th Annual Report, 2001
N.Y.), to acquire European American
Bank (Uniondale, N.Y.).
• Also in July, the Board approved an
application by Citigroup, Inc. (New
York, N.Y.), to acquire Grupo Financiero Banamex Accival, S.A. de C.V.
and Banco Nacional de Mexico, S.A.
(both in Mexico City, Mexico).
• In August, the Board approved an
application by First Union Corp.
(Charlotte, N.C.) to acquire Wachovia
Corp. (Winston-Salem, N.C). SunTrust Banks, Inc. (Atlanta, Ga.), submitted a competing bid for Wachovia,
which it withdrew after Wachovia
shareholders voted against SunTrust's
proposal.
Comments from the public on each
of these applications in relation to CRA
performance raised allegations primarily about predatory lending, insufficient lending to lower-income areas, or
inadequate banking services in lowerincome areas. In each case, the Board
found that the CRA records of the
depository institutions were consistent
with approval. In the case of the acquisition of European American Bank, the
Board ordered an on-site examination of
Citigroup's subprime-lending affiliates.
The Board also stipulated that Citigroup
must report quarterly for two years
on the status of litigation involving
subprime lending and on their compliance with court orders or court-approved
settlements.
During the year, the Board acted on
fourteen other bank and bank holding
company applications that involved protests by members of the public concerning the performance of insured depository institutions in relation to the CRA.
The Federal Reserve also reviewed
three applications involving institutions
having less than "satisfactory" CRA



ratings (that is, "needs to improve"
or "substantial noncompliance") and
another thirty-nine applications involving other issues related to the CRA, fair
lending, or compliance with consumer
credit protection laws.3

Dissemination of Community
Development Information
The Community Affairs Offices at the
Reserve Banks continue to hold regular
roundtable discussions with financial
institutions in their Districts on issues
related to the Community Reinvestment
Act and community development. During 2001, some of the Banks sponsored
training for lenders and community
groups on the disclosure and reporting
requirements for CRA-related agreements. (Also see the next section,
"Community Affairs.")

Community Affairs
The System's Community Affairs program supports the economic growth
objectives of the Federal Reserve by
providing information and technical
assistance to facilitate efficient markets
in historically underserved communities. The year 2001 marked twenty years
since the program's inception.
Community Affairs Offices throughout the System continued outreach
activities and programs in rural markets.
The Federal Reserve Banks of Atlanta,
Cleveland, Richmond, Kansas City,
and Minneapolis sponsored conferences
to foster workforce development and
encourage integration of community-

3. In addition, one application involving a CRA
protest, another application involving an adverse
CRA rating, and nine applications involving other
CRA issues, fair lending issues, or compliance
with consumer credit protection regulations were
withdrawn in 2001.

Consumer and Community Affairs
based research, policies, and practices
with community development activities.
The Board's staff continued to work
with the Rural Home Loan Partnership,
an interagency group committed to
increasing affordable housing in rural
communities.
The San Francisco, Minneapolis, and
Chicago Reserve Banks convened meetings and workshops for bankers, developers, and tribal representatives to provide information on the legal and policy
aspects of financing housing and small
businesses on Native American tribal
lands. The Board's Community Affairs
staff continued to participate in a task
force with representatives of other federal agencies, nonprofit organizations,
financial institutions, and other entities
to promote financial literacy programs
for members of Native American
communities.
Recognizing the importance of support services to workforce development,
the Community Affairs Offices participated in programs to improve access to
child care. The Seattle Branch of the
San Francisco Reserve Bank facilitated
development of a micro-loan fund for
child-care providers unable to secure
conventional lending, and the New York
and Philadelphia Reserve Banks sponsored a conference on investment and
lending models for child-care facilities.
The Community Affairs program
has expanded its reach to diverse
communities and populations through
effective use of information technology and communication tools. The
Boston Reserve Bank cosponsors
a web site to support faith-based
community developers (http://www.
faithandcommunityatwork.com), and
the Dallas Reserve Bank publishes
e-Perspectives, an electronic version
of its community affairs newsletter
(http://www.dallasfed.org / htm / pubs /
perspectonline.html).



129

The preservation of affordable housing remains a central concern of the
Community Affairs program. During
2001, Board staff served in various
capacities to support housing activities
conducted by external partners. They
served as liaison to the advisory board
for the Local Initiatives Support Corporation's Center for Home Ownership
and assisted with planning an annual
summit on housing issues. They also
provided support to Board member
Edward Gramlich, who chairs the board
of directors of the Neighborhood Reinvestment Corporation—a national nonprofit organization charged by the Congress with revitalizing older, distressed
communities.
Also during the year, the Board's
Community Affairs Office engaged in
interagency efforts to raise awareness of
issues having national scope. For example, staff members worked with other
agencies to publish Crossing the Bridge
to Self-Employment: A Federal Microenterprise Resource Guide.
Through the programs described
above, the Federal Reserve System
during 2001 sponsored more than 300
conferences and workshops, conducted
approximately 1,500 outreach meetings,
facilitated research, and distributed more
than 250,000 community economic
development publications.

Consumer Advisory Council
The Consumer Advisory Council,
whose members represent consumer and
community organizations, the financial
services industry, academic institutions,
and state agencies, advises the Board of
Governors on matters concerning laws
that the Board administers and other
issues related to consumer financial services. Council meetings are open to the
public.

130 88th Annual Report, 2001
In 2001, the Council met in March,
June, and October. The rules implementing the Community Reinvestment Act,
scheduled for review by banking and
thrift institution regulators in 2002, were
a major topic at all three meetings.
In March and June, Council members
commented on the definition of "assessment area," the investment test, and
the service test. They agreed that the
assessment area definition needs to recognize that technological change has
affected how and where financial institutions conduct business. Regarding the
investment and service tests, members
concluded that investments are important but challenging and difficult to
make and that the service test provides
opportunities for lenders to find innovative ways to serve communities and
build banking relationships. In October,
members offered views on the definition of small-business and communitydevelopment lending and on whether
loan originations should receive more
credit than loan purchases under the
lending test.
The proposed amendments to Regulation Z, designed to broaden the scope
of mortgage loans subject to the Home
Ownership and Equity Protection Act,
were a key topic at the March and June
meetings. In March, Council members
discussed expanding the dollar test
applied to the points and fees trigger
to include amounts paid at loan closing
for single-premium credit life insurance. The June discussion focused on a
proposal that creditors be prohibited
from refinancing a zero-interest or lowinterest loan into a higher-rate loan during the first five years of the loan unless
the refinancing is in the borrower's
interest; members considered the difficulty of defining "borrower's interest"
and of identifying low-cost loans.
In March and June, the Council discussed the Board's proposed changes



to Regulation C to improve the quality,
clarity, and utility of data collected
under the Home Mortgage Disclosure
Act. At both meetings, members focused
on the proposed requirements regarding
the reporting of the annual percentage
rate (APR) on home mortgage loans and
discussed the burdens and benefits of
having lenders report pricing and other
data. Some members asserted that the
reliability and validity of APR data for
pricing analysis was questionable, but
others believed that the reporting of the
data would facilitate public debate and
enable pricing concerns to be more
readily addressed.
Also discussed during 2001 were the
interim final rules governing the electronic delivery of disclosures required
under Regulations B (Equal Credit
Opportunity), E (Electronic Fund Transfers), M (Consumer Leasing), Z (Truth
in Lending), and DD (Truth in Savings).
In June and October, Council members
discussed the requirement that an e-mail
message be sent to the consumer when a
disclosure is placed on a company's web
site and supported flexibility in the rules
for delivery of these alerts. They also
discussed the challenges of re-delivering
returned e-mail messages and provided
differing views on the requirement that
an institution maintain disclosures on a
web site for ninety days.
In October, the Council began to identify issues for an upcoming review by
the Board of Regulation Z. Members
discussed the differences in disclosure
requirements for open- and closed-end
lending and noted that greater flexibility exists for open-end disclosures.
Future discussions will focus on the
types of disclosures that are important for credit card products and on
streamlining the disclosures for closedend mortgage loans to facilitate consumer comparisons of loan costs among
lenders.

Consumer and Community Affairs

HMDA Data and
Mortgage Lending Patterns
The Home Mortgage Disclosure Act
requires that mortgage lenders covered
by the act collect and make public certain data about their home purchase,
home improvement, and refinancing
loan transactions. Depository institutions generally are covered if they were
located in metropolitan areas, met the
asset threshold at the end of the preceding year, and originated at least one
home purchase loan (or refinancing) in
the preceding year. For 2000, the asset
threshold was $30 million; for 2001, it
was $31 million. Mortgage companies
are covered if (1) they were located in or
made loans in metropolitan areas,
(2) had assets of more than $10 million
(when combined with the assets of any
parent company) at the end of the preceding year or originated 100 or more
home purchase loans and refinancings
in the preceding year, and (3) their
home purchase loans (and refinancings)
accounted for 10 percent or more of
their total loans by dollar volume.
In 2001, a total of 6,704 depository
institutions and affiliated mortgage companies and 1,009 independent mortgage
companies reported HMDA data for
calendar year 2000. Lenders submitted
information about the geographic location of the properties related to loans
and loan applications, the disposition of
loan applications, and, in most cases, the
race or national origin, income, and sex
of applicants and borrowers. The Federal Financial Institutions Examination
Council (FFIEC) processed the data
and produced disclosure statements on
behalf of the Department of Housing
and Urban Development (HUD) and the
FFIEC member agencies.4
4. The FFIEC member agencies are the Board
of Governors of the Federal Reserve System, the



131

The FFIEC prepared individual disclosure statements for each lender that
reported data—one statement for each
metropolitan area in which the lender
had offices and reported loan activity. In
2001, the FFIEC prepared 52,776 disclosure statements, reporting data for
calendar year 2000. Each institution
made its disclosure statement public in
July, and reports containing aggregate
data for all lenders in a given metropolitan area were made available at central depositories in the nation's approximately 330 metropolitan areas. These
data are used by the FFIEC member
agencies, the reporting institutions, the
public, the Department of Justice, and
HUD. The data also assist HUD, the
Department of Justice, and state and
local agencies in responding to allegations of lending discrimination and in
targeting lenders for further inquiry.5
The data reported for 2000 covered
19.2 million loans and applications,
about 16 percent fewer than in 1999.
The decline was due primarily to a
decline of about 30 percent in refinancing activity. The number of home purchase loans extended in 2000 compared
with 1999 increased 8 percent for Asians
and 7 percent for Hispanics but fell
1 percent for blacks, 5 percent for
Native Americans, and 6 percent for
whites. Between 1993 and 2000, the
number of home purchase loans
extended increased 138 percent for Hispanics, 109 percent for Native AmeriFederal Deposit Insurance Corporation, the Office
of the Comptroller of the Currency, the Office of
Thrift Supervision, and the National Credit Union
Administration.
5. On behalf of the nation's seven active private mortgage insurance (PMI) companies, the
FFIEC also compiles information on applications
for PMI similar to the information on home mortgage lending collected under HMDA. Lenders
typically require PMI for conventional mortgages
that involve small down payments.

132 88th Annual Report, 2001
cans, 89 percent for blacks, 84 percent
for Asians, and 25 percent for whites.
For most income categories, the number of home purchase loans extended
was lower in 2000 than in 1999; the
number made to lower-income applicants fell 4 percent, but the number
made to upper-income applicants rose
3 percent. From 1993 through 2000,
the number of home purchase loans to
lower-income and upper-income applicants increased 79 percent and 56 percent respectively.
In 2000, 31 percent of Hispanic applicants and 27 percent of black applicants for home purchase loans sought
government-backed mortgages; the
comparable figure for white and Native
American applicants was 14 percent,
and for Asian applicants 9 percent.
Twenty-five percent of lower-income
applicants for home purchase loans,
compared with 9 percent of upperincome
applicants,
applied
for
government-backed mortgages.
Overall, the denial rate for conventional (that is, non-government-backed)
home purchase loans was 27 percent in
2000. The rate rose steadily from 1993
through 1998 but has now fallen slightly
(about 1 percentage point) for the second consecutive year. Denial rates for
conventional home purchase loans in
2000 were 45 percent for black applicants, 42 percent for Native American
applicants, 31 percent for Hispanic
applicants, 22 percent for white applicants, and 12 percent for Asian applicants. Except for Asian applicants, each
of these rates was lower than the comparable rate for 1999.

Economic Effects of the
Electronic Fund Transfer Act
As required by the Electronic Fund
Transfer Act (EFTA), the Board monitors the effects of the act on institutions'



costs as well as the benefits of the act
for consumers.
The proportion of U.S. households
using EFT services has grown over the
past decade at an annual rate of 3 percent, according to data from the Survey
of Consumer Finances (the most recent
data available from these triennial surveys were gathered in 1998; data from
the 2001 survey are not yet available).
Approximately 85 percent of households
use one or more EFT services—for
example, they use an ATM or debit card,
direct deposit, or direct payment.
Automated teller machines remain the
most widely used EFT service. About
two-thirds of U.S. households have an
ATM card. In 2001, the average number
of ATM transactions a month exceeded
1.1 billion, a slight increase over the
preceding year. The number of installed
ATMs rose about 19 percent, to about
324,000.
Direct deposit is also widely used.
About 60 percent of U.S. households
have funds deposited directly into their
transaction accounts (checking or savings). Use of the service is particularly
common in the public sector, accounting
for 78 percent of social security payments, 98 percent of federal salary and
retirement payments, and 33 percent of
federal income tax refunds during fiscal
year 2001.
A less widely used EFT payment
mechanism is direct bill-paying. About
36 percent of U.S. households have payments automatically deducted from their
transaction accounts.
About one-third of U.S. households
have debit cards, which are used at merchant terminals to debit their transaction
accounts. Point-of-sale (POS) systems
account for a fairly small share of electronic transactions, but their use continued to grow rapidly in 2001. From 2000
to 2001, the average number of POS
transactions a month rose about 34 per-

Consumer and Community Affairs
cent, from about 258.9 million to about
348.0 million, and the number of POS
terminals rose about 30 percent, to about
3.6 million.
The incremental costs associated
with the EFTA are difficult to quantify
because no one knows how industry
practices would have evolved in the
absence of statutory requirements. The
benefits of the act to consumers are also
difficult to measure, because the protections afforded by the act cannot be isolated from protections that would have
been provided in the absence of regulation. The available evidence suggests
that there have been no serious consumer problems in relation to the act
(see the section "Agency Reports on
Compliance with Consumer Protection
Laws and Regulations").

Compliance Activities
The Federal Reserve conducts compliance examinations to carry out its
responsibility for ensuring that state
member banks and certain foreign banking organizations comply with federal laws and regulations concerning
fair lending and consumer protections.
The Board provides consumer compliance training for the System's specialized examiners and participates in
compliance-related activities of the Federal Financial Institutions Examination
Council.
Compliance Examinations
During the 2001 reporting period
(July 1, 2000, through June 30, 2001),
the Federal Reserve conducted 343
consumer compliance examinations—
261 examinations of state member banks
and 82 examinations of foreign banking
organizations.6 To ensure that super6. The foreign banking organizations examined
by the Federal Reserve are organizations operating



133

visory resources are targeting higherrisk areas, a consumer compliance riskfocused supervision program was fully
implemented in 2001. The program
emphasizes evaluating the appropriateness of an institution's risk-management
practices and tailors supervisory activities to fit the institution's risk profile.
The program also incorporates various
monitoring procedures that are designed
to identify high-risk institutions and to
facilitate a more continuous supervisory
process.
Fair Lending
Pursuant to a 1991 amendment to the
Equal Credit Opportunity Act, the Board
refers to the Department of Justice any
violation of the act that it has reason
to believe constitutes a "pattern or practice" of discrimination. During 2001 the
Board referred one case involving disparate treatment in the underwriting of
automobile loans.
In May the Board supplemented the
interagency procedures for fair lending
examinations by adopting alternative
procedures for banks having lowdiscrimination-risk profiles. Typically,
such banks are stable community banks,
commonly specializing in commercial
or agricultural lending, that are located
in suburban or rural markets having
a low percentage of minority residents.
The alternative procedures are expected
to reduce the resources devoted to these
banks and to facilitate the allocation of
resources for more intensive analysis of
higher-risk institutions.
under section 25 or 25 (a) of the Federal Reserve
Act (Edge Act and agreement corporations) and
state-chartered commercial lending companies
owned or controlled by foreign banks. These institutions are not subject to the Community Reinvestment Act and typically engage in relatively few
activities that are covered by consumer protection
laws.

134 88th Annual Report, 2001

Examiner Training
Reserve Bank examiners receive training in consumer protection laws, fair
lending laws, and the Community
Reinvestment Act as well as in complaint analysis and investigation. During
the 2001 reporting period, 221 examiners were trained in thirteen sessions
of varying lengths. Offerings included
basic and advanced compliance courses
and courses on fair lending, the Community Reinvestment Act, and commercial
lending. The consumer compliance curriculum is continually monitored and
updated to reflect regulatory and marketplace changes.

Participation in FFIEC Activities
Through cooperation among its member
agencies, the FFIEC develops uniform
examination principles, standards, procedures, and report formats. In 2001, the
FFIEC issued a revised report format
and standardized tables for use in CRA
performance evaluations; host-state
loan-to-deposit ratios for determining
compliance with section 109 of the
Riegle-Neal Interstate Banking and
Branching Efficiency Act of 1994; and
documents providing answers to frequently asked questions about Regulation P (Consumer Privacy) and the
CRA.

Agency Reports on Compliance
with Consumer Protection Laws
and Regulations
The Board is required to report annually
on compliance with consumer protection laws and regulations by entities
supervised by the various federal agencies. Summarized in this section are
data collected from the twelve Federal
Reserve Banks, the FFIEC member



agencies, and other federal supervisory
agencies.7

Regulation B
(Equal Credit Opportunity)
The FFIEC agencies reported that
83 percent of the institutions examined
during the 2001 reporting period were
in compliance with Regulation B, compared with 81 percent for the 2000
reporting period. Of the institutions not
in full compliance, 20 percent had five
or fewer violations. The most frequent
violations involved the failure to take
one or more of the following actions:
• Provide a written notice of credit
denial or other adverse action containing a statement of the action taken,
the name and address of the creditor,
a notice of rights, and the name and
address of the federal agency that
enforces compliance
• Provide a statement of reasons for
credit denial or other adverse action
that is specific and indicates the principal reasons for the adverse action
• Collect information for monitoring
purposes about the race or national
origin, sex, marital status, and age of
the applicants seeking credit primarily
for the purchase or refinancing of a
principal residence
• Notify the credit applicant of the
action taken within the time frames
specified in the regulation.
Four formal enforcement actions containing provisions relating to Regula7. Because the agencies use different methods
to compile the data, the information presented
here supports only general conclusions. The 2001
reporting period was from July 1, 2000, through
June 30, 2001.

Consumer and Community Affairs
tion B were issued during the 2001
reporting period—three by the FDIC
and one by the OCC. The Federal Trade
Commission (FTC) filed one action and
continued other litigation against two
mortgage lenders for alleged violations
of the Equal Credit Opportunity Act
(ECOA). The alleged violations include,
among other things, failing to take written applications for mortgage loans,
failing to provide rejected applicants
with written notice of adverse action,
and failing to collect required information about the race or national origin, sex, marital status, and age of
applicants.
The other agencies that enforce the
ECOA—the Farm Credit Administration (FCA), the Department of Transportation (DOT), the Securities and
Exchange Commission (SEC), the Small
Business Administration (SBA), and the
Grain Inspection, Packers and Stockyards Administration of the Department
of Agriculture—reported substantial
compliance among the entities they
supervise. The FCA's examination and
enforcement activities revealed violations of the ECOA mostly attributable to
creditors' failure to collect information
for monitoring purposes and failure to
comply with rules regarding adverse
action notices. No formal enforcement
actions containing provisions relating
to Regulation B were initiated by these
agencies.

Regulation E
(Electronic Fund Transfers)
The FFIEC agencies reported that
approximately 95 percent of the institutions examined during the 2001 reporting period were in compliance with
Regulation E, compared with 94 percent for the 2000 reporting period. The
most frequent violations involved the



135

failure to comply with the following
requirements:
• Investigate an alleged error promptly
after receiving a notice of error
• Determine whether an error actually
occurred, and transmit the results of
the investigation and determination to
the consumer within ten business days
• Credit the customer's account in the
amount of the alleged error within ten
business days of receiving the error
notice if more time is needed to conduct the investigation
• Provide initial disclosures at the time
a consumer contracts for an electronic
fund transfer service or before the first
electronic fund transfer involving the
consumer's account is made.
In 2001, the FDIC issued three formal
enforcement actions containing provisions relating to Regulation E. The FTC
continued its efforts to educate consumers and businesses in this area and
released a new brochure, Electronic
Check Conversion, that gives consumers
information about this new form of electronic banking.

Regulation M (Consumer Leasing)
The FFIEC agencies reported that more
than 99 percent of the institutions examined during the 2001 reporting period
were in full compliance with Regulation M. This level of compliance is
comparable to the level during the 2000
reporting period. The few violations
noted involved failure to adhere to specific disclosure requirements. The agencies did not issue any formal enforcement actions containing provisions
relating to Regulation M.

136 88th Annual Report, 2001

Regulation Z (Truth in Lending)
The FFIEC agencies reported that
79 percent of the institutions examined
during the 2001 reporting period were
in compliance with Regulation Z, compared with 77 percent for the 2000
reporting period. Of the institutions
not in full compliance, 75 percent had
five or fewer violations, compared with
64 percent in 2000. The most frequent
violations involved the failure to take
one or more of the following actions:
• Accurately disclose the finance
charge, payment schedule, annual percentage rate, security interest in collateral, or amount financed
• Disclose the annual percentage rate
on a periodic statement using the term
"annual percentage rate"
• Provide disclosures within three business days of application as required
for applications for residential mortgages covered by the Real Estate
Settlement Procedures Act
• Ensure that disclosures reflect the
terms of the legal obligation between
the parties
• Provide the index value for adjustments to variable-rate loans.
Four formal enforcement actions containing provisions relating to Regulation Z were issued during the 2001
reporting period—three by the FDIC
and one by the OCC. In addition,
218 institutions supervised by the Federal Reserve, the FDIC, or the OTS were
required, under the Interagency Enforcement Policy on Regulation Z, to refund
a total of approximately $891,000 to
consumers in 2001 because of improper
disclosures.



In 2001, the FTC continued its efforts
to curb abusive practices by some
subprime mortgage lenders, initiating
one new action and pursuing two ongoing litigations against mortgage lenders
for alleged violations of the Truth and
Lending Act (TILA) and the Home
Ownership and Equity Protection Act.
In addition, the FTC obtained settlements in two cases that alleged violations of the TILA and Regulation Z—one involving vacation travel
packages and the other, Internet-access
products and services.
The DOT is currently investigating
cases involving four different air carriers regarding possible violations of the
TILA. All four cases involve the timeliness of processing requests for credit
card refunds. In 2001, the DOT continued to prosecute a cease-and-desist consent order issued in 1993 against a travel
agency and a charter operator. The complaint alleged that the two organizations
had violated Regulation Z by routinely
failing to send credit statements for
refund requests to credit card issuers
within seven days of receiving fully
documented credit refund requests from
customers.

Regulation AA
(Unfair or Deceptive Acts
or Practices)
The three banking regulators with
responsibility for enforcing Regulation AA's Credit Practices Rule—the
Federal Reserve, the OCC, and the
FDIC—reported that 99 percent of institutions examined during the 2001 reporting period were in compliance. Of the
institutions not in full compliance, the
most frequently cited violations involved
• Failing to provide a clear, conspicuous
disclosure regarding a cosigner's liability for a debt

Consumer and Community Affairs
• Entering into a consumer credit contract containing a nonpossessory security interest in household goods.
No formal enforcement actions containing provisions relating to Regulation A A were issued during the 2001
reporting period.

137

• Failure to provide all applicable information on account disclosures.
No formal enforcement actions containing provisions relating to Regulation DD were issued during the 2001
reporting period.

Regulation DD (Truth in Savings)

Consumer Complaints

The FFIEC agencies reported that
88 percent of institutions examined during the 2001 reporting period were in
compliance with Regulation DD. Of
the institutions not in full compliance,
the most frequently cited violations
involved

The Federal Reserve investigates complaints against state member banks and
forwards to the appropriate enforcement agency complaints it receives that
involve other creditors and businesses.
During 2001, the Federal Reserve
fully implemented an automated system for generating letters designed to
help Reserve Banks expedite responses
to consumer complaints. The lettergeneration system is a component of the
Complaints Analysis Evaluation System
and Reports (CAESAR) database, which
is used to track complaints and inquiries. The CAESAR system produces

• Advertisements that were inaccurate
or misleading (or both)
• Use of the phrase "annual percentage
yield" in an advertisement without
disclosing additional terms and conditions of customer accounts

Consumer Complaints against State Member Banks and Other Institutions Received by the
Federal Reserve System, 2001
Subject
Regulation
Regulation
Regulation
Regulation
Regulation
Regulation

B (Equal Credit Opportunity)
E (Electronic Fund Transfers)
H (Bank Sales of Insurance)
M (Consumer Leasing)
P (Privacy of Consumer Financial Information).
Q (Payment of Interest)

Regulation Z (Truth in Lending)
Regulation BB (Community Reinvestment) ...
Regulation CC (Expedited Funds Availability)
Regulation DD (Truth in Savings)
Fair Credit Reporting Act
Fair Debt Collection Practices Act

State member
banks

Other
institutionsl

Total

59
41
0
0
14
0

27
55
0
1
19
0

86
96
0
1
33
0

300
3
22
38
178

560
2

28
55
270
13

860
5
50
93
448
21

Fair Housing Act
Rood insurance rules
Regulations T, U, and X
Real Estate Settlement Procedures Act .
Unregulated practices

2
0
7
1,359

5
5
0
11
1,412

13
7
0
18
2,771

Total

2,039

2,463

4,502

1. Complaints against these institutions were referred
to the appropriate regulatory agencies.




138 88th Annual Report, 2001
Consumer Complaints Received by the Federal Reserve System,
by Subject of Complaint, 2001
Complaints against state member banks
Total

Investigated

Not investigated

Bank legally correct
Subject of complaint
Number

Percent

Unable
Explanation
to obtain
of law
sufficient
provided
information
to consumer
from
consumer

No reimbursement
or other
accommodation

Goodwill
reimbursement or
other
accommodation

Loans
Discrimination alleged
Real estate loans
Credit cards
Other loans
Other type of complaint
Real estate loans
Credit cards
Other loans

15
19
25

1
1
1

0
0
1

3
1
8

4
13
5

1
2
0

22
797
254

1
39
13

1
7
2

7
25
75

10
213
94

0
460
28

Deposits
Electronic fund transfers
Trust services . . . .
Other

608
41
25
233

30
2
1
11

5
0
2
12

99
5
8
75

257
17
11
79

112
7
0
18

2,039

100

30

306

703

628

...

Total

acknowledgment letters based on information maintained in the database but
also allows Reserve Banks to tailor letters to particular circumstances.
Besides conducting training for
Reserve Bank staff in complaint analysis and investigation during the year,
Board staff also held sessions on the
CAESAR query facility, which allows
the System to track individual complaints as well as to aggregate data for
purposes of trend analysis.
Also continuing in 2001 was the
System's residency program for Reserve
Bank staff who come to the Board
for several weeks at a time to work with
complaint staff on projects and to gain
familiarity with complaint operations in
Washington.




Complaints against
State Member Banks
In 2001 the Federal Reserve received
a total of 4,502 complaints—3,875 by
mail, 545 by telephone, 10 in person,
and 72 electronically via the Internet.
Complaint volume was reduced in the
fourth quarter because of problems in
the national mail system, including mail
facilities in the Washington metropolitan area.
About 45 percent of the complaints
were against state member banks (see
tables). Of the complaints against state
member banks, 56 percent involved
credit transactions: 3 percent alleged
discrimination on a basis prohibited
by law (race, color, religion, national

Consumer and Community Affairs

139

Consumer Complaints Received—Continued
Complaints against state member 1
)anks
Investigated

Customer
error

Bank
error

Factual or
contractual
dispute—
resolvable
only
by courts

Possible
bank
violation—
bank took
corrective
action

Matter in
litigation

Pending,
December 31

Referred to
other
agencies

Total
complaints

0
0
0

0
0
0

0
0
1

1
0
1

0
0
1

6
3
8

13
8
6

28
27
31

0
1
1

1
59
30

0
6
9

1
0
1

2
1
7

0
25
7

18
807
401

40
1,604
655

1
0
0
1

80
6
0
21

19
1
3
10

0
2
0
1

12
2
1
3

23
1
0
13

509
55
14
632

1,117
96
39
865

4

197

49

7

29

86

2,463

4,502

origin, sex, marital status, age, the fact
that the applicant's income comes from
a public assistance program, or the fact
that the applicant has exercised any right
under the Consumer Credit Protection
Act), and 53 percent concerned other
credit-related practices, such as the imposition of annual membership fees on
credit card accounts, the amount of
interest banks charge on credit card
accounts, or credit denial on a basis not
prohibited by law (for example, credit
history or length of residence). Thirty
percent of the complaints against state
member banks involved disputes about
interest on deposits and general deposit
account practices, and the remaining
14 percent concerned disputes about
electronic fund transfers, trust services,




or other practices. Information on the
outcomes of the investigations of these
complaints is provided in the table.
During 2001, the System completed
investigations of 181 complaints against
state member banks that were pending
at year-end 2000 and found three violations of regulations. In the vast majority of cases, the banks had correctly
handled customers' accounts; notwithstanding, banks chose to reimburse or
otherwise accommodate consumers in
more than half of these cases.
The Federal Reserve received more
than 1,800 inquiries about consumer
credit and banking policies and practices during the year. In responding
to these inquiries, the Board and the
Reserve Banks gave specific explana-

140 88th Annual Report, 2001
tions of laws, regulations, and banking
practices and provided relevant printed
materials on consumer issues.
To assess satisfaction with the System's handling of complaints, the Board
sends complainants follow-up questionnaires. Because of mail disruptions during the fourth quarter of 2001, analysis
of data for the entire year was impossible. However, data for the first three
quarters show that consumers were satisfied or very satisfied with the System's handling of their complaints.

Unregulated Practices
As required by section 18(f) of the Federal Trade Commission Act, the Board
continues to monitor complaints about
banking practices that are not subject
to existing regulations and to focus on
those complaints that concern possible
unfair or deceptive practices. In 2001
the Board received a wide range of complaints about unregulated practices. The
category that received the most complaints involved credit cards: Consumers complained about penalty charges
(125), interest rates and terms (118),
other miscellaneous problems involving




credit cards (113), and customer service
problems (101). The remainder of the
complaints concerned a wide range of
unregulated practices in other areas,
including such matters as check-cashing
problems experienced by non-account
holders, consumer dissatisfaction with
reduced availability of branch tellers,
and the marketing practice of banks'
sending what appear to be "live" checks
in the mail.

Complaint Referrals to HUD
In 2001 the Federal Reserve, in accordance with a memorandum of understanding between the Department of
Housing and Urban Development and
the federal bank regulatory agencies,
referred nine complaints to HUD that
alleged state member bank violations of
the Fair Housing Act. Of the six investigations completed by the Federal
Reserve, five revealed no evidence of
unlawful discrimination. The parties in
the sixth complaint were seeking resolution through the courts; the Federal
Reserve does not intervene in consumer
cases that are in litigation.
•

141

Banking Supervision and Regulation
The U.S. banking system maintained
its overall financial strength in 2001
despite having weathered some of the
most challenging operating conditions
in a decade. An already slowing economy slid into recession, dampening consumer confidence and equity markets
generally. Conditions became even
worse in the aftermath of the September 11 terrorist attacks in New York
and Washington, D.C. The effects of the
attacks and the bursting of the high-tech
bubble, together with the largest chapter 11 bankruptcy ever (filed by domestic energy-trading company Enron) and
events in Argentina, exacerbated a deterioration in credit conditions.
Nevertheless, banking industry net
income rose 6 percent during the year.
Asset growth continued, and the return
on assets remained at a historically high
level. Net interest margins narrowed
slightly, particularly at community
banks, in response to very low market
interest rates and reluctance by banks
to fully reflect lower rates in their
core deposit pricing. Monetary easing
induced a record volume of mortgage
loan originations and refinancings,
which contributed to strong growth in
fee income. However, depressed financial markets constrained larger banks'
ability to generate revenue from nontraditional banking activities, particularly investment banking, asset management, private equity investments,
and trading. Even with reduced marketsensitive revenues, total non-interest
income improved somewhat, buttressed
by securities gains (versus losses a year
earlier).
Credit costs mounted as banks raised
provisioning rates in excess of net



charge-off rates, both of which reached
the highest levels since 1992. Commercial net charge-off rates surged, reflecting the adverse effect on corporate
earnings of a retrenchment in business
investment, particularly investment in
equipment and software. With unemployment rates and personal bankruptcies rising, consumer net charge-off
rates rose moderately. Compared with
the previous year, the banking industry's
nonperforming assets grew 28 percent,
to $44.9 billion, or 1.1 percent of loans
and foreclosed assets, still well below
the peak that prevailed during the last
recession. Through this period, banks
maintained adequate loss reserves and
improved their capital ratios.
The generally benign effect of relatively stressful events on the financial
condition of U.S. banks in 2001 may
reflect, at least in part, the progress that
banks and their regulators have made
in identifying and responding promptly
to emerging weakness. Many banking
organizations, particularly large organizations, have developed and are
implementing more sophisticated riskmeasurement and risk-management systems that help them evaluate and price
credit risk better and identify changing
levels of risk as they occur.
Through the Basel Committee on
Banking Supervision, the Federal
Reserve and other bank supervisors
worldwide are building on banks' internal risk-measurement systems in revising regulatory capital requirements for
internationally active banks. In January
2001, the Basel Committee issued for
public comment a proposal to base capital requirements on an institution's internal credit-risk ratings and other factors,

142 88th Annual Report, 2001
such as its estimates of expected loss.
This development effort continues.
The terrorist attacks of September 11
temporarily disrupted many interbank
and securities settlement activities and
strained the activities of key institutions in these markets before communications and operating systems were
fully restored. Throughout the period,
Federal Reserve System supervisory
staff facilitated communications within
the banking and regulatory systems and
worked to minimize the disruptive
effects. The experience highlighted the
need to review and strengthen contingency plans within the financial system
and its oversight process. That work is
also actively under way.
November 2001 marked the second anniversary of enactment of
the Gramm-Leach-Bliley Act, which
allows bank holding companies to
become "financial holding companies" (FHCs) and to conduct a broad
range of banking, securities, and
insurance-underwriting activities. As the
"umbrella supervisor" of all FHCs, the
Federal Reserve relies as much as possible on the supervisory efforts of an
institution's primary bank supervisor
and nonbank functional regulator(s) to
ensure that any nonbank activities do
not present unacceptable risks to affiliated banks. By year-end, 567 domestic
bank holding companies and 23 foreign
banking organizations had received
FHC status, suggesting potentially widespread interest in the expanded powers
provided by the legislation. To date,
however, many FHCs are such in name
only, conducting little or no expanded
activity permissible under the law (see
box, "Organizational Evolution: Results
of the Gramm-Leach-Bliley Act").
Uncertainty is a key factor in any
commercial activity, and 2001 presented
significant challenges to many banks.
Nevertheless, the U.S. banking system



remains strong in its ability to deal with
adversities and to continue supporting
domestic and worldwide economic
growth.

Scope of Responsibilities for
Supervision and Regulation
The Federal Reserve is the federal
supervisor and regulator of all U.S. bank
holding companies (including financial
holding companies formed under the
authority of the Gramm-Leach-Bliley
Act) and of state-chartered commercial
banks that are members of the Federal
Reserve System. In overseeing these
organizations, the Federal Reserve seeks
primarily to promote their safe and
sound operation and their compliance
with laws and regulations, including the
Bank Secrecy Act and consumer protection and civil rights laws.1
The Federal Reserve also has responsibility for the supervision of all Edge
Act and agreement corporations; the
international operations of state member
banks and U.S. bank holding companies;
and the operations of foreign banking
companies in the United States.
The Federal Reserve exercises important regulatory influence over entry into
the U.S. banking system and the structure of the system through its administration of the Bank Holding Company
1. The Board's Division of Consumer and
Community Affairs is responsible for coordinating
the Federal Reserve's supervisory activities with
regard to the compliance of banking organizations
with consumer protection and civil rights laws. To
carry out this responsibility, the Federal Reserve
trains a number of its bank examiners in the evaluation of institutions with regard to such compliance. The chapter of this volume covering consumer and community affairs describes these
regulatory responsibilities. Compliance with other
banking statutes and regulations, which is treated
in this chapter, is the responsibility of the Board's
Division of Banking Supervision and Regulation
and the Federal Reserve Banks, whose examiners
also check for safety and soundness.

Banking Supervision and Regulation
Act, the Bank Merger Act (with regard
to state member banks), the Change in
Bank Control Act (with regard to bank
holding companies and state member
banks), and the International Banking
Act. The Federal Reserve is also responsible for imposing margin requirements
on securities transactions. In carrying
out these responsibilities, the Federal
Reserve coordinates its supervisory
activities with other federal banking
agencies, state agencies, functional regulators, and the bank regulatory agencies of other nations.

Supervision for
Safety and Soundness
To ensure the safety and soundness
of banking organizations, the Federal
Reserve conducts on-site examinations
and inspections and off-site surveillance and monitoring. It also undertakes
enforcement and other supervisory
actions.
Examinations and Inspections
The Federal Reserve conducts examinations of state member banks, branches
and agencies of foreign banks, and Edge
Act and agreement corporations. In a
process distinct from examinations, it
conducts inspections of holding companies and their nonbank subsidiaries. Preexamination planning and on-site review
of operations are integral parts of the
overall effort to ensure the safety and
soundness of financial institutions.
Whether it is an examination or an
inspection, the review entails (1) an
assessment of the quality of the processes in place to identify, measure,
monitor, and control risks, (2) an
appraisal of the quality of the institution's assets, (3) an evaluation of
management, including an assessment
of internal policies, procedures, con


143

trols, and operations, (4) an assessment
of the key financial factors of capital,
earnings, liquidity, and sensitivity to
market risk, and (5) a review for
compliance with applicable laws and
regulations.
State Member Banks
At the end of 2001, 970 state-chartered
banks (excluding nondepository trust
companies and private banks) were
members of the Federal Reserve System. These banks represented approximately 12.1 percent of all insured U.S.
commercial banks and held approximately 25.9 percent of all insured commercial bank assets in the United States.
The guidelines for Federal Reserve
examinations of state member banks
are fully consistent with section 10 of
the Federal Deposit Insurance Act, as
amended by section 111 of the Federal
Deposit Insurance Corporation Improvement Act of 1991 and by the Riegle
Community Development and Regulatory Improvement Act of 1994. A
full-scope, on-site examination of these
banks is required at least once a year;
exceptions are certain well-capitalized,
well-managed institutions having assets
of less than $250 million, which may be
examined once every eighteen months.
During 2001 the Federal Reserve
Banks conducted 534 examinations of
state member banks (some of them
jointly with state agencies), and state
banking departments conducted 264
independent examinations of state member banks.
Bank Holding Companies
At year-end 2001, a total of 6,318 U.S.
bank holding companies were in operation. These organizations controlled
6,420 insured commercial banks and
held approximately 94.2 percent of all
insured commercial bank assets.

144 88th Annual Report, 2001

Organizational Evolution:
Results of the Gramm-Leach-Bliley Act
With passage of the Gramm-Leach-Bliley
Act (GLBA) in 1999, the Congress
removed long-standing legal impediments
to the combining of banking, insurance,
and securities activities within a single
financial institution. Since then, more than
550 domestic bank holding companies
have elected to become financial holding
companies (FHCs). In addition, a few U.S.
securities firms and one large insurance
company have elected financial holding
company status. Data collected by the
Federal Reserve (summarized in the table)
document the increase in the number of
domestic financial holding companies since
the act's implementation. They also show a
substantial increase in U.S. financial holding company assets associated with GLBA
activities.
Many of the largest bank holding
companies are FHCs; most domestic
FHCs, however, are relatively small. As
of December 31, 2001, domestic FHCs

Federal Reserve guidelines call for
annual inspections of large bank holding
companies as well as smaller companies
that have significant nonbank assets.
In judging the financial condition of
the subsidiary banks owned by holding
companies, Federal Reserve examiners
consult examination reports prepared by
the federal and state banking authorities
that have primary responsibility for the
supervision of these banks, thereby
minimizing duplication of effort and
reducing the burden on banking organizations. In 2001, Federal Reserve examiners conducted 1,212 bank holding
company inspections, of which 1,118
were on site and 94 were off site, and
state examiners conducted 79 independent inspections.



reported $6.1 trillion in total assets, or
about 80 percent of U.S. bank holding company assets. Many large FHCs have used
the authority granted by the GLBA to
conduct securities underwriting and merchant banking activities; several have also
engaged in insurance underwriting. About
one-fifth of domestic financial holding
companies have established insurance
agencies under GLBA authority; insurance
brokerage is the only financial activity that
many smaller FHCs are conducting under
the act.
Twenty-three foreign banking organizations had also received FHC status as of
December 31, 2001. Sixteen of these companies were conducting financial activities under GLBA authority as of year-end
2001, primarily as broker-dealers (thirteen) and merchant banks (nine). Five of
the sixteen had insurance underwriting subsidiaries, and two were operating insurance
agencies.

Small, non-complex bank holding
companies—those that have less than
$1 billion in consolidated assets, do
not have debt outstanding to the public,
and do not engage in significant nonbank activities—are subject to a special
supervisory program that became effective in 1997. 2 The program permits a
more flexible approach to supervision of
those entities in a risk-focused environment. Each such holding company is
subject to off-site review once during the examination cycle for the com-

2. Certain modifications to this supervisory
program will be adopted at the beginning of 2002.
These modifications will extend the program to all
bank holding companies that have less than $1 billion in consolidated assets.

Banking Supervision and Regulation

145

Domestic FHCs and their activities under GLBA authority
2000

2001

Item
June 30

Merchant banking activities
Number
Carrying value of investments

|
j
j

Insurance underwriting activities
Number
Assets

91
371

112
416

114
453

44
47

58
60

58
77

31
529

GLBA activities, by number of FHCs
and related assets or investments
(billions of dollars)
Securities underwriting activities
Number
Assets

Dec. 31

36
28

Using GLBA authority
Large
Small

June 30

74
250

Number of FHCs
Large
Small

Dec. 31

35
519

41
619

39
668

16
5

16
8

21

9

25
8

7
114

116

15
327

21
342

13
25

19
43

30
58

33
68

|

j

Insurance agency activities
Number
Large
Small

NOTE. Large financial holding companies (FHCs)
are defined here as those with assets of $1 billion

pany's lead bank. In 2001 the Federal
Reserve conducted 2,594 reviews of
these companies.
Financial Holding Companies
As of year-end 2001, 567 domestic bank
holding companies and 23 foreign banking organizations had received financial holding company status. Of the
domestic institutions, 34 had consolidated assets of $15 billion or more,
80 between $1 billion and $15 billion,
54 between $500 million and $1 billion,
and 399 less than $500 million.
Specialized Examinations
The Federal Reserve conducts specialized examinations of banking organiza


or more; small FHCs, those with assets of less than
$1 billion.

tions in the areas of information technology, fiduciary activities, transfer agent
activities, and government and municipal securities dealing and brokering. The
Federal Reserve also conducts specialized examinations of certain entities,
other than banks, brokers, or dealers,
who extend credit subject to the Board's
margin regulations.
With passage of the Gramm-LeachBliley Act in 1999, the Federal Reserve
ceased conducting routine annual
examinations of securities underwriting
and dealing activities through so-called
section 20 subsidiaries of bank holding
companies. Under the act, the Federal
Reserve is generally required to rely on
the supervisory activities of the "functional regulator" for broker-dealer sub-

146 88th Annual Report, 2001
sidiaries unless the Board has cause to
believe that a broker-dealer poses a
material risk to an insured depository
affiliate. No such examinations for cause
were conducted during 2001.
The Federal Reserve has developed a
series of case studies to educate System
personnel responsible for supervising
nonbank activities about communications with, and reliance on the supervisory activities of, functional regulators
(that is, regulators for securities, commodities, and insurance activities).
Information Technology
In recognition of the importance of
information technology to safe and
sound operations in the financial industry, the Federal Reserve reviews the
information technology activities of the
banking institutions it examines as well
as certain independent data centers that
provide information technology services
to these institutions. In 2000, the information technology reviews of banking
institutions were integrated into the
overall process of supervision, and thus
all safety and soundness examinations
are now expected to include a review
of information technology risks and
activities. During the year, the Federal
Reserve was the lead agency in one
examination of a large, multiregional
data processing servicer examined in
cooperation with the other federal banking agencies.
Fiduciary Activities
The Federal Reserve has supervisory
responsibility for institutions that
together hold more than $15 trillion of
assets in various fiduciary capacities.
During on-site examinations of fiduciary activities, the institution's compliance with laws, regulations, and general



fiduciary principles and potential conflicts of interest are reviewed; its management and operations, including its
asset- and account-management, riskmanagement, and audit and control
procedures, are also evaluated. In 2001,
Federal Reserve examiners conducted
177 on-site trust examinations.
Transfer Agents and
Securities Clearing Agencies
As directed by the Securities Exchange
Act of 1934, the Federal Reserve conducts specialized examinations of those
state member banks and bank holding
companies that are registered with the
Board as transfer agents. Among other
things, transfer agents countersign and
monitor the issuance of securities, register the transfer of securities, and
exchange or convert securities. On-site
examinations focus on the effectiveness of the institution's operations and
its compliance with relevant securities
regulations. During 2001, the Federal
Reserve conducted on-site examinations
at 33 of the 108 state member banks and
bank holding companies that were registered as transfer agents. Also during
the year the Federal Reserve examined
one state member limited-purpose trust
company acting as a national securities
depository.
Government and Municipal Securities
Dealers and Brokers
The Federal Reserve is responsible for
examining state member banks and foreign banks for compliance with the Government Securities Act of 1986 and with
Department of the Treasury regulations
governing dealing and brokering in
government securities. Thirty-nine state
member banks and 9 state branches
of foreign banks have notified the

Banking Supervision and Regulation
Board that they are government securities dealers or brokers not exempt
from Treasury's regulations. During
2001 the Federal Reserve conducted
11 examinations of broker-dealer activities in government securities at these
institutions.
The Federal Reserve is also responsible for ensuring compliance with the
Securities Act Amendments of 1975 by
state member banks and bank holding
companies that act as municipal securities dealers. Of the 31 entities that dealt
in municipal securities during 2001,
10 were examined during the year.
Securities Credit Lenders
Under the Securities Exchange Act of
1934, the Federal Reserve Board is
responsible for regulating credit in certain transactions involving the purchase
or carrying of securities. In addition to
examining banks under its jurisdiction
for compliance with the Board's margin
regulations as part of its general examination program, the Federal Reserve
maintains a registry of persons other
than banks, brokers, and dealers who
extend credit subject to those regulations. The Federal Reserve may conduct
specialized examinations of these lenders if they are not already subject to
supervision by the Farm Credit Administration, the National Credit Union
Administration, or the Office of Thrift
Supervision.
At the end of 2001, 802 lenders other
than banks, brokers, or dealers were
registered with the Federal Reserve.
Other federal regulators supervised 183
of these lenders, and the remaining 619
were subject to limited Federal Reserve
supervision. On the basis of regulatory
requirements and annual reports, the
Federal Reserve exempted 273 lenders
from its on-site inspection program. The
securities credit activities of the remain


147

ing 346 lenders were subject to either a
biennial or triennial inspection. Sixtyfive inspections were conducted during
the year, compared with 147 in 2000.
Enforcement Actions
and Civil Money Penalties
In 2001 the Federal Reserve initiated 21
enforcement cases involving 30 separate
actions, such as cease-and-desist orders,
written agreements, removal and prohibition orders, and civil money penalties.
The Board of Governors collected
$66.4 million in civil money penalties,
which included a substantial collection
from the BCCI case, a long-standing
litigation matter. All funds collected
were remitted to the U.S. Department of
the Treasury.
All final enforcement orders issued
by the Board and all written agreements executed by the Reserve Banks
in 2001 are available to the public and
can be accessed from the Board's public
web site (http://www.federalreserve.gov/
boarddocs/enforcement).
In addition to formal enforcement
actions, the Reserve Banks in 2001
completed 111 informal enforcement
actions, such as resolutions with boards
of directors and memorandums of
understanding.

Risk-Focused Supervision
In recent years the Federal Reserve has
created several programs aimed at
enhancing the effectiveness of the supervisory process. The main objective of
these initiatives has been to sharpen the
focus on (1) those business activities
posing the greatest risk to banking organizations and (2) the organizations'
management processes for identifying,
measuring, monitoring, and controlling
their risks.

148 88th Annual Report, 2001
Regional Banking Organizations
The risk-focused supervision program
for regional banking organizations
applies to institutions having a functional management structure, a broad
array of products, and operations that
span multiple supervisory jurisdictions.
For smaller regional banking organizations, the supervisory program may
be implemented with a point-in-time
inspection; for larger institutions, the
program may take the form of a series of
targeted reviews. For the largest, most
complex institutions, the process is continuous, as described in the next section.
To minimize burden on the institution,
work is performed off site to the greatest
extent possible. Additionally, to reduce
the number of information requests to
the institution, examiners make use of
public and regulatory financial reports,
market data, information from the automated surveillance screening systems
(see later section "Surveillance and
Monitoring Programs"), and internal
management reports.
Large, Complex Banking Organizations
The Federal Reserve applies a riskfocused supervision program to large,
complex
banking
organizations
(LCBOs).3 The key features of the
LCBO supervision program are (1) identifying those LCBOs that, based on their
shared risk characteristics, present the
highest level of supervisory risk to the
Federal Reserve System, (2) maintaining continual supervision of these
institutions to keep current the Federal
Reserve's assessment of each organiza3. For an overview of the Federal Reserve's
LCBO program, see the article by Lisa M.
DeFerrari and David E. Palmer, "Supervision of
Large Complex Banking Organizations," in the
Federal Reserve Bulletin, vol. 87 (February 2001),

pp. 47-57.



tion's condition, (3) assigning to each
LCBO a supervisory team composed of
Reserve Bank staff members who have
skills appropriate for the organization's
risk profile (the team leader is the central point of contact, has responsibility
for only one LCBO, and is supported by
specialists skilled in evaluating the risks
of LCBO business activities and functions), and (4) promoting Systemwide
and interagency information-sharing
through an automated system.
Supporting the supervision process
is an automated application and
database—the Banking Organization
National Desktop (BOND)—which is
being developed to facilitate real-time,
secure information-sharing and collaboration across the Federal Reserve System and with certain other federal and
state regulators. The final stage of
phase I of BOND development was
implemented during 2001, and work
was begun on phase II, which will add
functionality that promotes analysis
across institutions.
The events of September 11, 2001,
directly and adversely affected the functioning of U.S. payment and clearing
systems, requiring an extraordinary
cooperative and coordinated effort
among bank supervisory agencies both
domestically and internationally. In
addition to providing supervisory guidance for regulated institutions during the
crisis, LCBO supervisory staffs across
the Federal Reserve System facilitated
the sharing of information among financial regulatory agencies worldwide; in
many instances, examiners were sent on
site to lend assistance to and assess the
status of key institutions.
Community Banks
The risk-focused supervision program
for community banks emphasizes that
certain elements are critical to the sue-

Banking Supervision and Regulation
cess of the risk-focused process. These
elements include adequate planning
time, completion of a pre-examination
visit, preparation of a detailed scopeof-examination memorandum, thorough
documentation of the work done, and
preparation of an examination report
tailored to the scope of the examination.
The framework for risk-focused supervision of community banks was developed jointly with the Federal Deposit
Insurance Corporation and has been
adopted by the Conference of State
Bank Supervisors.

Surveillance and Monitoring
Programs
The Federal Reserve uses automated
screening systems to monitor the financial condition and performance of state
member banks and bank holding companies between on-site examinations. The
screening systems analyze supervisory
data and regulatory financial reports to
identify companies that appear to be
weak or deteriorating. This analysis
helps to direct examination resources to
institutions exhibiting higher risk profiles. Screening systems also assist in
the planning of examinations by identifying companies that are engaging
in new or complex activities. Also used
in the monitoring process are quarterly Bank Holding Company Performance Reports prepared by the Federal
Reserve.
During 2001, the Federal Reserve
refined its surveillance program for
small bank holding companies to
respond to changes in supervisory
procedures for these institutions. The
revised screening systems focus on
identifying potential problems at parent
companies and nonbank subsidiaries
that could adversely affect affiliated
insured depository institutions. In particular, the screens address parent com


149

pany cash flow, intercompany transactions, parent company leverage, and
consolidated capital ratios. Also during
the year the Federal Reserve revised the
Bank Holding Company Performance
Report to incorporate new information
on sources of nonbank income and on
insurance activities.
The Federal Reserve works with the
other federal banking agencies to
enhance and coordinate surveillance
activities through the Task Force on Surveillance Systems of the Federal Financial Institutions Examination Council
(FFIEC).4
International Activities
The Federal Reserve supervises the
foreign branches of member banks;
overseas investments by member banks,
Edge Act and agreement corporations,
and bank holding companies; and
investments by bank holding companies
in export trading companies. It also
supervises the activities that foreign
banking organizations conduct through
entities in the United States, including branches, agencies, representative
offices, and subsidiaries.
Foreign-Office Operations of
U.S. Banking Organizations
The Federal Reserve examines the international operations of state member
banks, Edge Act corporations, and bank
holding companies principally at the
U.S. head offices of these organizations,
where the ultimate responsibility for
their foreign offices lies. In 2001 the
4. The member agencies of the FFIEC are the
Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation
(FDIC), the National Credit Union Administration
(NCUA), the Office of the Comptroller of the
Currency (OCC), and the Office of Thrift Supervision (OTS).

150 88th Annual Report, 2001
Federal Reserve examined 3 foreign
branches of state member banks and
7 foreign subsidiaries of Edge Act corporations and bank holding companies.
The examinations abroad were conducted with the cooperation of the
supervisory authorities of the countries
in which they took place; when appropriate, the examinations were coordinated with the Office of the Comptroller
of the Currency. Examiners also make
visits to the overseas offices of U.S.
banks to obtain financial and operating
information and, in some instances,
to evaluate their efforts to implement
corrective measures or to test their
adherence to safe and sound banking
practices.

international banking and foreign financial transactions. These corporations,
which in most cases are subsidiaries
of member banks, may (1) conduct a
deposit and loan business in states other
than that of the parent, provided that
the business is strictly related to international transactions, and (2) make foreign investments that are broader than
those of member banks because they
may invest in foreign financial organizations, such as finance companies and
leasing companies, as well as in foreign
banks.
Edge Act and agreement corporations
numbered 75 and were operating 17
branches at year-end 2001. These corporations are examined annually.

Foreign Branches of Member Banks

U.S. Activities of Foreign Banks

At the end of 2001, 64 member banks
were operating 937 branches in foreign
countries and overseas areas of the
United States; 34 national banks were
operating 725 of these branches, and 30
state member banks were operating the
remaining 212. In addition, 18 nonmember banks were operating 22 branches in
foreign countries and overseas areas of
the United States.

The Federal Reserve has broad authority
to supervise and regulate the U.S. activities of foreign banks that engage in
banking and related activities in the
United States through branches, agencies, representative offices, commercial
lending companies, Edge Act corporations, commercial banks, and certain
nonbank companies. Foreign banks continue to be significant participants in the
U.S. banking system.
As of year-end 2001, 208 foreign
banks from 56 countries were operating
287 state-licensed branches and agencies (of which 13 were insured by the
Federal Deposit Insurance Corporation)
as well as 51 branches licensed by the
Office of the Comptroller of the Currency (of which 6 had FDIC insurance).
These foreign banks also directly owned
15 Edge Act corporations and 3 commercial lending companies; in addition,
they held an equity interest of at least
25 percent in 90 U.S. commercial banks.
Further, 23 foreign banks and certain of
their affiliates were granted financial
holding company status.

Edge Act and Agreement Corporations
Edge Act corporations are international
banking organizations chartered by the
Board to provide all segments of the
U.S. economy with a means of financing international business, especially
exports. Agreement corporations are
similar organizations, state chartered or
federally chartered, that enter into an
agreement with the Board to refrain
from exercising any power that is not
permissible for an Edge Act corporation.
Under sections 25 and 25(A) of the
Federal Reserve Act, Edge Act and
agreement corporations may engage in



Banking Supervision and Regulation
Altogether, these U.S. offices of foreign banks at the end of 2001 controlled
approximately 19.0 percent of U.S. commercial banking assets. These foreign
banks also operated 181 representative
offices; an additional 97 foreign banks
operated in the United States solely
through a representative office.
State-licensed and federally licensed
branches and agencies of foreign banks
are examined on site at least once every
eighteen months, either by the Federal
Reserve or by a state or other federal
regulator; in most cases, on-site examinations are conducted at least once every
twelve months, but the period may be
extended to eighteen months if the
branch or agency meets certain criteria.
The Federal Reserve conducted or participated with state and federal regulatory authorities in 289 examinations during 2001.
Joint Program for
Supervising the U.S. Operations of
Foreign Banking Organizations
The Federal Reserve, in cooperation
with the other federal banking agencies
and with state banking agencies, conducts a joint program for supervising the
U.S. operations of foreign banking organizations. The program has two main
parts. One part focuses on the examination process for those foreign banking
organizations that have multiple U.S.
operations and is intended to improve
coordination among the various U.S.
supervisory agencies. The other part is a
review of the financial and operational
profile of each organization to assess its
general ability to support its U.S. operations and to determine what risks, if
any, the organization poses through its
U.S. operations. Together, these two processes provide critical information to
U.S. supervisors in a logical, uniform,
and timely manner. During 2001 the



151

program was refined further in light of
experience in using it over the past five
years.

Technical Assistance
In 2001 the Federal Reserve System
continued to provide technical assistance on bank supervisory matters
to foreign central banks and supervisory authorities. Technical assistance
involves visits by System staff members
to foreign authorities as well as consultations with foreign supervisors who
visit the Board or the Reserve Banks.
Technical assistance in 2001 was concentrated in Latin America, the Far East,
and former Soviet bloc countries.
During the year, the Federal Reserve
offered supervision training courses in
Washington, D.C., and in a number of
foreign jurisdictions exclusively for
foreign supervisory authorities. System
staff also took part in technical assistance and training missions led by the
International Monetary Fund, the World
Bank, the Inter-American Development Bank, the Asian Development
Bank, the Basel Committee on Banking
Supervision, and the Financial Stability
Institute.

Supervisory Policy
Within the supervisory policy function,
the Federal Reserve develops guidance
for examiners and financial institutions
as well as regulations for financial institutions under the supervision of the Federal Reserve. Staff members also participate in international supervisory forums
and provide support for the work of the
Federal Financial Institutions Examination Council.
Capital Adequacy Standards
During 2001 the Federal Reserve,
together with the other federal bank-

152 88th Annual Report, 2001
ing agencies, issued a final rule
that amended the capital standards for
recourse, direct credit substitutes, and
residual interests in asset securitizations.
The agencies also continued discussions
on a possible notice of proposed rulemaking to simplify the risk-based capital framework. The Federal Reserve
revised its policy of generally applying
its capital adequacy guidelines to toptier U.S. bank holding companies owned
by foreign banks qualifying as financial
holding companies under the GrammLeach-Bliley Act. Finally, the agencies
continued to work on developing final
rules governing securities borrowing
transactions and claims on securities
firms.
Recourse, Direct Credit Substitutes,
and Residual Interests in
Asset Securitizations
On November 29, 2001, the Federal
Reserve, together with the other federal
banking agencies, issued a final rule to
amend their respective risk-based and
leverage capital standards for the treatment of recourse obligations, direct
credit substitutes, and residual interests
that expose banks, bank holding companies, and thrift institutions to credit risk.
The final rule combined two earlier proposals on these matters that had overlapped in some respects. It makes use of
external credit ratings to match the riskbased capital assessment more closely
to an institution's relative risk of loss in
asset securitizations. The rule requires
that institutions hold risk-based capital
in an amount equal to the amount of
residual interests that arise in securitizations (or other transfers of assets) and
that are retained on the balance sheet. In
addition, credit-enhancing interest-only
strips receivables, either purchased
or retained, are limited to 25 percent
of tier 1 capital. Amounts exceeding



25 percent are to be deducted from tier 1
capital, which will have the effect of
reducing the leverage ratio as well as the
risk-based capital ratios. The portion of
the rule dealing with interest-only strips
receivables will go into effect at the end
of 2002.
Simplified Capital Framework for
Non-Complex Institutions
In November 2000, the federal banking
agencies published an advance notice of
proposed rulemaking and solicited comments on proposals for creating a simpler capital framework for non-complex
domestic financial institutions. Most
comments did not support significant
substantive changes to the existing
framework. After considering the comments, the agency staffs in 2001 decided
not to proceed with a simplified capital
approach. Instead, they are continuing
discussions on possible ways to modify the regulatory capital rules more
broadly.
Supervisory Policy on the Application
of Capital Requirements to Bank
Holding Companies Owned by Foreign
Banking Organizations
In January 2001, the Federal Reserve
revised its policy of subjecting all toptier U.S. bank holding companies to
the U.S. minimum regulatory capital
requirements. A limited exception was
made for top-tier U.S. bank holding
companies owned by foreign banks
qualifying as financial holding companies under the Gramm-Leach-Bliley
Act. For a foreign bank to qualify as a
financial holding company, the Board
must have determined that it is well
capitalized and well managed under
standards comparable to those applied
to U.S. banks owned by bank holding
companies qualifying as financial hold-

Banking Supervision and Regulation
ing companies. A top-tier U.S. bank
holding company owned by such a foreign bank will continue to be required
to report its capital under the U.S. capital adequacy guidelines for bank holding companies but will not be required
to meet the regulatory minimums. Minimum levels of capital for these organizations will instead be determined on a
supervisory basis. In making this revision, the Federal Reserve determined
that relying on the capital strength of
the consolidated foreign bank, as well
as requiring subsidiary banks to meet
appropriate capital and management
standards, is consistent with the Federal Reserve's supervisory assessment
process for domestic bank holding
companies.
Capital for Nonfinancial
Equity Investments
In February 2001, the Federal Reserve,
together with the OCC and the FDIC,
issued a proposal concerning the regulatory capital treatment of equity investments in nonfinancial companies held
by banks, bank holding companies, and
financial holding companies. The proposal represented a modification of a
proposal that had been issued in March
2000. Under the revised proposal, a
capital charge would be imposed that
would increase in steps as the banking
organization's level of concentration in
equity investments increased. Agency
monitoring also would increase as the
level of concentration in equity investments increased.
Securities Borrowing Transactions
In December 2000, the Federal Reserve,
together with the FDIC and the OCC,
issued an interim rule to revise the capital treatment of cash collateral that is
posted in connection with securities
borrowing transactions. The change was



153

intended to align the capital requirements for these transactions more appropriately with the risk involved and to
level the playing field for banking
organizations vis-a-vis their domestic
and foreign competitors. Among the
public comments submitted by the due
date of January 19, 2001, support for the
interim rule was unanimous. The interim
rule remains in effect.
Claims on Securities Firms
In December 2000, the federal banking agencies proposed to reduce from
100 percent to 20 percent the risk weight
accorded to claims on, and claims
guaranteed by, qualifying securities
firms in countries that are members of the Organisation for Economic
Co-operation and Development. The
change would bring the risk weight in
line with a 1998 revision to the Basel
Capital Accord. Qualifying U.S. securities firms would be broker-dealers registered with the Securities and Exchange
Commission (SEC) that are in compliance with the SEC's net capital rule
and meet certain other requirements.
Work continued during 2001, and the
agencies expect to issue a final rule in
the first quarter of 2002.
Fiduciary Activities
In February 2001, the Federal Reserve
issued guidance concerning the integration of trust and transfer agency
examinations into safety and soundness
examinations. Fiduciary activities and
related services generally include traditional trust services—such as personal
trust, corporate trust, and transfer agent
services—and employee benefit account
products and services, as well as custodial and securities lending services
and clearing-and-settlement, assetmanagement, and investment-advisory
activities. The intent of the guidance is

154 88th Annual Report, 2001
to improve integration of the supervisory assessment of banking organizations' fiduciary activities into the
overall safety and soundness supervision process and to focus supervisory
resources on areas of greatest risk.
Securities Activities of
State Member Banks
On May 14, 2001, the Federal Reserve
issued guidance to examiners and
other supervisory personnel regarding
changes to the permissible securities
activities of state member banks under
the Gramm-Leach-Bliley Act. The act
authorized well-capitalized state member banks to underwrite, deal in, and
invest in municipal revenue bonds without limitation as to the level of these
activities that may be conducted relative
to the bank's capital. Until that time,
state member banks could, without capital limitation, underwrite, deal in, or
invest in only general obligation municipal bonds backed by the full faith and
credit of an issuer having general powers of taxation.
Joint Agency Advisory on
Rate-Sensitive Deposits
In May 2001, the Federal Reserve,
together with the other federal banking
agencies, issued an interagency advisory
outlining the risk-management procedures that banking organizations should
follow in assessing and controlling the
risks associated with significant reliance
on brokered and rate-sensitive deposits.
The advisory states that deposits raised
through intermediary sources, such as
deposit brokers, the Internet, and other
automated service providers, may be
less stable than traditional deposits,
primarily because depositors making
deposits through intermediary sources
may not have other relationships with



the depository institution and may rapidly shift funds to another institution or
investment in search of a higher return.
The advisory states that banking organizations should employ appropriate systems to identify and control this risk.
Such systems include appropriate fundsmanagement policies, adequate due diligence in assessing deposit brokers and
financial risks, reasonable control and
limit structures, adequate information
systems, and contingency funding plans.
International Guidance on
Supervisory Policies
As a member of the Basel Committee on
Banking Supervision (Basel Committee), the Federal Reserve in 2001 participated in efforts to revise the international capital regime and to develop
international supervisory guidance. The
Federal Reserve's goals in these activities are to advance sound supervisory
policies for internationally active banking institutions and to improve the
stability of the international banking
system. The efforts are described in the
following sections.
Capital Adequacy
The Federal Reserve continued to participate in a number of technical working groups of the Basel Committee in
efforts to develop a new capital accord.
These groups, in grappling with a number of difficult issues, released several
consultative papers during 2001:
• In January, the Basel Committee
issued for public consultation a series
of papers setting forth proposals for a
new capital accord. This consultative
package laid the groundwork for formal and informal discussions with the
banking industry and other interested
parties on a revised international capital framework.

Banking Supervision and Regulation
• In continuing its work on a new capital accord, and in response to public
comments on the January consultative
package, the Basel Committee issued
for further consultation a number
of technical working papers, including "Internal Ratings-Based (IRB)
Treatment of Expected Losses and
Future Margin Income" (July); "RiskSensitive Approaches for Equity
Exposures in the Banking Book for
IRB Banks" (August); "Pillar 3—
Market Discipline" (September);
"Regulatory Treatment of Operational
Risk" (September); "Internal RatingsBased Approach to Specialized Lending Exposures" (October); and
"Treatment of Asset Securitizations"
(October).
Risk Management
The Federal Reserve contributed to a
number of supervisory policy papers,
reports, and recommendations issued
by the Basel Committee during 2001.
These documents were generally aimed
at improving the supervision of banks'
risk-management practices. The paper
"Review of Issues Relating to Highly
Leveraged Institutions" (issued in February) set forth sound risk-management
practices when dealing with highly
leveraged institutions. "Risk Management Principles for Electronic Banking"
(issued in May) was intended to help
banking institutions expand their existing risk-management policies and practices to cover their electronic-banking
activities. The paper "Customer Due
Diligence for Banks" (issued in October) provides guidance on effective
controls and procedures for getting to
know customers. The consultative paper
"Sound Practices for the Management
and Supervision of Operational Risk"
(issued in December) solicited banking
industry comments on a proposed range



155

of sound practices for the management
of operational risk.
Joint Forum
In its work with the Basel Committee,
the Federal Reserve also continued its
participation in the Joint Forum, a group
made up of representatives of the committee, the International Organization
of Securities Commissions, and the
International Association of Insurance
Supervisors. The Joint Forum works to
increase mutual understanding of issues
related to the supervision of firms operating in each of the financial sectors. In
this regard, the Federal Reserve contributed to two Joint Forum papers issued
in November 2001: "Risk Management
Practices and Regulatory Capital,"
which compares current industry practices in all three sectors, and "Core
Principles: Cross-Sectoral Comparison,"
which identifies similarities and differences among the core principles of the
three sectors.
Internal Control, Accounting,
and Disclosure
The Federal Reserve participates in
the Basel Committee's Task Force on
Accounting Issues and its Transparency
Group and represents the Basel Committee at international meetings on the
issues addressed by these groups. In particular, during 2001 the Federal Reserve
represented the Basel Committee at
meetings of the committee of the International Accounting Standards Board
(IASB) that works to improve accounting guidance concerning financial instruments. In addition, a representative
of the Federal Reserve was appointed a
member of the IASB's Standards Advisory Council.
During 2001 the Federal Reserve also
contributed to a letter and several papers

156 88th Annual Report, 2001
on internal control, accounting, and disclosure issued by the Basel Committee,
including the following:
• "Comment Letter on Fair Value
Accounting"—In this letter (issued in
September) the IASB solicited views
on the benefits and costs associated
with a fair value accounting model for
financial instruments. The Basel Committee recommended that the IASB
explore additional disclosure of fair
value information and improve standards for loan loss allowances and
disclosures about credit risk in lieu
of introducing a comprehensive fair
value accounting model at this time.
• "The Relationship Between Banking
Supervisors and Banks' External
Auditors"—This joint paper by the
Basel Committee and the International
Auditing Practices Committee (to be
issued in January 2002) provides
guidance on ways to strengthen the
relationship between bank auditors
and supervisors and incorporates the
Basel Committee's core principles for
effective banking supervision.
• "Internal Audit in Banks and the
Supervisor's
Relationship
with
Auditors"—This paper (issued in
August) sets forth objectives and principles for an effective bank internalaudit function, the role of internal
audit, and the banking supervisors'
views on ways to strengthen the relationship between banking supervisors
and internal and external auditors.
Staff members also supported the
Basel Committee's Task Force on
Accounting Issues in the development
of comment letters on major proposals of the International Federation of
Accountants (IFAC) and of IFAC's
International Auditing Practices Com


mittee (IAPC). Staff also represented
the Basel Committee's Task Force on
Accounting Issues at meetings with representatives of the IAPC and the International Forum on Accountancy Development to encourage the adoption of
enhanced international auditing standards and practices.
In December the Board sent a comment letter to the IASB on an international proposal to adopt fair value
accounting. The comment letter attached
a staff research report that explored a
number of issues arising from the proposal's suggestion that banks and other
companies use their internal creditgrading systems to estimate fair values
when certain criteria are met.
Gramm-Leach-Bliley Act
The Gramm-Leach-Bliley Act (GLBA)
repealed those provisions of the GlassSteagall Act and the Bank Holding
Company Act that restricted the ability
of bank holding companies to affiliate
with securities firms and insurance companies. The provisions of GLBA, and
the Federal Reserve's final rule, which
was adopted in January 2001, establish
conditions that a bank holding company
or a foreign bank must meet to be
deemed a financial holding company
and to engage in expanded activities.
In addition to controlling depository
institutions, financial holding companies may engage in securities underwriting and dealing, serve as an insurance
agent and insurance underwriter, act as
a futures commission merchant, and
engage in merchant banking. Permissible activities also include activities
that the Board and the Secretary of the
Treasury jointly determine to be financial in nature or incidental to financial
activities and activities that the Federal
Reserve determines are complementary
to a financial activity and do not pose a

Banking Supervision and Regulation
substantial risk to the safety and soundness of depository institutions or the
financial system generally.
On January 2, 2001, the Federal
Reserve and the Department of the Treasury issued an interim rule defining the
following as permissible activities: lending, exchanging, transferring, investing
for others, or safeguarding financial
assets other than money or securities;
providing any device or other instrumentality for transferring money or
other financial assets; and arranging,
effecting, or facilitating financial transactions for the account of third parties.
In addition, in February 2001 the Federal Reserve and the Department of the
Treasury extended the comment period
for a December 2000 proposal that
would include real estate brokerage and
real estate management as permissible
activities under GLBA.
Under GLBA, the Federal Reserve
has supervisory oversight authority and
responsibility for bank holding companies, including those that operate as
financial holding companies. The statute
streamlines the Federal Reserve's supervision for all bank holding companies
and sets forth parameters for the relationship between the Federal Reserve
and other regulators. The statute differentiates between the Federal Reserve's
relations with regulators of depository
institutions and its relations with functional regulators (that is, regulators for
insurance, securities, and commodities).
During 2001, the Federal Reserve continued its efforts to ensure that supervisory policies applied to banking institutions are consistent with the provisions
of GLBA.
In its role as the holding company
supervisor, the Federal Reserve in 2001
hosted two cross-sector meetings with
representatives of the banking agencies,
securities and commodities and futures
authorities, and state insurance com


157

missions. Cross-sector forums provide
an opportunity for multiple supervisors
(both federal and state) to discuss issues
of common interest and to enhance
communication and cooperation. At the
October meeting, the group focused on
the impact and implications of the September 11 terrorist attacks on each of
the sectors. Three cross-sector meetings
are scheduled for 2002.
Merchant Banking Activities
On January 31, 2001, the Board and
the Secretary of the Treasury jointly
adopted a final rule governing merchant
banking investments made by financial
holding companies.5 The rule implements provisions of GLBA that permit
financial holding companies to make
investments as part of a bona fide securities underwriting or merchant or
investment banking activity. The Board
and the Secretary incorporated a number of amendments to the final rule to
address issues raised by public commenters, to reduce potential regulatory
burdens, and to clarify the application
of the rule. These changes included
expanding the definition of "securities affiliate" to include a department
or division of a bank registered as a
municipal securities dealer; modifying
the provisions defining prohibited routine management and operation of portfolio companies; adopting a sunset provision for the investment thresholds
under the interim rule and eliminating
the dollar-based threshold for the review
of a financial holding company's merchant banking activities; streamlining
the rule's reporting and recordkeeping
requirements; broadening the definition
5. "Merchant banking" investments may be
made in any type of ownership interest and in any
type of nonfinancial entity (portfolio company)
and may represent any amount of the equity of a
portfolio company.

158 88th Annual Report, 2001
of "private equity" funds and clarifying
the rule's application to such funds; and
adopting several safe harbors to the
presumptions in the rule governing the
definition of "affiliate" for purposes of
sections 23A and 23B of the Federal
Reserve Act. The final rule became
effective February 15, 2001.

things, the FFIEC issued substantial
revisions to the Call Report; a statement
regarding a major revision of article 9 of
the Uniform Commercial Code; a policy
statement on methodologies and documentation in connection with allowances for loan and lease losses; and
guidance on risk-management issues.

Information-Security Standards

Bank Call Reports

Under section 501(b) of GLBA, the federal banking agencies are required to
issue standards for information security.
In February 2001, after soliciting public comment on a June 2000 proposal,
the agencies published "Interagency
Guidelines Establishing Standards for
Safeguarding Customer Information."
The guidelines require banks and holding companies to establish a written
information-security program and to
control the risk of unauthorized access
or other threats to the security and confidentiality of customer information.

As the federal supervisor of state member banks, the Federal Reserve, acting
in concert with the other federal banking
agencies through the FFIEC, requires
banks to submit quarterly Reports of
Condition and Income (the Call Report).
This report is the primary source of data
used in the supervision and regulation of
banks and in the ongoing assessment
of the overall soundness of the nation's
financial structure. Call Report data,
which also serve as benchmarks for the
financial information required in many
other Federal Reserve regulatory financial reports, are widely used by state and
local governments, state banking supervisors, the banking industry, securities
analysts, and the academic community.
For the 2001 reporting period, the
FFIEC implemented substantial revisions to the Call Report to streamline
the reporting requirements and to add
new items that focus on areas of increasing supervisory concern. The principal
revisions included

Financial Subsidiary Provisions
On August 16, 2001, the Board adopted
a final rule implementing the financial
subsidiary provisions of GLBA for state
member banks. The act authorizes state
member banks that comply with the
requirements of the rule to control, or
hold an interest in, a financial subsidiary, which may conduct certain financial activities that the parent bank may
not conduct directly. The final rule is
substantially similar to the interim rule
adopted by the Board in March 2000.

Federal Financial Institutions
Examination Council
During 2001, the Federal Reserve continued its active participation as a member of the Federal Financial Institutions
Examination Council. Among other



• Combining the three separate report
forms for banks of various sizes
that have only domestic offices
(FFIEC 032, 033, and 034) into a
single form (designated FFIEC 041),
while retaining the separate form
for banks having foreign offices
(FFIEC 031)
• Eliminating a number of data items
that were no longer warranted

Banking Supervision and Regulation
• Introducing a revised regulatory capital schedule that takes a step-by-step
"building block" approach to computing the key elements of the capital
ratios for all banks
• Collecting new information on asset
sales and certain nontraditional bank
activities. In addition, collection of
the Annual Report of Trust Assets
(FFIEC 001) and the Annual Report
of International Fiduciary Activities
(FFIEC 006) was discontinued and a
streamlined fiduciary-activities schedule was added to the Call Report.
Also, the Report of Assets and Liabilities of U.S. Branches and Agencies
of Foreign Banks (FFIEC 002) was
revised, effective with the June 2001
report, to maintain consistency with
the Call Report.
In October, the Federal Reserve and
the other federal banking agencies proposed a few revisions to the Call Report
to facilitate effective supervision. The
revisions would, effective with the
March 2002 report, add a few items
to conform with changes in generally
accepted accounting principles, specifically, the reporting requirements of
Statement of Financial Accounting Standard No. 141, Business Combinations,
and No. 142, Goodwill and Other Intangible Assets. The revisions would also
add several items to address new safety
and soundness considerations.
Revisions to Article 9 of the
Uniform Commercial Code
On February 28, 2001, the FFIEC issued
a statement regarding a major revision
of article 9 of the Uniform Commercial
Code and its effect on financial institutions. Article 9 governs transactions
involving the granting of credit secured
by personal property. Revised article 9



159

contains a number of new or revised
rules for secured transactions that affect
financial institutions' procedures, systems, documentation, and the enforceability of security interests. In the statement, the FFIEC advised financial
institutions and their legal counsel to
consider carefully the changes in state
law brought about by revised article 9 in
order to ensure the attachment and perfection of their existing and future security interests.
Risk-Management Controls in the
Use of Electronic Financial Services
In August 2001, the Federal Reserve
issued a new policy, developed by the
FFIEC member agencies, addressing
authentication in an electronic banking
environment. In recognition of the
importance of effective authentication
measures in reducing the risk of fraud
and strengthening information-security
programs, the guidance describes riskmanagement issues that banks should
consider as they design and update their
on-line customer-authentication systems. The main portion of the guidance gives background information
and describes sound risk-management
measures. Processes for verifying the
identity of prospective customers and
authenticating existing customers who
use on-line systems, such as Internet
banking services, are discussed, and
details are provided concerning various
authentication technologies and issues
to consider when implementing these
processes.

Efforts to Enhance Transparency
and Bank Regulatory Financial
Reports
The Federal Reserve has long supported
sound accounting policies and meaningful public disclosure by banking and

160 88th Annual Report, 2001
financial organizations to improve market discipline and foster stable financial
markets. Effective market discipline
can be an important complement to
bank supervision and regulation. As
financial institutions make more information available, market participants
are able to make better evaluations of
counterparty risk and better adjustments
to the availability and pricing of funds.
Thus, transparency can promote efficiency in financial markets and sound
practices by banks. The Federal Reserve
also seeks to strengthen audit and control standards for banks; the quality of
management information and financial
reporting is dramatically affected by internal control systems, including internal and external audit programs.
To advance these objectives, the Federal Reserve works with other regulators, the accounting profession, and a
wide variety of market participants, both
domestically and internationally.

be systematic, consistently applied, and
auditable; validated periodically; and
modified as needed to incorporate new
events or findings. The guidance also
provides examples of appropriate documentation and illustrations showing how
the guidance should be implemented.
Interagency Guidance on
Loans Held for Sale
In March the Federal Reserve, the other
federal banking agencies, and the
National Credit Union Administration
issued guidance regarding the appropriate treatment of loans that an institution
intends to sell. Consistent with GAAP,
the guidance requires an institution to
record a charge-off against the ALLL
when it decides to sell loans whose fair
value has declined for any reason other
than a change in the general market
level of interest or foreign exchange
rates.

Interagency Guidance on the
Allowance for Loan and Lease Losses

Private-Sector Working Group on
Public Disclosure

In July 2001, the Federal Reserve, the
Securities and Exchange Commission,
and the other federal banking agencies
issued joint guidance regarding documentation of the allowance for loan and
lease losses. The Federal Reserve and
the other federal banking agencies
issued the guidance as an FFIEC policy
statement, and the SEC issued parallel
guidance as Staff Accounting Bulletin
102. The guidance clarifies the agencies' expectations in regard to documentation supporting the methodology used
to calculate allowances for loan and
lease losses (ALLL). It requires that
a financial institution's ALLL methodology be consistent with generally
accepted accounting principles (GAAP)
and all outstanding supervisory guidance. Further, the methodology should

The Private-Sector Working Group on
Public Disclosure, a group composed of
senior executives from major domestic
and foreign banking organizations and
securities firms, was established by the
Federal Reserve to recommend ways
to enhance public financial statement
disclosures. The SEC and OCC also
participated in the effort. In January,
the working group released a report
recommending enhanced and morefrequent public disclosure of financial
information by banking and securities firms. Subsequently, the Federal
Reserve, SEC, and OCC issued supervisory guidance encouraging banking
organizations and securities firms to
follow these recommendations. Privatesector efforts, such as those of the
working group, and official regulatory




Banking Supervision and Regulation
initiatives can help foster consensus and
advance thinking on what constitutes
sound or best practice regarding public
disclosure.
Bank Holding Company
Regulatory Financial Reports
The Federal Reserve requires that U.S.
bank holding companies submit periodic regulatory financial reports. These
reports, the FR Y-9 and FR Y - l l
series, provide information essential
to the supervision of the organizations
and to the formulation of regulations
and supervisory policies. The Federal
Reserve also uses the information in
responding to requests from the Congress and the public for information on
bank holding companies and their nonbank subsidiaries.
The FR Y-9 series of reports provides standardized financial statements
for the consolidated bank holding
company. The reports are used to detect
emerging financial problems, review
performance and conduct pre-inspection
analysis, monitor and evaluate risk
profiles and capital adequacy, evaluate
proposals for bank holding company
mergers and acquisitions, and analyze
the holding company's overall financial
condition.
The FR Y - l l series of reports aids
the Federal Reserve in determining the
condition of bank holding companies
that are engaged in nonbanking activities and in monitoring the volume,
nature, and condition of their nonbanking subsidiaries.
In March 2001, the Federal Reserve
implemented numerous revisions to the
FR Y-9C report that streamlined the
reporting requirements. The streamlining was part of the Federal Reserve's
effort to achieve the objectives set forth
in section 307(c) of the Riegle Community Development and Regulatory



161

Improvement Act of 1994, which directs
the banking agencies to review the information that institutions report in the Call
Report and the bank holding company
reports and eliminate requirements that
are not warranted for safety and soundness or other public policy purposes.
As part of the streamlining process,
the Federal Reserve made changes to
other FR Y-9 and FR Y - l l series
reports to introduce more uniformity to
certain aspects of regulatory reporting.
The changes not only increased uniformity within the holding company
reports but also brought several reporting items into closer alignment with the
Call Report and the Thrift Financial
Report. Other modifications to the holding company reports were made so that
their form and content would more
closely resemble the manner in which
information is presented in financial
statements that banking organizations
prepare in accordance with generally
accepted accounting principles for other
financial reporting purposes.
Besides streamlining the FR Y-9C
reporting requirements by eliminating
information no longer of significant
value, the Federal Reserve also
improved the relevance of the FR Y-9C
by identifying new types of information
that are expected to be critical to the
Federal Reserve's future supervisory
data needs. The improvements focus on
new activities and other recent developments that may expose institutions to
new or different types of risk.
In light of the Gramm-Leach-Bliley
Act and the increased involvement
of banking organizations in merchant
banking and equity investment in nonfinancial companies, the Federal Reserve
implemented the new Consolidated
Bank Holding Company Report of
Equity Investments in Nonfinancial
Companies (FR Y-12), effective September 30, 2001.

162 88th Annual Report, 2001

Supervisory Information
Technology
The Supervisory Information Technology (SIT) function within the Board's
Division of Banking Supervision and
Regulation facilitates management of
information technology within the Federal Reserve's supervision function. Its
goals are to ensure that
• IT initiatives support a broad range of
supervisory activities without duplication or overlap
• The underlying IT architecture fully
supports those initiatives
• The supervision function's use of
technology takes advantage of the
systems and expertise available more
broadly within the Federal Reserve
System.
SIT works through assigned staff at
the Board of Governors and the Reserve
Banks and through a committee structure that ensures that key staff members
throughout the Federal Reserve System
participate in identifying requirements
and setting priorities for IT initiatives.
SIT also houses the management of the
National Information Center, a comprehensive repository for vital supervision
information.

SIT Activities
In 2001 SIT revised and updated the
operating plan for the ongoing approval
and reassessment of IT projects, which
was prepared in 2000. It is developing a
capital planning and information technology investment guide to ensure that
IT investments in proposed projects and
products support the function's strategic
goals. SIT is undertaking an enterprise
document management project to iden


tify, implement, and deploy a common
document-management technology for
the supervision function on a Systemwide basis. In 2001, as part of its
project-management training for Board
and Reserve Bank staff, it also revised
and updated the project managers' handbook, which draws on the best practices
in private industry and government.

Enhancements to the
National Information Center
The National Information Center (NIC)
is the Federal Reserve's comprehensive
repository for supervisory, financial, and
banking-structure data and documents.
NIC includes the National Examination
Data (NED) system, software that provides supervisory personnel and state
banking authorities with access to NIC
data, and the Central Document and
Text Repository (CDTR), which contains documents supporting the supervisory process.
In 2001 much work was accomplished to make the NED system available over the web and to add functionality to further support the supervision of
banking institutions. Implementation of
this new version of NED is planned for
the second quarter of 2002.
In September, new structure report
forms were put into use to capture
changes in the organizational structure
of bank holding companies (FR Y-10)
and foreign banking organizations
(FR Y-10F). Also, extensive revisions
were made to NIC to support the collection of data and the quality of reports. In
addition, an Internet-based reporting
mechanism was implemented to allow
bank holding companies to submit
reports electronically. During the year,
progress was made on enhancements
to the CDTR so that it will be able to
handle more documents, accept documents from other agencies, and permit

Banking Supervision and Regulation
web-based access. Implementation is
planned for June 2002.

Staff Training
The System Staff Development Program
trains staff members at the Board of
Governors, the Reserve Banks, and state
banking departments who have supervisory and regulatory responsibilities; students from foreign supervisory authorities attend training sessions on a spaceavailable basis. The program's goal is,
in part, to provide greater cross-training.
Training is offered at the basic, intermediate, and advanced levels in the four

disciplines of bank supervision: bank
examinations, bank holding company
inspections, surveillance and monitoring, and applications analysis. Classes
are conducted in Washington, D.C.,
as well as at other locations and are
sometimes held jointly with other
regulators.
The Federal Reserve System also
participates in training offered by the
FFIEC and by certain other regulatory
agencies. The System's involvement
includes developing and implementing
basic and advanced training in relation
to various emerging issues as well as in
specialized areas such as trust activities,

Training Programs for Banking Supervision and Regulation, 2001
Number of sessions conducted
Program
Total
Schools or seminars conducted by the Federal Reserve
Core schools
Banking and supervision elements
Operations and analysis
Bank management
Report writing
Management skills
Conducting meetings with management

Regional

10
6
4
20
9
16

5
1
20
9
16

11
24
4

24
4

Other schools
Loan analysis
Examination management
Real estate lending seminar
Specialized lending seminar
Senior forum for current banking and regulatory issues
Banking applications
Principles of fiduciary supervision
Commercial lending essentials for consumer affairs
Consumer compliance examinations I
Consumer compliance examinations II
CRA examination techniques
Fair lending examination techniques
Foreign banking organizations
Information systems continuing education
Capital markets seminars
Technology risk integration
Leadership dynamics
Seminar for senior supervisors of foreign central banks'
Other agencies conducting courses 2
Federal Financial Institutions Examination Council
The Options Institute
1. Conducted jointly with the World Bank.
2. Open to Federal Reserve employees.




163

37
1
. . Not applicable.

164 88th Annual Report, 2001
Student Examination Results, First Track, 2001
Specialty
Result

Core
proficiency

Safety and
soundness

Consumer
affairs

Trust

Information
technology

Passed
Failed

35
19

25
4

8
9

3
1

1
3

Total

54

29

17

4

4

NOTE. These examinations are for examiners hired before February 28, 1998.

A staff member seeking an examiner's commission follows one of two
training tracks. One track, for staff members hired before February 28, 1998,
involves a "core proficiency examination" as well as a specialty examination
in an area of the student's choice—
safety and soundness, consumer affairs,
trust, or information technology. Students on this track had to complete the
commissioning requirements by December 31, 2001. In 2001, 35 examiners
passed the core proficiency examination
(see table).
The other track, for staff members
hired after February 27, 1998, involves
a "first proficiency examination" as
well as a "second proficiency examination" in one of the four specialty areas.
The table below reflects 2001 pass rates
for the second track. At the end of 2001,
the System had 1,242 field examiners,
of which 861 were commissioned.

international banking, information technology, municipal securities dealing,
capital markets, payment systems risk,
white collar crime, and real estate lending. In addition, the System co-hosts the
World Bank Seminar for students from
developing countries.
In 2001 the Federal Reserve trained
2,832 students in System schools, 645 in
schools sponsored by the FFIEC, and 15
in other schools, for a total of 3,492,
including 234 representatives of foreign
central banks (see accompanying table).
The number of training days in 2001
totaled 18,483.
The System gave scholarship assistance to the states for training their
examiners in Federal Reserve and
FFIEC schools. Through this program,
445 state examiners were trained—
277 in Federal Reserve courses, 166
in FFIEC programs, and 2 in other
courses.

Student Examination Results, Second Track, 2001
Second proficiency
Result

First
proficiency

Safety and
soundness

Consumer
affairs

Trust

Information
technology

Passed
Failed

199
3

49
11

17
4

5
0

3
0

Total

202

60

21

5

3

NOTE. These examinations are for examiners hired after February 27, 1998.




Banking Supervision and Regulation

Regulation of the
U.S. Banking Structure
The Board of Governors administers the
Bank Holding Company Act, the Bank
Merger Act, the Change in Bank Control Act, and the International Banking
Act, each in relation to bank holding
companies, financial holding companies, member banks, and foreign banking organizations, as appropriate. In
doing so, the Federal Reserve acts on a
variety of proposals that directly or indirectly affect the structure of U.S. banking at the local, regional, and national
levels; the international operations of
domestic banking organizations; and
the U.S. banking operations of foreign
banks.
In November 2001, revisions to
Regulation K—which governs the foreign operations of U.S. banking organizations and the U.S. operations of
foreign banking organizations—were
implemented. In general, the revisions
streamlined foreign branching procedures for U.S. banking organizations,
authorized expanded activities at foreign branches of U.S. banks, and implemented recent statutory changes.
Changes were also made to the provisions governing permissible foreign
activities of U.S. banking organizations, including securities activities, and
investments made under general consent
procedures. In addition, the revisions
streamlined the application procedures
applicable to foreign banks seeking to
expand their operations in the United
States.

Bank Holding Company Act
Under the Bank Holding Company Act,
a corporation or similar organization
must obtain the Federal Reserve's
approval before forming a bank holding company through the acquisition



165

of one or more banks in the United
States. Once formed, a bank holding
company must receive Federal Reserve
approval before acquiring or establishing additional banks. The act also
identifies other activities permissible
for bank holding companies; depending on the circumstances, these activities may or may not require Federal
Reserve approval in advance of their
commencement.
Bank holding companies generally
may engage in only those activities that
the Board has previously determined to
be closely related to banking under section 4(c)(8) of the act. Since 1996, the
act has provided an expedited priornotice procedure for certain permissible
nonbank activities and for acquisitions
of small banks and nonbank entities.
Since that time the act has also permitted well-run bank holding companies
that satisfy certain criteria to commence
certain other nonbank activities on a
de novo basis without first obtaining
Federal Reserve approval.
When reviewing a bank holding company application or notice to engage in
an activity that requires prior approval,
the Federal Reserve considers the
financial and managerial resources of
the applicant, the future prospects of
both the applicant and the firm being
acquired, the convenience and needs of
the community to be served, the potential public benefits, the competitive
effects of the proposal, and the applicant's ability to make available to the
Board information deemed necessary
to ensure compliance with applicable
law. In the case of a foreign banking
organization seeking to acquire control
of a U.S. bank, the Federal Reserve
also considers whether the foreign
bank is subject to comprehensive supervision or regulation on a consolidated basis by its home country
supervisor. Data on decisions regard-

166 88th Annual Report, 2001
Decisions by the Federal Reserve on Domestic and International Applications, 2001
Action under authority delegated
by the Board of Governors

Proposal

Direct action
by the
Board of Governors

Approved
Formation of bank
holding
company
Merger of bank
holding
company
Acquisition or
retention of
bank
Acquisition of
nonbank
Merger of bank
Change in control
Establishment of a
branch, agency,
or representative
office by a
foreign bank
Other
Total

Denied

Director of the
Office
Division of Banking of the
Supervision and
Secretary
Regulation

Permitted Approved

Federal
Reserve Banks

Total

Denied Approved Approved Permitted

28

0

0

0

0

3

170

59

260

8

0

0

0

0

6

40

22

76

19

0

0

0

0

6

86

39

150

0
10
0

0
0
0

62
0
0

0
0
0

0
0
0

7
9
3

0
106
0

124
0
111

193
125
114

12

0

4

3

0

0

9

0

28

360

0

29

56

0

69

1,081

155

1,750

437

0

95

59

0

103

1,492

510

2,696

ing domestic and international applications in 2001 are shown in the accompanying table.
Since 2000, the Bank Holding Company Act has permitted the creation of
a special type of bank holding company called a financial holding company. Financial holding companies are
allowed to engage in a broader range of
nonbank activities than are traditional
bank holding companies: Among other
things, they may affiliate with securities firms and insurance companies and
engage in certain merchant banking
activities. Bank holding companies
seeking financial holding company status must file a written declaration with
the Federal Reserve System; most declarations are acted on by one of the
Reserve Banks under authority delegated by the Board of Governors. In
2001, 135 domestic financial holding



company declarations and 3 foreign
bank declarations were approved.
Financial holding companies do not
have to obtain the Board's prior
approval to engage in or acquire a company engaged in new financial activities
under GLBA. Instead, the financial
holding company must notify the Board
within thirty days after commencing a
new activity or acquiring a company
engaged in a new activity. A financial
holding company also may engage in
certain other activities that have been
determined to be financial in nature or
incidental to a financial activity or that
are determined to be complementary to
a financial activity.
Bank Merger Act
The Bank Merger Act requires that all
proposals involving the merger of

Banking Supervision and Regulation
insured depository institutions be acted
on by the appropriate federal banking
agency. If the institution surviving the
merger is a state member bank, the Federal Reserve has primary jurisdiction.
Before acting on a merger proposal, the
Federal Reserve considers the financial
and managerial resources of the applicant, the future prospects of the existing
and combined institutions, the convenience and needs of the community to
be served, and the competitive effects
of the proposed merger. It also considers the views of certain other agencies regarding the competitive factors
involved in the transaction. During
2001 the Federal Reserve approved
125 merger applications.
When the FDIC, the OCC, or the
OTS has jurisdiction over a merger, the
Federal Reserve is asked to comment on
the competitive factors; by using standard terminology in assessing competitive factors in merger cases, the four
agencies have sought to ensure consistency in administering the act. The Federal Reserve submitted 653 reports on
competitive factors to the other agencies
in 2001.
Change in Bank Control Act
The Change in Bank Control Act
requires persons seeking control of a
U.S. bank or bank holding company to
obtain approval from the appropriate
federal banking agency before completing the transaction. The Federal Reserve
is responsible for reviewing changes in
the control of state member banks and
bank holding companies. In its review,
the Federal Reserve considers the financial position, competence, experience,
and integrity of the acquiring person;
the effect of the proposed change on the
financial condition of the bank or bank
holding company being acquired; the
effect of the proposed change on compe


167

tition in any relevant market; the completeness of information submitted by
the acquiring person; and whether the
proposed change would have an adverse
effect on the federal deposit insurance funds. As part of the process, the
Federal Reserve may contact other
regulatory or law enforcement agencies
for information about each acquiring
person.
The appropriate federal banking agencies are required to publish notice of
each proposed change in control and to
invite public comment, particularly from
persons located in the markets served by
the institution being acquired.
In 2001 the Federal Reserve approved
114 proposed changes in control of
state member banks and bank holding
companies.
International Banking Act
The International Banking Act, as
amended by the Foreign Bank Supervision Enhancement Act of 1991, requires
foreign banks to obtain Federal Reserve
approval before establishing branches,
agencies, commercial lending company
subsidiaries, or representative offices in
the United States.
In reviewing proposals, the Federal
Reserve generally considers whether
the foreign bank is subject to comprehensive supervision or regulation on a
consolidated basis by its home country
supervisor. It also considers whether the
home country supervisor has consented
to the establishment of the U.S. office;
the financial condition and resources
of the foreign bank and its existing U.S.
operations; the managerial resources
of the foreign bank; whether the home
country supervisor shares information
regarding the operations of the foreign
bank with other supervisory authorities;
whether the foreign bank has provided
adequate assurances that information

168 88th Annual Report, 2001
concerning its operations and activities
will be made available to the Board,
if deemed necessary to determine and
enforce compliance with applicable law;
whether the foreign bank has adopted
and implemented procedures to combat
money laundering and whether the home
country of the foreign bank is developing a legal regime to address money
laundering or is participating in multilateral efforts to combat money laundering; and the record of the foreign bank
with respect to compliance with U.S. law.
In 2001 the Federal Reserve approved
28 applications by foreign banks to
establish branches, agencies, and representative offices in the United States.

Overseas Investments by
U.S. Banking Organizations
U.S. banking organizations may engage
in a broad range of activities overseas.
Many of the activities are conducted
indirectly through Edge Act and agreement corporation subsidiaries. Although
most foreign investments are made
under general consent procedures that
involve only an after-the-fact notification to the Board, large and other significant investments require the prior
approval of the Board. Excluding proposals relating to recent large domestic
mergers, the Federal Reserve in 2001
approved 26 proposals for significant
overseas investments by U.S. banking
organizations. The Federal Reserve also
approved 1 application to acquire an
Edge Act corporation, 3 to extend the
corporate existence of an established
Edge Act corporation, and 12 to establish or acquire a new agreement
corporation.
Applications by Member Banks
State member banks must obtain Federal Reserve approval to establish



domestic branches, and all member
banks (including national banks) must
obtain Federal Reserve approval to
establish foreign branches. When
reviewing proposals to establish domestic branches, the Federal Reserve considers the scope and character of the
proposed banking activities to be conducted. When reviewing proposals for
foreign branches, the Federal Reserve
considers, among other things, the condition of the bank and the bank's experience in international banking. Once a
member bank has received authority to
open a branch in a particular foreign
country, that bank may open additional
branches in that country without prior
approval from the Federal Reserve.
Excluding proposals related to recent
large domestic mergers, the Federal
Reserve in 2001 acted on proposals
involving 1,399 new or merger-related
domestic branches and granted prior
approval for the establishment of 13 foreign branches.
State member banks also must obtain
Federal Reserve approval to establish
financial subsidiaries. These subsidiaries
may engage in activities that are financial in nature or incidental to financial
activities, including certain securitiesand insurance-related activities that the
parent bank may not conduct directly. In
2001, 6 applications for financial subsidiaries were approved.
Stock Repurchases by
Bank Holding Companies
A bank holding company may repurchase its own shares from its shareholders. When the company borrows
money to buy the shares, the transaction increases the company's debt
and decreases its equity. The Federal
Reserve may object to stock repurchases
by holding companies that fail to meet
certain standards, including the Board's

Banking Supervision and Regulation
capital adequacy guidelines. In 2001
the Federal Reserve reviewed 20 stock
repurchase proposals by bank holding
companies; all were approved by a
Reserve Bank under delegated authority.

Public Notice of
Federal Reserve Decisions
Most decisions by the Federal Reserve
that involve a bank holding company, a
bank merger, a change in control, or the
establishment of a new U.S. banking
presence by a foreign bank are effected
by an order or an announcement. Orders
state the decision, the essential facts
of the application or notice, and the
basis for the decision; announcements
state only the decision. All orders and
announcements are made public immediately; they are subsequently reported
in the Board's weekly H.2 statistical
release and in the monthly Federal
Reserve Bulletin. The H.2 release also
includes announcements of applications
and notices received by the Federal
Reserve but not yet acted on. For each
pending application and notice, the
related H.2A states the deadline for
comments. The Board's public web site
(http://www.federalreserve.gov) continues to provide information relevant to
the applications process.

Timely Processing of Applications
The Federal Reserve sets internal target
time frames for the processing of applications. The setting of targets promotes
efficiency at the Board and the Reserve
Banks and reduces the burden on applicants. Generally, the length of the target
period ranges from twelve to sixty days,
depending on the type of application
or notice filed. In 2001, 92 percent of
applications were processed within the
established time period.



169

Delegation of Applications
Historically, the Board of Governors has
delegated certain regulatory functions,
including the authority to approve, but
not to deny, certain types of applications, to the Reserve Banks, to the
Director of the Board's Division of
Banking Supervision and Regulation,
and to the Secretary of the Board. In
2001, 80 percent of the applications processed were handled under delegated
authority.

Enforcement of
Other Laws and Regulations
The Board's enforcement responsibilities also extend to financial disclosures
by state member banks; securities credit;
and efforts, under the Bank Secrecy Act,
to counter money laundering.
Financial Disclosures by
State Member Banks
State member banks that issue securities
registered under the Securities Exchange
Act of 1934 must disclose certain information of interest to investors, including
annual and quarterly financial reports
and proxy statements. By statute, the
Board's financial disclosure rules must
be substantially similar to those of the
Securities and Exchange Commission.
At the end of 2001, twenty-three state
member banks were registered with the
Board under the Securities Exchange
Act.
Securities Credit
Under the Securities Exchange Act, the
Board is responsible for regulating
credit in certain transactions involving
the purchase or carrying of securities.
The Board's Regulation T limits the
amount of credit that may be provided

170 88th Annual Report, 2001
by securities brokers and dealers when
the credit is used to trade debt and
equity securities. The Board's Regulation U limits the amount of credit that
may be provided by lenders other than
brokers and dealers when the credit is
used to purchase or carry publicly held
equity securities if the loan is secured by
those or other publicly held equity securities. The Board's Regulation X applies
these credit limitations, or margin
requirements, to certain borrowers and
to certain credit extensions, such as
credit obtained from foreign lenders by
U.S. citizens.
Several regulatory agencies enforce
the Board's securities credit regulations.
The SEC, the National Association of
Securities Dealers, and the national
securities exchanges examine brokers
and dealers for compliance with Regulation T. The federal banking agencies
examine banks under their respective
jurisdictions for compliance with Regulation U; the Farm Credit Administration, the National Credit Union Administration, and the Office of Thrift
Supervision examine lenders under their
respective jurisdictions for compliance
with Regulation U, and the Federal
Reserve examines other Regulation U
lenders.
Since 1990 the Board has published a
list of foreign stocks that are eligible for
margin treatment at broker-dealers on
the same basis as domestic margin securities. In 2001 the foreign list was
revised in March and September.

Anti-Money Laundering
The Department of the Treasury's regulation (31 CFR 103) implementing the
Currency and Foreign Transactions
Reporting Act (commonly referred to as
the Bank Secrecy Act) requires banks
and other types of financial institutions
to file certain reports and maintain cer


tain records. These documents record
information on persons involved in large
currency transactions and on suspicious
activity related to possible violations of
federal law, including money laundering
and other financial crimes. The act is a
primary tool in the fight against money
laundering; its requirements inhibit
money laundering by creating a paper
trail of financial transactions that helps
law enforcement and regulators identify
and trace the proceeds of illegal activity.
In addition to the specific requirements of the Bank Secrecy Act (BSA),
the Board's Regulation H (12 CFR
208.63) requires each banking organization supervised by the Federal Reserve
to develop a written program for BSA
compliance that is formally approved
by the institution's board of directors.
The compliance program must (1) establish a system of internal controls to
ensure compliance with the act, (2) provide for independent compliance testing, (3) identify individuals responsible
for coordinating and monitoring day-today compliance, and (4) provide training for personnel as appropriate. To
monitor compliance, each Reserve Bank
has designated a senior, experienced
examiner as the Bank Secrecy Act and
anti-money-laundering contact. During
examinations of state member banks and
U.S. branches and agencies of foreign banks, specially trained examiners
review the institution's compliance with
the act.
The Board has a special investigations section in the Division of Banking
Supervision and Regulation that conducts financial investigations, provides
expertise to the U.S. law enforcement
community for investigation and training initiatives, and offers training to
various foreign central banks and government agencies; section staff speak at
banking conferences to promote best
practices in the industry. Internationally,

Banking Supervision and Regulation
the section has provided anti-moneylaundering training and technical assistance to countries in Asia; in Eastern
Europe, including the newly independent states; in South and Central
America; and in the Caribbean. Staff
members have also participated in
numerous multilateral anti-moneylaundering initiatives such as the Financial Action Task Force and the Basel
Committee on Banking Supervision.
In 2001, the Federal Reserve continued to provide expertise and guidance to
the Bank Secrecy Act Advisory Group,
a committee established by the Congress at the Department of the Treasury
to seek measures to reduce unnecessary burdens created by the act and to
increase the utility of data gathered
under the act to aid regulators and law
enforcement. The Federal Reserve also
assisted the Treasury Department in providing feedback to financial institutions
on the reporting of suspicious activity.
Since the terrorist attacks of September 11, the Federal Reserve has played
an important role in many joint activities with bank supervisory and law
enforcement authorities and the banking community, both domestically and
abroad, to combat money laundering
and terrorist financing. In addressing the
mandates of the anti-money-laundering
provisions of the USA PATRIOT Act,
the Federal Reserve issued a supervi-

171

sory letter in November to all domestic
and foreign banking organizations under
its supervision. The letter described the
act's provisions, highlighted those provisions needing immediate attention by
financial institutions and supervisory
staff, and described the new rules that
would be issued under the act.
At the request of Treasury staff and
consistent with statutory requirements
for consultation, the Federal Reserve has
been actively assisting in the development of these new rules. Of the twenty
working groups established by the Treasury Department to carry out the different regulatory projects required by the
act, Federal Reserve staff are involved
in fifteen. The Federal Reserve also
established a PATRIOT Act Working Group composed of senior, experienced Bank Secrecy Act/anti-moneylaundering examiners from throughout
the System. This group, which is
charged with overseeing the System's
implementation of the new law, worked
on drafting new examination procedures
and developing a new training curriculum for examiners who conduct Bank
Secrecy Act and anti-money-laundering
examinations.
Loans to Executive Officers
Under section 22(g) of the Federal
Reserve Act, a state member bank must

Loans by State Member Banks tc their Executive Officers, 2000 and 2001
Number

Amount (dollars)

Range of interest
rates charged
(percent)

2000
October 1-December 31

702

59,232,000

5.5-20.8

2001
January 1-March 31
April 1-June 30
July 1-September 30

633
710
665

65,663,000
51,109,000
56,830,000

2.0-21.0
3.9-18.0
4.6-19.5

Period

SOURCE. Call Reports.




172 88th Annual Report, 2001
include in its quarterly Call Report
information on all extensions of credit
by the bank to its executive officers
since the date of the preceding report.
The accompanying table summarizes
this information for 2001.

Federal Reserve Membership
At the end of 2001, 3,058 banks were
members of the Federal Reserve System




and were operating 49,102 branches.
These banks accounted for 38 percent of
all commercial banks in the United
States and for 74 percent of all commercial banking offices.
•

173

Federal Reserve Banks
The Federal Reserve Banks devoted
considerable attention in 2001 to
improving security, operational efficiency, and service quality. This chapter
describes those efforts as well as other
activities affecting the Reserve Banks.

Major Initiatives
Since the terrorist attacks on September 11, the Federal Reserve has reevaluated its contingency and business continuity plans and operations and is taking
steps to enhance them. All information
technology infrastructures—both within
and outside the Federal Reserve's
control—that support critical operations
are being reexamined to ensure that they
have appropriate security, redundancy,
and diversity. Experience gained from
preparing for the century date change and
in the aftermath of the attacks is being
applied to strengthen further the Federal
Reserve's national incident-response procedures and communications.
In 2001, the Federal Reserve Banks
made an ambitious commitment to
reduce System costs in certain areas significantly over the next three years. To
achieve this objective, they initiated several cost-reduction projects in the information technology, accounting, and
human resources functions.
Among the cost-reduction projects are
several to centralize or standardize common information technology utilities
and resources. The Reserve Banks are
also collaborating on several projects to
eliminate duplication of efforts in application development and to identify commercially available alternatives to software planned for development. These
efforts will enable the Banks to be more



cost effective while continuing to provide high-quality, reliable services.
Another cost-reduction project begun
during the year was a concentrated multiyear effort to reduce employee benefit
costs by consolidating health and welfare plans and their administration, by
outsourcing, and by implementing costeffective benefit-plan design strategies.
The savings from these efforts are
expected to fully offset enhancements
of employee benefits that are intended
to make employment at the Federal
Reserve more attractive and thus
improve the institution's ability to compete for and retain the skilled professionals, technical staff, and key executives needed to carry out the Federal
Reserve's mission.

Developments in
Federal Reserve Priced Services
The Monetary Control Act of 1980
requires that the Federal Reserve set fees
for providing "priced services" to
depository institutions that, over the
long run, recover all the direct and indirect costs of providing the services as
well as the imputed costs, such as the
taxes that would have been paid and the
return on equity that would have been
earned had the services been provided
by a private firm. The imputed costs and
imputed profit are collectively referred
to as the private-sector adjustment factor (PSAF).1 Over the past ten years, the
1. Along with income taxes and the return on
equity, the PSAF is made up of three additional
imputed costs: interest on debt, sales taxes, and
assessments for deposit insurance from the Federal Deposit Insurance Corporation. Also allocated
to priced services are assets and personnel costs of

174

88th Annual Report, 2001

September 11 and the Payments System
We are blessed with a financial system that is creative, that is flexible, that
is innovative. Banks—including the central bank—were there when they were
needed and did what was required with dispatch. We should be proud of the
banking system's role in minimizing the economic fallout of that tragic day.
Alan Greenspan, Chairman, Board of Governors
For several days after the terrorist attacks
on September 11, 2001, communications
and connectivity problems disrupted portions of the nation's payments system
infrastructure, requiring many banks, securities dealers, and settlement utilities in
lower Manhattan to relocate their operations to contingency sites. Although most
backup procedures worked as planned,
telecommunications problems impaired
some firms' ability to communicate with
counterparties and employees and to transmit payment and settlement instructions.
Transportation problems in the Manhattan
area also made it difficult to move employees to contingency sites.
Disruptions to the payments system due
to telecommunications and transportation
problems resulted in payment delays and
liquidity dislocations among financial market participants for several days. As one
indication of liquidity dislocations, from
September 12 to 14, the balances that
depository institutions held in their Federal

Federal Reserve Banks have recovered
99.8 percent of their priced services
costs, including the PSAF (table).
Overall, fees charged in 2001 for
priced services increased approximately
5.2 percent from 2000.2 Revenue from

the Board of Governors that are related to priced
services; in the pro forma statements at the end of
the chapter, Board expenses are included in operating expenses, and Board assets are part of longterm assets.
2. Based on a chained Fisher Ideal price index
not adjusted for quality changes.



Reserve accounts averaged ten times their
usual level, with more than 70 percent of
those balances held by just six institutions,
compared with the 20 percent this group
normally holds. Disruptions in large payment flows also resulted from problems
in the clearance and settlement of U.S. government securities transactions and the
redemption of maturing commercial paper
transactions.
Although electronic funds transfer systems, such as Fedwire, CHIPS, the automated clearinghouse (ACH), and credit and
debit card networks, were not directly
affected by the attacks, some participants
experienced connectivity problems, resulting in a decline in payments activity. The
value of aggregate daily payments over
CHIPS, for example, was lower than
normal through September 14 but recovered the following week, while the value
of government securities transfers over
the Fedwire securities transfer system
remained low through the week of Septem-

priced services was $926.5 million,
other income related to priced services
was $33.9 million, and costs related to
priced services were $901.9 million,
resulting in net revenue of $58.5 million
and a recovery rate of 95.0 percent of
costs, including the PSAF.3

3. Financial data reported throughout this
chapter—revenue, other income, cost, net revenue, and income before taxes—can be linked to
the pro forma statements at the end of the chapter.
Other income is revenue from investment of clearing balances, net of earnings credits, an amount

Federal Reserve Banks

ber 17. Although the value of Fedwire
funds transfers initially declined on September 11, the value of transfers increased
materially starting on September 12 and
remained high throughout the month.
The Federal Reserve responded to these
disruptions in a variety of ways. On the
morning of September 11, the Federal
Reserve announced, "The Federal Reserve
System is open and operating. The discount window is available to meet liquidity
needs." Depository institutions affected by
the disruptions to the payments system borrowed heavily from the window for several
days. In addition, the Federal Reserve provided a large volume of reserves through
open market operations. Daylight and overnight overdrafts also increased dramatically, reflecting the difficulties that account
holders experienced in managing their Federal Reserve accounts as a result of payments system disruptions. In view of these
difficulties, the Reserve Banks waived daylight overdraft fees and overnight overdraft
penalty fees from September 11 through 21
for all account holders. To support the
direct provision of U.S. dollar liquidity to
foreign-based entities, the Federal Reserve
arranged currency swaps with the Bank of
Canada, the Bank of England, and the
European Central Bank.

Check Collection
Federal Reserve Bank operating expenses and imputed costs for commercial check services in 2001 totaled
$754.4 million, compared with $680.1
million in 2000. Revenue from check
termed net income on clearing balances. Total cost
is the sum of operating expenses, imputed costs
(interest on debt, interest on float, sales taxes, and
the Federal Deposit Insurance Corporation assessment), imputed income taxes, and the targeted
return on equity. Net revenue is revenue plus net
income on clearing balances minus total cost.



175

The Federal Reserve also worked closely
with the financial industry to restore connectivity and the normal flow of payments.
The Board used its authority under the
Telecommunications Service Priority program to expedite emergency provision
of telecommunications circuits for the
Reserve Banks and several key payment
providers and market utilities in the New
York City area. In addition, the Federal
Reserve extended the operating hours of
the Fedwire funds and securities transfer
systems to give financial institutions and
their customers more time to process each
day's intended payments. The Federal
Reserve also executed a significant number
of off-line Fedwire funds payment orders
on behalf of institutions that were experiencing connectivity problems. Finally, the
Reserve Banks continued to credit the
value of all check deposits to depositing
institutions' accounts, even if the Reserve
Banks could not present the checks to
(and debit the accounts of) paying banks
because airplanes were grounded. As a
result of the decision to credit these deposits, daily check float, which normally is
less than $1 billion, peaked at $47.4 billion
on September 13, providing an additional
significant source of liquidity to the banking system.

operations totaled $764.7 million, and
other income amounted to $28.5 million. Net income from check services
was $38.9 million, a $44.4 million, or
53.3 percent, decrease compared with
2000 net income.
The Reserve Banks handled 16.9 billion checks in 2001, a decrease of
0.5 percent from 2000 (see table). The
volume of checks deposited that
required processing by the Reserve
Banks increased 0.8 percent, a slightly
slower rate than the 1.1 percent increase
in 2000. The volume of fine-sort checks,

176 88th Annual Report, 2001
Priced Services Cost Recovery, 1992-2001
Millions of dollars except as noted
Year

Revenue from
services'

Operating
expenses and
imputed costs2

Targeted return
on equity

Total
costs

Cost recovery
(percent)3

1992
1993
1994
1995

760.8
774.5
767.2
765.2

710.7
820.4
760.2
752.7

24.9
17.5
21.0
31.5

735.6
837.9
781.2
784.2

103.4
92.4
98,2
97.6

1996
1997
1998
1999
2000
2001

815.9
818.8
839.8
867.6
922.8
960.4

746.4
752.8
743.2
775.7
818.2
901.9

42.9
54.3
66.8
57.2
98.4
109.2

789.3
807.1
809.9
833.0
916.6
1,011.1

103.4
101.5
103.7
104.2
100.7
95.0

8,293.0

7,782.2

523.7

8,305.9

99.8

1992-2001

NOTE. In this and the following tables, components
may not sum to totals or yield percentages shown because
of rounding. Amounts in bold are restatements due to
errors in previously reported data.
1. Includes revenue from services of $8,025.2 million
and other income and expense (net) of $267.8 million for
the ten-year period.

2. Includes operating expenses of $6,861.3 million,
imputed costs of $552.4 million, and imputed income
taxes of $275.0 million for the ten-year period. Also,
the effect of one-time accounting changes net of taxes of
$74.1 million and $19.4 million is included for 1993 and
1995 respectively.
3. Revenue from services divided by total costs.

which are presorted by the depositing
banks according to paying bank,
declined 10.4 percent, compared with a
10.7 percent decrease in 2000.
The Reserve Banks continued to
encourage the use of electronic check
products to make the collection system
more efficient. In 2001, the percentage
of all checks presented electronically by
the Reserve Banks to paying banks was
21.7 percent (approximately 3.7 billion
checks), compared with 20.4 percent
in 2000. The Reserve Banks captured
images of 8.1 percent of the checks they
collected, compared with 7.2 percent in
2000.
To assess the potential benefits, in
terms of error corrections and operational processes, of keeping image
copies of all checks processed, the New
York Reserve Bank's Utica office continued a pilot project to capture images
of the checks processed on all its highspeed check sorters. The Minneapolis
Bank's Helena Branch concluded its
pilot project to use check images to

expedite check returns; lessons learned
during the project are being incorporated into new proposals to exploit technology and reduce transportation costs
in check clearing.
During 2001, the Federal Reserve
Banks continued a five-year check modernization project to install uniform
software and hardware for check processing, check imaging, and check
adjustments in forty-five Reserve Bank
offices and to give depository institutions web-based access to check services. The project costs are expected to
be recovered over the long run because
the modernization effort will increase
operating efficiency and make it possible to offer additional services to
depository institutions.




Automated Clearinghouse
Reserve Bank operating expenses and
imputed costs for commercial automated
clearinghouse (ACH) services totaled
$67.7 million in 2001. Revenue from

Federal Reserve Banks 111
Activity in Federal Reserve Priced Services, 2001, 2000, and 1999
Thousands of items
Percent change
Service

2001

2000

1999
2000 to 2001

Commercial checks
Funds transfers
Securities transfers
Commercial ACH
Noncash services
Cash transportation

16,905,016
115,308
6,708
4,448,361
412
18

16,993,800
111,175
5,666
3,812,191
519
19

17,075,008
105,408
5,147
3,343,615
613
18

1999 to 2000

-.5
3.7
18.4
16.7
-20.7
-5.3

-.5
5.5
10.1
14.0
-15.3
5.6

NOTE. Activity in commercial checks is the total number of commercial checks collected, including processed
and fine-sort items; in funds transfers and securities transfers, the number of transactions originated on line and off
line; in commercial ACH, the total number of commercial

items processed; in noncash services, the number of items
on which fees are assessed; and in cash transportation,
the number of registered mail shipments and FRBarranged armored carrier stops.

ACH operations and other income
totaled $79.4 million, resulting in net
income of $11.9 million. The Reserve
Banks processed 4.4 billion commercial
ACH transactions (worth $12.7 trillion),
an increase of 16.7 percent from 2000.
In 2000, the Board approved a new
approach to pricing ACH transactions
that the Reserve Banks deliver through
and receive from private-sector ACH
operators (PSOs). Among other things,
the Board authorized the Reserve Banks
to initiate discussions with the PSOs to
negotiate the structure and level of fees
that the Reserve Banks charge the PSOs
for processing inter-operator transactions as well as the fees that the Reserve
Banks pay the PSOs. Negotiations continued into 2001, and a new interoperator fee structure became effective
on October 1. On that same date, the
Reserve Banks also implemented a new
pricing method for their depository institution ACH customers. Monthly fixed
fees were increased, and per-item fees
were decreased. The new method better
corresponds to the Reserve Banks' ACH
cost structure, which is characterized by
high fixed and low variable costs.
In August, the Reserve Banks began
the process of consolidating at two

Reserve Bank offices the support for
ACH operations once provided by each
of the twelve Federal Reserve Banks.
Support activities being consolidated
include ensuring the timely and accurate
processing of payments, maintaining the
integrity of the ACH application, monitoring file processing, and responding
to customers' questions. The consolidation, which is expected to reduce ACH
costs while maintaining service quality,
is scheduled to be complete by the end
of the first quarter of 2002.




Fedwire Funds Transfer and
Net Settlement
Reserve Bank operating expenses and
imputed costs for Fedwire funds transfer and net settlement services totaled
$56.7 million in 2001. Revenue from
these operations totaled $61.8 million, and other income amounted to
$2.0 million, resulting in net income of
$7.1 million.
Funds Transfer
The Fedwire funds transfer system
allows depository institutions to draw

178 88th Annual Report, 2001
Fees Paid by Depository Institutions for
Selected Federal Reserve Priced Services,
2000 and 2001
Dollars
Item

2000

2001

.33
.24
.17
15.00

.33
.24
.16
15.00

.95
12.00
60-175

.95
12.00
60-100

Account maintenance
Per issue
Per account

.45
15.00

.45
15.00

Transfers, each 2
Off-line surcharge

.70
18.00

.70
25.00

40.00

40.00

4.75
2.50

4.75
2.50

FEDWIRE FUNDS TRANSFERS,
BY VOLUME TIER 1

Tier
(number of transfers per month)2
1 (1 to 2,500)
2 (2,501 to 80,000)
3 (80,001 and more)
Off-line surcharge
NET SETTLEMENT,
BY TYPE OF SERVICE

Net settlement sheet
Entries, each
Files, each
Minimum per month
FEDWIRE SECURITIES

NONCASH COLLECTION

Bonds, each
Deposit envelopes
(per envelope of coupons)3
1-5
6-50
Cash letters
(flat fee, by number of
envelopes of coupons)3
1-5
6-50

7.50
15.00

7.50
15.00

Return items, each

15.00

20.00

NOTE. Rates for 2000 are as of April 3.
1. Rates apply only to their specified volume tiers.
2. Originated and received.
3. Deposits and cash letters may contain no more than
50 envelopes of coupons.

on their reserve or clearing balances at
the Reserve Banks and transfer funds
to other institutions. The number of
Fedwire funds transfers originated
by depository institutions increased
3.7 percent in 2001, to 115,308 million. In August, the Reserve Banks
reduced the transfer fee for the highestvolume tier while keeping other fees
unchanged (table). The off-line funds



transfer surcharge also remained
unchanged.4
In September, the Reserve Banks
began the final phase of consolidating
the operations of the Fedwire funds
transfer service.5 The consolidation is
expected to reduce operating costs upon
its completion in August 2002.
Net Settlement
Private clearing arrangements that
exchange and settle transactions may
use the Reserve Banks' net settlement
service to settle their transactions. The
Reserve Banks provide settlement services to approximately 70 local and
national private arrangements, including
local check clearinghouse associations,
automated clearinghouse networks, and
credit card processors. In 2001, the
Reserve Banks processed more than
417,000 settlement entries for these
arrangements, and fees remained at their
2000 levels.
Fedwire Securities Service
The Fedwire securities service allows
depository institutions to transfer securities issued by the U.S. Treasury, federal
government agencies, and other entities
electronically to other institutions in the
United States. Reserve Bank operating
expenses and imputed costs for providing this service totaled $19.5 million
in 2001. Revenue totaled $19.0 million, and other income amounted to
$0.7 million, resulting in net income of
$0.2 million. Approximately 6,708 million transfers were processed on the
4. Depository institutions that do not have an
electronic connection to the Fedwire funds transfer system can originate transfers via "off-line"
telephone instructions.
5. The first phase of this and the Fedwire securities service consolidation was completed in
March 1999.

Federal Reserve Banks

179

system during the year, an increase of
18.4 percent from 2000.6 The basic pertransfer fee for transfers originated and
received by depository institutions and
the monthly account maintenance fees
were unchanged in 2001, while the offline securities transaction surcharge was
increased from $18.00 to $25.00.
In September, the Reserve Banks
began the final phase of consolidation
of the Fedwire securities service in an
effort to reduce costs. The consolidation
is expected to be complete in August
2002.
The Government National Mortgage
Association (Ginnie Mae) announced
plans in 2001 to have its securities clear
and settle on the Fedwire securities
transfer system. The conversion is
expected to be complete by March 2002.

The Reserve Banks charge fees for
providing special cash-related services,
such as currency packaged in a nonstandard way. These services—
collectively referred to as "special cash
services"—account for a very small
proportion (less than 1 percent) of the
total cost of cash services provided by
the Reserve Banks to depository institutions. Operating expenses and imputed
costs for special cash services totaled
$2.1 million in 2001. Revenue and other
income totaled $2.3 million, resulting in
net income of $0.2 million.

Noncash Services

Float

The Federal Reserve provides a service
to collect and process municipal bearer
bonds and coupons issued by state and
local governments (referred to as "noncash" items). The service, which has
been centralized at one Federal Reserve
office, processed 412,000 noncash transactions in 2001.
Operating expenses and imputed costs
for noncash services totaled $1.6 million
in 2001. Revenue from noncash operations totaled $2.0 million, resulting in
net income of $0.4 million. The return-

Federal Reserve float decreased in 2001
to a daily average of $604.6 million,
from a daily average of $774.2 million
in 2000. The Federal Reserve recovers
the cost of float associated with priced
services as part of the fees for those
services.

6. The expenses, revenues, and volumes
reported here are for transfers of securities issued
by federal government agencies, governmentsponsored enterprises, and international institutions such as the World Bank. The Fedwire securities service also provides account maintenance,
transfer, and settlement services for U.S. Treasury
securities. When the Reserve Banks provide these
services, they act as fiscal agents of the United
States. The Treasury Department assesses fees on
depository institutions for some of these services.
For details, see the section "Fiscal Agency Services" later in this chapter.



item fee was increased from $15 to $20,
and the other collection fees remained
the same.

Special Cash Services

Developments in
Currency and Coin
Currency volume in the Federal Reserve
System continued to be high in 2001.
Reserve Banks received 33.5 billion
notes from circulation in 2001, a slight
increase from the 33.3 billion notes
received in 2000, the Y2K flowback
year (when depository institutions
returned the extra vault cash they had
held in anticipation of the century date
change). Reserve Banks also made payments of 34.3 billion notes to circulation
in 2001, a 7 percent increase from 2000.
The Federal Reserve Bank of San
Francisco officially opened the Phoenix

180 88th Annual Report, 2001
cash-processing center on September 4.
The center will operate as a satellite
office of the Los Angeles Branch.

Developments in
Fiscal Agency and
Government Depository Services
The total cost of providing fiscal agency
and depository services to the Treasury
in 2001 amounted to $246.5 million,
compared with $262.5 million in 2000
(table). The cost of providing services
to other government agencies was
$38.9 million, compared with $39.4 million in 2000. In 2001, the Reserve Banks
requested reimbursement by the Treasury and other government agencies
of $285.4 million for fiscal agency

and depository expenses, a decrease of
$16.6 million from 2000.

Fiscal Agency Services
As fiscal agents, Reserve Banks provide
to the Treasury services related to the
federal debt. For example, they issue,
transfer, reissue, exchange, and redeem
marketable Treasury securities and savings bonds; they also process secondary
market transfers initiated by depository
institutions.
Marketable Treasury Securities
Reserve Bank operating expenses for
activities related to marketable Treasury
securities in 2001 (Treasury Direct,

Expenses of Federal Reserve Banks for Fiscal Agency and Depository Services,
2001, 2000, and 1999
Thousands of dollars
2001

2000

1999

Bureau of the Public Debt
Savings bonds
Treasury Direct
Commercial book entry
Marketable Treasury issues
Definitive securities and Treasury coupons
Other services
Total

69,569.8
37,326.6
9,998.1
11,366.8
610.9
150.7
129,022.9

70,786.7
41,259.3
13,924.6
14,224.3
1,069.3
132.5
141,404.7

70,285.8
40,446.2
15,744.2
13,715.1
4,886.7
100.4
145,178.4

Financial Management Service
Treasury tax and loan and Treasury general account
Government check processing
Automated clearinghouse
Government agency check deposits
Fedwire funds transfers
Other services
Total

31,106.0
30,310.2
9,665.2
2,272.9
199.2
30,771.5
104,324.9

38,649.0
31,866.9
10,799.1
2,218.8
182.9
27,015.4
110,732.2

34,971.0
33,365.4
11,263.4
2,422.7
187.7
20,423.5
102,633.7

Other Treasury
Total
Total, Treasury

13,149.8
246,497.5

10,362.8
262,499.7

7,786.8
255,598.9

13,197.2

16,463.7

18,643.9

Agency and service
DEPARTMENT OF THE TREASURY

OTHER FEDERAL AGENCIES

Department of Agriculture
Food coupons
U.S. Postal Service
Postal money orders
Miscellaneous agencies
Other services
Total, other agencies
Total reimbursable expenses




11,255.0

9,213.5

6,623.3

14,434.0
38,886.2

13,747.1
39,424.3

13,983.0
39,250.2

28533.7

301,924.0

294,849.1

Federal Reserve Banks
Fedwire book-entry system, marketable
issues, definitive securities, and Treasury coupons) totaled $59.3 million,
a 15.9 percent decrease from 2000.
The Reserve Banks processed nearly
258,000 tenders for Treasury securities,
compared with 220,000 in 2000, and
handled 2.8 million reinvestment
requests, compared with 2.0 million in
2000.
The Reserve Banks operate two bookentry securities systems for Treasury
securities: the Fedwire system, which
provides custody and transfer, and Treasury Direct, which provides custody services only.7 Almost all book-entry Treasury securities, 97.5 percent of the
total par value outstanding at year-end
2001, were maintained on Fedwire; the
remainder were maintained on Treasury
Direct. The Reserve Banks in 2001
originated 7.8 million Fedwire transfers
of Treasury securities, a 1.9 percent
increase from 2000.
On behalf of Treasury Direct customers, the Reserve Bank designated to
handle sales sold nearly 15,000 securities worth $699.9 million, compared
with more than 16,000 securities worth
$581.2 million in 2000, collecting
almost $510,000 in fees on behalf of the
Treasury, a decrease of 8.4 percent from
the almost $557,000 in fees collected in
2000.
Savings Bonds
Reserve Bank operating expenses
for savings bond activities totaled
$69.6 million in 2001, a decrease of
1.7 percent from 2000. The Banks
7. The Fedwire book-entry securities mechanism is also used for safekeeping and transfer of
securities issued by federal government agencies,
government-sponsored enterprises, or international institutions. For details, see the section
"Fedwire Securities Service" earlier in this
chapter.



181

printed and mailed 37.8 million savings
bonds on behalf of the Treasury's
Bureau of the Public Debt, a 3.3 percent
increase from 2000. They also processed
nearly 5.5 million original-issue transactions for the Series I (inflationindexed) savings bond and 26.2 million original-issue transactions for the
Series EE savings bond. In addition, the
Banks processed approximately 563,000
redemption, reissue, and exchange transactions, a 1.0 percent decrease from
2000. Reserve Bank staff responded to
1.6 million service calls from owners of
savings bonds, a 4.4 percent increase
from 2000.
Depository Services
The Reserve Banks maintain the Treasury's funds account, accept deposits of
federal taxes and fees, pay checks drawn
on the Treasury's account, and make
electronic payments on behalf of the
Treasury.
Federal Tax Payments
Reserve Bank operating expenses
related to federal tax payments in 2001
totaled $31.1 million. The Federal
Reserve enhanced the Treasury tax and
loan program at midyear 2001 by
enabling the Treasury to invest funds
with eligible depository institutions
throughout the afternoon rather than just
in the morning, adding approximately
$3.0 million to Treasury's investment
income. It also worked with the Treasury to develop a pilot program whereby
the Treasury could place investments
with depository institutions for a set
term, the interest rate being determined
by auction.
Payments Processed for the Treasury
Reserve Bank operating expenses
related to government payments in 2001

182 88th Annual Report, 2001
amounted to $42.4 million. The Banks
processed 900.4 million ACH transactions for the Treasury, an increase of
7.4 percent from 2000. They also processed 345.8 million paper government
checks, an increase of 32.0 percent from
2000. In addition, the Banks issued
nearly 435,000 paper fiscal agency
checks, a decrease of 17.4 percent from
2000.
During the year, a Reserve Bank
assisted Treasury's efforts to facilitate
electronic payments to the federal government. The Bank began sending ACH
debits and making related accounting
entries for Treasury's Pay.gov web site
and began converting checks received
by the Treasury at the point of sale at
four overseas military bases.

Services Provided to Other Entities
The Reserve Banks provide fiscal
agency and depository services to other
domestic and international agencies
when they are required to do so by the
Secretary of the Treasury or when they
are required or permitted to do so by
federal statute. One such service is the
provision of food coupon services for
the Department of Agriculture. Reserve
Bank operating expenses for food coupon services in 2001 totaled $13.2 million, 19.8 percent lower than in 2000.
The Banks redeemed 587 million food
coupons, a decrease of 14.5 percent
from 2000. The Federal Reserve System
is consolidating food coupon processing
and expects 2001 consolidations to save
more than $500,000 per year.
As fiscal agents of the United States,
the Reserve Banks also process all
postal money orders deposited by banks
for collection. In 2001, they processed
229.4 million postal money orders,
approximately the same number as in
2000.



Information Technology
The Federal Reserve continued in 2001
to provide highly reliable and secure
electronic services and expanded its
electronic access options to depository
institutions. Significant progress was
made on the System's project to implement frame relay technology on Fednet,
the telecommunications network that
supports both external electronic connections between the Federal Reserve
and depository institutions and internal
communications among Reserve Banks.
The improvements will improve the
speed, reliability, and performance of
the depository institutions' electronic
connections during contingencies and
will also increase the capacity and flexibility to support new electronic services
using web-based technologies. The
Reserve Banks continued to improve
electronic access options for depository
institutions and to offer web-based
applications for check imaging, cash
ordering, and savings bonds processing.
The Banks plan to offer other new webbased services over the next several
years.

Examinations of
Federal Reserve Banks
Section 21 of the Federal Reserve Act
requires the Board of Governors to order
an examination of each Federal Reserve
Bank at least once a year. The Board
engages a public accounting firm to perform an annual audit of the combined
financial statements of the Reserve
Banks (see the section "Federal Reserve
Bank Combined Financial Statements").
The public accounting firm also audits
the annual financial statements of each
of the twelve Banks. The Reserve Banks
use the framework established by the
Committee of Sponsoring Organizations
of the Treadway Commission (COSO)

Federal Reserve Banks
in assessing their internal controls over
financial reporting, including the safeguarding of assets. Within this framework, each Reserve Bank provides an
assertion letter to its board of directors
annually confirming adherence to the
COSO standards, and a public accounting firm certifies management's assertion and issues an attestation report to
the Bank's board of directors and to the
Board of Governors.
The firm engaged for the audits of
the individual and combined financial
statements of the Reserve Banks for
2001 was PricewaterhouseCoopers LLP
(PwC). Fees for these services totaled
$1.3 million. In order to ensure auditor
independence, the Board requires that
PwC be independent in all matters relating to the audit. Specifically, PwC may
not perform services for the Reserve
Bank or others that would place it in a
position of auditing its own work, making management decisions on behalf
of the Reserve Banks, or in any other
way impairing its audit independence.
In 2001 the Reserve Banks engaged
PwC for advisory services totaling
$0.9 million, $0.7 million of which was
for project management advisory services related to the System's check modernization project. The Board believes
that these advisory services do not
directly affect the preparation of the
financial statements audited by PwC and
are not incompatible with the services
provided by PwC as an independent
auditor.
In 2001, the examinations by the
Board's Division of Reserve Bank
Operations and Payment Systems of the
Reserve Banks, using a format consistent with the integrated COSO framework, assessed the efficiency and effectiveness of operations, the reliability
of financial reporting, compliance with
applicable laws and regulations, and the
safeguarding of assets. The annual atten


183

tion at each Reserve Bank includes an
assessment of the effectiveness of the
Bank's internal audit function.
Each year, to assess compliance with
the policies established by the Federal
Reserve's Federal Open Market Committee (FOMC), the division also examines the accounts and holdings of the
System Open Market Account at the
Federal Reserve Bank of New York and
the foreign currency operations conducted by that Bank. In addition, a public accounting firm certifies the schedule of participated asset and liability
accounts and the related schedule of
participated income accounts at yearend. Division personnel follow up on
the results of these audits. The FOMC
receives the external audit reports and
the report on the division's follow-up.

Income and Expenses
The accompanying table summarizes the
income, expenses, and distributions of
net earnings of the Federal Reserve
Banks for 2000 and 2001.
Income in 2001 was $31,871 million,
compared with $33,964 million in 2000.
Total expenses were $2,718 million
($1,834 million in operating expenses,
$250 million in earnings credits granted
to depository institutions, and $295 million in assessments for expenditures
by the Board of Governors). The cost
of new currency was $339 million.
Revenue from priced services was
$926.5 million.
The profit and loss account showed a
net loss of $1,117 million. The loss was
due primarily to unrealized losses on
assets denominated in foreign currencies revalued to reflect current market
exchange rates. Statutory dividends paid
to member banks totaled $428 million,
$18 million more than in 2000; the rise
reflects an increase in the capital and
surplus of member banks and a conse-

184 88th Annual Report, 2001
Income, Expenses, and Distribution of Net Earnings
of Federal Reserve Banks, 2001 and 2000
Millions of dollars

2001

2000

Current income
Current expenses
Operating expenses'
Earnings credits granted

31,871
2,085
1,834
250

33,964
1,972
1,586
385

Current net income
Net additions to (deductions from, - ) current net income
Cost of unreimbursed services to Treasury
Assessments by the Board of Governors
For expenditures of Board
For cost of currency

29,786
-1,117
0
634
295
339

31,992
-1,492
8
624
188
436

Net income before payments to Treasury
Dividends paid
Transferred to surplus

28,035
428
518

29,868
410
4,115

Payments to Treasury2

27,089

25,344

Item

1. Includes a net periodic credit for pension costs of
$331 million in 2001 and $393 million in 2000.

quent increase in the paid-in capital
stock of the Reserve Banks.
Payments to the Treasury in the form
of interest on Federal Reserve notes
totaled $27,089 million in 2001, up from
$25,344 million in 2000; the payments
equal net income after the deduction of
dividends paid and of the amount necessary to bring the surplus of the Reserve
Banks to the level of capital paid in.
In the "Statistical Tables" section of
this volume, table 5 details the income
and expenses of each Federal Reserve
Bank for 2001, and table 6 shows a
condensed statement for each Bank for
the years 1914 through 2001. A detailed
account of the assessments and expenditures of the Board of Governors appears
in the section "Board of Governors
Financial Statements."

2. Interest on Federal Reserve notes.

(see table). Holdings of U.S. government securities increased $31,152 million, and holdings of loans increased
$32 million.
The average rate of interest earned
on the Reserve Banks' holdings of government securities declined to 5.46 percent, from 6.20 percent in 2000, and
the average rate of interest earned on
loans declined to 3.18 percent, from
6.27 percent.

Volume of Operations
Table 8 in the "Statistical Tables" section shows the volume of operations in
the principal departments of the Federal
Reserve Banks for the years 1996
through 2001.

Federal Reserve Bank Premises
Holdings of Securities and Loans
The Reserve Banks' average daily holdings of securities and loans during
2001 amounted to $559,323 million, an
increase of $31,184 million from 2000



In 2001, construction of the Atlanta
Reserve Bank's new headquarters building and the San Francisco Bank's new
cash-processing center in Phoenix was
completed.

Federal Reserve Banks

185

Securities and Loans of Federal Reserve Banks, 1999-2001
Millions of dollars except as noted

Item and year

Average daily holdings71
1999
2000
2001 ..
Earnings
1999
2000
2001

Total

U.S.
government
securities'

495,606
528,139
559,323

495,384
527,774
558,926

221
365
397

28,227
32,760
30,536

28,216
32,737
30,523

11
23
13

5.70
6.20
5.46

5.70
6.20
5.46

5.02
6.27
3.18

Average interest rate (percent)
1999
2000
2001 .
.
1. Includes federal agency obligations.
2. Does not include indebtedness assumed by the Federal Deposit Insurance Corporation.

The Board approved a new building
program for the Chicago Bank's Detroit
Branch. The Bank relocated its checkprocessing function from its headquarters building to leased space near
Midway Airport in Chicago and sold
its Westgate warehouse in suburban
Chicago.
Design work for the Dallas Bank's
new Houston Branch building continued. The Kansas City Bank continued to
analyze the long-term planning options
for its headquarters facility, and the
St. Louis Bank initiated a similar analysis of its headquarters facility.
The San Francisco Bank began a
study of the long-term business needs




Loans 2

3. Based on holdings at opening of business.

and planning options for its Seattle
and Portland Branches. The lease on
the Cleveland Bank's regional checkprocessing center in Columbus, Ohio,
was renewed.
The multiyear renovation program
and the cleaning and repair of the exterior stonework continued at the New
York Bank's headquarters building.
An improvement program for the main
chiller plant in the headquarters building
continued. Also, the improvements to
the New York Bank's leased office facility in New York City were completed.
At all facilities, security enhancement
programs were undertaken as a result of
the events of September 11.
•

186 88th Annual Report, 2001

Pro Forma Financial Statements for Federal Reserve Priced Services
Pro Forma Balance Sheet for Priced Services, December 31, 2001 and 2000
Millions of dollars
2001

Item
Short-term assets (Note 1)
Imputed reserve requirements
on clearing balances
Investment in marketable securities . . .
Receivables
Materials and supplies
Prepaid expenses
Items in process of collection
Total short-term assets

860.8
7,747.3
76.5
3.1
30.5
1,772.1

Long-term assets (Note 2)
Premises
Furniture and equipment
Leases and leasehold improvements ..
Prepaid pension costs
Total long-term assets

2000

473.0
176.1
88.1
760.8

Total assets . . .

Long-term liabilities
Long-term debt
Postretirement/postemployment
benefits obligation
Total long-term liabilities

471.9
171.2
65.3
659.9
1,498.0

1,368.3

11,988.3

12,245.7

6,886.1
3,878.1
113.2
.0

8,524.5
1,855.7
20.8
89.2

10,877.4

10,490.3
443.0

519.7

243.9

257.8

Total liabilities
Equity
Total liabilities and equity (Note 3) . . .
NOTE. Components may not sum to totals because of
rounding. Amounts in bold are restatements due to errors
in previously reported data.




10,877.4

10,490.3

....

Short-term liabilities
Clearing balances and balances
arising from early credit
of uncollected items
Deferred-availability items
Short-term debt
Short-term payables
Total short-term liabilities

667.0
6,002.6
74.9
3.2
35.2
4,094.6

777.4

686.9

11,267.7

11,564.3

720.6

681.4

11,988.3

12,245.7

The accompanying notes are an integral part of these
pro forma priced services financial statements.

Federal Reserve Banks

187

Pro Forma Income Statement for Federal Reserve Priced Services, 2001 and 2000
Millions of dollars
Item

2000

2001

Revenue from services provided
to depository institutions (Note 4)
Operating expenses (Note 5)
Income from operations
Imputed costs (Note 6)
Interest on float
Interest on debt
Sales taxes
FDIC insurance
Income from operations after
imputed costs
Other income and expenses (Note 7)
Investment income
Earnings credits
Income before income taxes
Imputed income taxes (Note 8)
Net income ...
. .
MEMO: Targeted return on equity (Note 9) ...

926.5
814.9
111.7
15.5
32.0
12.6
.0

881.5
716.5
165.1
12.8
31.5
9.3
.0

60.1

53.6

51.6
273.3
-239.4

NOTE. Components may not sum to totals because of
rounding. Amounts in bold are restatements due to errors
in previously reported data.

33.9
85.4
26.9
58.5
109.2

111.4
411.8
-370.5

41.3
152.7
48.1
104.6
98.4

The accompanying notes are an integral part of these
pro forma priced services financial statements,

Pro Forma Income Statement for Federal Reserve Priced Services, by Service, 2001
Millions of dollars

Total

Commercial
check
collection

Funds
transfer
and net
settlement

Fedwire
securities

ComACH

Noncash
services

Cash
services

Revenue from services
(Note 4)

926.5

764.7

61.8

19.0

76.9

2.0

2.2

Operating expenses
(Note 5)

814.9

684.3

50.3

18.4

58.5

1.3

2.0

Income from operations

111.7

80.4

11.4

.6

18.4

.7

.2

Imputed costs (Note 6)

60.1

52.2

3.1

L0

_3.8

_A

J)

Income from operations
after imputed costs

51.6

28.2

8.4

-.4

14.6

.6

2

Other income and expenses,
net (Note 7)

33.9

28.5

2.0

.7

2.5

.0

.1

[ncome before income taxes ..

85.4

56.7

10.4

.3

17.2

.6

.2

Imputed income taxes
(Note 8)

26.9

17.9

3.3

.1

5.4

.2

.1

58.5

38.9

7.1

.2

11.8

.4

.2

109.2

90.2

7.4

2.3

8.9

.2

.1

Net income
MEMO: Targeted return on
equity (Note 9)

NOTE. Components may not sum to totals because of
rounding.




The accompanying notes are an integral part of these
pro forma priced services financial statements.

188 88th Annual Report, 2001
Pro Forma Income Statement for Federal Reserve Priced Services, by Service, 2000
Millions of dollars

Total

Commercial
check
collection

Funds
transfer
and net
settlement

Fedwire
securities

Commercial
ACH

Noncash
services

Cash
services

881.5

728.6

61.9

17.8

68.8

2.3

2.1

716.5

595.5

49.5

14.0

53.6

L7

2J

165.1

133.1

12.4

3.8

15.2

.6

.0

53.6

46.3

3.1

.8

3.3

.1

.0

Income from operations
after imputed costs
Other income and expenses,
net (Note 7)

111.4

86.8

9.3

3.0

11.9

41.3

34.7

2.7

.8

2.9

_A_

Income before income taxes ..

152.7

121.5

12.0

3.8

14.8

.6

Item

Revenue from services
(Note 4)
Operating expenses
(Note 5)
Income from operations
Imputed costs (Note 6)

Imputed income taxes
(Note 8)

.1

MEMO: Targeted return on
equity (Note 9)

48.1

38.3

3.8

1.2

4.7

_2

104.6

Net income

83.2

8.2

2.6

10.1

A

.i

98.4

80.8

7.5

1.9

8.0

.2

.i

NOTE. Components may not sum to totals because of
rounding. Amounts in bold are restatements due to errors
in previously reported data.

The accompanying notes are an integral part of these
pro forma priced services financial statements,

FEDERAL RESERVE BANKS
NOTES TO PRO FORMA FINANCIAL STATEMENTS FOR PRICED SERVICES
(1) SHORT-TERM ASSETS

The imputed reserve requirement on clearing balances
held at Reserve Banks by depository institutions reflects a
treatment comparable to that of compensating balances
held at correspondent banks by respondent institutions.
The reserve requirement imposed on respondent balances
must be held as vault cash or as non-earning balances
maintained at a Reserve Bank; thus, a portion of priced
services clearing balances held with the Federal Reserve
is shown as required reserves on the asset side of the
balance sheet. The remainder of clearing balances is
assumed to be invested in three-month Treasury bills,
shown as investment in marketable securities.
Receivables are (1) amounts due the Reserve Banks for
priced services and (2) the share of suspense-account and
difference-account balances related to priced services.
Materials and supplies are the inventory value of shortterm assets.
Prepaid expenses include salary advances and travel
advances for priced-service personnel.
Items in process of collection is gross Federal Reserve
cash items in process of collection (CIPC) stated on a
basis comparable to that of a commercial bank. It reflects
adjustments for intra-System items that would otherwise




be double-counted on a consolidated Federal Reserve
balance sheet; adjustments for items associated with nonpriced items, such as those collected for government
agencies; and adjustments for items associated with
providing fixed availability or credit before items are
received and processed. Among the costs to be recovered
under the Monetary Control Act is the cost of float, or net
CIPC during the period (the difference between gross
CIPC and deferred-availability items, which is the portion
of gross CIPC that involves a financing cost), valued at
the federal funds rate.
(2) LONG-TERM ASSETS

Consists of long-term assets used solely in priced services, the priced-services portion of long-term assets
shared with nonpriced services, and an estimate of the
assets of the Board of Governors used in the development
of priced services. Effective Jan. 1, 1987, the Reserve
Banks implemented the Financial Accounting Standards
Board's Statement of Financial Accounting Standards
No. 87, Employers' Accounting for Pensions (SFAS 87).
Accordingly, the Reserve Banks recognized credits to
expenses of $101.0 million in 2001 and $115.5 million in
2000 and corresponding increases in this asset account.

Federal Reserve Banks
(3) LIABILITIES AND EQUITY

Under the matched-book capital structure for assets,
short-term assets are financed with short-term payables
and short-term debt in 2001 and only short-term debt in
2000. Long-term assets are financed with long-term debt
and equity in a proportion equal to the ratio of long-term
debt to equity for the fifty largest bank holding companies, which are used in the model for the private-sector
adjustment factor (PSAF). The PSAF consists of the taxes
that would have been paid and the return on capital that
would have been provided had priced services been furnished by a private-sector firm. Other short-term liabilities include clearing balances maintained at Reserve
Banks and deposit balances arising from float. Other
long-term liabilities consist of accrued postemployment
and postretirement benefits costs and obligations on capital leases.
(4) REVENUE

Revenue represents charges to depository institutions for
priced services and is realized from each institution
through one of two methods: direct charges to an institution's account or charges against its accumulated earnings credits.
(5) OPERATING EXPENSES

Operating expenses consist of the direct, indirect, and
other general administrative expenses of the Reserve
Banks for priced services plus the expenses for staff
members of the Board of Governors working directly on
the development of priced services. The expenses for
Board staff members were $4.9 million in 2001 and
$4.2 million in 2000. The credit to expenses under
SFAS 87 (see note 2) is reflected in operating expenses.
The income statement by service reflects revenue, operating expenses, and imputed costs. Certain corporate
overhead costs not closely related to any particular priced
service are allocated to priced services in total based on
an expense-ratio method, but are allocated among priced
services based on management decision. Corporate overhead was allocated among the priced services during
2001 and 2000 as follows (in millions):
2001

2000

Check
ACH
Funds transfer
Book entry
Noncash services
Special cash services

43.5
4.4
3.5
1.9
.1
.0

40.3
3.7
4.3
1.1
.1
.1

Total

53.4

49.6

(6) IMPUTED COSTS

Imputed costs consist of interest on float, interest on debt,
sales taxes, and the FDIC assessment. Interest on float is
derived from the value of float to be recovered, either
explicitly or through per-item fees, during the period.
Float costs include costs for checks, book-entry securities, noncash collection, ACH, and funds transfers.




189

Interest is imputed on the debt assumed necessary to
finance priced-service assets. The sales taxes and FDIC
assessment that the Federal Reserve would have paid had
it been a private-sector firm are among the components of
the PSAF (see note 3).
Float costs are based on the actual float incurred for
each priced service. Other imputed costs are allocated
among priced services according to the ratio of operating
expenses less shipping expenses for each service to the
total expenses for all services less the total shipping
expenses for all services.
The following list shows the daily average recovery of
actual float by the Reserve Banks for 2001 in millions of
dollars:
Total float
Unrecovered float
Float subject to recovery
Sources of recovery of float
Income on clearing balances
As-of adjustments
Direct charges
Per-item fees

1,056.3
112.3
944.0
94.4
451.7
505.3
(107.4)

Unrecovered float includes float generated by services
to government agencies and by other central bank services. Float recovered through income on clearing balances is the result of the increase in investable clearing
balances; the increase is produced by a deduction for float
for cash items in process of collection, which reduces
imputed reserve requirements. The income on clearing
balances reduces the float to be recovered through other
means. As-of adjustments and direct charges refer to float
that is created by interterritory check transportation and
the observance of non-standard holidays by some depository institutions. Such float may be recovered from the
depository institutions through adjustments to institution
reserve or clearing balances or by billing institutions
directly. Float recovered through direct charges and peritem fees is valued at the federal funds rate; credit float
recovered through per-item fees has been subtracted from
the cost base subject to recovery in 2001. The 2001 float
levels were unusually high because of the effect of September 11 events.
(7) OTHER INCOME AND EXPENSES

Consists of investment income on clearing balances and
the cost of earnings credits. Investment income on clearing balances represents the average coupon-equivalent
yield on three-month Treasury bills applied to the total
clearing balance maintained, adjusted for the effect of
reserve requirements on clearing balances. Expenses for
earnings credits granted to depository institutions on their
clearing balances are derived by applying the average
federal funds rate to the required portion of the clearing
balances, adjusted for the net effect of reserve requirements on clearing balances.
(8) INCOME TAXES

Imputed income taxes are calculated at the effective tax
rate derived from the PSAF model (see note 3).
(9) RETURN ON EQUITY

The after-tax rate of return on equity that the Federal
Reserve would have earned had it been a private business
firm, as derived from the PSAF model (see note 3).

191

The Board of Governors and the
Government Performance and Results Act
Under the Government Performance and
Results Act of 1993 (GPRA), federal
agencies are required, in consultation
with the Congress and outside stakeholders, to prepare a strategic plan covering a multiyear period and to submit
annual performance plans and performance reports. Although it is not covered by the act, the Board of Governors
has chosen to voluntarily comply with
the act.

Strategic and Performance Plans
The Board's most recent strategic plan
in the GPRA format, released in December 2001, covers the period 2001-05.
Like the earlier plan, which covered
1997-2002, the most recent document
states the Board's mission, articulates
major goals for the period, outlines strategies for achieving those goals, and discusses the environment and other factors that could affect their achievement.
It also addresses issues that cut across
agency jurisdictional lines, identifies
key quantitative measures of performance, and discusses the evaluation of
performance.
The Board's most recent performance
plan covers its 1998-99 budget.1 The
plan sets forth specific targets for some
1. The Board's budget covers two calendar
years (making it slightly incongruent with the
act's requirement that a performance plan be submitted for each fiscal year). Neither a performance
plan for 2000-01 nor a performance report for
1998-99 was prepared, as staff attention was
diverted to matters associated with the century
date change and the Gramm-Leach-Bliley Act. A
performance plan for 2002-03 will be issued in
the second quarter of 2002.



of the performance measures identified
in the strategic plan (except those associated with the monetary policy function). It also describes the operational
processes and resources needed to meet
those targets and discusses validation
and verification of results.
The strategic and performance plans
are available on the Board's public
web site (http://www.federalreserve.gov/
boarddocs/rptcongress). The Board's
mission statement and a summary of
the goals and objectives set forth in
the strategic and performance plans are
given below.

Mission
The mission of the Board is to foster the
stability, integrity, and efficiency of the
nation's monetary, financial, and payment systems so as to promote optimal
macroeconomic performance.

Goals and Objectives
The Federal Reserve has three primary
goals with interrelated and mutually
reinforcing elements:
Goal
To conduct monetary policy that promotes the achievement of maximum
sustainable long-term growth; price stability fosters that goal.
Objectives
• Stay abreast of recent developments
and prospects in the U.S. economy

192 88th Annual Report, 2001

•

•

•

•

and financial markets and in those
abroad, so that monetary policy decisions will be well informed
Enhance our knowledge of the structural and behavioral relationships
in the macroeconomic and financial
markets and improve the quality of
the data used to gauge economic
performance, through developmental
research activities
Implement monetary policy effectively in rapidly changing economic
circumstances and in an evolving
financial market structure
Contribute to the development of U.S.
international policies and procedures,
in cooperation with the Department of
the Treasury and other agencies
Promote understanding of Federal
Reserve policy among other government policy officials and the general
public.

Goal
To promote a safe, sound, competitive,
and accessible banking system and
stable financial markets.
Objectives
• Provide comprehensive and effective
supervision of U.S. banks, bank and
financial holding companies, U.S.
operations of foreign banking organizations, and related entities
• Promote overall financial stability,
manage and contain systemic risk, and
ensure that emerging financial crises
are identified early and successfully
resolved
• Improve efficiency and effectiveness
and reduce burden on supervised
institutions
• Promote equal access to banking
services
• Administer and ensure compliance
with consumer protection statutes



relating to consumer financial transactions (Truth in Lending, Truth in
Savings, Consumer Leasing, and
Electronic Funds Transfer) to carry
out congressional intent, striking the
proper balance between protection of
consumers and burden to the industry.
Goal
To provide high-quality professional
oversight of Reserve Bank operations
and to foster the integrity, efficiency,
and accessibility of U.S. payment and
settlement systems.
Objectives
• Develop sound, effective policies and
regulations that foster payment system
integrity, efficiency, and accessibility
• Produce high-quality assessments of
Federal Reserve Bank operations,
projects, and initiatives that assist
Federal Reserve management in fostering and strengthening sound internal control systems and efficient and
effective performance
• Conduct research and analysis that
contributes to policy development
and/or increases the Board's and others' understanding of payment system
dynamics and risk.

Interagency Coordination
Interagency coordination helps focus
efforts to eliminate redundancy and
lower costs. As required by the Government Performance and Results Act and
in conformance with past practice, the
Board has worked closely with other
federal agencies to consider plans and
strategies for programs, such as bank
supervision, that cross jurisdictional
lines. In particular, coordination with the
Department of the Treasury and other
agencies is evident throughout both the

The Board of Governors and the Government Performance and Results Act

strategic and performance plans. Much
of the Board's formal effort to plan
jointly has been made through the Federal Financial Institutions Examination
Council (FFIEC), a group made up of
the five federal agencies that regulate
depository institutions.2 In addition, a
coordinating committee of representatives of the chief financial officers of
2. The FFIEC consists of the Board of Governors of the Federal Reserve System, the Federal
Deposit Insurance Corporation, the National
Credit Union Administration, the Office of the
Comptroller of the Currency, and the Office of
Thrift Supervision. It was established in 1979 pursuant to title X of the Financial Institutions Regulatory and Interest Rate Control Act of 1978. The
FFIEC is a formal interagency body empowered to
prescribe uniform principles, standards, and report




193

the five agencies has been created to
address and report on strategic planning
issues of mutual concern. This working
group has been meeting since June
1997. These and similar planning efforts
can significantly lower the government's costs for data processing and
other activities as well as depository
institutions' costs for complying with
federal regulations.
•
forms for the federal examination of financial
institutions and to make recommendations to promote uniformity in the supervision of financial
institutions. The FFIEC also provides uniform
examiner training and has taken a lead in developing standardized software needed for major data
collection programs to support the requirements of
the Home Mortgage Disclosure Act and the Community Reinvestment Act.

195

Federal Legislative Developments
One federal law was enacted during
2001 that significantly affects the Federal Reserve System and the institutions
it supervises. In addition, legislation was
proposed by the Board of Governors
that would, if enacted, facilitate check
truncation and enhance the efficiency
of the nation's payments system as a
whole.

USA PATRIOT Act
The Uniting and Strengthening America by Providing Appropriate Tools
Required to Intercept and Obstruct Terrorism Act of 2001 (USA PATRIOT
Act), Public Law 107-56, enacted on
October 26, 2001, adds to and amends
existing laws, including laws pertaining
to financial institutions, to enhance
domestic security following the September 11, 2001, attacks. Title III of the act
amends various federal banking laws
and other laws related to financial institutions or products, principally the Bank
Secrecy Act but also the Bank Holding
Company Act of 1956, the Fair Credit
Reporting Act, and the Right to Financial Privacy Act. In addition, the USA
PATRIOT Act amends the Federal
Reserve Act to authorize certain System
personnel to act as law enforcement officers and carry firearms to protect and
safeguard System premises and staff.
Title III of the act directs certain
government agencies, principally the
Department of the Treasury in consultation with the Board of Governors of the
Federal Reserve System, to take steps to
investigate and curtail money laundering and other activities that might be
undertaken to finance terrorist actions
or disrupt legitimate banking opera-




tions. The following discussion summarizes title III and describes the portions
that bear significantly on the Federal
Reserve System and the institutions it
supervises.
Title III requires a broad range of
financial institutions in the United States
to establish anti-money-laundering programs, including policies, procedures,
controls, and audit functions.1 Covered
financial institutions must establish controls that are reasonably designed to
detect instances of money laundering
through certain correspondent or private banking accounts. In addition, these
institutions generally may not establish
or administer correspondent accounts
in the United States for, or on behalf of,
a foreign shell bank.
Title III also directs the Secretary of
the Treasury (Secretary), in consultation
with the Board of Governors and the
Securities and Exchange Commission
(SEC), to issue regulations that generally would require securities brokers and
dealers to submit suspicious activity
reports regarding suspected moneylaundering transactions. The Secretary
and the federal financial regulators must
also issue joint regulations for financial
institutions regarding the verification
of customer identification upon account
opening.
Under title III, the Secretary, in
consultation with certain other government officials, including the Chairman
of the Board of Governors, may impose
1. Financial institutions supervised by the
Board and other federal financial regulators are
subject to existing regulations that direct the
institutions to implement anti-money-laundering
programs.

196 88th Annual Report, 2001
special measures to address moneylaundering problems associated with
specific foreign jurisdictions, foreign
financial institutions, and transactions
involving such jurisdictions or institutions. Title III also amends the Bank
Holding Company Act and the Bank
Merger Act to reflect the Board's practice of considering the effectiveness of
an institution's anti-money-laundering
activities when evaluating certain applications under these acts.
Title III directs the Secretary, in consultation with certain agencies and parties, including the Chairman, to evaluate
certain provisions of the USA PATRIOT
Act and to report to the Congress on the
findings. The report must include recommendations for any additional legislative action. Moreover, the Secretary,
the SEC, and the Board must submit
joint recommendations to the Congress
on regulations that would apply certain
provisions of the Bank Secrecy Act to
registered and unregistered investment
companies and on whether personal
holding companies should be required
to disclose their beneficial owners when




conducting certain actions at domestic
financial institutions.

Proposed Check Truncation Act
In December, the Board proposed that
Congress adopt legislation to facilitate
check truncation.2 The proposed legislation, titled the Check Truncation Act, is
designed to foster payment system innovation and enhance payment system efficiency by reducing some of the legal
impediments to check truncation that
exist under current law. If enacted, the
proposed legislation would enable banks
to expand the use of electronics in the
collection and return of checks, reducing the industry's reliance on transportation to move checks across the nation.
Details are available on the Board's web
site at http://www.federalreserve.gov/
paymentsys.htm.
•
2. Check truncation refers to any of a number
of arrangements in which the original paper checks
are removed from the collection or return process
before reaching either paying or depositary banks,
respectively, or reaching their customers.

Records




199

Record of Policy Actions
of the Board of Governors
Regulation B
Equal Credit Opportunity
Regulation E
Electronic Fund Transfers
Regulation M
Consumer Leasing
Regulation Z
Truth in Lending
Regulation DD
Truth in Savings
March 19, 2001—Interim Rules
The Board approved interim rules to
provide uniform standards for the electronic delivery of disclosures required
under Regulations B, E, M, Z, and DD,
effective March 30, 2001, with mandatory compliance by a date to be designated in the final rules.1
Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, Meyer, and Gramlich.
Several federal statutes and the implementing regulations administered by the
Board require that written disclosures be
provided in connection with certain con-

NOTE. In voting records throughout this chapter, Board members, except Chairman Greenspan
and Vice Chairman Ferguson, are listed in order of
seniority.
1. The interim rules originally required mandatory compliance by October 1, 2001. Because it is
considering adjustments to the rules to provide
additional flexibility, on August 1, 2001, the Board
lifted the mandatory compliance date for the
interim rules.



sumer financial services transactions.
Under the Electronic Signatures in
Global and National Commerce Act
(E-Sign Act), electronic documents and
signatures have the same validity as
paper documents and handwritten signatures. In this light, the Board approved
interim amendments to Regulations B,
E, M, Z, and DD to accommodate electronic disclosures if the consumer has
affirmatively consented in accordance
with the E-Sign Act. The amendments
also provide guidance on complying
with the regulations' timing and delivery requirements when electronic disclosures are used, to ensure that consumers
have an adequate opportunity to access
and retain the information. In addition,
the Board requested public comment on
the interim rules.
Regulation D
Reserve Requirements of
Depository Institutions
October 9, 2001—Amendments
The Board amended Regulation D to
decrease the amount of net transaction
accounts at depository institutions to
which a lower reserve requirement
applies (low reserve tranche) and to
increase the amount of reservable liabilities exempt from reserve requirements
(reserve exemption level) for 2002,
effective for the reserve computation
period beginning November 27, 2001,
for institutions reporting weekly.
Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, Meyer, and Gramlich.

200 88th Annual Report, 2001
Under the Monetary Control Act of
1980, depository institutions, Edge corporations, agreement corporations, and
U.S. agencies and branches of foreign
banks are subject to reserve requirements set by the Board. The act directs
the Board to adjust annually the amount
of the low reserve tranche to reflect
changes in net transaction accounts at
depository institutions. Recent declines
in net transaction accounts warranted a
decrease in the low reserve tranche
from $42.8 million to $41.3 million,
and the Board amended Regulation D
accordingly.
The Garn-St Germain Depository
Institutions Act of 1982 establishes a
zero percent reserve requirement on the
first $2 million of an institution's reservable liabilities. The act also provides for
annual adjustments to that exemption
amount based on increases in reservable
liabilities at depository institutions.
Recent growth in reservable liabilities
warranted an increase in the amount
exempted from reserve requirements
from $5.5 million to $5.7 million,
and the Board amended Regulation D
accordingly.
For institutions reporting weekly, the
amendments are effective with the
reserve computation period beginning
November 27, 2001, and the corresponding reserve maintenance period
beginning December 27, 2001. For institutions reporting quarterly, the amendments are effective with the reserve
computation period beginning December 18, 2001, and the corresponding
reserve maintenance period beginning
January 17, 2002.
To reduce the reporting burden on
small institutions, depository institutions
having total deposits below specified
levels are required to report their deposits and reservable liabilities quarterly or
less frequently, while larger institutions



must report weekly.2 To reflect increases
in the rate of growth of total deposits at
all depository institutions, the Board
increased the deposit cutoff levels used
in determining the frequency and detail
of reporting from $101 million to
$106.9 million for nonexempt depository institutions, beginning in September 2002.
Exempt institutions (those with total
reservable liabilities not exceeding the
reserve exemption level of $5.7 million) that have at least $5.7 million in
total deposits may report annually, and
exempt institutions that have less than
$5.7 million in total deposits are not
required to file deposit reports.
Regulation E
Electronic Fund Transfers
February 27, 2001—Amendments
The Board amended Regulation E to
require disclosure of certain fees associated with automated teller machine
(ATM) transactions, effective March 9,
2001, with mandatory compliance by
October 1, 2001.
Votes for this action: Messrs. Greenspan,
Ferguson, Meyer, and Gramlich. Absent
and not voting: Mr. Kelley.

The Electronic Fund Transfer Act,
which is implemented by Regulation E,
was amended by the Gramm-Leach2. All U.S. branches and agencies of foreign
banks and Edge and agreement corporations are
required to submit the Report of Transaction
Accounts, Other Deposits, and Vault Cash
(FR 2900) weekly regardless of size. In addition,
depository institutions that obtain funds from nonU.S. sources or that have foreign branches or international banking facilities continue to be required
to file the Report of Certain Eurocurrency Transactions (FR 2950/FR 2951) at the same frequency
as they file the FR 2900 report.

Board Policy Actions
Bliley Act to add certain requirements
for ATM transactions. The amendments
to Regulation E implement these provisions by requiring ATM operators that
impose a fee to post a notice to that
effect on or at the ATM and to disclose
the amount of the fee either on the
screen or on a paper notice before the
customer is committed to completing
the transaction. Financial institutions are
also required to include in their initial
disclosures to a customer contracting for
electronic fund transfer services a notice
that a fee may be imposed by an ATM
operator not holding the customer's
account or by any national, regional,
or local network used to complete the
transaction.

Regulation H
Membership of
State Banking Institutions
in the Federal Reserve System
January 17, 2001—Amendments
The Board approved a final rule that
provides an alternative to the debt-rating
requirement for certain large state member banks that propose to own a financial subsidiary, effective March 5, 2001.
Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, and Gramlich. Absent
and not voting: Mr. Meyer.
The Board and the Department of
the Treasury jointly approved a final
rule that establishes an alternative to
the debt-rating requirement that certain
large banks may meet when they seek
to acquire a financial subsidiary and
thereby engage in expanded financial
activities. The final rule is substantially
similar to the interim rule adopted in
March 2000.
Under the Gramm-Leach-Bliley Act,
a national or state member bank that



201

is among the 100 largest insured banks
may control or hold an interest in a
financial subsidiary if the bank has at
least one issue of outstanding eligible
debt that is rated in one of the three
highest rating categories by a nationally
recognized statistical rating organization. Banks among the second 50 largest
insured banks may also qualify under an
alternative standard that the Board and
the Secretary of the Treasury determine
by regulation to be comparable and consistent with the debt-rating requirement.
The final rule, which for state member banks is incorporated in Regulation H, provides that a bank qualifies
under the alternative standard if it has a
current long-term issuer credit rating
from a nationally recognized statistical
rating organization that is within the
organization's three highest investmentgrade rating categories. A long-term
credit rating is defined as a written
opinion that assesses the bank's overall capacity and willingness to pay in a
timely manner its unsecured, dollardenominated financial obligations that
mature in not less than one year.

March 7, 2001—Delay of
Effective Date
The Board extended, from April 1 to
October 1, 2001, the effective date for a
new rule that provides consumer protections in connection with insurance sales
by state member banks.
Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, Meyer, and Gramlich.
The Board, jointly with the Federal
Deposit Insurance Corporation, the
Office of the Comptroller of the Currency, and the Office of Thrift Supervision, approved a six-month extension
of the effective date of a new inter-

202 88th Annual Report, 2001
agency final rule on the sale of insurance by depository institutions that had
been published on December 4, 2000.
The new joint rule implements the consumer protection provisions of the
Gramm-Leach-Bliley Act applicable to
the retail sale, solicitation, advertising,
or offer of an insurance product or annuity by a depository institution or by a
person engaged in such activities at an
office of or on behalf of a depository
institution. The agencies provided the
extension to give institutions sufficient
time to ensure implementation of the
new protections.

August 8, 2001—Amendments
The Board approved a final rule amending Regulation H to permit qualifying state member banks to engage in
expanded financial activities through
financial subsidiaries, effective September 17, 2001.
Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, Meyer, and Gramlich.
The Board approved a final rule
implementing the provisions of the
Gramm-Leach-Bliley Act that authorize qualifying state member banks to
control or hold an interest in a financial
subsidiary, which may engage in certain
activities that are financial in nature,
or incidental thereto, but that the parent
bank may not conduct directly. The
final rule is substantially similar to the
interim rule approved by the Board in
March 2000 and to the rule adopted by
the Office of the Comptroller of the
Currency for financial subsidiaries of
national banks.
The final rule provides a streamlined
prior-notice procedure for acquiring an
interest in a financial subsidiary; incorporates the capital, managerial, Community Reinvestment Act (CRA), and other



qualifying criteria for a state member
bank to own a financial subsidiary; and
describes the procedures and restrictions
that would apply if a state member bank
or an affiliate ceased to meet these criteria. It also provides guidance on how
the act's capital deduction and CRA
requirements apply to a state member
bank having a financial subsidiary.

Regulation H
Membership of
State Banking Institutions
in the Federal Reserve System
Regulation Y
Bank Holding Companies and
Change in Bank Control
October 15, 2001—Amendments
The Board approved amendments to
Regulations H and Y to revise the regulatory capital treatment of securitization transactions by state member banks
and bank holding companies, including
financial holding companies, effective
January 1, 2002.
Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, Meyer, and Gramlich.
The Board, jointly with the Federal
Deposit Insurance Corporation, the
Office of the Comptroller of the Currency, and the Office of Thrift Supervision, amended the regulatory capital
standards to address the treatment of
recourse obligations, residual interests,
and direct credit substitutes related to
securitization transactions that expose
banking and thrift institutions to credit
risk. The amended standards better
reflect the institutions' relative exposure
to credit risks and provide a more consistent regulatory capital treatment for
certain transactions that involve similar risk. They also increase consistency

Board Policy Actions
among the supervisory agencies in the
area of regulatory capital requirements.
For transactions entered into before the
effective date, institutions may either
adopt any portion of the final rule that
would reduce their capital requirements
or defer adoption until December 31,
2002, if complying with the rule would
increase their capital requirements.

December 10, 2001—Amendments
The Board amended the capital guidelines in Regulations H and Y to establish minimum capital requirements for
equity investments in nonfinancial companies by state member banks and bank
holding companies, including financial
holding companies, effective April 1,
2002.
Votes for this action: Messrs. Greenspan,
Ferguson, Meyer, and Gramlich, Ms. Bies,
and Mr. Olson. Absent and not voting:
Mr. Kelley.
The Board, jointly with the Federal
Deposit Insurance Corporation and the
Office of the Comptroller of the Currency, adopted special minimum capital requirements for equity investments
in nonfinancial companies by banks
and bank holding companies, including
financial holding companies. The final
rule imposes a series of marginal capital
charges on covered equity investments
that increase with the level of the banking organization's overall exposure to
nonfinancial equity investments relative to its tier 1 capital. The new capital
requirements apply symmetrically to
equity investments made by banks and
bank holding companies in nonfinancial
companies. The new charges apply to
equity investments held under the merchant banking authority of the GrammLeach-Bliley Act, the authority to
acquire up to 5 percent of the voting
shares of any company under sec


203

tion 4(c)(6) or 4(c)(7) of the Bank Holding Company Act, the portfolio investment authority under Regulation K
(International Banking Operations), the
authority to make investments in small
business investment companies (SBICs)
under the Small Business Investment
Act, and the authority to make investments under section 24 of the Federal
Deposit Insurance Act (other than
section 24(f)). The rule exempts from
the new capital charges any individual
investment made by a bank or bank
holding company before March 13,
2000. In addition, the new charges do
not apply to investments made in or
through SBICs to the extent that such
investments, in the aggregate, represent
15 percent or less of the banking organization's tier 1 capital.

Regulation K
International Banking Operations
Rules Regarding
Delegation of Authority
October 10, 2001—Amendments
The Board approved amendments to
Regulation K to eliminate unnecessary
regulatory burden, increase transparency, and streamline the approval process for U.S. banking organizations
seeking to expand their operations
abroad and for foreign banks seeking to
expand their U.S. operations, effective
November 26, 2001.
Votes for this action: Messrs. Greenspan,
Ferguson, Meyer, and Gramlich. Absent
and not voting: Mr. Kelley.
Consistent with the Riegle Community Development and Regulatory
Improvement Act, the Federal Reserve
Act, and the International Banking Act,
the Board approved amendments in connection with its review of Regulation K.

204 88th Annual Report, 2001
The amended provisions regulate the
foreign investments and activities of
all member banks, Edge and agreement
corporations, and bank holding companies (subpart A); U.S. activities of foreign banking organizations (subpart B);
and export trading companies (subpart C). The Board also requested public comment on proposed amendments
to provisions on international lending
supervision (subpart D).
The amendments provide streamlined
foreign branching procedures for U.S.
banking organizations, authorize expanded activities by foreign branches
of U.S. banks, and implement recent
statutory amendments that permit member banks to invest up to 20 percent of
their capital and surplus in Edge corporations. Regulation K's provisions governing permissible foreign activities
of U.S. banking organizations, including
securities activities, and investments by
U.S. banking organizations under the
general consent procedures also were
amended. Other revisions streamline
the applications procedures for foreign
banks seeking to expand operations in
the U.S., modify provisions concerning
the qualification of foreign banking organizations for exemption from the nonbanking prohibitions in section 4 of the
Bank Holding Company Act, and implement provisions of the Riegle-Neal
Interstate Banking and Branching Efficiency Act that affect foreign banks.
The Board also delegated authority to
Board staff and the Reserve Banks to
approve certain transactions.
Regulation Y
Bank Holding Companies and
Change in Bank Control
January 10, 2001—Amendments
The Board approved a final rule on the
merchant banking activities of financial



holding companies, effective February 15, 2001, replacing the Board's
interim rule on this subject, which had
become effective on March 17, 2000.
Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, Meyer, and Gramlich.
The Board and the Department of the
Treasury jointly approved a final rule
incorporated in Regulation Y to implement the merchant banking provisions
of the Gramm-Leach-Bliley Act. Like
the interim rule it replaces, the final rule
defines the scope of permissible merchant banking activities and implements
the limitations in the act on the potential mixing of banking and commerce.
The rule contains provisions designed
to protect the safety and soundness of
depository institutions. It also contains
streamlined recordkeeping and reporting
provisions to assist in monitoring compliance with, and to prevent evasions
of, the Bank Holding Company and
Gramm-Leach-Bliley Acts.
The final rule differs from the interim
rule in several key respects. It modifies
the interim rule's provisions defining
prohibited routine management and
operation of portfolio companies and
provides three situations in which financial holding companies will not be presumed to control portfolio companies
for purposes of applying sections 23A
and 23B of the Federal Reserve Act.
In addition, the final rule broadens the
definition of "private equity funds,"
clarifies the rule's application to such
funds, and expands the types of financial holding companies that may engage
in merchant banking activities. The
final rule also adopts a sunset provision
for the aggregate investment thresholds
included in the interim rule and eliminates immediately the dollar-based
investment threshold for the review of a
financial holding company's merchant
banking activities.

Board Policy Actions

Regulation Z
Truth in Lending
December 12, 2001—Amendments
The Board amended Regulation Z to
expand the applicability of the Home
Ownership and Equity Protection Act,
effective December 20, 2001, with
mandatory compliance by October 1,
2002.

205

regard to their ability to repay the loan
and revise the consumer disclosures
that must be provided before a loan
closing.

Miscellaneous Interpretations

Applicability of Sections 23A and
23B of the Federal Reserve Act
to Derivative Transactions with
Votes for this action: Messrs. Greenspan, Affiliates and Intraday
Ferguson, Meyer, and Gramlich, Ms. Bies,
and Mr. Olson. Absent and not voting: Extensions of Credit to Affiliates

Mr. Kelley.
The Home Ownership and Equity
Protection Act amended the Truth in
Lending Act to address potentially abusive practices in connection with closedend home-equity loans that are not
home-purchase loans. It imposes substantive limitations, such as restrictions
on short-term balloon notes and prepayment penalties, and additional disclosure requirements on these types of
loans if annual percentage rates or fees
exceed specified threshold amounts. The
Board is authorized to expand the act's
applicability and to prohibit certain
practices.
The Board approved amendments that
make more home-equity loan transactions subject to the act by lowering the
rate-based threshold for first-lien loans
and by including certain charges for
optional credit insurance and creditprotection plans in the calculation of
the fee-based threshold. The amendments also restrict certain acts and practices, such as refinancing a covered loan
within one year unless the refinancing
is in the borrower's interest and wrongfully documenting a covered loan as an
open-end credit transaction to evade
the act. In addition, the amendments
strengthen the act's prohibition on loans
based on homeowners' equity without



May 2, 2001- -Interim
Amendments
The Board adopted interim rules on the
applicability of sections 23 A and 23B of
the Federal Reserve Act to derivative
transactions and intraday extensions
of credit involving insured depository
institutions and their affiliates, effective
January 1, 2002.
Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, Meyer, and Gramlich.
The interim amendments implement
provisions of the Gramm-Leach-Bliley
Act that require the Board to adopt rules
under section 23A to address credit
exposure arising out of derivative transactions between insured depository
institutions and their affiliates and intraday extensions of credit by insured
depository institutions to their affiliates. The interim rules require insured
depository institutions to adopt policies
and procedures reasonably designed
to monitor, manage, and control credit
exposures in derivative transactions with
their affiliates and in intraday extensions of credit to their affiliates. In addition, they clarify that these transactions
are subject to section 23B. The Board
also requested public comment on the
interim rules.

206 88th Annual Report, 2001

Applicability of Section 23 A of
the Federal Reserve Act to the
Purchase of Securities from
Certain Affiliates
Applicability of Section 23A of
the Federal Reserve Act to Loans
and Extensions of Credit Made
by a Member Bank
to a Third Party
May 2, 2001—Amendments
The Board adopted rules regarding the
applicability of section 23A of the
Federal Reserve Act to certain transactions involving securities affiliates of
insured depository institutions, effective
June 11, 2001.
Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, Meyer, and Gramlich.
Section 23A restricts the ability of a
member bank to fund its affiliates
through investments, loans, asset acquisitions, or certain other transactions,
including transactions that involve a
member bank and a nonaffiliated party
to the extent that the proceeds from the
transaction are used for the benefit of
or are transferred to an affiliate of the
bank. The amendments provide that
certain transactions involving securities affiliates of insured depository
institutions are not covered under section 23A.
The Board adopted an interpretation
that expands the types of asset purchases eligible for exemption under the
provision in section 23A that exempts
the purchase from an affiliate of an asset
that has a readily identifiable and publicly available market quotation. The
interpretation increases the ability of
insured depository institutions to purchase securities from their registered
broker-dealer affiliates while ensuring
that the transactions are conducted in a



manner consistent with safe and sound
banking practices.
The Board also adopted an interpretation and provided exemptions applicable to certain loans made by insured
depository institutions to customers who
use the loan proceeds to purchase a
security or other asset through an affiliate of the depository institution. The
interpretation confirms that section 23A
does not apply to such loan and purchase transactions as long as the affiliate
is acting exclusively as a broker in the
transaction and the affiliate retains no
portion of the loan proceeds. The Board
also exempted from section 23A any
portion of the loan that an affiliate
retains as a market-rate brokerage commission or agency fee. In addition, the
Board provided exemptions for transactions in which loan proceeds are used
by a customer to purchase a third party's
security through a broker-dealer affiliate of the institution that makes the
loan if the affiliate is acting as a riskless
principal in the securities transaction.
Finally, the Board provided an exemption for extensions of credit used by
customers to purchase securities from a
broker-dealer affiliate of the institution
extending the credit under a preexisting
credit line not entered into in contemplation of the securities purchase.

Rules Regarding
Equal Opportunity
January 2, 2001—Interim
Amendments
The Board approved interim amendments to its Rules Regarding Equal
Opportunity, effective January 25, 2001.
Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, Meyer, and Gramlich.
The Board's Rules Regarding Equal
Opportunity require a workplace that is

Board Policy Actions
free of discrimination based on race,
color, religion, sex, national origin,
age, physical or mental disability, or
retaliation and provide a procedure for
processing discrimination complaints.
The rules, which were adopted under
the Federal Reserve Act, are substantially similar to the Equal Employment Opportunity Commission's regulations for federal sector employment.
In November 1999, the Commission
amended its regulations, and the Board's
interim amendments implement the
changes that are applicable to Board
employment. In addition, the interim
amendments revise provisions in the
rules that prohibit discrimination on
the basis of disability and address the
employment of noncitizens, which are
not covered by the Commission's regulations. The Board also requested public
comment on the interim amendments.

Policy Statements and
Other Actions

207

ticipant") designates another depository
institution or other service provider to
initiate, receive, or otherwise process
Fedwire funds transfers or book-entry
securities transfers that are posted to the
participant's account at the Federal
Reserve. The Federal Reserve's experience with the Fedwire third-party access
policy indicates that, properly managed,
such arrangements pose little additional
risk to the Federal Reserve. Supervisory
guidance on outsourcing, issued by the
Board and the other federal banking
regulators in 2000, addresses domestic and foreign arrangements and sets
forth basic supervisory expectations
for outsourcing of Fedwire and other
information- and transaction-processing
activities conducted by banking organizations. Fedwire outsourcing arrangements will continue to be reviewed as
appropriate during the normal supervisory process. In this light, the Board
concluded that the administrative burden on participants of complying with a
separate third-party access policy warranted its rescission.

April 4, 2001—Policy Statement
on Payments System Risk
The Board rescinded the third-party
access policy for Fedwire transactions
in connection with its review of the Federal Reserve's Policy Statement on Payments System Risk, effective April 9,
2001.
Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, Meyer, and Gramlich.
In 1987, the Board, as part of its
policy to reduce payments system
risk, approved a set of conditions
under which Fedwire third-party access
arrangements could be established. The
Board allowed institutions meeting
the conditions to establish third-party
access arrangements under which a
sending or receiving institution ("par


May 29, 2001—Policy Statement
on Payments System Risk
The Board rescinded its interaffiliate
transfer policy, effective January 1,
2002.
Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, Meyer, and Gramlich.
In 1987, the Board modified its Policy Statement on Payments System Risk
to include a policy on interaffiliate transfers that addressed potential risks arising from credit decisions among affiliates that are not at arm's length. The
Board has rescinded the interaffiliate transfer policy because the risks
addressed by the policy are appropriately addressed through the existing

208 88th Annual Report, 2001
supervisory process and the Reserve
Banks' credit-risk-management controls.
May 29, 2001—Policy Statement
on Payments System Risk
The Board approved an interim policy
statement that gives depository institutions access to intraday credit from
the Federal Reserve Banks above their
self-assessed net debit caps, effective
May 30, 2001.
Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, Meyer, and Gramlich.
Controlling depository institutions'
use of intraday Federal Reserve credit,
commonly known as daylight overdrafts, is an integral part of the Board's
Policy Statement on Payments System
Risk. The interim policy statement promotes risk-reduction efforts while minimizing disruptions to the payments system. It allows depository institutions
having self-assessed net debit caps,
which are maximum limits on their daylight overdrafts, to pledge collateral for
additional daylight overdraft capacity
above their net debit caps, subject to
Reserve Bank approval. The interim
policy statement reflects the Board's
ongoing efforts to ensure that the payments system functions effectively and
efficiently. The Board also requested
public comment on the interim policy
statement.

December 7, 2001—Policy
Statement on Payments
System Risk
The Board approved revisions to its
Policy Statement on Payments System
Risk, effective December 10, 2001,
except as noted below.
Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, Meyer, and Gramlich.



The Board adopted, with minor modifications, the interim policy statement
on depository institutions' use of Federal Reserve intraday credit, or daylight overdrafts, that was approved on
May 29, 2001, and is discussed above.
In addition, the Board approved modifications to the criteria for determining
foreign banking organizations' U.S.
capital equivalency measure for purposes of calculating their net debit caps,
effective February 21, 2002. The Board
also approved modifications to the posting time for electronic check presentments to a depository institution's
Federal Reserve account for purposes
of measuring daylight overdrafts; the
modifications, made in order to remove
a potential impediment to the use of
electronic check presentment, became
effective April 1, 2002. Finally, the
Board decided to retain the $50 million
limit on the value of book-entry securities transfers.

Discount Rates in 2001
During 2001, the Board of Governors
approved twelve reductions, totaling
43/4 percentage points, in the basic
discount rate charged by the Federal
Reserve Banks. These actions lowered
the basic rate from 6 percent at the start
of the year to 11A percent in December. There were no rate increases during 2001. The rates for seasonal and
extended credit, which are recalculated
biweekly in keeping with market-related
formulas, exceeded the basic rate by
varying amounts during the year.
Basic Discount Rate
The Board's decisions on the basic discount rate were made against the background of the policy actions of the Federal Open Market Committee (FOMC)
and related economic and financial

Board Policy Actions

209

of continuing indications of a softening
economy characterized by further weakness in capital spending, inventory
liquidation, and deteriorating export
markets. However, household spending
was being well maintained, and Federal
Reductions in the Basic Rate
Reserve officials took account of the
during 2001
considerable easing of monetary policy
From January 3 to December 11, 2001, undertaken in recent months, whose
the Board approved twelve reductions in effect had not yet been fully felt, and of
the basic rate in conjunction with simi- Congressional approval of tax cuts that
lar decreases in the target for the federal would help to support the economy in
funds rate set at meetings of the FOMC. coming quarters. Even so, the risks were
As the year began, information relating seen as still tilted toward further econotably to sales and production sug- nomic weakness that called for some
gested that the expansion had begun added easing in monetary policy.
to weaken considerably in late 2000.
Despite cumulative reductions of
Against that background and given indi- 3 percentage points in the basic discations that inflation pressures remained count rate and the federal funds rate
contained, the FOMC lowered the target by August, the economy appeared to
federal funds rate by 50 basis points and remain vulnerable to further deteriorathe Board decided that an equal reduc- tion, with more-widespread indications
tion in the basic discount rate was also of weakness and mounting job losses.
appropriate. Over the months that fol- Against this background, the terrorist
lowed, evidence of a marked slowdown attacks on September 11 posed a severe
in the growth of economic activity inten- threat to financial markets and the econsified. Businesses substantially reduced omy. The uncertainty created by the
their investment spending in response to attacks depressed equity prices, raised
weakening demand for their goods and risk premiums, and further restrained
services, an oversupply of some types economic activity. In these circumof capital, and declining profits. Many stances, the Federal Reserve acted
business firms also sought to reduce promptly to provide massive amounts of
what they viewed as excessive inven- liquidity on a temporary basis to facilitories, fostering a decline in manufac- tate the functioning of financial markets
turing output and an upturn in unem- and took several actions to reduce its
ployment. Concurrently, business and policy rates further. Three reductions
consumer confidence eroded, although of 50 basis points were made in the
household spending continued to grow, basic discount rate and the federal funds
albeit at a somewhat reduced pace. rate from mid-September through early
Against this background, the Board November. By the first part of Decemand the FOMC eased monetary policy ber, there were signs that the weakness
aggressively in a series of coordinated in aggregate demand might be abating,
50 basis point rate reductions over the though those indications were still quite
first five months of the year.
limited and tentative. Over the closing
In late June and again in August, months of the year, efforts to liquidate
lesser reductions of 25 basis points in inventories and reduce capital spending
the basic discount rate and the federal continued to induce production cutfunds rate were made in the context backs. However, after displaying some
developments. These
reviewed more fully
this Report, including
FOMC meetings held

developments are
in other parts of
the minutes of the
in 2001.




210 88th Annual Report, 2001
weakness immediately after the events
in September, household spending subsequently appeared to have returned to
a moderate growth trend. Low interest
rates and widespread price discounting, among other factors, were helping
to hold up expenditures on household
durables and residential construction
despite a high degree of consumer caution. Moreover, stock prices reversed
their post-attack losses and an upturn
in new orders for capital goods suggested that business confidence might
be returning. In this situation, while the
risks to the economy were still viewed
as tilted toward weakness, the Board
and the FOMC agreed that further
reductions in their policy rates should be
limited to 25 basis points. At year-end,
the key policy rates were at their lowest
nominal levels in four decades.

Structure of Discount Rates
The basic discount rate is the rate normally charged on loans to depository
institutions for short-term adjustment
credit, while flexible, market-related
rates generally apply to seasonal and
extended credit. The flexible rates are
calculated every two weeks in accordance with formulas that are approved
by the Board.
The objective of the seasonal credit
program is to help smaller institutions
meet liquidity needs arising from a clear
pattern of intra-yearly movements in
their deposits and loans. Funds may be
provided for longer periods than those
permitted under adjustment credit. Since
its introduction in early 1992, the flexible rate charged on seasonal credit
has been closely aligned with shortterm market rates; it is never less than
the basic rate applicable to adjustment
credit.
The purpose of extended credit is
to assist depository institutions that are



under sustained liquidity pressure and
are not able to obtain funds from other
sources. The rate for extended credit is
50 basis points higher than the rate for
seasonal credit and is at least 50 basis
points above the basic rate. In appropriate circumstances, the basic rate may be
applied to extended-credit loans for up
to thirty days, but any further borrowings would be charged the flexible,
market-related rate.
Exceptionally large adjustment-credit
loans that arise from computer breakdowns or other operating problems not
clearly beyond the reasonable control
of the borrowing institution are assessed
the highest rate applicable to any credit
extended to depository institutions. No
loans of this type were made during
2001.
At the end of 2001, the structure of
discount rates was as follows: a basic
rate of 1.25 percent for short-term
adjustment credit and rates of 1.80 percent for seasonal credit and 2.30 percent for extended credit. During 2001,
the rate for seasonal credit ranged from
a high of 6.45 percent to a low of
1.80 percent; that for extended credit
ranged from a high of 6.95 percent to a
low of 2.30 percent.
Board Votes
Under the Federal Reserve Act, the
boards of directors of the Federal
Reserve Banks must establish rates on
loans to depository institutions at least
every fourteen days and must submit
such rates to the Board of Governors for
review and determination. The Reserve
Banks are also required to submit on the
same schedule requests to renew the formulas based on short-term market interest rates for calculating the rates on
seasonal and extended credit. Votes on
the reestablishment of the formulas
for these flexible rates are not shown in

Board Policy Actions
this summary. All votes taken by the
Board of Governors during 2001 were
unanimous.
Votes on the Basic Discount Rate3
January 3, 2001. Effective this date, the
Board approved actions taken by the
directors of the Federal Reserve Banks
of New York, Cleveland, Atlanta, Kansas City, Dallas, and San Francisco to
reduce the basic discount rate by lA percentage point, to 53/4 percent. The same
decrease was approved for the Federal
Reserve Bank of St. Louis, effective
January 4, 2001. The Board also indicated that it stood ready to approve Federal Reserve Bank requests to lower the
basic rate further, to 5V2 percent.

211

directors of the Federal Reserve Banks
of New York, Philadelphia, Cleveland,
Atlanta, Chicago, Minneapolis, Dallas,
and San Francisco to reduce the basic
discount rate by Vi percentage point,
to 5 percent. The same decrease was
approved for the Federal Reserve Bank
of St. Louis, effective February 1, 2001.
Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, Meyer, and Gramlich.
Votes against this action: None.
The Board subsequently approved the
same reduction for the Federal Reserve
Banks of Boston and Richmond, effective January 31, 2001, and the Federal
Reserve Bank of Kansas City, effective
February 1, 2001.

Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, Meyer, and Gramlich.
Votes against this action: None.

March 20, 2001. Effective this date,
the Board approved actions taken by the
directors of the Federal Reserve Banks
January 4, 2001. Effective this date, of Boston, New York, Philadelphia,
the Board approved actions taken by the Cleveland, Richmond, Atlanta, Chicago,
directors of the Federal Reserve Banks Minneapolis, Kansas City, Dallas, and
of Boston, New York, Philadelphia, San Francisco to reduce the basic disCleveland, Richmond, Atlanta, Chicago, count rate by xh percentage point, to
Minneapolis, Kansas City, Dallas, and 4V2 percent. The same reduction was
San Francisco to lower the basic dis- approved for the Federal Reserve Bank
count rate by VA or Vi percentage point, of St. Louis, effective March 21, 2001.
to 5x/2 percent. The Board also approved
an action taken by the directors of the
Votes for this action: Messrs. Greenspan,
Federal Reserve Bank of St. Louis to
Ferguson, Kelley, Meyer, and Gramlich.
reduce the basic rate by lA percentage
Votes against this action: None.
point, to 5Vi percent, effective January 5, 2001.
April 18, 2001. Effective this date, the
Board approved actions taken by the
Votes for this action: Messrs. Greenspan, directors of the Federal Reserve Banks
Ferguson, Kelley, Meyer, and Gramlich.
of Boston, New York, Philadelphia,
Votes against this action: None.
Cleveland, Atlanta, Minneapolis, KanJanuary 31, 2001. Effective this date, sas City, Dallas, and San Francisco to
the Board approved actions taken by the reduce the basic discount rate by Vi percentage point, to 4 percent.
3. There were two vacancies on the Board of
Governors from the start of the year until December?, 2001.



Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, Meyer, and Gramlich.
Votes against this action: None.

212 88th Annual Report, 2001
The Board subsequently approved the
same actions taken by the directors of
the Federal Reserve Banks of Richmond
and Chicago, effective April 19, 2001,
and by the directors of the Federal
Reserve Bank of St. Louis, effective
April 20, 2001.
May 15, 2001. Effective this date, the
Board approved actions taken by the
directors of the Federal Reserve Banks
of New York, Richmond, Chicago, and
San Francisco to reduce the basic discount rate by Vi percentage point, to
3Vi percent. An identical decrease was
approved for the Federal Reserve Bank
of St. Louis, effective May 16, 2001.
Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, Meyer, and Gramlich.
Votes against this action: None.
The Board subsequently approved the
same actions taken by the directors of
the Federal Reserve Banks of Boston,
Atlanta, Kansas City, and Dallas, effective May 16, 2001, and by the directors
of the Federal Reserve Banks of Philadelphia, Cleveland, and Minneapolis,
effective May 17, 2001.
June 27, 2001. Effective this date, the
Board approved actions taken by the
directors of the Federal Reserve Banks
of Boston, New York, Philadelphia,
Atlanta, Chicago, Dallas, and San Francisco to reduce the basic discount rate
by lA percentage point, to ?>lA percent.
Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, Meyer, and Gramlich.
Votes against this action: None.
The Board subsequently approved
identical actions taken by the directors
of the Federal Reserve Banks of Cleveland, Richmond, Minneapolis, and Kansas City, effective June 28, 2001, and by
the directors of the Federal Reserve



Bank of St. Louis, effective June 29,
2001.
August 21, 2001. Effective this date,
the Board approved actions taken by
the directors of the Federal Reserve
Banks of Boston, New York, Philadelphia, Richmond, Chicago, Kansas City,
Dallas, and San Francisco to reduce the
basic discount rate by lA percentage
point, to 3 percent.
Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, Meyer, and Gramlich.
Votes against this action: None.
The Board subsequently approved the
same actions taken by the directors of
the Federal Reserve Bank of Minneapolis, effective August 22, 2001, and by
the directors of the Federal Reserve
Banks of Cleveland, Atlanta, and
St. Louis, effective August 23, 2001.
September 17, 2001. Effective this
date, the Board approved actions taken
by the directors of the Federal Reserve
Banks of Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta,
Chicago, Minneapolis, Kansas City,
Dallas, and San Francisco to reduce
the basic discount rate by Vi percentage point, to IVi percent. An identical
decrease was approved for the Federal
Reserve Bank of St. Louis, effective
September 18, 2001.
Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, Meyer, and Gramlich.
Votes against this action: None.
October 2, 2001. Effective this date,
the Board approved actions taken by the
directors of the Federal Reserve Banks
of Boston, New York, Cleveland, Richmond, Atlanta, Chicago, Kansas City,
Dallas, and San Francisco to reduce the
basic discount rate by Vi percentage
point, to 2 percent. A similar decrease

Board Policy Actions
was approved for the Federal Reserve
Bank of St. Louis, effective October 3,
2001.
Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, Meyer, and Gramlich.
Votes against this action: None.

213

apolis, effective November 7, 2001, and
by the directors of the Federal Reserve
Banks of Boston, Cleveland, Atlanta,
Kansas City, and Dallas, effective
November 8, 2001.

December 11, 2001. Effective this
date, the Board approved actions taken
by the directors of the Federal Reserve
Banks of Boston, New York, Philadelphia, Chicago, and San Francisco to
reduce the basic discount rate by lA percentage point, to \lA percent. An identical decrease was approved for the FedNovember 6, 2001. Effective this date,
the Board approved actions taken by the eral Reserve Bank of St. Louis, effective
directors of the Federal Reserve Banks December 12, 2001.
of New York, Richmond, and San FranVotes for this action: Messrs. Greenspan,
cisco to reduce the basic discount rate
Ferguson, Meyer, Gramlich, Ms. Bies,
by Vi percentage point, to IVz percent.
The Board subsequently approved the
same actions taken by the directors of
the Federal Reserve Banks of Minneapolis and Philadelphia, effective October 3 and 4, 2001, respectively.

Votes for this action: Messrs. Greenspan,
Ferguson, Kelley, Meyer, and Gramlich.
Votes against this action: None.

The Board subsequently approved
identical actions taken by the directors
of the Federal Reserve Banks of Philadelphia, Chicago, St. Louis, and Minne-




and Mr. Olson. Votes against this action:
None. Absent and not voting: Mr. Kelley.

The Board subsequently approved the
same actions taken by the directors of
the Federal Reserve Banks of Cleveland, Richmond, Atlanta, Minneapolis, Kansas City, and Dallas, effective
December 13, 2001.
.

215

Minutes of Federal Open Market
Committee Meetings
The policy actions of the Federal Open
Market Committee, contained in the
minutes of its meetings, are presented in
the ANNUAL REPORT of the Board of
Governors pursuant to the requirements
of section 10 of the Federal Reserve
Act. That section provides that the
Board shall keep a complete record of
the actions taken by the Board and by
the Federal Open Market Committee on
all questions of policy relating to open
market operations, that it shall record
therein the votes taken in connection
with the determination of open market
policies and the reasons underlying each
policy action, and that it shall include in
its annual report to the Congress a full
account of such actions.
The minutes of the meetings contain
the votes on the policy decisions made
at those meetings as well as a resume of
the information and discussions that led
to the decisions. The summary descriptions of economic and financial conditions are based on the information that
was available to the Committee at the
time of the meetings rather than on data
as they may have been revised later.
Members of the Committee voting for
a particular action may differ among
themselves as to the reasons for their
votes; in such cases, the range of their
views is noted in the minutes. When
members dissent from a decision, they
are identified in the minutes and a summary of the reasons for their dissent is
provided.
Policy directives of the Federal Open
Market Committee are issued to the
Federal Reserve Bank of New York as
the Bank selected by the Committee to



execute transactions for the System
Open Market Account. In the area of
domestic open market operations, the
Federal Reserve Bank of New York
operates under three sets of instructions
from the Federal Open Market Committee: an Authorization for Domestic
Open Market Operations, Guidelines for
the Conduct of System Open Market
Operations in Federal Agency Issues,
and a Domestic Policy Directive. (A
new Domestic Policy Directive is
adopted at each regularly scheduled
meeting.) In the foreign currency area,
the Committee operates under an
Authorization for Foreign Currency
Operations, a Foreign Currency Directive, and Procedural Instructions with
Respect to Foreign Currency Operations. These policy instruments are
shown below in the form in which they
were in effect at the beginning of 2001.
Changes in the instruments during the
year are reported in the minutes for the
individual meetings.

Authorization for Domestic
Open Market Operations
In Effect January 1, 2001
1. The Federal Open Market Committee
authorizes and directs the Federal Reserve
Bank of New York, to the extent necessary to carry out the most recent domestic
policy directive adopted at a meeting of the
Committee:
(a) To buy or sell U.S. Government
securities, including securities of the Federal
Financing Bank, and securities that are direct
obligations of, or fully guaranteed as to
principal and interest by, any agency of the

216 88th Annual Report, 2001
United States in the open market, from or to
securities dealers and foreign and international accounts maintained at the Federal
Reserve Bank of New York, on a cash, regular, or deferred delivery basis, for the System Open Market Account at market prices,
and, for such Account, to exchange maturing
U.S. Government and Federal agency securities with the Treasury or the individual
agencies or to allow them to mature without
replacement; provided that the aggregate
amount of U.S. Government and Federal
agency securities held in such Account
(including forward commitments) at the
close of business on the day of a meeting of
the Committee at which action is taken with
respect to a domestic policy directive shall
not be increased or decreased by more than
$12.0 billion during the period commencing
with the opening of business on the day following such meeting and ending with the
close of business on the day of the next such
meeting;
(b) To buy U.S. Government securities
and obligations that are direct obligations of,
or fully guaranteed as to principal and interest by, any agency of the United States, from
dealers for the account of the Federal
Reserve Bank of New York under agreements for repurchase of such securities or
obligations in 90 calendar days or less, at
rates that, unless otherwise expressly authorized by the Committee, shall be determined
by competitive bidding, after applying reasonable limitations on the volume of agreements with individual dealers; provided that
in the event Government securities or agency
issues covered by any such agreement are
not repurchased by the dealer pursuant to the
agreement or a renewal thereof, they shall be
sold in the market or transferred to the System Open Market Account.
(c) To sell U.S. Government securities
and securities that are direct obligations of,
or fully guaranteed as to principal and interest by, any agency of the United States to
dealers for System Open Market Account
under agreements for the resale by dealers of
such securities or obligations in 90 calendar
days or less, at rates that, unless otherwise
expressly authorized by the Committee, shall
be determined by competitive bidding, after
applying reasonable limitations on the volume of agreements with individual dealers.



2. In order to ensure the effective conduct
of open market operations, the Federal Open
Market Committee authorizes the Federal
Reserve Bank of New York to lend on an
overnight basis U.S. Government securities
held in the System Open Market Account to
dealers at rates that shall be determined by
competitive bidding but that in no event shall
be less than 1.0 percent per annum of the
market value of the securities lent. The Federal Reserve Bank of New York shall apply
reasonable limitations on the total amount of
a specific issue that may be auctioned, and
on the amount of securities that each dealer
may borrow. The Federal Reserve Bank
of New York may reject bids which could
facilitate a dealer's ability to control a single
issue as determined solely by the Federal
Reserve Bank of New York.
3. In order to ensure the effective conduct of
open market operations, while assisting in
the provision of short-term investments for
foreign and international accounts maintained at the Federal Reserve Bank of New
York, the Federal Open Market Committee
authorizes and directs the Federal Reserve
Bank of New York (a) for System Open
Market Account, to sell U.S. Government
securities to such foreign and international
accounts on the bases set forth in paragraph l(a) under agreements providing for
the resale by such accounts of those securities within 90 calendar days on terms comparable to those available on such transactions
in the market; and (b) for New York Bank
account, when appropriate, to undertake with
dealers, subject to the conditions imposed on
purchases and sales of securities in paragraph l(b), repurchase agreements in U.S.
Government and agency securities, and to
arrange corresponding sale and repurchase
agreements between its own account and
foreign and international accounts maintained at the Bank. Transactions undertaken
with such accounts under the provisions of
this paragraph may provide for a service fee
when appropriate.
4. In the execution of the Committee's decision regarding policy during any intermeeting period, the Committee authorizes and
directs the Federal Reserve Bank of
New York, upon the instruction of the Chairman of the Committee, to adjust somewhat

Minutes of FOMC Meetings 217
in exceptional circumstances the degree of
pressure on reserve positions and hence the
intended federal funds rate. Any such adjustment shall be made in the context of the
Committee's discussion and decision at its
most recent meeting and the Committee's
long-run objectives for price stability and
sustainable economic growth, and shall be
based on economic, financial, and monetary developments during the intermeeting
period. Consistent with Committee practice, the Chairman, if feasible, will consult
with the Committee before making any
adjustment.

Guidelines for the Conduct of
System Open Market Operations
in Federal Agency Issues
In Effect January 1, 2001
1. System open market operations in Federal agency issues are an integral part of total
System open market operations designed to
influence bank reserves, money market conditions, and monetary aggregates.
2. System open market operations in Federal agency issues are not designed to support individual sectors of the market or
to channel funds into issues of particular
agencies.

Domestic Policy Directive
In Effect January 1, 20011
The Federal Open Market Committee seeks
monetary and financial conditions that will
foster price stability and promote sustainable
growth in output. To further its long-run
objectives, the Committee in the immediate
future seeks conditions in reserve markets
consistent with maintaining the federal funds
rate at an average of around 6V2 percent.

The Committee also approved the
sentence below for inclusion in the press
statement to be released shortly after the
December 19, 2000, meeting:
1. Adopted by the Committee at its meeting on
December 19, 2000.



Against the background of its long-run
goals of price stability and sustainable economic growth and of the information currently available, the Committee believes that
the risks are weighted mainly toward conditions that may generate economic weakness
in the foreseeable future.

Authorization for Foreign
Currency Operations
In Effect January 1, 2001
1. The Federal Open Market Committee
authorizes and directs the Federal Reserve
Bank of New York, for System Open Market
Account, to the extent necessary to carry out
the Committee's foreign currency directive
and express authorizations by the Committee pursuant thereto, and in conformity with
such procedural instructions as the Committee may issue from time to time:
A. To purchase and sell the following
foreign currencies in the form of cable transfers through spot or forward transactions on
the open market at home and abroad, including transactions with the U.S. Treasury, with
the U.S. Exchange Stabilization Fund established by Section 10 of the Gold Reserve
Act of 1934, with foreign monetary authorities, with the Bank for International Settlements, and with other international financial
institutions:
Canadian dollars
Danish kroner
Euro
Pounds sterling
Japanese yen

Mexican pesos
Norwegian kroner
Swedish kronor
Swiss francs

B. To hold balances of, and to have
outstanding forward contracts to receive or
to deliver, the foreign currencies listed in
paragraph A above.
C. To draw foreign currencies and to
permit foreign banks to draw dollars under
the reciprocal currency arrangements listed
in paragraph 2 below, provided that drawings by either party to any such arrangement
shall be fully liquidated within 12 months
after any amount outstanding at that time
was first drawn, unless the Committee,
because of exceptional circumstances, specifically authorizes a delay.

218 88th Annual Report, 2001
D. To maintain an overall open position in all foreign currencies not exceeding
$25.0 billion. For this purpose, the overall
open position in all foreign currencies is
defined as the sum (disregarding signs) of
net positions in individual currencies. The
net position in a single foreign currency is
defined as holdings of balances in that currency, plus outstanding contracts for future
receipt, minus outstanding contracts for
future delivery of that currency, i.e., as the
sum of these elements with due regard to
sign.

ing operating arrangements with foreign
central banks on System holdings of foreign
currencies, the Federal Reserve Bank of
New York shall not commit itself to maintain
any specific balance, unless authorized by
the Federal Open Market Committee. Any
agreements or understandings concerning the
administration of the accounts maintained by
the Federal Reserve Bank of New York with
the foreign banks designated by the Board
of Governors under Section 214.5 of Regulation N shall be referred for review and
approval to the Committee.

2. The Federal Open Market Committee directs the Federal Reserve Bank of
New York to maintain reciprocal currency
arrangements ("swap" arrangements) for the
System Open Market Account for periods up
to a maximum of 12 months with the following foreign banks, which are among those
designated by the Board of Governors of the
Federal Reserve System under Section 214.5
of Regulation N, Relations with Foreign
Banks and Bankers, and with the approval of
the Committee to renew such arrangements
on maturity:

5. Foreign currency holdings shall be invested to ensure that adequate liquidity is
maintained to meet anticipated needs and so
that each currency portfolio shall generally
have an average duration of no more than
18 months (calculated as Macaulay duration). When appropriate in connection with
arrangements to provide investment facilities
for foreign currency holdings, U.S. Government securities may be purchased from foreign central banks under agreements for
repurchase of such securities within 30 calendar days.

Foreign bank

Bank of Canada . . .
Bank of Mexico ...

Amount
of arrangement
(millions of
dollars equivalent)
2,000
3,000

Any changes in the terms of existing swap
arrangements, and the proposed terms of any
new arrangements that may be authorized,
shall be referred for review and approval to
the Committee.
3. All transactions in foreign currencies
undertaken under paragraph l.A. above
shall, unless otherwise expressly authorized
by the Committee, be at prevailing market
rates. For the purpose of providing an investment return on System holdings of foreign
currencies, or for the purpose of adjusting
interest rates paid or received in connection
with swap drawings, transactions with foreign central banks may be undertaken at
non-market exchange rates.
4. It shall be the normal practice to arrange
with foreign central banks for the coordination of foreign currency transactions. In mak


6. All operations undertaken pursuant to
the preceding paragraphs shall be reported
promptly to the Foreign Currency Subcommittee and the Committee. The Foreign
Currency Subcommittee consists of the
Chairman and Vice Chairman of the Committee, the Vice Chairman of the Board of
Governors, and such other member of the
Board as the Chairman may designate (or in
the absence of members of the Board serving
on the Subcommittee, other Board members
designated by the Chairman as alternates,
and in the absence of the Vice Chairman of
the Committee, his alternate). Meetings of
the Subcommittee shall be called at the
request of any member, or at the request of
the Manager, System Open Market Account
("Manager"), for the purposes of reviewing
recent or contemplated operations and of
consulting with the Manager on other matters relating to his responsibilities. At the
request of any member of the Subcommittee,
questions arising from such reviews and consultations shall be referred for determination
to the Federal Open Market Committee.
7. The Chairman is authorized:
A. With the approval of the Committee, to enter into any needed agreement or

Minutes of FOMC Meetings 219
understanding with the Secretary of the Treasury about the division of responsibility for
foreign currency operations between the System and the Treasury;
B. To keep the Secretary of the Treasury fully advised concerning System foreign currency operations, and to consult with
the Secretary on policy matters relating to
foreign currency operations;
C. From time to time, to transmit
appropriate reports and information to the
National Advisory Council on International
Monetary and Financial Policies.
8. Staff officers of the Committee are authorized to transmit pertinent information on
System foreign currency operations to appropriate officials of the Treasury Department.
9. All Federal Reserve Banks shall participate in the foreign currency operations for
System Account in accordance with paragraph 3 G(l) of the Board of Governors'
Statement of Procedure with Respect to Foreign Relationships of Federal Reserve Banks
dated January 1, 1944.

Foreign Currency Directive
In Effect January 1, 2001
1. System operations in foreign currencies
shall generally be directed at countering disorderly market conditions, provided that
market exchange rates for the U.S. dollar
reflect actions and behavior consistent with
the IMF Article IV, Section 1.
2. To achieve this end the System shall:
A. Undertake spot and forward purchases and sales of foreign exchange.
B. Maintain
reciprocal
currency
("swap") arrangements with selected foreign central banks.
C. Cooperate in other respects with
central banks of other countries and with
international monetary institutions.

currencies, and to facilitate operations of the
Exchange Stabilization Fund.
C. For such other purposes as may be
expressly authorized by the Committee.
4. System foreign currency operations shall
be conducted:
A. In close and continuous consultation and cooperation with the United States
Treasury;
B. In cooperation, as appropriate, with
foreign monetary authorities; and
C. In a manner consistent with the obligations of the United States in the International Monetary Fund regarding exchange
arrangements under the IMF Article IV.

Procedural Instructions with
Respect to Foreign Currency
Operations
In Effect January 1, 2001
In conducting operations pursuant to the
authorization and direction of the Federal
Open Market Committee as set forth in the
Authorization for Foreign Currency Operations and the Foreign Currency Directive,
the Federal Reserve Bank of New York,
through the Manager, System Open Market
Account ("Manager"), shall be guided by
the following procedural understandings
with respect to consultations and clearances
with the Committee, the Foreign Currency
Subcommittee, and the Chairman of the
Committee. All operations undertaken pursuant to such clearances shall be reported
promptly to the Committee.
1. The Manager shall clear with the Subcommittee (or with the Chairman, if the
Chairman believes that consultation with the
Subcommittee is not feasible in the time
available):

A. To adjust System balances in light
of probable future needs for currencies.

A. Any operation that would result in a
change in the System's overall open position
in foreign currencies exceeding $300 million
on any day or $600 million since the most
recent regular meeting of the Committee.

B. To provide means for meeting System and Treasury commitments in particular

B. Any operation that would result in a
change on any day in the System's net posi-

3. Transactions may also be undertaken:




220 88th Annual Report, 2001
tion in a single foreign currency exceeding
$150 million, or $300 million when the
operation is associated with repayment of
swap drawings.
C. Any operation that might generate a
substantial volume of trading in a particular
currency by the System, even though the
change in the System's net position in that
currency might be less than the limits specified in I.B.

Present:
Mr. Greenspan, Chairman
Mr. McDonough, Vice Chairman
Mr. Ferguson
Mr. Gramlich
Mr. Hoenig
Mr. Kelley
Mr. Meyer
Ms. Minehan
Mr. Moskow
Mr. Poole

D. Any swap drawing proposed by a
foreign bank not exceeding the larger of
(i) $200 million or (ii) 15 percent of the size
of the swap arrangement.

Messrs. Jordan, McTeer, Santomero,
and Stern, Alternate Members
of the Federal Open Market
Committee

2. The Manager shall clear with the Committee (or with the Subcommittee, if the
Subcommittee believes that consultation
with the full Committee is not feasible in the
time available, or with the Chairman, if the
Chairman believes that consultation with
the Subcommittee is not feasible in the time
available):

Messrs. Broaddus, Guynn, and
Parry, Presidents of the
Federal Reserve Banks of
Richmond, Atlanta, and
San Francisco respectively

A. Any operation that would result in a
change in the System's overall open position
in foreign currencies exceeding $1.5 billion
since the most recent regular meeting of the
Committee.

Mr. Kohn, Secretary and Economist
Mr. Bernard, Deputy Secretary
Ms. Fox, Assistant Secretary
Mr. Gillum, Assistant Secretary
Mr. Mattingly, General Counsel
Mr. Baxter, Deputy General Counsel
Ms. Johnson, Economist
Mr. Stockton, Economist

B. Any swap drawing proposed by
a foreign bank exceeding the larger of
(i) $200 million or (ii) 15 percent of the
size of the swap arrangement.

Ms. Cumming, Messrs. Fuhrer, Hakkio,
Howard, Hunter, Lindsey, Rasche,
Reinhart, and Slifman, Associate
Economists

3. The Manager shall also consult with the
Subcommittee or the Chairman about proposed swap drawings by the System and
about any operations that are not of a routine
character.

Mr. Fisher, Manager, System Open
Market Account

Meeting Held on
January 30-31, 2001

Ms. Johnson,3 Secretary of the Board,
Office of the Secretary, Board of
Governors

A meeting of the Federal Open Market
Committee was held in the offices of
the Board of Governors of the Federal
Reserve System in Washington, D.C.,
beginning on Tuesday, January 30,
2001, at 9:00 a.m. and continuing on
Wednesday, January 31, 2001, at
9:00 a.m.



Mr. Winn,2 Assistant to the Board,
Office of Board Members,
Board of Governors

Mr. Simpson, Senior Adviser, Division
of Research and Statistics, Board
of Governors

2. Attended Tuesday session only.
3. Attended portion of meeting relating to a
staff study of the Federal Reserve asset portfolio.

Minutes of FOMC Meetings, January
Mr. Madigan, Associate Director,
Division of Monetary Affairs,
Board of Governors
Messrs. Oliner, Struckmeyer, and
Whitesell, Assistant Directors,
Divisions of Research and
Statistics, Research and Statistics,
and Monetary Affairs respectively,
Board of Governors
Messrs. Morton,2 Rosine,2 and Sack,2
Senior Economists, Divisions of
International Finance, Research
and Statistics, and Monetary
Affairs respectively, Board of
Governors
Mr. Reifschneider,4 Section Chief,
Division of Research and
Statistics, Board of Governors
4

Ms. Garrett, Economist, Division of
Monetary Affairs, Board of
Governors
Ms. Low, Open Market Secretariat
Assistant, Division of Monetary
Affairs, Board of Governors
Mr. Lang, Executive Vice President,
Federal Reserve Bank of
Philadelphia
Messrs. Beebe, Eisenbeis, Goodfriend,
Kos, Ms. Krieger, Messrs.
Rosenblum, and Sniderman,
Senior Vice Presidents, Federal
Reserve Banks of San Francisco,
Atlanta, Richmond, New York,
New York, Dallas, and Cleveland
respectively
Mr. Weber, Vice President, Federal
Reserve Bank of Minneapolis
In the agenda for this meeting, it was
reported that advices of the election of
the following members and alternate
members of the Federal Open Market
Committee for the period commencing

4. Attended Wednesday session only.



221

January 1, 2001, and ending December 31, 2001, had been received and
that these individuals had executed their
oaths of office.
The elected members and alternate
members were as follows:
William J. McDonough, President of the
Federal Reserve Bank of New York,
with Jamie B. Stewart, Jr., First Vice
President of the Federal Reserve Bank
of New York, as alternate
Cathy E. Minehan, President of the Federal Reserve Bank of Boston, with
Anthony M. Santomero, President of
the Federal Reserve Bank of Philadelphia, as alternate
Michael H. Moskow, President of the
Federal Reserve Bank of Chicago, with
Jerry L. Jordan, President of the Federal
Reserve Bank of Cleveland, as alternate
William Poole, President of the Federal
Reserve Bank of St. Louis, with Robert D. McTeer, Jr., President of the
Federal Reserve Bank of Dallas, as
alternate
Thomas M. Hoenig, President of the Federal
Reserve Bank of Kansas City, with
Gary H. Stern, President of the Federal Reserve Bank of Minneapolis, as
alternate
By unanimous vote, the following
officers of the Federal Open Market
Committee were elected to serve until
the election of their successors at the
first regularly scheduled meeting of
the Committee after December 31, 2001,
with the understanding that in the event
of the discontinuance of their official
connection with the Board of Governors
or with a Federal Reserve Bank, they
would cease to have any official connection with the Federal Open Market
Committee:
Alan Greenspan
William J. McDonough

Chairman
Vice Chairman

222 88th Annual Report, 2001
Donald L. Kohn
Normand R.V. Bernard
Lynn S. Fox and
Gary P. Gillum
J. Virgil Mattingly, Jr.
Thomas C. Baxter, Jr.
Karen H. Johnson and
David J. Stockton

Secretary and
Economist
Deputy Secretary
Assistant
Secretaries
General Counsel
Deputy General
Counsel
Economists

Christine M. Cumming, Jeffrey C. Fuhrer,
Craig S. Hakkio, William C. Hunter,
David H. Howard, David E. Lindsey,
Robert H. Rasche, Vincent R. Reinhart,
and Lawrence Slifman, Associate
Economists

By unanimous vote, Peter R. Fisher
was selected to serve at the pleasure
of the Committee as Manager, System
Open Market Account, on the understanding that his selection was subject to
being satisfactory to the Federal Reserve
Bank of New York.
Secretary's note: Advice subsequently was
received that the selection of Mr. Fisher as
Manager was satisfactory to the board of
directors of the Federal Reserve Bank of
New York.

By unanimous vote, the minutes
of the meetings of the Federal Open
Market Committee held on December 19, 2000, and January 3, 2001, were
approved.
The next item on the agenda encompassed issues relating in part to the discount window and other matters that are
within the legal purview of the Board of
Governors. Accordingly, a Board meeting was formally convened and this item
was considered in a joint Board-Federal
Open Market Committee session. The
Board members voted unanimously at
the outset to close the Board meeting.
At its meeting in March 2000, the
Committee asked the staff to undertake



a broad study of alternative approaches
to the management of the System asset
portfolio in the current and prospective
environment of large budget surpluses
and rapid associated declines in the
amount of Treasury debt outstanding.
Such paydowns were having favorable
effects on the macroeconomy and would
not impair the Committee's ability to
pursue its overall economic objectives.
But the FOMC's historical reliance on
purchases and sales of Treasury securities to implement monetary policy
would be difficult to maintain if steep
paydowns of debt were, as seemed
likely, to continue. To prepare for such
a contingency, the Committee needed to
identify and explore alternative instruments for the conduct of monetary
policy.
In their discussion at this meeting,
the members agreed that continuing
paydowns of Treasury debt outstanding could create complications for the
implementation of monetary policy well
before the full repayment of marketable
federal debt. In particular, the Treasury
market could be expected to become
less liquid over time, making it more
difficult for the Federal Reserve to
accommodate the trend growth of currency through outright purchases of
Treasuries without unduly affecting
market prices. Reduced activity in the
Treasury repurchase agreement (RP)
market could complicate the use of such
obligations to respond to seasonal and
unexpected variations in the aggregate
supply of reserves.
In reviewing the possibilities, the
members noted that relative to investments in Treasury securities, all of the
options could entail significant drawbacks, including increases in credit risk,
reductions in liquidity, and potentially
distorting effects on relative prices in
financial markets. In light of these
potential issues, the Committee agreed

Minutes of FOMC Meetings, January 223
that it should proceed cautiously and
maintain the current emphasis on Treasury securities in the SOMA portfolio,
especially the portion of the portfolio
held outright, for as long as practicable.
In that regard, some members suggested
that the Committee look carefully at
whether it could loosen the limits it currently imposes on holdings of individual
Treasury issues without causing undue
market distortions. Some felt it would
be desirable to consider buying and
holding Ginnie Mae mortgage-backed
securities, which are guaranteed by the
full faith and credit of the United States.
A few members suggested that consideration might be given to the possibility of
continuing to rely on Treasury securities, even as the publicly held debt is
paid down, by acquiring such securities
through special arrangements with the
Treasury.
In the near term, the members agreed
that it would be useful to extend for at
least another year the temporary authority, in effect since late August 1999, of
the Manager to supplement repurchase
agreements in Treasuries and direct
agency debt with repurchase transactions in mortgage-backed securities
guaranteed by a federal agency or a
government-sponsored enterprise. They
also asked the staff to investigate the
possibility of authorizing the Desk to
engage in RP operations using assets
that could be purchased under existing legal authority but were not currently authorized by the Committee—
specifically, certain debt obligations of
U.S. state and local governments and of
foreign governments. Making a wider
range of assets available for RP operations would reduce the potential for distortions to the pricing of instruments
collateralizing RPs, but would entail
resolving a number of issues. The Congress and market participants would
need to be consulted before the Com


mittee decided to undertake any such
operations.
From a somewhat longer-term perspective, Committee members identified several alternative issues for further study. One involved the appropriate
degree of reliance on outright purchases
of a broader array of assets relative
to greater use of temporary short-term
transactions undertaken through intermediaries. A number of members saw
advantages to the greater reliance on
the latter—RPs with security dealers
and discount window loans to depository institutions—especially when they
involved a wide range of underlying
assets. It was noted that such instruments would afford the Federal Reserve
considerable protection against credit
risks, could be structured to provide substantial liquidity to respond to unanticipated changes in the supply or demand
for reserves, and, relative to outright
purchases of the underlying collateral,
could help to mitigate potential distortions to asset pricing and credit allocation. Many members indicated that
a potentially attractive approach to
expanding the role of the discount window might involve auctioning such
credit to financially sound depository
institutions. Some members expressed
reservations about this option, noting
that such a program would have to be
carefully structured in order to avoid
situations in which some institutions
might become heavily dependent on
such credit or engage in excessive risk
taking. But extremely heavy reliance
on temporary transactions could itself
influence credit flows, suggesting that
approaches to staying longer with Treasury securities or adding new assets not
currently allowed by law to the permanent portfolio would also need to be
studied.
The use of private securities for
temporary transactions or permanent

224

88th Annual Report, 2001

portfolio holdings had a number of riskmanagement and accounting implications that would need to be examined
carefully. Another aspect that required
further examination was the approach
to diversification of the System portfolio in order to minimize any effects
on credit conditions. In this context,
the members compared the merits of an
incremental approach in which classes
of private securities were gradually
added to the RP pool or the permanent
portfolio, with the safest and most liquid
being used first, to an alternative
approach in which very broad diversification was sought quickly through
investment in diverse pools of assets.
In view of the importance of these
issues and their complexity, the Committee determined to explore various
means to seek the input of the public
and the Congress to develop and refine
alternatives and to investigate all the
associated policy issues.
By unanimous vote, the Committee approved amendments to paragraphs l(b), l(c), and 3 of the Authorization for Domestic Open Market
Operations to permit temporary operations with a maturity limit of 65 business days.

Authorization for Domestic
Open Market Operations
(Amended January 30, 2001)
1. The Federal Open Market Committee
authorizes and directs the Federal Reserve
Bank of New York, to the extent necessary to carry out the most recent domestic
policy directive adopted at a meeting of the
Committee:
(a) To buy or sell U.S. Government
securities, including securities of the Federal
Financing Bank, and securities that are direct
obligations of, or fully guaranteed as to
principal and interest by, any agency of the
United States in the open market, from or



to securities dealers and foreign and international accounts maintained at the Federal
Reserve Bank of New York, on a cash, regular, or deferred delivery basis, for the System
Open Market Account at market prices, and,
for such Account, to exchange maturing U.S.
Government and Federal agency securities
with the Treasury or the individual agencies
or to allow them to mature without replacement; provided that the aggregate amount of
U.S. Government and Federal agency securities held in such Account (including forward
commitments) at the close of business on the
day of a meeting of the Committee at which
action is taken with respect to a domestic
policy directive shall not be increased or
decreased by more than $12.0 billion during
the period commencing with the opening of
business on the day following such meeting
and ending with the close of business on the
day of the next such meeting;
(b) To buy U.S. Government securities
and obligations that are direct obligations of,
or fully guaranteed as to principal and interest by, any agency of the United States, from
dealers for the account of the Federal
Reserve Bank of New York under agreements for repurchase of such securities or
obligations in 65 business days or less, at
rates that, unless otherwise expressly authorized by the Committee, shall be determined
by competitive bidding, after applying reasonable limitations on the volume of agreements with individual dealers; provided that
in the event Government securities or agency
issues covered by any such agreement are
not repurchased by the dealer pursuant to the
agreement or a renewal thereof, they shall be
sold in the market or transferred to the System Open Market Account;
(c) To sell U.S. Government securities
and obligations that are direct obligations of,
or fully guaranteed as to principal and interest by, any agency of the United States to
dealers for System Open Market Account
under agreements for the resale by dealers of
such securities or obligations in 65 business
days or less, at rates that, unless otherwise
expressly authorized by the Committee, shall
be determined by competitive bidding, after
applying reasonable limitations on the volume of agreements with individual dealers.
2. In order to ensure the effective conduct
of open market operations, the Federal Open
Market Committee authorizes the Federal
Reserve Bank of New York to lend on an

Minutes of FOMC Meetings, January 225
overnight basis U.S. Government securities
held in the System Open Market Account to
dealers at rates that shall be determined by
competitive bidding but that in no event shall
be less than 1.0 percent per annum of the
market value of the securities lent. The Federal Reserve Bank of New York shall apply
reasonable limitations on the total amount of
a specific issue that may be auctioned, and
on the amount of securities that each dealer
may borrow. The Federal Reserve Bank
of New York may reject bids which could
facilitate a dealer's ability to control a single
issue as determined solely by the Federal
Reserve Bank of New York.
3. In order to ensure the effective conduct
of open market operations, while assisting
in the provision of short-term investments
for foreign and international accounts maintained at the Federal Reserve Bank of New
York, the Federal Open Market Committee
authorizes and directs the Federal Reserve
Bank of New York (a) for System Open
Market Account, to sell U.S. Government
securities to such foreign and international
accounts on the bases set forth in paragraph l(a) under agreements providing for
the resale by such accounts of those securities in 65 business days or less on terms
comparable to those available on such transactions in the market; and (b) for New York
Bank account, when appropriate, to undertake with dealers, subject to the conditions
imposed on purchases and sales of securities
in paragraph l(b), repurchase agreements in
U.S. Government and agency securities, and
to arrange corresponding sale and repurchase
agreements between its own account and
foreign and international accounts maintained at the Bank. Transactions undertaken
with such accounts under the provisions of
this paragraph may provide for a service fee
when appropriate.
4. In the execution of the Committee's
decision regarding policy during any intermeeting period, the Committee authorizes
and directs the Federal Reserve Bank of New
York, upon the instruction of the Chairman
of the Committee, to adjust somewhat in
exceptional circumstances the degree of
pressure on reserve positions and hence the
intended federal funds rate. Any such adjustment shall be made in the context of the
Committee's discussion and decision at its
most recent meeting and the Committee's



long-run objectives for price stability and
sustainable economic growth, and shall be
based on economic, financial, and monetary developments during the intermeeting
period. Consistent with Committee practice, the Chairman, if feasible, will consult
with the Committee before making any
adjustment.

By unanimous vote, the Committee
approved until the Committee's first
scheduled meeting in 2002 an extension
of the temporary suspension of paragraphs 3 to 6 of the Guidelines for the
Conduct of System Operations in Federal Agency Issues. For the year ahead,
the Guidelines therefore continued to
read as follows:
Guidelines for the Conduct of
System Open Market Operations
in Federal Agency Issues
(Reaffirmed January 30, 2001)
1. System open market operations in Federal agency issues are an integral part of total
System open market operations designed to
influence bank reserves, money market conditions, and monetary aggregates.
2. System open market operations in
Federal agency issues are not designed to
support individual sectors of the market or
to channel funds into issues of particular
agencies.
By unanimous vote, the Foreign Currency Authorization was reaffirmed in
the form shown below.

Authorization for Foreign
Currency Operations
(Reaffirmed January 30, 2001)
1. The Federal Open Market Committee
authorizes and directs the Federal Reserve
Bank of New York, for System Open Market
Account, to the extent necessary to carry out
the Committee's foreign currency directive
and express authorizations by the Committee pursuant thereto, and in conformity with
such procedural instructions as the Committee may issue from time to time:

226 88th Annual Report, 2001
A. To purchase and sell the following
foreign currencies in the form of cable transfers through spot or forward transactions on
the open market at home and abroad, including transactions with the U.S. Treasury, with
the U.S. Exchange Stabilization Fund established by Section 10 of the Gold Reserve
Act of 1934, with foreign monetary authorities, with the Bank for International Settlements, and with other international financial
institutions:
Canadian dollars
Danish kroner
Euro
Pounds sterling
Japanese yen

Mexican pesos
Norwegian kroner
Swedish kronor
Swiss francs

B. To hold balances of, and to have
outstanding forward contracts to receive or
to deliver, the foreign currencies listed in
paragraph A above.
C. To draw foreign currencies and to
permit foreign banks to draw dollars under
the reciprocal currency arrangements listed
in paragraph 2 below, provided that drawings by either party to any such arrangement
shall be fully liquidated within 12 months
after any amount outstanding at that time
was first drawn, unless the Committee,
because of exceptional circumstances, specifically authorizes a delay.
D. To maintain an overall open position in all foreign currencies not exceeding
$25.0 billion. For this purpose, the overall
open position in all foreign currencies is
defined as the sum (disregarding signs) of
net positions in individual currencies. The
net position in a single foreign currency is
defined as holdings of balances in that currency, plus outstanding contracts for future
receipt, minus outstanding contracts for
future delivery of that currency, i.e., as the
sum of these elements with due regard to
sign.
2. The Federal Open Market Committee directs the Federal Reserve Bank of
New York to maintain reciprocal currency
arrangements ("swap" arrangements) for the
System Open Market Account for periods up
to a maximum of 12 months with the following foreign banks, which are among those
designated by the Board of Governors of the
Federal Reserve System under Section 214.5
of Regulation N, Relations with Foreign
Banks and Bankers, and with the approval of
the Committee to renew such arrangements
on maturity:



Foreign bank

Bank of Canada
Bank of Mexico

Amount of
arrangement
(millions of
dollars equivalent)
2,000
3,000

Any changes in the terms of existing swap
arrangements, and the proposed terms of any
new arrangements that may be authorized,
shall be referred for review and approval to
the Committee.
3. All transactions in foreign currencies
undertaken under paragraph l.A. above
shall, unless otherwise expressly authorized
by the Committee, be at prevailing market
rates. For the purpose of providing an investment return on System holdings of foreign
currencies, or for the purpose of adjusting
interest rates paid or received in connection
with swap drawings, transactions with foreign central banks may be undertaken at
non-market exchange rates.
4. It shall be the normal practice to
arrange with foreign central banks for the
coordination of foreign currency transactions. In making operating arrangements
with foreign central banks on System holdings of foreign currencies, the Federal
Reserve Bank of New York shall not commit
itself to maintain any specific balance unless
authorized by the Federal Open Market
Committee. Any agreements or understandings concerning the administration of the
accounts maintained by the Federal Reserve
Bank of New York with the foreign banks
designated by the Board of Governors under
Section 214.5 of Regulation N shall be
referred for review and approval to the
Committee.
5. Foreign currency holdings shall be
invested to ensure that adequate liquidity is
maintained to meet anticipated needs and so
that each currency portfolio shall generally
have an average duration of no more than
18 months (calculated as Macaulay duration). When appropriate in connection with
arrangements to provide investment facilities
for foreign currency holdings, U.S. Government securities may be purchased from foreign central banks under agreements for
repurchase of such securities within 30 calendar days.
6. All operations undertaken pursuant to
the preceding paragraphs shall be reported

Minutes of FOMC Meetings, January 227
promptly to the Foreign Currency Subcommittee and the Committee. The Foreign Currency Subcommittee consists of the Chairman and Vice Chairman of the Committee,
the Vice Chairman of the Board of Governors, and such other member of the Board
as the Chairman may designate (or in the
absence of members of the Board serving on
the Subcommittee, other Board members
designated by the Chairman as alternates,
and in the absence of the Vice Chairman
of the Committee, his alternate). Meetings
of the Subcommittee shall be called at the
request of any member, or at the request of
the Manager, System Open Market Account
("Manager"), for the purposes of reviewing
recent or contemplated operations and of
consulting with the Manager on other matters relating to his responsibilities. At the
request of any member of the Subcommittee,
questions arising from such reviews and consultations shall be referred for determination
to the Federal Open Market Committee.
7. The Chairman is authorized:
A. With the approval of the Committee, to enter into any needed agreement or
Understanding with the Secretary of the Treasury about the division of responsibility for
foreign currency operations between the System and the Treasury;
B. To keep the Secretary of the Treasury fully advised concerning System foreign currency operations, and to consult with
the Secretary on policy matters relating to
foreign currency operations;
C. From time to time, to transmit
appropriate reports and information to the
National Advisory Council on International
Monetary and Financial Policies.
8. Star! officers of the Committee are
authorized to transmit pertinent information on System foreign currency operations
to appropriate officials of the Treasury
Department.
9. All federal Reserve Banks shall participate in the foreign currency operations
for System Account in accordance with paragraph 3 G(l) of the Board of Governors'
Statement of Procedure with Respect to Foreign Relationships of Federal Reserve Banks
dated January 1, 1944.

By unanimous vote, the Foreign Currency directive was reaffirmed in the
form shown below.



Foreign Currency Directive
(Reaffirmed January 30, 2001)
1. System operations in foreign currencies shall generally be directed at countering
disorderly market conditions, provided that
market exchange rates for the U.S. dollar
reflect actions and behavior consistent with
the IMF Article IV, Section 1.
2. To achieve this end the System shall:
A. Undertake spot and forward purchases and sales of foreign exchange.
B. Maintain
reciprocal
currency
("swap") arrangements with selected foreign central banks.
C. Cooperate in other respects with
central banks of other countries and with
international monetary institutions.
3. Transactions may also be undertaken:
A. To adjust System balances in light
of probable future needs for currencies.
B. To provide means for meeting System and Treasury commitments in particular
currencies, and to facilitate operations of the
Exchange Stabilization Fund.
C. For such other purposes as may be
expressly authorized by the Committee.
4. System foreign currency operations
shall be conducted:
A. In close and continuous consultation and cooperation with the United States
Treasury;
B. In cooperation, as appropriate, with
foreign monetary authorities; and
C. In a manner consistent with the obligations of the United States in the International Monetary Fund regarding exchange
arrangements under the IMF Article IV.

By unanimous vote, the Procedural
Instructions with Respect to Foreign
Currency Operations were reaffirmed in
the form shown below.
Procedural Instructions with
Respect to Foreign
Currency Operations
(Reaffirmed January 30, 2001)
In conducting operations pursuant to the
authorization and direction of the Federal
Open Market Committee as set forth in the
Authorization for Foreign Currency Operations and the Foreign Currency Directive,

228 88th Annual Report, 2001
the Federal Reserve Bank of New York,
through the Manager, System Open Market
Account ("Manager"), shall be guided by
the following procedural understandings
with respect to consultations and clearances
with the Committee, the Foreign Currency
Subcommittee, and the Chairman of the
Committee. All operations undertaken pursuant to such clearances shall be reported
promptly to the Committee.
1. The Manager shall clear with the Subcommittee (or with the Chairman, if the
Chairman believes that consultation with the
Subcommittee is not feasible in the time
available):
A. Any operation that would result in a
change in the System's overall open position
in foreign currencies exceeding $300 million
on any day or $600 million since the most
recent regular meeting of the Committee.
B. Any operation that would result in a
change on any day in the System's net position in a single foreign currency exceeding $150 million, or $300 million when the
operation is associated with repayment of
swap drawings.
C. Any operation that might generate a
substantial volume of trading in a particular
currency by the System, even though the
change in the System's net position in that
currency might be less than the limits specified in l.B.
D. Any swap drawing proposed by a
foreign bank not exceeding the larger of
(i) $200 million or (ii) 15 percent of the size
of the swap arrangement.
2. The Manager shall clear with the Committee (or with the Subcommittee, if the
Subcommittee believes that consultation
with the full Committee is not feasible in the
time available, or with the Chairman, if the
Chairman believes that consultation with the
Subcommittee is not feasible in the time
available):
A. Any operation that would result in a
change in the System's overall open position
in foreign currencies exceeding $1.5 billion
since the most recent regular meeting of the
Committee.
B. Any swap drawing proposed by a
foreign bank exceeding the larger of (i) $200
million or (ii) 15 percent of the size of the
swap arrangement.
3. The Manager shall also consult with
the Subcommittee or the Chairman about



proposed swap drawings by the System and
about any operations that are not of a routine
character.

On January 22, 2001, the continuing
rules, regulations, and other instructions
of the Committee had been distributed
with the advice that, in accordance with
procedures approved by the Committee,
they were being called to the Committee's attention before the January 30-31
organization meeting to give members
an opportunity to raise any questions
they might have concerning them. Members were asked to indicate if they
wished to have any of the instruments in
question placed on the agenda for consideration at this meeting. The Guidelines for the Conduct of System Operations in Federal Agency Issues were
placed on the agenda and an extension of their temporary amendment was
approved as noted above.
The Manager of the System Open
Market Account reported on recent
developments in foreign exchange markets. There were no open market operations in foreign currencies for the System's account in the period since the
previous meeting.
The Manager also reported on developments in domestic financial markets
and on System open market transactions
in government securities and federal
agency obligations during the period
December 20, 2000, through January 30,
2001. By unanimous vote, the Committee ratified these transactions.
The Committee then turned to a
discussion of the economic and financial outlook and the implementation of
monetary policy over the intermeeting
period ahead. A summary of the economic and financial information available at the time of the meeting and of
the Committee's discussion is provided
below, followed by the domestic policy
directive that was approved by the Com-

Minutes of FOMC Meetings, January 229
mittee and issued to the Federal Reserve
Bank of New York.
The information reviewed at this
meeting indicated that the expansion
of economic activity had slowed appreciably over the fourth quarter. Consumer
and business spending decelerated further, with outlays for consumer durables
and business equipment particularly
weak. Housing construction remained
relatively firm, though significantly
below its brisk pace of earlier in the
year. The slower growth of final spending resulted in inventory overhangs in
a number of industries, most notably
those related to the motor vehicle sector.
Manufacturing production declined
sharply as a result, and overall employment gains moderated further. Price
inflation was still relatively subdued.
Labor demand softened further in
December, with private nonfarm payroll employment continuing to increase
slowly and the average workweek to
decline. Nonetheless, the labor market
remained very tight and the unemployment rate held at 4 percent, its average
for the year. Reduced labor demand in
manufacturing accounted for much of
the slowdown in nonfarm payroll gains
in the fourth quarter, with factory payrolls falling sharply further in December, but in addition sizable cuts in net
new hires were recorded in the helpsupply and construction industries.
The contraction in industrial production that began in October, largely in
the motor vehicle sector, deepened and
broadened in November and December.
For the fourth quarter as a whole, the
drop in production was concentrated
in manufacturing; mining activity fell
by less while utilities output surged late
in the year in response to unseasonably cold weather. Most of the initial
weakness in manufacturing output was
related directly or indirectly to the slowing in the motor vehicle sector, but by



year-end all major market groups had
registered steep declines in production.
Weaker factory activity in December
resulted in a sizable drop in the rate of
capacity utilization in manufacturing
to a level further below its long-run
average.
Against a background of slowing
growth of disposable personal income
and abrupt declines in consumer sentiment, consumer spending decelerated
substantially in the fourth quarter. Purchases of motor vehicles slumped and
outlays for other goods increased only
a little. However, spending on services
picked up somewhat in November (latest data), reflecting at least in part higher
expenditures for heating services owing
to unseasonably cold weather.
The decline in mortgage rates since
the middle of last year had provided
some support to residential building
activity. Total housing starts increased
slightly further in December, with
single-family starts recording a brisk
rise that might have been, in part, a
response to the lower mortgage rates.
By contrast, multifamily starts slowed,
more than reversing November's runup. Sales of new homes jumped in
December to a very high level, but sales
of existing homes dropped considerably.
Business fixed investment contracted
slightly in the fourth quarter, reflecting a
sizable decline in business spending on
equipment and software that was offset
in part by a large increase in nonresidential construction. Data on nominal shipments of nondefense capital goods in
the fourth quarter indicated a drop in
office and computing equipment, only
a small gain in communications equipment, and a decline, on net, in non-hightech equipment. By contrast, investment
in nonresidential structures increased
briskly further in October and November (latest data). While spending for new
office buildings was rising less rapidly,

230 88th Annual Report, 2001
outlays for other commercial structures
picked up, and investment in industrial
structures remained robust.
Business inventories on a bookvalue basis mounted further in October
and November. Despite production
cutbacks, stockbuilding in manufacturing remained rapid and sizable inventory overhangs had emerged in some
industries, particularly those related to
the motor vehicle sector. As a result,
the aggregate stock-sales ratio for the
manufacturing sector continued its
upward drift that began early last year.
Sizable inventory buildups and associated overhangs also were apparent in
portions of the retail sector, and the
aggregate inventory-sales ratio for the
sector remained at the upper end of its
range over the past year. At the wholesale level, inventory accumulation was
moderate in October and November, but
the sector's inventory-sales ratio continued to be at the top of its range for the
last twelve months.
The U.S. trade deficit in goods and
services fell slightly in October and
November after having posted a new
record high in September. Nevertheless,
the average deficit for October and
November was larger than the rate for
the third quarter. The value of exports
declined in both months, and the average value for the two-month period was
below the third-quarter level; the weakness in exports was spread across a
number of trade categories. The value
of imports for the first two months of
the fourth quarter was slightly above the
third-quarter average. Economic growth
in foreign industrial countries moderated in the second half of last year.
The pace of economic expansion in the
euro area softened somewhat further in
the fourth quarter, as consumer spending
remained weak. In Japan, available indicators suggested that economic activity
had stagnated in the fourth quarter. Eco


nomic growth in Canada and the United
Kingdom seemed to have slowed somewhat in the fourth quarter. In addition,
the latest data for the major developing
countries pointed to reduced expansion
in many of those countries.
By most measures, price inflation had
remained moderate in recent months.
Judging by the consumer price index
(CPI), total and core consumer prices
rose mildly over November and December, but both accelerated somewhat on a
year-over-year basis. In terms of the personal consumption expenditure (PCE)
chain-type price index, however, core
consumer price inflation was modest
in both November (latest data) and the
twelve months ended in November, and
there was essentially no change year
over year. At the producer level, core
prices edged up over the NovemberDecember period, and the rise in core
prices over the year was minimal as
well. With regard to labor costs, the
employment cost index of hourly compensation for private industry workers
(ECI) decelerated noticeably in the
fourth quarter, with both the wage and
benefit components recording smaller
gains. However, growth of ECI compensation picked up somewhat in 2000 from
1999, probably owing in large part to
the upward trend in productivity growth.
Productivity improvements also showed
through to the average hourly earnings
of production or nonsupervisory workers, which exhibited a roughly similar
acceleration.
At its meeting on December 19, 2000,
the Committee adopted a directive that
continued to call for maintaining conditions in reserve markets consistent with
an unchanged federal funds rate of about
6V2 percent. At the same time, however,
the members concluded that the balance
of risks had shifted sufficiently that they
had become weighted toward conditions
that could generate economic weakness

Minutes of FOMC Meetings, January 231
in the foreseeable future. Indeed, very
recent information had seemed to signal
sudden further weakness, but it was
largely anecdotal and most of the aggregate data on spending and employment
suggested continued economic expansion, albeit at a relatively slow rate. As
a result, most members believed that it
would be prudent to await further confirmation of a noticeably weaker expansion before implementing any monetary
easing, particularly given the current
high level of resource utilization and
the record over the last several years
of strong rebounds from brief lulls in
growth. If, however, incoming data were
to reinforce the recent anecdotal indications, the Committee would be prepared
to respond promptly.
Open market operations during the
intermeeting period were initially
directed toward maintaining the federal
funds rate at the Committee's targeted
level of 6V2 percent. However, information that became available in the weeks
after the December meeting tended to
confirm the earlier indications of weakness in spending, and at a telephone
conference on January 3, 2001, the
Committee approved a V percentage
2
point reduction in the federal funds rate,
to 6 percent, and also agreed that the
risks remained weighted toward economic weakness. The federal funds rate
remained close to the Committee's targets over the intermeeting period, and
interest rates on short-term Treasury
securities and high-quality private debt
obligations declined over the period
almost as much as the funds rate. The
Committee's action seemed to help ease
some concerns about the longer-term
outlook, and risk spreads on lower-grade
bonds fell substantially while broad
indexes of U.S. stock market prices rose
on balance over the intermeeting period.
In foreign exchange markets, the
trade-weighted value of the dollar



changed little on balance over the intermeeting interval in terms of an index of
major foreign currencies. The dollar lost
ground against the euro as market participants took note of the deterioration
of near-term prospects for economic
growth in the United States relative to
those for Europe. However, that decline
was roughly counterbalanced by a rise
in the dollar against the yen, reflecting continuing economic stagnation in
Japan. The dollar posted a small gain
against an index of the currencies of
other important trading partners, largely
reflecting expectations that some
emerging economies might be adversely
affected by slower growth in the United
States.
The broad monetary aggregates accelerated sharply in December and apparently strengthened further in January.
The pickup in M2 growth evidently
reflected a flight from heightened equity
market volatility late last year to the
safety and liquidity of M2 assets along
with a recent narrowing of the opportunity costs of holding funds in M2
accounts. M3 grew even faster than M2,
boosted in part by stepped-up issuance
of large time deposits to fund a pickup
in bank credit. The expansion of domestic nonfinancial debt increased in
November and December (latest data),
reflecting greater business borrowing,
perhaps to finance growing inventories
and smaller contractions in the amount
of federal debt outstanding.
The staff forecast prepared for this
meeting suggested that, after a pause
associated in part with an inventory correction, the economic expansion would
regain strength over the next two years
and gradually move to a rate near the
staff's current estimate of the growth of
the economy's potential output. The
period of subpar activity was expected
to foster an appreciable slackening of
resource utilization and some modera-

232 88th Annual Report, 2001
tion in core price inflation. The forecast
anticipated that the expansion of domestic final demand would be held back to
some extent by the decline in household
net worth associated with the downturn
that had occurred in equity prices, the
remaining effects of prior monetary
restraint, and the continuation of somewhat stringent credit terms and conditions on some types of loans by financial institutions. As a result, growth of
spending on consumer durables was
expected to be appreciably below that of
the first half of last year and housing
demand to be about unchanged from its
recent level. Business fixed investment,
notably outlays for equipment and software, was projected to resume relatively
robust growth after a comparatively
brief period of adjustment of capital
stocks to more desirable levels; growth
abroad was seen as supporting the
expansion of U.S. exports; and fiscal
policy was assumed to become more
expansionary.
In the Committee's discussion of current and prospective economic developments, members commented that while
a slowdown in the expansion over the
second half of 2000 was not unexpected
in light of the previously unsustainable
rate of increase in output, the speed and
extent of the slowdown were much more
pronounced than they had anticipated.
Consumer spending and business capital
investment had decelerated markedly,
partly in association with a sharp decline
in consumer and business confidence.
This weakening, which was especially
evident in durable goods producing
industries, had led to large cutbacks in
manufacturing output as numerous business firms attempted to pare what they
now viewed as excessive inventories.
The eventual degree and duration of
the softening in economic conditions
were difficult to predict. In particular,
it was unclear whether the pause in the



economic expansion would be largely
limited to a relatively short inventory
correction or would involve a more
extensive cyclical adjustment.
In general, members saw favorable
prospects for an appreciable recovery
in overall business activity as the year
progressed. Members referred to indications that both residential and nonresidential construction activity had
remained relatively robust and to fragmentary data and anecdotal reports
suggesting that consumer spending had
steadied or possibly turned up early this
year. Several commented that the sound
condition of the banking system was
another supportive factor. Some also
observed that, counter to the experience
generally associated with the onset of
earlier recessions, monetary growth had
been well maintained in recent months,
and a few noted that long-term interest
rates currently were appreciably below
their peaks of the past year. The prospect that fiscal policy might begin to
move in an expansionary direction later
in the year was cited as another factor in
the outlook for stronger economic activity. A decline in energy prices, should
it materialize as anticipated in futures
markets, would have a positive effect on
both business and consumer spending
by lowering business costs and raising
disposable consumer incomes adjusted
for energy costs. Perhaps the most critical element in this outlook was the persistence of elevated growth in structural
labor productivity, which seemed likely
to play a vital role in supporting growth
in incomes and aggregate demand while
also helping to limit inflation pressures.
At the same time, members also
saw considerable downside risks to
the economic expansion. Energy prices
remained elevated and were continuing
to depress business and household purchasing power; the overhang of excess
capital stocks in some sectors could turn

Minutes of FOMC Meetings, January 233
out to be sizable, depressing investment
spending for some time; consumer
confidence could worsen appreciably
more in the face of weaker expansion
of incomes and higher job layoffs; and
investor concerns about earnings could
increase further, sparking lower equity
prices and tighter standards and terms
on credit.
Except for prices of energy and medical services, the currently available
information indicated relatively subdued
rates of inflation, and recent surveys
pointed to little change in inflation
expectations. Looking ahead, members
anticipated that somewhat reduced pressures in labor and product markets
would foster some softening in consumer price inflation over coming
quarters, a development that would be
abetted should prices of oil and natural
gas ease during the year in line with
current market expectations.
In preparation for a semi-annual
report to Congress, the members of the
Board of Governors and the presidents
of the Federal Reserve Banks provided
individual projections of the growth in
nominal and real GDP, the rate of unemployment, and the rate of inflation
for the year 2001. The forecasts were
concentrated in ranges of 4 to 5 percent for the growth in nominal GDP
and 2 to 2lA percent for the expansion in
real GDP, implying some strengthening
of economic activity as the year progressed. With growth in business activity falling short of the expansion in the
economy's potential, the rate of unemployment was expected to rise somewhat to an average of about AVi percent by the fourth quarter of the year.
Forecasts of the rate of inflation, as
measured by the chain-type price index
for personal consumption expenditures,
were centered in a range of VA to
2lA percent, reflecting declines from the
inflation rate last year largely stemming



from the projected reductions in energy
prices.
The marked deceleration in final sales
experienced late last year was concentrated in consumer spending for motor
vehicles and other durable goods and
in business expenditures for equipment
and software. In the household sector,
rapidly declining consumer confidence,
apparently associated in important measure with increasing worker layoffs and
growing concerns about future job prospects, had contributed to generally disappointing retail sales during the holiday season. There was some evidence
that sales had stabilized and possibly
risen slightly in January, though a part
of the improvement could reflect steep
price discounts for the purpose of reducing inventories. Other negative factors
cited by the members included the
adverse wealth effects of the decrease in
stock market valuations, relatively high
consumer debt service burdens, and possible retrenchment by consumers after
an extended period of large increases
in purchases and related buildups of
consumer durables. Nonetheless, in the
absence of possible developments leading to further deterioration in consumer
sentiment, the members saw reasonable
prospects for strengthening consumer
spending this year even assuming some
decline in such expenditures relative to
income. An important factor in this outlook was the expectation of some reduction in energy prices, which would boost
disposable incomes available for nonenergy expenditures and likely provide
a fillip to consumer sentiment in the
process. Moreover, with the relatively
high rate of growth in structural productivity showing little or no signs of waning, the longer-run prospects for household incomes remained positive. On
balance, the various factors weighing on
the outlook for consumer spending later
this year seemed favorable, though sub-

234 88th Annual Report, 2001
stantial downside risks clearly would
persist for some interim period of uncertain duration.
The depressing effects of lagging final
sales on business investment spending,
notably for equipment and software,
were reinforced by deterioration in the
financial balance sheets of some business firms, tighter supply conditions
in segments of the credit markets, and
a buildup in excess capacity that had
eroded profitability. In this regard, members referred to earlier unsustainable
rates of investment by many high-tech
firms that were now obliged to retrench
despite still high rates of growth in the
demand for their products and services.
With regard to the nonresidential construction sector, members provided
anecdotal reports of continued high
levels of activity in several parts of the
country and little evidence of the substantial overbuilding that had characterized the construction industry in earlier
periods of developing economic weakness. On balance, while the business
investment outlook seemed vulnerable
to somewhat greater than projected
weakness in the short run, the members
were persuaded that, against the background of large continuing gains in
structural productivity and cost savings
from further investment in equipment
and software, business firms were likely
to accelerate their spending for new
capital after a period of adjustment.
Concerning the outlook for housing
activity, recent statistical and anecdotal
reports indicated that housing sales and
construction were being well maintained
and indeed were a bright spot in several
regions. Reduced mortgage interest rates
appeared to be largely offsetting the
marked decline in consumer confidence.
Accordingly, and contrary to the experience in earlier periods of softening economic activity, the stabilization of housing activity at a pace near its current



fairly high level was seen as a reasonable expectation.
The outlook for inventory investment
was more uncertain. The drop in final
sales during late 2000 evidently was
much faster than generally expected,
and inventories rose considerably over
the fourth quarter as a whole despite
sharp downward adjustments in manufacturing output. In keeping with just-intime inventory policies, which had been
furthered in recent years by advances in
technology that allowed faster and more
complete readings on sales and adjustments in orders, efforts to reduce inventories were continuing in recent weeks
and net inventory liquidation was anticipated in the current quarter. Looking
further ahead, a number of members
commented that they expected a period
of inventory correction that would be
relatively sharp but short by historical
standards. Improvements in inventory
management and related indications that
inventory overhangs were small compared to earlier historical experience
were factors in this assessment. At the
same time, members recognized that the
inventory correction had just begun and
its duration would depend importantly
on the ongoing strength of final sales. In
this regard, developments bearing on
business and consumer confidence and
willingness to spend would play a crucial, though at this point uncertain, role.
Members expressed some divergence
of views regarding the outlook for foreign economic activity and the implications for the domestic economy. Some
emphasized that most of the nation's
important trading partners had growing
economies that were likely to provide
support for expanding U.S. exports.
Other members were concerned about
indications of growing weakness in a
number of foreign economies that might
increasingly inhibit U.S. exports and add
to competitive pressures on U.S. produc-

Minutes of FOMC Meetings, January 235
ers in domestic markets. The large current account deficit was seen as a factor
pointing to potential depreciation of the
dollar over time, with adverse repercussions on domestic inflation albeit favorable effects on exports.
In their comments about the outlook
for inflation, members noted that current
indicators continued on the whole to
point to subdued price increases, with
lagging demand and strong competitive
pressures in many markets severely
limiting the ability of business firms to
raise their prices. Labor markets were
described as still tight across the nation,
but reports of layoffs in specific industries were increasing and numerous
business contacts indicated that openings were now much easier to fill in
many job markets. There were some
related indications that wage pressures
might be easing. Against the background of a sluggish economy in the
near term and forecasts of only moderate economic growth, the members
anticipated that inflation would remain
contained over the forecast horizon. A
key factor in this assessment continued
to be their outlook for rapid further gains
in structural productivity that would
help to hold down increases in unit labor
costs. Other factors included the prospect of some decline in energy prices
and the persistence of generally benign
inflation expectations. On balance, with
pressures in labor and product markets
ebbing, the outlook for inflation was a
source of diminished though persisting
concern.
In the Committee's discussion of
policy for the intermeeting period ahead,
all the members endorsed a proposal
calling for a further easing in reserve
conditions consistent with a 50 basis
point decrease in the federal funds rate
to a level of 5lA percent. Such a policy
move in conjunction with the 50 basis
point reduction in early January would



represent a relatively aggressive policy
adjustment in a short period of time, but
the members agreed on its desirability
in light of the rapid weakening in the
economic expansion in recent months
and associated deterioration in business
and consumer confidence. The extent
and duration of the current economic
correction remained uncertain, but the
stimulus provided by the Committee's
policy easing actions would help guard
against cumulative weakness in economic activity and would support the
positive factors that seemed likely to
promote recovery later in the year. Several members observed that the evolving
nature of the domestic economy, including the ongoing improvements in inventory management and the increase in
managerial flexibility to alter the level
and mix of capital equipment, associated in part with the greater availability
of information, appeared to have fostered relatively prompt adjustments by
businesses to changing economic conditions. As a consequence, monetary policy reactions to shifts in economic trends
needed in this view to be undertaken
more aggressively and completed sooner
than in the past. In current circumstances, members saw little inflation risk
in such a "front-loaded" easing policy,
given the reduced pressures on resources
stemming from the sluggish performance of the economy and relatively
subdued expectations of inflation.
All the members agreed that the
balance of risks sentence in the press
statement to be released shortly after
this meeting should continue to indicate
that the risks would remain tilted toward
economic weakness even after today's
easing action. The members saw substantial underlying strength and resilience in the economy and they remained
optimistic about its prospects beyond
the near term in light of the monetary
policy stimulus that was being imple-

236 88th Annual Report, 2001
mented and the persistence of rapid
advances in productivity. In this regard,
some members commented that the
upside risks could not be totally dismissed. But with the adjustments to
the stock of capital, consumer durable
goods, and inventories to more sustainable levels likely only partly completed
and with investors in financial markets
remaining skittish, the risks that growth
would persist below that of the economy' s productivity-enhanced potential
continued to dominate the outlook.
At the conclusion of this discussion,
the Committee voted to authorize and
direct the Federal Reserve Bank of New
York, until it was instructed otherwise,
to execute transactions in the System
Account in accordance with the following domestic policy directive:
The Federal Open Market Committee
seeks monetary and financial conditions that
will foster price stability and promote sustainable growth in output. To further its longrun objectives, the Committee in the immediate future seeks conditions in reserve
markets consistent with reducing the federal funds rate to an average of around
5 ^percent.

The vote encompassed approval of
the sentence below for inclusion in the
press statement to be released shortly
after the meeting:
Against the background of its long-run
goals of price stability and sustainable economic growth and of the information currently available, the Committee believes that
the risks are weighted mainly toward conditions that may generate economic weakness
in the foreseeable future.
Votes for this action: Messrs. Greenspan,
McDonough, Ferguson, Gramlich, Hoenig, Kelley, Meyer, Ms. Minehan, Messrs.
Moskow and Poole. Votes against this
action: None.
By notation vote completed on
March 15, 2001, the Federal Open Mar


ket Committee voted unanimously to
select Dino Kos as Manager for Domestic and Foreign Operations of the System Open Market Account to serve
in that capacity until the first regularly
scheduled meeting after December 31,
2001, subject to the understanding that
in the event of the discontinuance of his
official connection with the Federal
Reserve Bank of New York he would
cease to have any official connection
with the Federal Open Market Committee. It also was understood that this
selection needed to be satisfactory to
the Federal Reserve Bank of New York.
Advice subsequently was received that
the selection of Mr. Kos as Manager
was satisfactory to the board of directors
of that Bank.
It was agreed that the next meeting of
the Committee would be held on Tuesday, March 20, 2001.
The meeting adjourned at 10:50 a.m.
on January 31,2001.
Donald L. Kohn
Secretary

Meeting Held on
March 20, 2001
A meeting of the Federal Open Market
Committee was held in the offices of
the Board of Governors of the Federal
Reserve System in Washington, D.C.,
beginning at 9:00 a.m. on Tuesday,
March 20, 2001.
Present:
Mr. Greenspan, Chairman
Mr. McDonough, Vice Chairman
Mr. Ferguson
Mr. Gramlich
Mr. Hoenig
Mr. Kelley
Mr. Meyer
Ms. Minehan
Mr. Moskow
Mr. Poole

Minutes of FOMC Meetings, March
Messrs. Jordan, McTeer, Santomero,
Stern, and Stewart, Alternate
Members of the Federal Open
Market Committee
Messrs. Broaddus, Guynn, and Parry,
Presidents of the Federal Reserve
Banks of Richmond, Atlanta, and
San Francisco respectively
Mr. Kohn, Secretary and Economist
Mr. Bernard, Deputy Secretary
Mr. Gillum, Assistant Secretary
Ms. Fox, Assistant Secretary
Mr. Baxter, Deputy General Counsel
Ms. Johnson, Economist
Mr. Stockton, Economist
Ms. Cumming, Messrs. Fuhrer, Hakkio,
Howard, Hunter, Lindsey, Rasche,
Reinhart, Slifman, and Wilcox,
Associate Economists
Mr. Kos, Manager, System Open
Market Account
Ms. Smith and Mr. Winn, Assistants
to the Board, Office of Board
Members, Board of Governors
Mr. Ettin, Deputy Director, Division
of Research and Statistics,
Board of Governors
Mr. Simpson, Senior Adviser, Division
of Research and Statistics, Board
of Governors
Messrs. Madigan, Oliner, and
Struckmeyer, Associate Directors,
Divisions of Monetary Affairs,
Research and Statistics, and
Research and Statistics, Board
of Governors
Mr. Whitesell, Assistant Director,
Division of Monetary Affairs,
Board of Governors
Ms. Low, Open Market Secretariat
Assistant, Division of Monetary
Affairs, Board of Governors
Mr. Barron, First Vice President,
Federal Reserve Bank of Atlanta



237

Messrs. Eisenbeis and Goodfriend,
Mses. Krieger and Mester, and
Mr. Rolnick, Senior Vice
Presidents, Federal Reserve Banks
of Atlanta, Richmond, New York,
Philadelphia, and Minneapolis
respectively
Ms. Orrenius, Economist, Federal
Reserve Bank of Dallas
Mr. Trehan, Research Advisor, Federal
Reserve Bank of San Francisco
Mr. Haubrich, Consultant, Federal
Reserve Bank of Cleveland
By unanimous vote, the minutes of
the meeting of the Federal Open Market
Committee held on January 30-31,
2001, were approved.
By unanimous vote, David Wilcox
was elected to serve as an Associate
Economist for the period until the first
regularly scheduled meeting of the
Committee after December 31, 2001.
The Manager of the System Open
Market Account reported on developments in foreign exchange markets.
There had been no operations in foreign
currencies for the System's account
since the previous meeting.
The Manager also reported on
developments in domestic financial
markets and on System open market
transactions in U.S. government securities and federal agency obligations
during the period January 31, 2001,
through March 19, 2001. By unanimous
vote, the Committee ratified these
transactions.
The Committee then turned to a
discussion of the economic and financial outlook and the implementation of
monetary policy over the intermeeting
period ahead. A summary of the economic and financial information available at the time of the meeting and of
the Committee's discussion is provided
below, followed by the domestic policy

238 88th Annual Report, 2001
directive that was approved by the Committee and issued to the Federal Reserve
Bank of New York.
The information reviewed at this
meeting suggested that economic
activity continued to expand very slowly
in the first quarter. Growth of final
spending apparently picked up slightly,
with consumer expenditures recording another moderate gain, business
purchases of equipment and software
increasing sluggishly after a fourthquarter decline, and homebuilding
remaining relatively firm. However,
inventory overhangs were still apparent
in some industries, and manufacturing
production was cut sharply further.
Overall employment gains were relatively well maintained, and labor
markets were still tight though showing signs of softening. Price inflation
had picked up a little but, abstracting
from energy, had remained relatively
subdued.
After a sluggish fourth quarter, private nonfarm payroll employment rose
at a slightly higher rate on average
in January and February, though still
considerably below the pace of the first
three quarters of 2000. Manufacturing
and related industries, notably helpsupply and wholesale trade, experienced
further large declines in payrolls in
the January-February period. However,
hiring elsewhere held up relatively
well, especially in construction, which
recorded a surge in employment in January. While the labor market remained
tight on balance, the unemployment rate
increased to 4.2 percent in February, and
other indicators such as initial claims for
unemployment insurance suggested that
pressures in labor markets had begun to
abate.
The contraction in industrial production that began in October accelerated
and broadened in the first two months
of the year. In manufacturing, output fell



further in the motor vehicle sector, and
production continued to decelerate in
high-tech industries. The rate of capacity utilization in manufacturing dropped
noticeably in January and February to a
level further below its long-run average.
Against a background of slowing
income gains and a sizable pullback in
consumer sentiment since last autumn,
consumer spending evidently grew only
moderately on balance in January and
February. Purchases of motor vehicles
picked up in response to increased
marketing incentives put in place by
Chrysler and General Motors, and retail
sales of items other than motor vehicles
climbed moderately. Spending on services was held down in January (latest
data) by reduced expenditures for heating services as winter temperatures
returned to more seasonal levels following unusually cold weather late last year;
excluding heating, however, spending
on other services rose slowly.
The decline in mortgage rates that
began around the middle of last year
continued to provide support to residential building activity. Total housing
starts rose somewhat further in January
and February, reflecting net increases
in both single-family and, especially,
multifamily units. Sales of new homes
dropped sharply in January (latest data),
after having surged in December, but
remained quite robust by historical
standards. Sales of existing homes
rebounded in January after having fallen
considerably in December and were up
slightly on balance over the two months.
The limited available information
suggested that business fixed investment
was firming early this year after a
decline in the fourth quarter of last year.
Nominal shipments of nondefense capital goods other than aircraft and parts
changed little on balance in December
and January, while prices of high-tech
equipment continued to fall. Moreover,

Minutes of FOMC Meetings, March 239
orders for nondefense capital goods
turned up briskly in January after a
sharp fourth-quarter drop. Nonresidential construction activity continued its
robust rise early in the year. Strength in
building activity was widespread across
the sector, most notably in new office
construction.
Business inventories on a book-value
basis increased in January at about
the rapid fourth-quarter pace; inventory positions appeared to be especially
large for construction materials, metals,
electrical equipment, paper, chemicals,
and textiles. In the manufacturing sector, overall stocks jumped in January
while shipments fell, and the aggregate
inventory-shipments ratio rose to its
highest level in two years. In the wholesale trade sector, aggregate stocks
fell again in January and the sector's
inventory-sales ratio edged down to the
middle of its very narrow range for the
past year. Retail stocks continued to
climb in January, but sales rose by more;
the sector's inventory-sales ratio also
edged lower, but it remained near the
top of its range for the past twelve
months.
The U.S. trade deficit in goods and
services changed little in December but
posted a new record high for the fourth
quarter. The value of exports dropped
substantially in that quarter, with notable
declines occurring in agricultural products, aircraft, automotive products, computers and semiconductors, consumer
goods, and telecommunications equipment. The value of imports remained
at the high level recorded in the third
quarter. Lower imports of automotive
products, chemicals, computers and
semiconductors, and steel were offset
by higher imports of consumer goods
and telecommunications equipment and
smaller increases in other categories of
trade. Economic growth in the foreign
industrial countries was at a moderate



rate on average in the fourth quarter.
Expansion in the euro area picked
up, while growth in Canada and the
United Kingdom slowed significantly.
The Japanese economy rebounded in
the fourth quarter but was little changed
on balance over the second half of the
year, and recent indicators suggested a
sharply weaker performance in the early
part of this year. In addition, growth in
the major developing countries slowed
markedly in the fourth quarter, with the
slowdown in most of those countries
reflecting weaker demand for their
exports.
Price inflation had picked up a bit
recently. The consumer price index
(CPI) jumped in January (latest data),
reflecting a surge in energy prices;
moreover, the index increased considerably more during the twelve months
ending in January than it did during the
previous twelve months. The core component of the CPI also accelerated in
January and on a year-over-year basis,
but by lesser amounts than did the total
index. The increase in the core personal
consumption expenditure (PCE) chaintype price index in January matched that
of the core CPI; on a year-over-year
basis, however, the pickup in core PCE
inflation was a little smaller than that for
the core CPI. At the producer level, core
finished goods retraced in February only
part of the sizable step-up in prices
recorded in January, and core producer
price inflation was up somewhat on a
year-over-year basis. With regard to
labor costs, recent data also pointed to
some acceleration. Compensation per
hour in the nonfarm business sector
advanced appreciably more rapidly in
the fourth quarter of 2000 and for the
year as a whole. That trend also showed
through to the average hourly earnings
of production or nonsupervisory workers through February, which exhibited a
roughly similar acceleration.

240 88th Annual Report, 2001
At its meeting on January 30-31,
2001, the Committee adopted a directive
that called for maintaining conditions
in reserve markets consistent with a
decrease of 50 basis points in the
intended level of the federal funds rate,
to about 5V2 percent. This move, in conjunction with the easing on January 3,
was intended to help guard against
cumulative weakness in economic activity and to provide some support to a
rebound in growth later in the year. In
the existing circumstances, the members
agreed that the balance of risks remained
weighted toward conditions that could
generate economic weakness in the
foreseeable future. Though rapid
advances in underlying productivity
were expected to continue, the adjustments to stocks of capital, consumer
goods, and inventories to more sustainable levels were only partly completed, and financial markets remained
unsettled.
Open market operations were directed
throughout the intermeeting period
toward maintaining the federal funds
rate at the Committee's reduced target
level of 5x/2 percent, and the funds rate
stayed close to that target. However,
incoming economic data, a steady flow
of disappointing corporate earnings
reports, related sharp declines in stock
prices, and a notable drop in consumer
confidence led market participants to
conclude that more monetary easing
would be required. Yields on Treasury
securities, both short- and long-term,
moved appreciably lower. However,
rates on high-yield private debt obligations fell only a little, and banks further
tightened standards and terms on business loans, given the weakening outlook
for profits. Broad indexes of U.S. stock
market prices moved sharply lower, with
the tech-heavy Nasdaq experiencing an
especially large drop. Nonetheless, the
trade-weighted value of the dollar rose



somewhat over the intermeeting interval
in terms of many of the major foreign
currencies. The dollar strengthened most
against the currencies of countries that
were seen to have the greatest potential
for economic weakening, notably Japan.
The dollar also posted a small gain
against an index of the currencies of
other important trading partners.
The broad monetary aggregates continued to grow rapidly in February,
though at slightly lower rates than in
January. The strength in M2 was concentrated in its liquid components,
apparently in response to the further narrowing of opportunity costs, the yield
advantage of money funds relative to
longer-term investments, and the appeal
of a safe haven from volatile equity
markets. M3 grew somewhat less rapidly than M2; a pullback in the issuance
of bank-managed liabilities, particularly
large time deposits, was associated with
slower expansion of bank credit. Growth
of domestic nonfinancial debt decelerated noticeably in January (latest data),
reflecting reduced expansion of debt in
the nonfederal sectors coupled with a
larger contraction in the amount of federal debt outstanding.
The staff forecast prepared for this
meeting suggested that, after a period
of slow growth associated in part with
an inventory correction, the economic
expansion would gradually regain
strength over the next two years and
move toward a rate near the staff's current estimate of the growth of the economy's potential output. The period of
subpar expansion was expected to foster
an appreciable easing of pressures on
resources and some moderation in core
price inflation. The forecast anticipated
that the expansion of domestic final
demand would be held back to an extent
by the decline in household net worth
associated with the downturn that had
occurred in equity prices, the lingering

Minutes of FOMC Meetings, March 241
effects of last year's relatively high
interest rates, and the continuation of
relatively stringent terms and conditions
on some types of loans by financial
institutions. As a result, growth of
spending on consumer durables was
expected to be appreciably below the
rapid pace in the first half of last year,
and housing demand would increase
only a little from its recent level. Business fixed investment, notably outlays
for equipment and software, was projected to resume relatively robust
growth after a period of adjustment of
capital stocks to more desirable levels;
growth abroad was seen as supporting
the expansion of U.S. exports; and fiscal
policy was assumed to become more
expansionary.
In the Committee's discussion of current and prospective economic developments, members commented that the
recent statistical and anecdotal information had been mixed, but they viewed
evolving business conditions as consistent on the whole with a continued softness in economic activity. Members
noted that consumer spending had
strengthened early in the year and housing activity had remained at a relatively
high level. These positive developments
needed to be weighed against an appreciable weakening in business investment
spending and the near-term restraining
effects of a drawdown in inventories.
Looking ahead, while sales and production data suggested that excess
inventories were being worked off, the
adjustment did not appear to have
been completed. Beyond the inventory
correction, the members continued to
anticipate an acceleration of the expansion over time, though likely on a more
delayed basis and at a more gradual
pace than they had forecast earlier. They
noted a number of favorable underlying factors that would tend to support
a rebound, including solid productivity



growth, stable low inflation, generally
sound financial institutions, lower interest rates, and relatively robust expansion
in many measures of money. However,
the members saw clear downside risks
in the outlook for consumer and investment spending in the context of the
marked decline that had occurred in
equity prices and consumer confidence,
and in expected business profitability,
and they were concerned that weaker
exports might also hold down the expansion of economic activity. With regard
to the outlook for inflation, some recent
measures of increases in core prices had
fluctuated on the high side of earlier
expectations, but apart from energy
prices and medical costs, inflation was
still relatively quiescent. With the
growth in output likely to remain below
the expansion of the economy's potential for a while, members anticipated
that inflation would remain subdued.
Mirroring the statistics for the nation
as a whole, business conditions in different parts of the country displayed mixed
industry patterns, but members reported
that overall business activity currently
appeared to be growing at a sluggish
pace in most regions, and business contacts were exhibiting a heightened sense
of caution, or even concern, in some
industries. In their review of developments in key sectors of the economy,
members indicated that they saw favorable prospects for continued moderate growth in consumer expenditures,
though considerable uncertainty surrounded this outlook. Downside risks
cited by the members included the
substantial declines that had already
occurred in measures of consumer confidence and equity wealth, and the possibility that consumer sentiment might
be undermined even further by continued volatility and additional declines
in the stock market and by rising concerns about job losses amid persistent

242 88th Annual Report, 2001
announcements of layoffs. Members
also referred to the retarding effects on
consumer expenditures of elevated levels of household debt and high energy
costs. Against this background, consumers might well endeavor to boost their
savings, and even a fairly small increase
in what currently was a quite low saving
rate would have large damping effects
on aggregate demand that could weaken,
if not abort, the expansion. To date,
however, overall consumer spending
had remained relatively strong and
seemingly at odds with measures of
consumer confidence and reduced
equity wealth. How this divergence
might eventually be resolved was a significant source of uncertainty and downside risk. On balance, while there were
reasons to be concerned about the outlook for consumer spending, members
believed that recent spending trends
and the outlook for further growth in
employment and incomes pointed to
continued expansion in this key sector
of the economy, though likely at a relatively sluggish pace.
Another major source of downside
risk to the expansion was business fixed
investment. Spending for equipment and
software declined in the fourth quarter,
and the available statistical and anecdotal reports pointed to weakness during
the first half of this year, largely reflecting developments in high-tech industries. Substantial downward adjustments
to expected near-term business earnings
had persisted, suggesting that firms saw
investment as much less profitable than
they had before and that cash flows
would be constrained. Many businesses
also were inhibited in their investment
activities by less accommodative financial conditions associated with weaker
equity markets and tighter credit terms
and conditions imposed by banking
institutions. As a consequence, a substantial volume of planned investment



was being postponed, if not canceled.
The capital stock had grown at an unsustainable pace for a time, so some downshifting in investment was inevitable.
Moreover, those earlier very substantial investment outlays seemed to have
created excess capacity in a number of
industries, and how large an adjustment
in spending for business equipment
might now be under way was still
unclear, especially with regard to hightech industries. At the same time, the
information available for the first
quarter indicated considerable strength
in nonresidential construction activity,
including large outlays on public-sector
infrastructure projects in some areas.
On balance, business spending for plant
and equipment was likely to pick up
only gradually this year. Over the longer
term, however, a return to more robust
business investment seemed likely,
and indeed business earnings forecasts
beyond the nearer term had not declined
very much, reflecting continuing expectations of substantial profit opportunities related to persisting strong gains in
productivity.
Housing activity was generally holding up well across the country, as the
effects of appreciably reduced mortgage
interest rates apparently compensated
for the negative effects of declining
financial wealth on the demand for
housing. While housing construction
was generally described as elevated,
some members referred to overbuilding
or weakness in some local housing markets. It was noted that homebuilders
were generally optimistic about the
prospects for the year ahead, given their
current backlogs and expectations of
further growth in employment and
incomes.
The ongoing adjustments in business
inventories had played a significant
role in curbing the growth of economic
activity in recent months, but such

Minutes of FOMC Meetings, March 243
adjustments seemed likely gradually to
become a more neutral factor over the
balance of this year. In the motor vehicle industry, inventory liquidation had
been especially pronounced and the
process now seemed largely completed.
However, the inventory-correction process in high-tech industries apparently
was not as far along. In the absence
of renewed weakness in overall final
demand, which could not be ruled out
given current consumer and business
confidence, production would need to
pick up at some point to accommodate
ongoing final demand. Some members
observed that the adjustment in inventories might require more time than
they had anticipated earlier. In any
event, completion of the process clearly
would foster an upturn in manufacturing
activity.
Members commented on the downside risks to U.S. exports and the U.S.
expansion from what appeared to be
softening economic conditions in a number of important foreign economies. In
some countries, the risks were exacerbated by the apparent inability or unwillingness of government officials to
address underlying structural problems
in their economies and financial systems. Members noted anecdotal reports
of weakening business conditions in a
number of Asian and South American
nations. The potential impact on exports
of less vigor in the global economy
would be augmented, of course, by
the strength of the dollar in foreign
exchange markets.
Although labor markets in general
remained tight throughout the nation,
anecdotal reports of less scarce labor
resources were becoming more frequent in some areas or occupations.
Some price increases had been noted;
however, apart from the energy and
health care sectors, price inflation had
remained relatively subdued, evidently



reflecting the combination of diminished
growth in overall demand and strong
competitive pressures in most markets.
With regard to the outlook for wages
and prices, members commented that
the prospects for an extended period of
growth in demand at a pace below the
economy's potential should ease pressures on labor and other resources and
help to contain inflation.
In the Committee's discussion of policy for the intermeeting period ahead,
most of the members preferred and all
could support a further easing of reserve
conditions consistent with a 50 basis
point reduction in the federal funds rate,
to 5 percent. The members agreed that
a strengthening in the economic expansion over coming quarters was a reasonable expectation, but absent further easing in monetary policy that pickup was
unlikely to bring growth to an acceptable pace in the foreseeable future. Business investment would be held back
by lower earnings expectations and a
capital overhang of unknown dimensions; consumption was subject to
downside risks from previous decreases
in equity wealth and declining confidence; and the strong dollar and weaker
foreign growth would constrain exports.
Inflation was likely to be damped by
ebbing pressures on labor and product
markets. While many of the members
generally believed that additional policy
easing might well prove to be necessary
at some time, the easing favored by most
members incorporated what they viewed
as an adequate degree of stimulus under
current economic conditions and represented an appropriately calibrated step
given the uncertainties in the economic
outlook. It was noted in this regard that
in combination with the two easing
actions earlier this year, the Committee
would have implemented in a relatively
short period a considerable amount
of monetary easing whose economic

244 88th Annual Report, 2001
effects would be felt over time. However, some commented that the amount
of financial stimulus was much smaller
than might otherwise be expected from
policy easing of this cumulative amount
because it had been accompanied by
further declines in stock market prices,
more stringent financing terms for many
business borrowers, and a stronger dollar, all of which would be holding down
domestic spending and production.
Indeed, financial markets had come to
place some odds on a larger move of
75 basis points in recent days, importantly reflecting the possibility of a
presumed policy response to the sizable declines in equity prices that had
occurred as earnings prospects proved
disappointing. Most members agreed,
however, that in the context of their
focus on the economy, smaller, possibly more frequent, policy adjustments
were appropriate to afford them the
opportunity to recalibrate policy in
rapidly changing and highly uncertain
circumstances.
A few members expressed a preference for a 75 basis point reduction in the
federal funds rate. In their view, a more
forceful action was justified by current
and prospective economic conditions.
The members agreed that even with a
further 50 basis point reduction in the
federal funds rate, the risks to the economy would remain decidedly to the
downside. This conclusion would be
reflected in the press statement to be
released after today's meeting. The
statement also would emphasize the
need for close monitoring of rapidly
evolving economic conditions. The
members anticipated that in the relatively long interval before the next regularly scheduled meeting on May 15,
2001, economic developments might
suggest the desirability of a Committee
conference call to assess business conditions across the nation and to consider



the possible need for a further policy
adjustment.
At the conclusion of this discussion,
the Committee voted to authorize and
direct the Federal Reserve Bank of New
York, until it was instructed otherwise,
to execute transactions in the System
Account in accordance with the following domestic policy directive:
The Federal Open Market Committee
seeks monetary and financial conditions that
will foster price stability and promote sustainable growth in output. To further its longrun objectives, the Committee in the immediate future seeks conditions in reserve
markets consistent with reducing the federal
funds rate to an average of around 5 percent.

The vote encompassed approval of
the sentence below for inclusion in the
press statement to be released shortly
after the meeting:
Against the background of its long-run
goals of price stability and sustainable economic growth and of the information currently available, the Committee believes that
the risks are weighted mainly toward conditions that may generate economic weakness
in the foreseeable future.
Votes for this action: Messrs. Greenspan,
McDonough, Ferguson, Gramlich, Hoenig, Kelley, Meyer, Ms. Minehan, Messrs.
Moskow and Poole. Votes against this
action: None.

The Chairman called for a recess after
this vote and convened a meeting of the
Board of Governors to consider reductions of one-half percentage point in the
discount rate that had been proposed by
all the Federal Reserve Banks. After the
recess, the Chairman informed the Committee that the pending reductions had
been approved.
It was agreed that the next meeting
of the Committee would be held on
Tuesday, May 15, 2001. The meeting
adjourned at 1:15 p.m.

Minutes of FOMC Meetings, March 245

Telephone Conferences
On April 11, 2001, the Committee
reviewed economic and financial developments since its last meeting and discussed the possible need for some further easing of monetary policy. The data
and anecdotal information were mixed:
They did not indicate that the economy
had been weakening further, but they
raised questions about the potential
strength of a rebound in growth over
coming quarters. In particular, heightened business concerns about future
sales and further downward revisions to
expected earnings threatened to restrain
capital spending for some time. In the
circumstances, the members could see
the need for a further easing of policy
at some point, though some had a strong
preference for taking such actions at
regularly scheduled meetings. They all
agreed that an easing on this date would
not be advisable, inasmuch as the attendant surprise to most outside observers
risked unpredictable reactions in financial markets that had been especially
volatile in recent days, and additional
important data would become available
over the near term.
A week later, on April 18, 2001, the
Committee held a telephone conference
meeting for the purpose of considering
a policy easing action. The members
noted that the statistical and anecdotal
information received since the last conference call had supported their view
that an easing of policy would be appropriate. In addition to the continuing
concerns about business plans for capital investment, consumer spending had
leveled out and confidence had fallen
further. In these circumstances, lower
interest rates were likely to be necessary
to foster more satisfactory economic
expansion. With financial markets more
settled, and with nearly a month until



the Committee's May meeting, an easing move was called for at this time.
Although a few preferred to wait until
the next scheduled meeting, all the
members supported or could accept a
proposal for an easing of reserve conditions consistent with a reduction of
50 basis points in the federal funds rate
to a level of 4Vi percent. The Committee
voted to authorize and direct the Federal
Reserve Bank of New York, until it was
instructed otherwise, to execute transactions in the System Account in accordance with the following domestic policy directive:
The Federal Open Market Committee
seeks monetary and financial conditions that
will foster price stability and promote sustainable growth in output. To further its longrun objectives, the Committee in the immediate future seeks conditions in reserve
markets consistent with reducing the federal funds rate to an average of around
4V2 percent.
The vote encompassed approval of
the sentence below for inclusion in the
press statement to be released shortly
after the meeting:
Against the background of its long-run
goals of price stability and sustainable economic growth and of the information currently available, the Committee believes that
the risks are weighted mainly toward conditions that may generate economic weakness
in the foreseeable future.
Votes for this action: Messrs. Greenspan,
McDonough, Ferguson, Gramlich, Hoenig, Kelley, Meyer, Ms. Minehan, Messrs.
Moskow and Poole. Votes against this
action: None.
Chairman Greenspan indicated that
shortly after this meeting the Board
of Governors would consider pending
requests of eight Federal Reserve Banks

246 88th Annual Report, 2001
to reduce the discount rate by 50 basis
points.
Donald L. Kohn
Secretary

Meeting Held on
May 15, 2001
A meeting of the Federal Open Market
Committee was held in the offices of
the Board of Governors of the Federal
Reserve System in Washington, D.C.,
on Tuesday, May 15, 2001, starting at
9:00 a.m.
Present:
Mr. Greenspan, Chairman
Mr. McDonough, Vice Chairman
Mr. Ferguson
Mr. Gramlich
Mr. Hoenig
Mr. Kelley
Mr. Meyer
Ms. Minehan
Mr. Moskow
Mr. Poole
Messrs. Jordan, McTeer, Santomero,
and Stern, Alternate Members
of the Federal Open Market
Committee
Messrs. Broaddus, Guynn, and Parry,
Presidents of the Federal Reserve
Banks of Richmond, Atlanta, and
San Francisco respectively
Mr. Kohn, Secretary and Economist
Mr. Gillum, Assistant Secretary
Ms. Fox, Assistant Secretary
Mr. Mattingly, General Counsel
Ms. Johnson, Economist
Mr. Stockton, Economist
Ms. Cumming, Messrs. Fuhrer, Hakkio,
Howard, Lindsey, Rasche,
Reinhart, Slifman, and Wilcox,
Associate Economists
Mr. Kos, Manager, System Open
Market Account



Mr. Ettin, Deputy Director, Division
of Research and Statistics,
Board of Governors
Mr. Simpson, Senior Adviser, Division
of Research and Statistics,
Board of Governors
Messrs. Connors,5 Madigan, Oliner,
and Struckmeyer, Associate
Directors, Divisions of
International Finance, Monetary
Affairs, Research and Statistics,
and Research and Statistics,
Board of Governors
Mr. Whitesell, Assistant Director,
Division of Monetary Affairs,
Board of Governors
Mr. Skidmore, Special Assistant to the
Board, Office of Board Members,
Board of Governors
Mr. Kumasaka, Assistant Economist,
Division of Monetary Affairs,
Board of Governors
Ms. Low, Open Market Secretariat
Assistant, Division of Monetary
Affairs, Board of Governors
Mr. Connolly, First Vice President,
Federal Reserve Bank of Boston
Messrs. Beebe, Eisenbeis, and
Goodfriend, Mses. Mester and
Perlmutter, Messrs. Rosenblum
and Sniderman, Senior Vice
Presidents, Federal Reserve Banks
of San Francisco, Atlanta,
Richmond, Philadelphia,
New York, Dallas, and Cleveland
respectively
Mr. Sullivan, Vice President, Federal
Reserve Bank of Chicago
Mr. Weber, Senior Research Officer,
Federal Reserve Bank of
Minneapolis

5. Attended portion of meeting relating to staff
briefings.

Minutes of FOMC Meetings, May 247
By unanimous vote, the minutes of mittee and issued to the Federal Reserve
the meeting of the Federal Open Market Bank of New York.
Committee held on March 20, 2001,
The information reviewed at this
were approved.
meeting suggested that the economic
The Manager of the System Open expansion remained very sluggish.
Market Account reported on recent Household spending, especially for
developments in foreign exchange mar- housing and motor vehicles, had held
kets. There were no open market opera- up relatively well, but business investtions in foreign currencies for the Sys- ment was quite weak and appeared to
tem's account in the period since the be decreasing further. Persistent invenprevious meeting.
tory overhangs in a number of sectors
The Manager also reported on devel- had led to additional substantial cuts in
opments in domestic financial markets manufacturing production. Reflecting
and on System open market transactions in part the downtrend in manufacturin government securities and federal ing output, labor demand had weakened
agency obligations during the period considerably and unemployment had
March 20, 2001, through May 14, 2001. risen. Price inflation had picked up a
By unanimous vote, the Committee rati- little but, abstracting from energy, had
remained relatively subdued.
fied these transactions.
By unanimous vote, the Committee
Private nonfarm payroll employment
approved the extension for one year fell sharply in April after a small drop
beginning in December 2001 of the in March. Manufacturing, construction,
System's reciprocal currency ("swap") and the service sector recorded large
arrangements with the Bank of Canada payroll declines in April, and gains elseand the Bank of Mexico. The arrange- where were small. The unemployment
ment with the Bank of Canada is in the rate increased further, to 4.5 percent in
amount of $2 billion equivalent and that April, and initial claims for unemploywith the Bank of Mexico in the amount ment insurance averaged over the four
of $3 billion equivalent. Both arrange- weeks ended April 28 were at their highments are associated with the Federal est level since 1993.
Reserve's participation in the North
Industrial production declined appreAmerican Framework Agreement. The ciably further in April. Manufacturing
early vote to renew the System's partici- output registered a seventh consecutive
pation in the swap arrangements matur- monthly drop, while a robust boost to
ing in December relates to the provision mining activity associated with strong
that each party must provide six months gains in crude oil and gas production
prior notice of an intention to terminate was offset by a decrease in utilities
its participation.
output in a period of unusually warm
The Committee then turned to a dis- weather. In manufacturing, the produccussion of the economic and financial tion of motor vehicles and parts was
outlook and the implementation of unchanged in April after having surged
monetary policy over the intermeeting in February and March, but the output
period ahead. A summary of the eco- of high-tech equipment continued to
nomic and financial information avail- trend steeply downward, and there was
able at the time of the meeting and of widespread weakness in the manuthe Committee's discussion is provided facture of other industrial products.
below, followed by the domestic policy Reflecting the production cutbacks, the
directive that was approved by the Com- rate of utilization of manufacturing



248 88th Annual Report, 2001
capacity fell even further below its longrun average.
Consumer spending had held up
relatively well thus far this year despite
the deceleration in personal incomes,
reduced household net worth, and deterioration in consumer sentiment since
last autumn. After a solid first-quarter
gain, nominal retail sales rose briskly in
April, reflecting strong outlays at general merchandise and apparel stores,
building and material outlets, and automotive dealers. Growth of spending on
services slowed in the first quarter (latest data), partly because of a weatherrelated drop in consumption of energy
services.
Low mortgage rates continued to
provide support to residential building
activity. The first-quarter average for
total housing starts was the strongest
quarterly reading in a year despite a
March decline in starts that might have
been exaggerated by unusual weather
patterns. In addition, sales of new and
existing homes remained brisk through
March. New home sales reached a new
high in March, and sales of existing
homes were only a little below their
record high in June 1999.
Against the background of a sluggish
economy and deteriorating earnings,
business capital spending on equipment
and software declined somewhat further
in the first quarter. Increased purchases
of cars and trucks were among the few
areas of strength in business equipment expenditures; elsewhere, outlays
for high-tech equipment decreased on a
quarterly basis for the first time since
the 1990 recession, and spending for
equipment such as industrial machinery
changed little. Moreover, recent data
on orders for nondefense capital goods
suggested that some further slippage
in future spending for equipment was
likely. By contrast, nonresidential construction continued to expand briskly;



expenditures for oil and gas exploration
surged in the first quarter, and nonresidential building activity continued at a
rapid pace, with sizable gains recorded
for most major categories of buildings.
Business inventories on a book-value
basis fell steeply further in March,
with roughly half of the decline reflecting a runoff of motor vehicle stocks
at the wholesale and retail levels.
Despite the sharp liquidation of inventories in the manufacturing sector in
February and March, the aggregate
inventory-shipments ratio for that sector edged higher in March to a level
well above that of a year ago. In the
wholesale trade sector, aggregate stocks
dropped somewhat on balance in the
first quarter and the sector's stock-sales
ratio edged lower; nonetheless, the sector's ratio in March also was above its
level of a year earlier. Retail inventories
ran off in February and March after a
small January rise, and the sector's
inventory-sales ratio decreased somewhat on balance to around the middle of
its range for the past twelve months.
The U.S. trade deficit in goods and
services narrowed considerably in February, reflecting a further rise in the
value of exports and a sharp drop in the
value of imports. The average deficit
for the first two months of the year was
smaller than that for the fourth quarter.
Nonetheless, exports for the JanuaryFebruary period were below the fourthquarter average, with notable declines
occurring in automotive products,
industrial supplies, and semiconductors.
The slowdown in imports in JanuaryFebruary was broadly spread across
trade categories, with the largest
decreases occurring in automotive products, high-tech goods, and oil. Recent
information indicated that economic
activity in the foreign industrial countries had decelerated since the fourth
quarter. Expansion in the euro area, the

Minutes of FOMC Meetings, May 249
United Kingdom, and Canada appeared
to have slowed significantly, while the
Japanese economy seemed to have faltered after a brief rebound late last year.
In addition, economic growth in the
major developing countries had softened markedly, with the slowdown
in most of those countries reflecting
weaker external demand.
Overall inflation had been held down
thus far this year by a deceleration in
energy prices, but by some measures
core price inflation had picked up a bit.
The total consumer price index (CPI)
increased moderately in February and
March (latest data), and the increase in
that index during the past twelve months
was smaller than that during the previous twelve-month period, reflecting
reduced increases in energy prices. By
contrast, core CPI inflation picked up
slightly in the February-March period
and on a year-over-year basis. However,
inflation as measured by the core personal consumption expenditure (PCE)
chain-type price index, though also running a little higher in February-March,
recorded a small decline on a year-overyear basis. At the producer level, core
finished goods inflation was subdued in
March and April but moved up somewhat on a year-over-year basis. With
regard to labor costs, growth in the
employment cost index (ECI) for hourly
compensation picked up noticeably in
the first quarter of this year; however,
the gain in compensation for the four
quarters ended in March was a little
below the large increase for the fourquarter period ended in March 2000. By
contrast, average hourly earnings of production or nonsupervisory workers rose
more briskly in April and on a yearover-year basis.
At its meeting on March 20, 2001, the
Committee adopted a directive that
called for maintaining conditions in reserve markets consistent with a decrease



of 50 basis points in the intended level
of the federal funds rate, to about 5 percent. This action, in conjunction with a
further easing of Vi percentage point on
April 18, was intended to help promote
a more satisfactory economic expansion
going forward. Under then-current conditions, the members agreed that the balance of risks remained weighted toward
conditions that could generate economic
weakness in the foreseeable future.
Federal funds traded at rates near the
Committee's target levels over the intermeeting period. Other short-term interest rates generally fell somewhat less
than the reduction in the federal funds
rate because the markets had anticipated
the easing in policy, though only in part.
In contrast to the declines in short-term
rates, longer-term yields rose on balance
as investors apparently became more
confident of a pickup in output growth,
supported in part by improved prospects
for substantial federal tax reductions.
The more optimistic assessment of the
economic outlook and the unexpected
intermeeting easing action apparently
contributed to a narrowing of risk premiums on lower-grade private debt obligations and to a rise in equity prices.
Better-than-expected first-quarter earnings also boosted stock prices, and broad
indexes of U.S. stock market prices
moved substantially higher.
In foreign exchange markets, the
trade-weighted value of the dollar in
terms of many of the major foreign currencies changed little on balance over
the intermeeting interval. A number of
major foreign central banks cut their
policy rates during the period, but by
less than the two easing steps in the
United States. The dollar's appreciation
against the euro was offset by its decline
in terms of the yen and the Canadian
dollar. The dollar also was essentially
unchanged in terms of an index of the
currencies of other important trading

250 88th Annual Report, 2001
partners. The value of the Mexican peso
rose appreciably against the dollar as
monetary authorities maintained their
tight policy stance and as spreads on
Mexican debt narrowed. In contrast,
concerns about potential spillovers from
Argentina's worsening financial difficulties depressed the value of the Brazilian real relative to the dollar.
The broad monetary aggregates continued to grow rapidly in March and
April. In addition to the effects of lower
market interest rates, extensive mortgage financing activity and a flight
to safety from volatile equity markets
likely added to M2's strong upward
trend. The expansion of M3 was bolstered by robust growth of institutiononly money funds and by greater issuance of managed liabilities included
in this aggregate to help finance faster
growth of bank credit and a shift in bank
funding from foreign to U.S. sources.
The debt of domestic nonfinancial sectors had grown at a moderate pace on
balance through April.
The staff forecast prepared for this
meeting suggested that, after a period
of slow growth associated in part with
an inventory correction, the economic
expansion would gradually regain
strength over the next two years and
move back toward a rate near the staff's
current estimate of the growth of the
economy's potential output. The period
of subpar expansion was expected to
foster an easing of pressures on
resources and some moderation in core
price inflation. Despite the substantial
easing in the stance of monetary policy,
the forecast anticipated that the expansion of domestic final demand would be
held back to an extent by some of the
developments in financial markets—in
particular, the decline in household net
worth associated with the earlier downturn in equity prices, the continuation of
relatively stringent terms and conditions



on some types of loans by financial
institutions, and the appreciation of the
dollar. Partly as a result of the decline in
household wealth, growth of consumer
spending was expected to remain relatively low for some time, and housing
demand would increase only a little
from its recent level. However, business
fixed investment, notably outlays for
equipment and software, would resume
relatively good growth after a period
of adjustment of capital stocks to more
desirable levels; a projected recovery
in the growth of foreign economies
was seen as providing increased support
for U.S. exports; and fiscal policy was
assumed to become more expansionary.
In the Committee's discussion of current and prospective economic developments, members commented that the
slowdown in the expansion to a now
quite sluggish pace was likely to be
more prolonged than they had anticipated earlier and indeed, with the economy displaying some signs of fragility
and inventories still appearing excessive
in some sectors, it was not entirely clear
that the slowing in the growth of the
economy had bottomed out. Despite the
crosscurrents and uncertainties that were
involved, members saw an upturn in the
economic expansion by later in the year
as the most likely outlook. This view
was premised in large measure on the
lagged effects of the Committee's relatively aggressive easing actions this
year, including any further easing that
might be adopted at this meeting, growing prospects of some fiscal policy
stimulus later in the year, and more
generally the favorable effects of still
substantial productivity gains on profit
opportunities and income growth and
hence on business and household
demands for goods and services. As
business profits stabilized and final
demand firmed, inventory liquidation
would come to an end, adding to the

Minutes of FOMC Meetings, May 251
upward momentum of economic activity. The members were uncertain as to
the degree and timing of the strengthening in final demand, and although a relatively prompt and strong rebound could
not be ruled out, many saw a variety
of factors that pointed to the possibility
that the upturn could be weaker or more
delayed than the central tendencies of
their expectations. With regard to the
outlook for inflation, a number of members expressed concern about a tendency
for some measures of inflation to edge
higher this year, but many members
expected that the easing of pressures in
labor and product markets that already
had occurred, and that was likely to
continue in the months ahead, would
damp inflation going forward.
In their review of developments
across the nation, members referred to
quite sluggish economic conditions in
many parts of the country. Weakness
remained especially pronounced in
manufacturing, but as reflected in the
employment data for April and in widespread anecdotal reports, softening had
spread to other sectors of the economy
as well. At the same time, pockets of
strength could be found in a number of
industries, notably in energy and construction, and overall business activity
continued to display considerable vigor
in a number of regions. Members noted
that business confidence had deteriorated, but some also observed that the
pessimism tended to be limited to the
nearer term and was accompanied by
favorable expectations regarding the
outlook later in the year and in 2002.
With regard to the outlook for key
sectors of the economy, a number of
members commented that consumer
spending had held up reasonably well
in recent months despite a variety of
adverse developments including the
negative wealth effects of stock market
declines, widely publicized job cut


backs, heavy consumer debt loads, and
previous overspending by many consumers. A recent survey had indicated
that consumer sentiment had firmed a
little, but the survey results had yet to
be confirmed by additional surveys and
the level of consumer confidence was
still well below earlier highs. As in the
past, consumer spending attitudes likely
would depend importantly on trends
in employment and income, and further
increases in unemployment in the period
just ahead along with the negative
wealth effects of earlier stock market
price declines and the persistence of
high energy costs were likely to constrain the growth in consumer expenditures over coming quarters.
Household expenditures on home
construction had been maintained at a
relatively robust level in recent months,
evidently reflecting the cushioning
effects of very attractive mortgage interest rates. Housing activity was described
as a source of strength in many regions.
Housing prices had tended to edge
higher across the nation, though there
were signs that the price appreciation
had eased in some parts of the country,
notably on the West Coast. While the
prevailing negative influences on household spending might spill over a bit
more to housing activity during the year
ahead, there were few current developments in housing markets that might be
read as signaling any marked weakening
in this sector of the economy.
A softening in business demand for
capital equipment had accounted for
much of the slowdown in the growth of
final demand in late 2000 and early
2001. The latest available data on new
orders pointed to further, and possibly
larger, declines in business spending on
equipment and software over the months
ahead. Members cited anecdotal and
survey reports that indicated many business firms were canceling, cutting back,

252 88th Annual Report, 2001
or stretching out planned capital expenditures. It was difficult to see any signs
of a significant near-term turnaround in
business spending for equipment and
software, and the timing and strength
of a subsequent rebound would depend
importantly on the outlook for sales and
profits. With regard to profit expectations, the most recent data showed
continued markdowns, but the pace of
downward revisions was diminishing. It
was too early to conclude that the outlook for profits might be approaching a
degree of stability or be near the point
of turning up, and in any event it was
clear that business sentiment currently
was quite gloomy. Looking to the future,
however, members anticipated that continuing gains in efficiency engendered
by new technologies would provide substantial profit opportunities and likely
strengthen investment spending during
the course of the year ahead. In the
meantime, nonresidential construction
and energy-related investments were a
source of some support to investment
spending, but they provided only a very
partial offset to widespread weakness in
other business spending.
Ongoing efforts to reduce excess
inventories were continuing to curb
output in manufacturing industries and
to restrain growth in overall economic
activity. A number of members commented that anecdotal and other evidence suggested that considerable
progress already had been made in scaling down unwanted inventories, notably
of motor vehicles, but substantial further
progress probably would be needed in
high-tech industries where sales were
still falling. How long inventory cutbacks would continue to exert a significant drag on the economic expansion
remained a key uncertainty in the economic outlook. In the view of many
members, the adjustment process might
not be substantially completed until



much later in the year and could take
even longer for high-tech firms. This
evaluation assumed continued sluggish
growth in final demand during the
period immediately ahead. Stronger
growth, which could not be ruled out,
would of course bring inventory-sales
ratios to desired levels more quickly.
Members also expressed concern
about the potential implications for U.S.
expansion from developments abroad.
To some extent, economic difficulties in
foreign nations had occurred in concert
with softening activity in the United
States, and notable weakness in world
high-tech markets along with the downward adjustment in equity prices globally represented a downside risk factor
worldwide. The anticipated recovery in
this country would help to strengthen
many foreign economies and in turn
improve prospects for U.S. exports.
Members noted, however, that in some
nations persisting structural problems
presented threats to national economic
prosperity and international trade. On
balance, while the external risks to the
U.S. economy clearly were to the downside, at least over the nearer term, the
prospective rebound in U.S. economic
activity and stimulative macroeconomic
policies abroad were expected to contribute to strengthening growth worldwide and to improving prospects for
exports during the year ahead.
The nation's fiscal outlook was seen
as supportive of aggregate demand.
While the exact structure of tax cuts was
still being negotiated, passage of new
fiscal measures seemed imminent and
likely would help bolster consumption
spending beginning later in the year.
Whatever its precise timing, the expansionary fiscal package would undoubtedly join at some point in coming quarters with the lagged effects of the
System's policy easing actions to foster
strengthening economic expansion.

Minutes of FOMC Meetings, May 253
A number of members commented
that the persisting updrift in some key
measures of core inflation had become
increasingly worrisome. In this regard,
they noted that some of the recent
increases in bond yields could represent
a rise in long-term inflation expectations. Such a rise would not be entirely
unexpected in the context of improving
sentiment about the strength of the
expansion, the potentially adverse implications for costs of the cyclical weakness in productivity, and the possibility
that high energy prices and their
passthrough effects might persist longer
than had been anticipated earlier. To
a considerable extent, however, any
uptick in inflation expectations likely
represented a reversal of anticipated
declines in inflation earlier this year
when economic prospects had seemed
weaker and survey data did not confirm
any increase in long-term inflation
expectations. Moreover, not all measures of core inflation had accelerated;
in particular, core PCE price inflation
had been quite stable on a twelve-month
basis for some time.
Looking ahead, most members did
not foresee a significant rise in inflation
as a likely prospect. They cited the
prevalence of highly competitive conditions in most markets, which continued
to make it very difficult for business
firms to raise prices despite pressures to
do so in a period of rising labor, energy,
and other costs. Widespread evidence of
some lessening of pressures in most
labor markets across the nation had not
yet resulted in lower wage inflation, but
the members expected that recent and
anticipated ebbing of pressures on labor
and other resources and associated slack
in product markets in a period of continuing subpar economic growth, along
with projected declines in energy prices,
would hold down inflation over the
forecast horizon. Nonetheless, there



were some risks of rising inflation. An
unexpectedly strong rebound in economic growth could begin to put added
upward pressure on prices at a time
when labor markets were still tight
by historical standards and accelerating
productivity no longer held down
increases in unit labor costs. Given the
lags in the effectiveness of monetary
policy, such pressure might materialize
before the effects of countervailing
actions by the Committee had a chance
to take hold.
In the Committee's discussion of policy for the forthcoming intermeeting
period, all but one of the members indicated that they could support a proposal
calling for further easing of reserve
conditions consistent with a 50 basis
point reduction in the federal funds
rate to a level of 4 percent. One member expressed a strong preference for a
25 basis point reduction and two others
indicated that they could have accepted
that more limited easing move. Despite
their somewhat differing preferences, all
the members agreed that further easing
was desirable in light of what they
viewed as the continuing weakness in
the economy, the absence of evidence
that growth had stabilized or was about
to rebound, and still decidedly downside
risks to the economic expansion. Some
members noted that, although policy had
been eased substantially, it might still
be considered to be only marginally
accommodative in relation to the forces
that were damping aggregate demand.
Accordingly, the action contemplated
for today was needed to provide adequate stimulus to an economy whose
outlook for significant strengthening
remained tenuous in a climate of fragile business and consumer confidence.
Members noted that the lagged effects
of the monetary policy easing implemented earlier this year were still very
hard to discern, though they should be

254 88th Annual Report, 2001
felt increasingly over the year ahead. In
this regard the risks of rising inflation
could not be dismissed, and while those
risks appeared to be quite limited for the
nearer term, excessive monetary stimulus had to be avoided to avert rising
inflation expectations and added inflation pressures over time. Members who
preferred or could support a 25 basis
point easing action gave particular
emphasis to the desirability at this point
of taking and signaling a more cautious
approach to policy, relative to the
50 basis point federal funds rate reductions the Committee had been implementing, given the lagged effects of the
substantial reduction in the federal funds
rate to date, the accompanying buildup
in liquidity, and the related risk that a
further aggressive easing action would
increase the odds of an overly accommodative policy stance and rising inflation pressures in the future.
All the members accepted a proposal
to include in the press statement to be
released after this meeting a sentence
indicating that the Committee continued
to regard the risks to the economic outlook as being tilted toward weakness
even after today's easing action. Forecasts of growth in business earnings and
spending continued to be revised down,
and until that process ended, weakness
in demand seemed to be the main threat
to satisfactory economic performance.
At the same time the members anticipated that a neutral balance of risks
statement could be appropriate before
long, probably well before substantial
evidence had emerged that economic
growth had strengthened appreciably,
once the Committee could see that policy had eased enough to promote a
future return to maximum sustainable
economic growth. Indeed, it was not
clear how much more the federal funds
rate might have to be reduced after
today in the absence of further signifi


cantly adverse shocks, and some members noted that the end of the easing
process might be near. Even so, with the
economy perhaps still in the midst of a
process of weakening growth in aggregate demand of unknown persistence
and dimension, the members generally
agreed that, given prevailing uncertainties, it would be premature for the Committee to shift its balance of risks statement at this time.
At the conclusion of this discussion,
the Committee voted to authorize and
direct the Federal Reserve Bank of New
York, until it was instructed otherwise,
to execute transactions in the System
Account in accordance with the following domestic policy directive:
The Federal Open Market Committee
seeks monetary and financial conditions that
will foster price stability and promote sustainable growth in output. To further its longrun objectives, the Committee in the immediate future seeks conditions in reserve
markets consistent with reducing the federal
funds rate to an average of around 4 percent.

The vote encompassed approval of
the sentence below for inclusion in the
press statement to be released shortly
after the meeting:
Against the background of its long-run
goals of price stability and sustainable economic growth and of the information currently available, the Committee believes that
the risks continue to be weighted mainly
toward conditions that may generate economic weakness in the foreseeable future.
Votes for this action: Messrs. Greenspan,
McDonough, Ferguson, Gramlich, Kelley,
Meyer, Ms. Minehan, Messrs. Moskow
and Poole. Vote against this action:
Mr. Hoenig.

Mr. Hoenig dissented because he preferred a less aggressive easing action
involving a reduction of 25 basis points
in the federal funds rate. While the risks

Minutes of FOMC Meetings, June 255
of weaker economic growth still tended
to dominate those of rising inflation and
called for some further easing, the Committee had added significant liquidity to
the economy this year through its cumulatively large easing actions. The lagged
effects of those actions should be felt
increasingly over time. Moreover, following the rapid and aggressive policy
actions already taken, a more cautious
policy move at this point would in his
view appropriately limit the risks of producing an overly accommodative policy
stance and rising inflation over time.
The Chairman called for a recess after
this vote and convened a meeting of the
Board of Governors to consider one-half
percentage point reductions in the discount rate that had been proposed by a
number of Federal Reserve Banks. After
the recess, the Chairman informed the
Committee that the pending reductions
had been approved.
It was agreed that the next meeting of
the Committee would be held on
Tuesday-Wednesday, June 26-27, 2001.
The meeting adjourned at 1:15 p.m.
Donald L. Kohn
Secretary

Meeting Held on
June 26-27, 2001
A meeting of the Federal Open Market
Committee was held in the offices of
the Board of Governors of the Federal
Reserve System in Washington, D.C.,
beginning on Tuesday, June 26, 2001, at
2:00 p.m. and continuing on Wednesday, June 27, 2001, at 9:00 a.m.
Present:
Mr. Greenspan, Chairman
Mr. McDonough, Vice Chairman
Mr. Ferguson
Mr. Gramlich
Mr. Hoenig



Mr. Kelley
Mr. Meyer
Ms. Minehan
Mr. Moskow
Mr. Poole
Messrs. Jordan, McTeer, Santomero,
and Stern, Alternate Members
of the Federal Open Market
Committee
Messrs. Broaddus, Guynn, and Parry,
Presidents of the Federal Reserve
Banks of Richmond, Atlanta, and
San Francisco respectively
Mr. Kohn, Secretary and Economist
Mr. Bernard, Deputy Secretary
Mr. Gillum, Assistant Secretary
Ms. Fox, Assistant Secretary
Mr. Mattingly, General Counsel
Mr. Baxter, Deputy General Counsel
Ms. Johnson, Economist
Mr. Stockton, Economist
Messrs. Fuhrer, Hakkio, Howard,
Hunter, Lindsey, Rasche, Reinhart,
Slifman, and Wilcox, Associate
Economists
Mr. Kos, Manager, System Open
Market Account
Ms. Smith and Mr. Winn, Assistants
to the Board, Office of Board
Members, Board of Governors
Mr. Ettin, Deputy Director, Division
of Research and Statistics,
Board of Governors
Mr. Simpson, Senior Adviser, Division
of Research and Statistics,
Board of Governors
Mr. Madigan, Associate Director,
Division of Monetary Affairs,
Board of Governors
Messrs. Oliner and Struckmeyer,
Associate Directors, Division
of Research and Statistics,
Board of Governors

256 88th Annual Report, 2001
Messrs. Freeman6 and Whitesell,
Assistant Directors, Divisions
of International Finance and
Monetary Affairs, Board of
Governors
Ms. Kusko6 and Mr. Sichel,7 Senior
Economists, Division of Research
and Statistics, Board of Governors
Mr. Nelson,6 Senior Economist, and
Ms. Garrett, Economist, Division
of Monetary Affairs, Board
of Governors
Mr. Fleischman,7 Economist, Division
of Research and Statistics,
Board of Governors
Ms. Low, Open Market Secretariat
Assistant, Division of Monetary
Affairs, Board of Governors
Ms. Pianalto, First Vice President,
Federal Reserve Bank of
Cleveland
Messrs. Beebe, Eisenbeis, and
Goodfriend, Mses. Krieger and
Mester, Messrs. Rolnick,
Rosenblum, and Steindel, Senior
Vice Presidents, Federal Reserve
Banks of San Francisco, Atlanta,
Richmond, New York,
Philadelphia, Minneapolis,
Dallas, and New York
respectively
Mr. Altig, Vice President, Federal
Reserve Bank of Cleveland
Mr. Fernald,8 Economist, Federal
Reserve Bank of Chicago

By unanimous vote, the minutes of
the meeting of the Federal Open Market
Committee held on May 15, 2001, were
approved.

6. Attended portion of meeting relating to staff
presentations.
7. Attended portion of meeting relating to productivity developments.
8. Attended Tuesday's session only.



The Manager of the System Open
Market Account reported on recent developments relating to foreign exchange
markets. There were no open market
operations in foreign currencies for the
System's account in the period since the
previous meeting.
The Manager also reported on developments in domestic financial markets
and on System open market transactions
in government securities and federal
agency obligations during the period
May 15, 2001, through June 26, 2001.
By unanimous vote, the Committee ratified these transactions.
The Committee then turned to a discussion of the economic and financial
outlook and the implementation of
monetary policy over the intermeeting
period ahead. A summary of the economic and financial information available at the time of the meeting and of
the Committee's discussion is provided
below, followed by the domestic policy
directive that was approved by the Committee and issued to the Federal Reserve
Bank of New York.
The information reviewed at this
meeting suggested that economic activity continued to grow little, if at all,
in the second quarter. Employment fell
somewhat over the first two months of
the quarter, industrial output dropped
sharply, and the limited available information suggested that both probably
continued to decline in June. Expansion
in consumer spending appeared to have
slowed and business purchases of equipment and software had fallen appreciably, though homebuilding had been
well maintained. Energy prices had been
relatively flat recently, at a high level,
and core price inflation had moderated a
little.
Private nonfarm payroll employment
fell slightly further in May after a sharp
drop in April and lackluster growth in
the first quarter. Manufacturing recorded

Minutes of FOMC Meetings, June 257
additional widespread job losses in May,
and there were signs that weakness in
employment was spreading to related
sectors, notably wholesale trade and
help-supply services. By contrast, construction employment rebounded in
May, retracing part of its large April
loss, and hiring in finance, insurance,
and real estate remained brisk. The
unemployment rate edged lower in May,
to 4.4 percent, but initial unemployment
insurance claims and other data suggested persisting softening in the labor
market in that month.
The rapid contraction in industrial
production continued unabated in May,
with manufacturing output registering
an eighth consecutive monthly drop.
Moreover, output from electric utility
plants fell, and mining activity slowed
further in May following a strong firstquarter gain. Within manufacturing,
decreases in output were widely spread
across sectors, and the production of
high-tech equipment continued to plummet. The motor vehicle industry was
one of the few sectors to record a rise
in production. The further contraction in
production in May brought the rate of
utilization of manufacturing capacity to
its lowest level since 1983.
Growth of consumer spending
seemed to have slowed in the second
quarter, reflecting the deceleration in
personal income, the rise in unemployment, and the earlier decline in household net worth. Nominal retail sales
were up only slightly in May after a
brisk rise in April, and the average rate
of increase over the two months was
somewhat slower than that of the first
quarter.
Low mortgage rates continued to
provide support to residential building
activity in April and May despite a
weakening labor market and sluggish
growth in personal income. Total housing starts in April-May remained at



the high first-quarter level, as stronger
single-family starts offset a slower pace
of multifamily starts. Sales of new and
existing homes slipped in April (latest
data) after both reached near-record levels in March.
Business spending on equipment and
software declined further early in the
second quarter in response to sluggish
sales, an erosion of earnings and corporate cash flows, and an uncertain
outlook for future sales and earnings.
Shipments of nondefense capital goods
slumped in April, and the weakness
in incoming orders suggested that shipments would fall further in coming
months. Fleet sales of cars and trucks,
which had been among the few areas
of strength in business equipment
expenditures in the first quarter, also
slowed. By contrast, nonresidential construction remained robust, though the
level of activity slipped a little in April
and slightly higher vacancy rates and
smaller increases in rents suggested that
the profitability of new nonresidential
investment might be lessening. Strength
was particularly evident in outlays for
industrial structures, partly reflecting
construction of electric power plants and
facilities for cogeneration of power by
industrial companies, and in continuing
strong oil and gas exploration activity.
Business inventories on a book-value
basis edged higher in April after a sizable runoff in the first quarter. Excluding motor vehicles, manufacturing
stocks were little changed in April, but
shipments were down sharply and the
aggregate inventory-shipments ratio for
the sector remained on a steep upward
trend, with many industries facing sizable inventory overhangs. In the wholesale sector, inventories rose in step with
sales; the sector's inventory-sales ratio
was unchanged in April and remained at
the top of its range for the past twelve
months. Retail inventories continued

258 88th Annual Report, 2001
to decline in April, and the sector's
inventory-sales ratio decreased further
and was near the middle of its range for
the past twelve months.
The U.S. trade deficit in goods and
services continued to shrink in April.
The value of exports fell, with most
of the drop occurring in capital goods,
notably computers and semiconductors.
The value of imports also decreased but
by slightly more than exports, reflecting sizable declines in capital and consumer goods that were partly offset by
increases in oil and automotive products. Recent information indicated that
economic growth in the euro area and
the United Kingdom in the first quarter
was at about the reduced pace seen in
the fourth quarter, and growth likely
stayed relatively slow more recently.
Expansion in Canada appeared to have
weakened recently after a slight pickup
in the first quarter. In Japan, the contraction in economic activity that began
early in the year appeared to have continued into the second quarter. Most
of the developing countries, with the
notable exception of China, also were
experiencing an economic slowdown
that was related at least in part to weaker
external demand.
Core price inflation had moderated a
little recently after a pickup earlier in
the year. The core consumer price index
(CPI) rose relatively slowly in April and
May, and the increase in that index during the past twelve months was about
the same as that during the previous
twelve-month period. The core personal
consumption expenditure (PCE) chaintype price index presented a similar picture, with inflation in April and May a
little lower than earlier in the year and
no change in inflation on a year-overyear basis. Core producer price inflation
for finished goods also was subdued in
the April-May period but edged higher
on a year-over-year basis. There also



were indications that upward pressures
on energy prices had abated somewhat.
In particular, the return of some domestic refineries to operation after maintenance or breakdowns and a surge in
imports had replenished gasoline stocks,
and as a result wholesale and retail gasoline prices had retreated recently. With
regard to labor costs, average hourly
earnings of production or nonsupervisory workers continued to rise in April
and May at the relatively brisk rate that
had prevailed over the past year.
At its meeting on May 15, 2001, the
Committee adopted a directive that
called for maintaining conditions in reserve markets consistent with a decrease
of 50 basis points in the intended level
of the federal funds rate, to about 4 percent. The members generally agreed that
this action was necessary in light of the
continuing weakness of the economic
expansion and the lack of evidence that
output growth had stabilized or was
about to rebound, coupled with a climate of fragile business and consumer
confidence. In addition, the members
believed that the balance of risks
remained weighted toward conditions
that could generate economic weakness
in the foreseeable future.
Federal funds traded at rates near the
Committee's target level over the intermeeting period. Other short-term market
rates declined somewhat following the
Committee's announcement of the easing action and subsequently moved
down noticeably further in response
to weaker-than-expected news on economic activity and corporate earnings.
Yields on long-term Treasury and
investment-grade corporate securities
fell appreciably during the intermeeting
interval, but rates on speculative-grade
bonds rose sharply in response to the
adverse earnings news. The pessimistic
earnings reports also weighed on equity
prices, which edged lower on balance.

Minutes of FOMC Meetings, June 259
In foreign exchange markets, the
trade-weighted value of the dollar in
terms of many of the major foreign
currencies increased slightly over the
intermeeting interval, as the dollar's
appreciation against the euro and other
European currencies more than offset
the U.S. dollar's further decline against
the Canadian dollar. European currencies weakened in response to disappointing data on economic activity, with
inflation concerns seen as constraining
countervailing monetary easing actions.
The dollar also was up slightly on net
in terms of an index of the currencies
of other important trading partners. The
real was adversely affected by Brazil's
internal problems and spillovers from
Argentina's financial difficulties, while
the Mexican peso benefited from continued foreign interest in Mexican investments and from high oil prices.
The broad monetary aggregates continued to grow rapidly in the second
quarter, reflecting the effects of lower
opportunity costs of holding liquid
deposits and money market mutual
funds, a buildup in deposits associated
with extensive mortgage financing
activity, and a flight to liquidity and
safety from volatile equity markets. The
debt of domestic nonfinancial sectors
expanded at a moderate pace on balance
through May.
The staff forecast prepared for this
meeting suggested that after a period
of very slow growth associated in large
part with an inventory correction, a sizable decline in capital spending, and a
related sharp contraction in manufacturing output, the economic expansion
would gradually regain strength over the
forecast horizon and move back to a rate
around the staff's current estimate of the
growth of the economy's potential output. The period of subpar expansion
was expected to foster an appreciable
easing of pressures on resources and



some moderation in core price inflation.
Despite the substantial monetary easing
that had been implemented already and
the fiscal stimulus, including federal
tax rebates, that was in train, the forecast anticipated that sluggish hiring and
the decline in household wealth would
restrain the growth of both consumer
spending and housing demand. Business fixed investment, notably outlays
for equipment and software, would be
weaker for a while but would return to
relatively robust growth after a period of
adjustment of capital stocks to more
desirable levels. The gradual strengthening of investment, together with a projected improvement in foreign economies that was seen as providing some
support for U.S. exports, would foster
the pickup in growth of demand and
output.
In the Committee's discussion of current and prospective economic developments, members noted that by some
measures overall economic activity
remained at a reasonably high level.
However, recent data indicated that
growth of spending and output was quite
sluggish and below the pace many members had anticipated at the time of the
previous meeting. Weakness in business
spending for equipment and software,
efforts to reduce excess inventories, and
the ongoing adaptation to lower equity
prices in the United States and around
the world were likely to hold back
economic activity in the short run.
Nonetheless, the members continued to
anticipate a strengthening as the year
progressed and during 2002, fostered to
a large extent by the lagged effects on
spending of the substantial easing in
monetary policy since early this year,
the stimulus from recently enacted tax
cuts, and the positive effects on household and business purchasing power of
some recent reductions in energy prices.
In addition, the abatement and eventual

260 88th Annual Report, 2001
turnaround of the downward adjustments to capital spending and inventories would add impetus to economic
growth going forward. It was noted,
however, that the unique characteristics of the current cyclical experience,
including the heavy concentration of
weakness in business expenditures and
manufacturing output, increased the
uncertainty that surrounded any forecast. Most of the members believed that
the risks to the expansion, notably for
the nearer term, remained to the downside of current forecasts. Potential
sources of shortfalls included the effects
of possible further increases in unemployment on consumer and business
confidence; the risks of disappointing
business earnings that could damp
investment and, through lower equity
prices, consumption; and the growing
indications of weakness in foreign
economies that could limit demand for
exports. In an environment of diminished pressures in product and labor
markets and of lower energy costs,
members commented that price pressures were likely to remain contained, at
least over the near to intermediate term.
In preparation for the midyear monetary policy report to Congress, the members of the Board of Governors and the
presidents of the Federal Reserve Banks
provided individual projections of the
growth of GDP, the rate of unemployment, and the rate of inflation for the
years 2001 and 2002. The forecasts of
the rate of expansion in real GDP had
central tendencies of 1 lA to 2 percent for
2001, suggesting at least a little acceleration in the second half of the year, and
3 to 2>lA percent for 2002. The civilian
rates of unemployment associated with
these forecasts had central tendencies of
43/4 to 5 percent in the fourth quarter of
2001 and 43A to 5V4 percent in the fourth
quarter of 2002. Forecasts of the rate of
inflation, as measured by the chain price



index for personal consumption expenditures, were centered on a range of 2 to
21/2 percent for this year and 13A to
2Vi percent in 2002.
Continuing softness in the expansion
of economic activity was mirrored in
anecdotal reports of business conditions
in much of the nation. Typical regional
reports referred to slowing increases
in economic activity from an already
reduced pace or to the persistence of
sluggish business activity and generally
downbeat business sentiment. Manufacturing continued to display particular
weakness. However, actions to reduce
excess inventories or to address problems relating to overcapacity in some
sectors of the economy, including telecommunications and other high-tech
industries, were under way and were
likely to exert a decreasing drag on economic activity over coming quarters as
corrective adjustments were completed.
Financial conditions, while generally
supportive of greater spending, presented a mixed picture in some respects.
Short- and intermediate-term interest
rates had fallen substantially this year,
and long-term yields had moved down
late last year. But equity prices were
only holding their own after a substantial decline earlier and the dollar had
appreciated. Though lenders were cautious about marginally creditworthy
firms, most businesses were finding
ample credit available at attractive
terms.
In their comments about developments in key sectors of the economy,
members noted that overall business
activity had been supported, at least to
this point, by the relative strength of
household demand. Growth in consumer
spending for goods and services, while
moderating appreciably since earlier in
the year, had nonetheless held up unexpectedly well given the adverse wealth
effects associated with the declines in

Minutes of FOMC Meetings, June 261
stock market prices, relatively high levels of consumer indebtedness, and job
losses in a growing number of industries. Members referred in particular to
the persisting strength in demand for
light motor vehicles, which evidently
was boosted by continuing sales incentives and attractive financing terms.
Looking ahead, the outlook for consumer spending was subject to a number
of downside risks that included the
possibility of rising unemployment and
further weakness in the stock market,
which could damp consumer confidence
as well as income and wealth. However,
some further growth in consumer spending remained the most likely prospect
for the balance of the year in light of the
impetus provided by monetary and fiscal policy and the apparent stabilization
in consumer sentiment in recent months
after its earlier decline.
Housing activity remained at a high
level as attractive mortgage interest rates
evidently continued to counterbalance
the negative effects on consumer attitudes of somewhat weaker labor markets and reduced stock market wealth.
While housing activity in a number of
areas continued to be described as fairly
robust, members noted that residential
sales and construction had slipped in
some parts of the nation. Even so, given
existing backlogs and the continued
availability of attractive mortgage rates,
nationwide housing construction was
expected to remain near its currently
elevated level.
The near-term outlook for business
fixed investment seemed less promising.
The weakness in spending for new
equipment and software had played a
key role in the softening of the overall
expansion of economic activity in recent
quarters, and a material pickup in such
expenditures did not appear likely until
the latter part of this year or early next
year. Indeed, anecdotal reports from



many business firms indicated that they
were delaying at least some equipment
and software outlays until evidence of
an upturn in their sales and earnings
began to accumulate. Caution was
especially pronounced among high-tech
firms, many of which had experienced
major cutbacks in the demand for their
products and services. An analysis prepared for this meeting suggested that
in the aggregate the apparent overhang
of excess capital might not be large,
but the dimensions and duration of the
adjustment in spending on capital goods
were a major source of uncertainty in
the outlook, and there was some risk of
substantially greater weakness in investment spending than was forecast for
coming months. Beyond the nearer term,
however, the prospects for an upturn in
investment outlays seemed favorable in
the context of profit opportunities associated with expectations of continued
elevated rates of technological progress
and rapid declines in the prices of new
equipment. In this regard the members
reviewed several staff reports that generally concluded that the growth of productivity in the years ahead was highly
likely to remain appreciably stronger
than it had been from the mid-1970s
to the mid-1990s, though how much
stronger was an open question. With
regard to the outlook for nonresidential
construction activity, members referred
to signs of developing weakness in some
commercial real estate markets, but
there were few reports of overbuilding
and the construction of commercial
facilities was being well maintained in
other parts of the country. On balance,
further modest growth in nonresidential construction, though well below the
average pace in recent quarters, was
seen as a likely prospect.
Business efforts to bring their inventories into better alignment with sales
were a key factor in the deceleration

262 88th Annual Report, 2001
of overall economic activity in recent
quarters and in forecasts that the upturn
in economic activity would be relatively
limited over the balance of the year.
Net inventory liquidation appeared to
have diminished in the current quarter
from its pace earlier in the year, but
inventory-sales ratios had risen further
in recent months, especially for hightech equipment. Accordingly, liquidation was not likely to abate substantially
further for some time.
With regard to the foreign sector of
the economy, members commented that
economic activity had softened more
than anticipated in many nations that
were important trading partners, with
clearly negative implications for U.S.
exports. Major Latin American countries were experiencing particularly
severe economic difficulties, but growth
was slowing or economic activity
declining in many industrial countries
as well. At the same time, a number of
important U.S. industries were subject to
increased domestic competition from
foreign imports. While growth abroad
could be expected to rebound next year,
responding in part to faster expansion in
the US. economy, the nearer-term outlook for U.S. and indeed world trade
was less favorable.
In their review of the outlook for inflation, members generally anticipated
that increases in consumer prices would
remain relatively subdued over the next
several quarters. Factors underlying that
assessment included the emergence of
less taut conditions in labor markets,
relatively low capacity utilization rates
in manufacturing, and the persistence
of highly competitive conditions in most
product markets that made it very difficult for business firms to preserve or
increase their profit margins by raising
prices. Moreover, energy prices recently
had declined appreciably, and the earlier inflationary effects of energy price



increases on a broad range of costs and
prices appeared to have begun to subside as a result. Inflation expectations
that currently appeared by various measures and survey results to be essentially
flat or even to have declined a bit were
reinforcing the factors holding down
price increases. Some negatives in the
inflation outlook also were noted, such
as some increase in labor compensation
including rapid advances in health care
costs, and a consequent squeeze on
profit margins that was exacerbated by a
cyclical decline in productivity gains.
Labor pressures on business costs might
persist for a time in lagged response to
earlier advances in headline consumer
price inflation and labor productivity,
but their effects would tend to diminish
or to be offset over time if, in line with
the members' forecasts, pressures on
labor resources continued to ease. Some
members expressed concern about the
longer-run prospects for wages and
prices if the stimulative stance of monetary policy was maintained too long and
allowed demand pressures to outrun the
economy's potential.
In the Committee's discussion of policy for the intermeeting period ahead,
all but one of the members supported
both some further easing of reserve conditions consistent with a 25 basis point
reduction in the target federal funds
rate and the retention of the Committee's public statement that the risks were
weighted toward excessively soft economic performance. The information
received since the May meeting suggested a somewhat weaker economic
performance than most had anticipated,
and the members were persuaded that
in the absence of firm evidence that the
deceleration in the economic expansion
had run its course a further easing action
was needed at this point to help stabilize
the economy. With greater slack in labor
and product markets, and with inflation

Minutes of FOMC Meetings, June 263
expectations contained, an added easing
ran very little risk of exacerbating price
pressures, provided the Committee was
prepared to firm the stance of policy
promptly if and when demand pressures
threatened to intensify. One member
was persuaded that policy had already
become so expansionary that further
easing ran an unacceptable risk of exacerbating inflation over time.
A smaller easing move than those the
Committee had been making earlier this
year was deemed desirable by the members in light of the substantial easing
that already had been implemented since
the start of this year. By a number of
measures—including the level of real
federal funds rates, the robust growth
of the monetary aggregates, and the
ready availability of finance to most
borrowers—policy had become stimulative. Such a policy stance was appropriate for a time to counter the various
forces holding back economic expansion. But much of the lagged effects of
the Committee's earlier easing actions
had not yet been felt in the economy,
and they would be supplemented in
coming quarters by the implementation
of the recently legislated tax cut stimulus. In these circumstances, a smaller
move than those undertaken earlier this
year would have the advantage of reducing the odds on adding to inflation pressures later and of underlining the Committee's assessment of its policy stance.
In the view of a number of members, the
Committee might well be near the end
of its easing cycle. At the same time,
several emphasized that they did not
want to rule out further easing later if
warranted by the tenor of incoming economic information.
All except one of the members
accepted a proposal to retain the Committee's press statement that the risks
would continue to be weighted toward
economic weakness after today's easing



move. The member who opposed additional policy easing expressed strong
reservations about such a statement
because in his view it likely would be
interpreted as an intention to ease policy
further, which was contrary to his own
assessment that a more neutral outlook
regarding the future course of policy
was desirable. In the view of most
members, however, the weakness of the
recent information relating to the performance of the economy was consistent
with unbalanced risks at least insofar as
it pertained to the outlook for the rest
of this year, and their primary policy
concern at this point remained the
strength of economic activity rather than
potentially worsening inflation over the
longer term.
At the conclusion of this discussion,
the Committee voted to authorize and
direct the Federal Reserve Bank of New
York, until it was instructed otherwise,
to execute transactions in the System
Account in accordance with the following domestic policy directive:
The Federal Open Market Committee
seeks monetary and financial conditions that
will foster price stability and promote sustainable growth in output. To further its longrun objectives, the Committee in the immediate future seeks conditions in reserve
markets consistent with reducing the federal funds rate to an average of around
VA percent.

The vote encompassed approval of
the sentence below for inclusion in the
press statement to be released shortly
after the meeting:
Against the background of its long-run
goals of price stability and sustainable economic growth and of the information currently available, the Committee believes
that the risks continue to be weighted mainly
toward conditions that may generate economic weakness in the foreseeable future.

264 88th Annual Report, 2001
Votes for this action: Messrs. Greenspan,
McDonough,
Ferguson,
Gramlich,
Hoenig, Kelley, Meyer, Ms. Minehan, and
Mr. Moskow. Vote against this action:
Mr. Poole.
Mr. Poole dissented because he
believed that FOMC actions this year
had already established a highly stimulative monetary policy stance. The M2
and MZM measures of money had risen
at annual rates in excess of 10 percent
and 20 percent respectively over the past
six months, and the real federal funds
rate was very likely below its equilibrium level. Other more qualitative information on financial conditions pointed
in the same direction. Economic forecasts were that the economy's growth
would resume later this year and the fact
that long-term interest rates had not
declined since December also indicated
that the market anticipated a revival of
faster economic growth before long.
Given the lags in monetary processes,
he believed that adding further monetary policy stimulus raised an undue
risk of fostering higher inflation in the
future. Moreover, against this background, he was especially concerned
that a statement that the Committee
continued to view the balance of risks
as weighted toward weakness would be
read in the market as a sign that the
Committee was likely to ease further
in the near term. He thought future
developments were equally likely to
warrant an action in either direction, and
he did not think the Committee should
take a step that probably would cause
expectations of further easing to become
embedded in market interest rates.
It was agreed that the next meeting of
the Committee would be held on Tuesday, August 21, 2001.
The meeting adjourned at 12:25 p.m.



Notation Vote
By notation vote completed on August
16, 2001, the Committee members voted
unanimously to elect Vincent R. Reinhart to the position of economist for the
period until the first regularly scheduled
meeting in 2002, with the understanding
that in the event of the discontinuance
of his official connection with the Board
of Governors he would cease to have
any official connection with the Federal
Open Market Committee.
Donald L. Kohn
Secretary

Meeting Held on
August 21, 2001
A meeting of the Federal Open Market
Committee was held in the offices of
the Board of Governors of the Federal
Reserve System in Washington, D.C.,
on Tuesday, August 21, 2001, at
9:00 a.m.
Present:
Mr. Greenspan, Chairman
Mr. McDonough, Vice Chairman
Mr. Ferguson
Mr. Gramlich
Mr. Hoenig
Mr. Kelley
Mr. Meyer
Ms. Minehan
Mr. Moskow
Mr. Poole
Messrs. Jordan, McTeer, Santomero,
and Stern, Alternate Members
of the Federal Open Market
Committee
Messrs. Broaddus, Guynn, and Parry,
Presidents of the Federal Reserve
Banks of Richmond, Atlanta, and
San Francisco respectively
Mr. Kohn, Secretary and Economist
Mr. Bernard, Deputy Secretary
Mr. Gillum, Assistant Secretary

Minutes of FOMC Meetings, August
Mr. Mattingly, General Counsel
Mr. Baxter, Deputy General Counsel
Ms. Johnson, Economist
Mr. Reinhart, Economist
Mr. Stockton, Economist
Ms. Cumming, Messrs. Hakkio,
Howard, Hunter, Lindsey, Rasche,
Slifman, and Wilcox, Associate
Economists
Mr. Kos, Manager, System Open
Market Account
Ms. Smith, Assistant to the Board,
Office of Board Members,
Board of Governors
Mr. Ettin, Deputy Director, Division
of Research and Statistics,
Board of Governors
Mr. Madigan, Deputy Director,
Division of Monetary Affairs,
Board of Governors
Mr. Simpson, Senior Adviser, Division
of Research and Statistics,
Board of Governors
Messrs. Oliner and Struckmeyer,
Associate Directors, Division
of Research and Statistics,
Board of Governors
Mr. Helkie, Assistant Director,
Division of International Finance,
Board of Governors
Mr. Whitesell, Assistant Director,
Division of Monetary Affairs,
Board of Governors
Mr. Skidmore, Special Assistant to the
Board, Office of Board Members,
Board of Governors
Mr. Kumasaka, Assistant Economist,
Division of Monetary Affairs,
Board of Governors
Ms. Low, Open Market Secretariat
Assistant, Office of Board
Members, Board of Governors
Ms. Browne, Executive Vice President,
Federal Reserve Bank of Boston



265

Messrs. Eisenbeis and Lacker,
Ms. Mester, Messrs. Rosenblum
and Sniderman, Senior Vice
Presidents, Federal Reserve
Banks of Atlanta, Richmond,
Philadelphia, Dallas, and
Cleveland respectively
Ms. Hargraves and Mr. Judd, Vice
Presidents, Federal Reserve Banks
of New York and San Francisco
respectively
Mr. Webber, Senior Research Officer,
Federal Reserve Bank of
Minneapolis
By unanimous vote, the minutes of
the meeting of the Federal Open Market
Committee held on June 26-27, 2001,
were approved.
The Manager of the System Open
Market Account reported on recent developments relating to foreign exchange
markets. There were no open market
operations in foreign currencies for the
System's account in the period since the
previous meeting.
The Manager also reported on developments in domestic financial markets
and on System open market transactions
in U.S. government securities and securities issued or fully guaranteed by federal agencies during the period June 27,
2001, through August 20, 2001. By
unanimous vote, the Committee ratified
these transactions.
The Committee then turned to a discussion of the economic and financial
outlook and the implementation of
monetary policy over the intermeeting
period ahead. A summary of the economic and financial information available at the time of the meeting and of
the Committee's discussion is provided
below.
The information reviewed at this
meeting suggested that economic activity exhibited little, if any, upward movement in midsummer. Increases in house-

266 88th Annual Report, 2001
hold expenditures on consumer items
and housing appeared to have been
relatively well maintained, but business capital expenditures had weakened
substantially since early in the year.
Efforts to reduce inventories were continuing, and manufacturing activity had
decreased further. Employment had
declined over recent months. With
energy prices having turned down, overall consumer price inflation had eased
slightly in recent months, while core
measures of consumer prices showed
mixed changes on a twelve-month basis.
Measures of labor costs had decelerated
on balance.
Private nonfarm payroll employment,
after declining appreciably during the
second quarter, fell further in July, led
by additional job losses in manufacturing and help-supply services. Labor
demand remained weak in other sectors,
with employment in most industries flat
to down. The unemployment rate edged
up to 4.5 percent in June and remained
at that level in July. Although initial
claims for unemployment insurance had
declined in recent weeks, on balance
data suggested persisting softening in
the labor market.
Industrial production edged lower in
July after larger drops in each of the
previous three months. Motor vehicle
assemblies rose markedly, but production of high-tech equipment continued
to plummet, registering its largest onemonth decline in more than a decade.
Outside those two industries, manufacturing production either moved sideways or fell slightly. The rate of utilization of manufacturing capacity was
little changed in July and remained well
below its long-run average.
Growth in consumer spending slowed
somewhat in the second quarter, but
except for automotive dealers, retailers
reported sizable gains in July. Consumer
confidence appeared to have stabilized



at moderately favorable levels in recent
months. Supported by low mortgage
rates, residential building activity had
held up well this year. In July, singlefamily starts increased slightly from a
strong pace in the first and second quarters, though permits fell marginally.
Sales of new homes rose in June (latest
data), and sales of existing homes edged
down but remained only slightly below
their historical peak.
Business spending on equipment and
software declined substantially in the
second quarter after falling somewhat in
the preceding two quarters. The weakness stemmed from sluggish growth in
business sales, significantly reduced corporate cash flows, and continued uncertainty about prospects for future sales
and earnings. Shipments of nondefense
capital goods declined in June after a
modest increase in May, but for the second quarter as a whole they contracted
at more than twice the first-quarter pace.
Moreover, orders data for June were
extraordinarily weak, led by a steep
decline in communications equipment.
Those data, as well as numerous anecdotal reports, suggested further weakness in spending for equipment and
software going forward. Nonresidential
construction, which had held up well in
the first quarter, was down substantially
in the second quarter, as spending for
office, industrial, and lodging facilities contracted sharply. Vacancy rates,
particularly in high-tech centers, had
increased significantly in recent months,
as demand for office space and data
centers plunged. In contrast, expenditures for drilling and mining equipment
soared further in the second quarter.
Business inventory liquidation was
sizable in the second quarter, at a pace
estimated to be a bit more rapid than in
the first quarter. Manufacturing stocks,
particularly of computers and electronic
products, were reduced substantially;

Minutes of FOMC Meetings, August
however, shipments of those products
also plunged and the inventory-sales
ratio in the computer and electronics
sector rose further from an already high
level. Elsewhere in manufacturing, the
ratio of stocks to sales held steady, with
stocks remaining high in a number of
manufacturing industries despite aggressive production cutbacks. Inventories
rose in the wholesale sector and, given
sluggish sales of late, the ratio of inventories to sales moved sharply higher in
the second quarter. Stocks in the automobile sector declined over the quarter
and moved lower in July. Retail inventories, excluding motor vehicles, fell
moderately and the sector's inventorysales ratio edged lower.
The U.S. trade deficit in goods and
services narrowed over the May-June
period and was about $20 billion smaller
at an annual rate in the second quarter
than in the first. The value of imports
dropped sharply in the second quarter.
The value of exports also decreased
significantly, with most of the decline in
capital goods, primarily computers and
semiconductors. Recent information on
foreign industrial economies suggested
that growth weakened further in the second quarter. The Japanese economy contracted in the quarter, and growth in the
euro area appeared to have weakened
substantially. Among the developing
countries, economic and financial conditions had deteriorated further in Argentina. In most other developing countries,
the pace of economic growth continued
to decline.
Consumer price inflation had eased in
recent months, as energy prices turned
down and increases in core consumer
prices subsided after a pickup early in
the year. The core consumer price index
(CPI) rose in July at about the same
pace as in the second quarter, but the
twelve-month change in that index had
increased slightly. However, revised



267

data indicated that the core personal
consumption expenditure (PCE) chain
index had decelerated on a year-overyear basis. At the producer level, prices
fell in July, leaving the twelve-month
change in the producer price index for
finished goods somewhat below the
twelve-month change of a year earlier.
With regard to labor costs, the employment cost index (ECI) increased at a
somewhat slower pace in the twelve
months ended in June than over the preceding twelve months.
At its meeting on June 26-27, 2001,
the Committee adopted a directive that
called for maintaining conditions in reserve markets consistent with a decrease
of 25 basis points in the intended level
of the federal funds rate, to about
33A percent. This action was deemed
appropriate in light of incoming information indicating somewhat weaker
economic performance than most members had anticipated and the absence of
firm evidence that the deceleration in
the economic expansion had run its
course or that output growth was about
to rebound. With greater slack in labor
and product markets and with inflation
expectations contained, the members
agreed that the balance of risks continued to be weighted toward conditions
that could generate economic weakness
in the foreseeable future.
Federal funds traded at rates near the
Committee's reduced target level over
the intermeeting period, and other shortterm rates also fell. Market participants
became less optimistic regarding the
economic outlook over the intermeeting
period, inducing widespread declines
in longer-term Treasury yields over the
period that were most pronounced at
the shorter end of the coupon maturity
spectrum. Except for the obligations of
the most troubled sectors, declines in
investment-grade corporate bond yields
were about in line with those on Trea-

268 88th Annual Report, 2001
sury issues of comparable maturity,
leaving most risk spreads little changed
on balance. A spate of weak secondquarter earnings reports and sizable
reductions in analysts' earnings projections for the remainder of the year took
a toll on equity markets, however, and
broad stock market indexes moved
down appreciably over the intermeeting
interval.
The trade-weighted value of the dollar, after an extended period of strength,
fell against most major foreign currencies, with much of the decline occurring
in the days just before this meeting. The
decline was particularly marked against
the yen, the euro, and the Swiss franc. In
contrast, the dollar was little changed
against the currencies of some major
trading partners, including Canada and
Mexico.
Growth in the broad monetary aggregates remained strong in July but was
below the average pace over the first
half of the year. Despite some recent
slowing, deposit growth was held up by
a flight to liquidity and safety in light
of the poor performance and substantial volatility in equity markets. Foreign
demands for U.S. currency also boosted
money growth in July.
The staff forecast prepared for this
meeting suggested that, after a period
of very slow growth associated in large
part with very weak business fixed
investment and to some extent with
an inventory correction, the economic
expansion would gradually regain
strength over the forecast horizon and
move back to a rate around the staff's
current estimate of the growth of the
economy's potential output. The period
of subpar expansion was expected to
foster an appreciable easing of pressures
on resources and some moderation in
core price inflation. Although substantial monetary easing had already been
implemented and fiscal stimulus was in



train, the forecast anticipated that the
expansion of domestic final demand
would continue to be held back by the
effects on household net worth of recent
and possible future declines in stock
market prices and by damped consumer
and business sentiment in a weaker job
market. With long-term trends in innovation holding up reasonably well,
business fixed investment, notably outlays for equipment and software, likely
would return to relatively robust growth
after a period of adjustment of capital
stocks to more desirable levels, and a
projected pickup in foreign economies
was seen as providing some support for
U.S. exports.
In the Committee's discussion of
current and prospective economic developments, many of the members commented that the anticipated strengthening in economic expansion had not
yet occurred and, indeed, that the economy and near-term economic prospects
appeared to have deteriorated marginally further in the period since the previous meeting. Several members referred
to a number of recently available economic indicators that in their view suggested the possibility that the string of
disappointing readings on the economy
might be about to end, but those indicators were insufficiently robust and too
recent to provide conclusive evidence
of emerging stabilization, much less
that some overall strengthening might
be under way. Among other things, the
economy was still adjusting to downward revisions to expected earnings and
to perceptions of greater risk and associated declines in wealth. In sum, the timing of the pickup in the growth of the
economy had again been pushed back.
Even so, the prospects for an upswing
over coming quarters remained favorable against the backdrop of the lagged
effects of substantial monetary policy
easing already implemented this year,

Minutes of FOMC Meetings, August 269
the recent passage and initial implementation of stimulative fiscal policy
measures, the progress businesses had
already achieved toward completing
inventory adjustments, and the underlying support for business investments
from continued technological innovations. Nonetheless, the members recognized that the recovery in business fixed
investment, the major source of weakness in the economy, was likely to follow a more extended period of adjustment than had been anticipated in their
earlier forecasts. With regard to the
outlook for inflation, members reported
on widespread indications of some
slackening in what were still generally
tight labor markets and also noted that
capacity utilization rates had declined
substantially in many industries. The
reduced pressures on resources along
with expectations of some further
declines in energy prices were seen by
many members as likely to foster a modest deceleration in many measures of
wages and prices.
Statistical evidence of an ongoing,
though gradual, worsening in overall
business conditions was supported by
anecdotal reports from around the
nation. Weakness continued to be concentrated in manufacturing, notably in
the high-tech sector and in high-tech
service industries. Indications that the
softening was spreading more generally
were still fairly limited as suggested by
employment data and anecdotal reports.
At the same time, members cited some
still quite tentative signs that declines
in manufacturing had slowed or that
activity had steadied in some depressed
industries.
In their review of developments in
key sectors of the economy, members
again emphasized the ongoing strength
in household spending and its vital role
in moderating the weakness in overall
economic activity. Tax rebates, declin


ing energy prices, and widespread discounting of retail prices were cited as
positive factors in support of consumer
spending on a wide range of goods and
services. In addition, increasingly persuasive evidence indicated that realized capital gains from the sale of homes
were a source of fairly significant
amounts of consumer purchasing power
in the economy. Looking ahead, members expressed some concern about how
long the household sector would continue to prop up the economy in the
absence of an upturn in business expenditures. While accommodative financial
conditions and reduced income tax rates
should continue to undergird consumer
spending and the data on retail sales
for July displayed relatively impressive gains, negative wealth effects from
falling stock market prices, declining
payrolls, and sluggish income gains—
should they persist—might well depress
consumer expenditures over coming
months. In this regard, some recent
anecdotal reports pointed to weaker
retail sales, importantly including motor
vehicles. There also were some recent
indications of declining consumer confidence, and many retailers had become
less optimistic about the outlook for
sales over the balance of the year.
Homebuilding generally had remained robust in recent months, as
relatively low mortgage interest rates
continued to offset weakness in employment and incomes and the negative
effects of declining stock market wealth.
Most regions continued to report strong
housing markets, albeit with evidence of
some weakening in sales of high-priced
homes in a number of areas. For now,
however, there were few signs that overall housing activity might be softening,
though members noted that potentially
bearish factors relating to the outlook
for consumer spending might at some
point also affect housing.

270 88th Annual Report, 2001
With household spending already
elevated relative to income and its rate
of increase unlikely to strengthen materially, if at all, under foreseeable nearterm economic conditions, the anticipated upturn in overall economic
expansion would depend critically on
business investment spending and in
turn on improved prospects for business profits and cash flows. Business
capital expenditures appeared to be
slowing sharply further after posting
large declines earlier in the year in
conjunction with the marking down of
the expected growth of demand for and
profitability of capital equipment, weak
sales, the emergence of substantial
excess capacity in many industries,
notably in high-tech facilities, and the
resulting decline in earnings. Market
forecasts of business profits were progressively being reduced, and as a consequence members saw little likelihood
of a marked turnaround in business capital investment over the months ahead
despite some elements of strength such
as sizable construction projects involving public utilities, energy, and, in some
areas, public works. Indeed, history
strongly suggested that capital spending might well fall below sustainable
levels for a time as business firms over
adjusted on the downside to previously
excessive or misdirected buildups of
capital resources. While the near-term
outlook for business investment was not
promising and considerable uncertainty
surrounded the timing of the eventual
upturn, members remained optimistic
about the longer-term prospects for capital expenditures. In the context of a still
favorable outlook for continued elevated
rates of technological progress, business
firms reportedly had not yet exploited
many potentially profitable investment
opportunities.
The persistence of substantial inventory liquidation was another negative



factor in the current performance
of the economy. While considerable
progress reportedly had been made by
numerous business firms in reducing
their inventories to bring them into better alignment with sales, a rebound to
inventory accumulation did not appear
imminent for the economy as a whole.
Unexpected weakness in final demands
would, of course, lead to additional
efforts to pare inventories, which would
tend to damp and delay the rebound.
Even so, leaner inventories had favorable implications for production going
forward.
Fiscal policy developments were a
supportive factor in the economy. The
tax rebates currently being distributed
undoubtedly were having a limited
but positive effect on consumers, which
likely would continue over coming
months. The impetus could not be measured precisely, but it was reflected in
available anecdotal reports. Moreover,
the reductions in income tax rates would
have an ongoing effect in boosting
disposable household incomes. On the
negative side, financial difficulties in a
number of states were being met in part
through higher taxes that implied at least
some offset to the federal tax relief.
Many of the members expressed concern about what appeared to be cumulating weakness in numerous foreign
economies that would feed back to the
U.S. economy through reduced demand
for U.S. exports and potentially through
perceptions of greater risks in financial
markets. A number of major industrial
economies were growing more slowly
than had been expected earlier in the
summer. Moreover, severe economic
and financial problems in a few developing nations could spill over to their trading partners and other similarly situated
countries that could in turn have adverse
repercussions more generally on the
world economy.

Minutes of FOMC Meetings, August
The members generally viewed a
modest decline in inflation as a reasonable prospect, at least for a while.
Reports from around the nation indicated that labor market conditions had
eased, though they remained generally
tight and workers available to fill a
variety of skilled job openings continued to be in short supply. On balance,
however, upward pressures on labor
compensation appeared to be easing
somewhat despite large increases in the
costs of medical care. Competitive pressures continued to make it very difficult
for business firms to raise their prices,
and there were no signs that widespread
discounting might be coming to an end.
An apparent downtrend in the costs of
energy was another favorable factor in
the outlook for inflation. Some members
expressed a degree of concern, however,
about the longer-term outlook for inflation. Pressures on resources would rise
as the anticipated upturn and possible
above-trend growth brought the economy closer to full capacity utilization.
An important uncertainty in this regard
was the outlook for productivity, whose
growth might have moderated from the
unusually high growth rates of 1999 and
2000, with possibly adverse implications for labor costs at very low levels of
unemployment.
In the Committee's discussion of policy for the intermeeting period ahead, all
the members endorsed a proposal calling for a slight further easing in reserve
conditions consistent with a 25 basis
point reduction in the federal funds rate
to a level of Zxh percent. No member
expressed a preference for leaving policy unchanged or easing by more than
25 basis points. The economy had continued to be weak—indeed, weaker than
many had expected—and data and anecdotal reports from around the country
had yet to point to persuasive signs of
a turnaround. The monetary and fiscal



271

policy stimulus already in train seemed
adequate to promote and support an
eventual appreciable rise in the growth
of business activity to a pace near that
of the economy's potential, but the
strength and timing of the pickup
remained uncertain and further weakness was a distinct threat in the nearer
term. In particular, possible faltering in
household expenditures at a time when
business firms were still adjusting to
inventory imbalances and to capital
overinvestments would exacerbate the
slowdown in the economy and delay its
anticipated recovery. Growing concerns
about foreign economies added to the
current unease about potential near-term
developments.
Against the considerable forces of
restraint on aggregate demand, the federal funds rate had been lowered substantially and the monetary aggregates
were growing rapidly, but some members noted that in a number of respects
financial conditions did not indicate as
much oncoming stimulus. Since the start
of the year, long-term interest rates generally had not extended earlier declines,
prices in equity markets had fallen
substantially further, and the dollar had
appreciated in foreign exchange markets. Accordingly, the inflation risks of
some further monetary stimulus seemed
limited and were outweighed by the
need to lean against actual and potential shortfalls in demand and business
activity.
The members recognized that in light
of the lags in the effects of policy, the
easing process probably would have to
be terminated before available measures
of economic activity provided clear
evidence of a substantial strengthening
trend. In the view of some members,
this point might come relatively soon.
Beyond the nearer term members also
envisaged the desirability of moving
preemptively to offset some of the extra

272 88th Annual Report, 2001
monetary stimulus now in the economy
in advance of inflation pressures beginning to build. The members were fully
prepared to act on a timely basis, but
several emphasized the recognition lags
that would be involved in stopping and
subsequently beginning to reverse the
policy easing.
Given their views about the risks to
the economy, notably over the nearer
term, all the members supported the
retention of the sentence in the press
statement indicating that the risks continued to be weighted toward further
weakness in the foreseeable future.
At the conclusion of this discussion,
the Committee voted to authorize and
direct the Federal Reserve Bank of New
York, until it was instructed otherwise,
to execute transactions in the System
Account in accordance with the following domestic policy directive:
The Federal Open Market Committee
seeks monetary and financial conditions that
will foster price stability and promote sustainable growth in output. To further its longrun objectives, the Committee in the immediate future seeks conditions in reserve
markets consistent with reducing the federal funds rate to an average of around
3V2 percent.

The vote encompassed approval of
the sentence below for inclusion in the
press statement to be released shortly
after the meeting:
Against the background of its long-run
goals of price stability and sustainable economic growth and of the information currently available, the Committee believes that
the risks continue to be weighted mainly
toward conditions that may generate economic weakness in the foreseeable future.
Votes for this action: Messrs. Greenspan,
McDonough, Ferguson, Gramlich, Hoenig, Kelley, Meyer, Ms. Minehan, Messrs.
Moskow and Poole. Votes against this
action: None.



It was agreed that the next meeting of
the Committee would be held on Tuesday, October 2, 2001.
The meeting adjourned at 12:40 p.m.

Reciprocal Currency Arrangements
Following the terrorist attacks on September 11, 2001, the Committee established or enlarged reciprocal currency
(swap) arrangements with the European
Central Bank, the Bank of Canada, and
the Bank of England. The purpose of
these arrangements was to facilitate the
functioning of U.S. financial markets by
providing as necessary through the foreign central banks the liquidity in dollars needed by European, Canadian, and
British banks whose U.S. operations had
been disrupted by the disturbances in
the United States. These central bank
arrangements would mature in thirty
days unless extended by the Committee.
Except for an initial drawing of up to
$12 billion by the European Central
Bank on September 12, individual drawings were subject to approval by the
Foreign Currency Subcommittee of the
Federal Open Market Committee. Under
the agreements, dollars would be made
available in the form of deposits at the
Federal Reserve Bank of New York
in exchange for deposits in the counterparty central banks of an equivalent amount of their currencies. The
individual actions and votes were as
follows:
On September 12, 2001, available members of the Committee voted unanimously to
establish a $50 billion swap line with the
European Central Bank with a maturity of
thirty days unless renewed.
Votes for this action: Messrs. Greenspan,
Ferguson, Gramlich, Hoenig, Ms. Minehan, Messrs. Moskow, Poole, and Stewart.
Absent and not voting: Messrs. Kelley and

Minutes of FOMC Meetings, October 273
Meyer. Mr. Stewart voted as alternate for
Mr. McDonough.
On September 13, 2001, available members of the Committee voted unanimously to
increase the System's swap line with the
Bank of Canada from $2 billion to $10 billion, with the added facility to mature in
thirty days unless renewed.
Votes for this action: Messrs. Greenspan,
McDonough, Ferguson, Gramlich, Hoenig, Kelley, Ms. Minehan, Messrs.
Moskow and Poole. Absent and not voting: Mr. Meyer.
On September 14, 2001, available members of the Committee voted unanimously to
establish a $30 billion swap line with the
Bank of England, with a maturity of thirty
days unless renewed.
Votes for this action: Messrs. Greenspan,
McDonough, Ferguson, Hoenig, Kelley,
Ms. Minehan, Messrs. Moskow and Poole.
Absent and not voting: Messrs. Gramlich
and Meyer.

Intermeeting Policy Action
On September 13, 2001, the Committee
met by telephone conference to assess
economic and financial developments
stemming from the terrorist attacks on
September 11 and the possible need for
a monetary policy response. Banking
and other financial market conditions,
notably in New York City but also
around the nation, were discussed in
some detail as well as the outlook for
reopening the stock exchanges. While
the ongoing reactions to the recent tragedy were undoubtedly a negative factor
in the economic outlook, the members
agreed that financial markets were still
too disrupted and the economic outlook
too uncertain to provide an adequate
basis for a policy move at this time.
However, the members contemplated
the need for some policy easing in the
very near future. In the interim, the
System would continue to stand ready
to provide whatever liquidity might



be needed to counter unusual strains and
help assure the effective functioning of
the banking system and restore more
normal conditions in financial markets.
Subsequently, on September 17,
2001, the Committee members voted
unanimously to ease reserve conditions
appreciably further, consistent with a
reduction in the federal funds rate of
50 basis points to a level of 3 percent.
This policy action was associated with
the approval by the Board of Governors
of a reduction of equal size in the discount rate to a level of 2!/2 percent.
These actions were taken against the
backdrop of heightened concerns and
uncertainty created by the recent terrorist attacks and their potentially adverse
effects on asset prices and the performance of the economy. In conjunction
with these policy moves, the Federal
Reserve would continue to supply, as
needed, an atypically large volume of
liquidity to the financial system. As a
consequence, the Committee recognized
that the federal funds rate might fall
below its target on occasion until more
normal conditions were restored in the
functioning of the financial system. The
Committee's vote encompassed the
retention of a statement in its press
release indicating that the balance of
risks remained weighted toward weakness for the foreseeable future.
Votes for this action: Messrs. Greenspan,
McDonough, Ferguson, Gramlich, Hoenig, Kelley, Meyer, Ms. Minehan, Messrs.
Moskow and Poole. Votes against this
action: None.
Donald L. Kohn
Secretary

Meeting Held on
October 2, 2001
A meeting of the Federal Open Market
Committee was held in the offices of

274

88th Annual Report, 2001

the Board of Governors of the Federal
Reserve System in Washington, D.C.,
on Tuesday, October 2, 2001, at
9:00 a.m.
Present:
Mr. Greenspan, Chairman
Mr. McDonough, Vice Chairman
Mr. Ferguson
Mr. Gramlich
Mr. Hoenig
Mr. Kelley
Mr. Meyer
Ms. Minehan
Mr. Moskow
Mr. Poole
Messrs. Jordan, McTeer, Santomero,
and Stern, Alternate Members
of the Federal Open Market
Committee
Messrs. Broaddus, Guynn, and Parry,
Presidents of the Federal Reserve
Banks of Richmond, Atlanta, and
San Francisco respectively
Mr. Kohn, Secretary and Economist
Mr. Bernard, Deputy Secretary
Ms. Fox, Assistant Secretary
Mr. Mattingly, General Counsel
Ms. Johnson, Economist
Mr. Reinhart, Economist
Mr. Stockton, Economist
Ms. Cumming, Messrs. Fuhrer, Hakkio,
Howard, Lindsey, Rasche,
Slifman, and Wilcox, Associate
Economists
Mr. Kos, Manager, System Open
Market Account
Ms. Smith, Assistant to the Board,
Office of Board Members,
Board of Governors
Messrs. Ettin and Madigan, Deputy
Directors, Divisions of Research
and Statistics and Monetary
Affairs respectively, Board
of Governors
Mr. Simpson, Senior Adviser, Division
of Research and Statistics,
Board of Governors



Mr. Connors, Associate Director,
Division of International Finance,
Board of Governors
Messrs. Oliner and Struckmeyer,
Associate Directors, Division
of Research and Statistics,
Board of Governors
Mr. Whitesell, Assistant Director,
Division of Monetary Affairs,
Board of Governors
Mr. Kumasaka, Assistant Economist,
Division of Monetary Affairs,
Board of Governors
Ms. Low, Open Market Secretariat
Assistant, Office of Board
Members, Board of Governors
Messrs. Eisenbeis and Goodfriend,
Ms. Mester, Messrs. Rolnick,
Rosenblum, and Sniderman,
Senior Vice Presidents, Federal
Reserve Banks of Atlanta,
Richmond, Philadelphia,
Minneapolis, Dallas, and
Cleveland respectively
Messrs. Evans, Hilton, and Judd, Vice
Presidents, Federal Reserve Banks
of Chicago, New York, and
San Francisco respectively
By unanimous vote, the minutes of
the meeting of the Federal Open Market
Committee held on August 21, 2001,
and the conference calls held on September 13 and 17, 2001, were approved.
The Manager of the System Open
Market Account reported on recent
developments in foreign exchange markets. There were no open market operations in foreign currencies for the System's account in the period since the
previous meeting. The Manager also
reported on developments in domestic
financial markets and on System open
market transactions in government securities and securities issued or fully guaranteed by federal agencies during the
period August 21, 2001, through October 1, 2001. By unanimous vote, the

Minutes of FOMC Meetings, October 275
Committee ratified these transactions.
The Committee expressed its appreciation of the outstanding manner in which
the Federal Reserve Bank of New York
had carried out its open market operations and other responsibilities under
very difficult circumstances after the terrorist attacks on September 11, 2001.
The Committee then turned to a
discussion of the economic and financial outlook and the implementation of
monetary policy over the intermeeting
period ahead. A summary of the economic and financial information available at the time of the meeting and of
the Committee's discussion is provided
below.
The information reviewed at this
meeting suggested that the attacks of
September 11 might well have induced
a mild downturn in economic activity
after several months of little movement
in the level of economic activity. While
few nonfinancial economic data were
available on developments since the
attacks, anecdotal and survey reports
suggested that heightened uncertainty
and sharply reduced confidence had
curtailed consumer spending and had
intensified the downward trajectory in
business capital expenditures. Consumer
price inflation had remained relatively
subdued over the summer months.
Data for August portrayed some continued softening in overall labor market conditions. Private nonfarm payroll
employment fell appreciably further,
with the decline more than accounted
for by additional job losses in manufacturing. Labor demand remained sluggish
in most other sectors, though some
pickup was reported in services. The
unemployment rate rose to 4.9 percent
in August, its highest level in four years.
A sharp increase in initial claims for
unemployment insurance in recent
weeks was suggestive of additional deterioration in labor markets.



Industrial production fell substantially further in August after posting
monthly losses starting in October of
last year. Motor vehicle assemblies were
down sharply, reversing a large advance
in July, and production of high-tech
equipment continued to register large
declines. Outside of those two industries, production of business equipment, business supplies, consumer
nondurables, and materials also moved
appreciably lower. The rate of capacity
utilization in manufacturing continued
to fall, reaching its lowest level since
mid-1983.
Growth in consumer spending picked
up somewhat in July and August from
a reduced pace in the second quarter
despite a small drop in sales of new
motor vehicles. However, anecdotal
reports from around the nation pointed
to a downturn in September, largely
reflecting marked weakness after the
terrorist attacks. Indicators of consumer
confidence fell further in September.
Despite low mortgage interest rates,
residential building activity softened
somewhat in August and some indicators of housing demand, including mortgage applications for home purchases,
had downshifted a bit further in recent
weeks. However, builder backlogs
appeared to be large enough to sustain
homebuilding activity at a fairly elevated level for several months. Sales of
new homes edged up in August but were
little changed on balance since April.
Business capital spending contracted
substantially further over the summer
months, and anecdotal information after
September 11 pointed to even deeper
cutbacks by many firms. The added
weakness evidently stemmed from
increased concerns about future sales
and earnings, which also was reflected
in the sharp declines in stock market
prices after the equity markets reopened
on September 17. Available indicators

276 88th Annual Report, 2001
suggested that expenditures for equipment and software had remained on a
sharp downward trajectory into late
summer, though the overall decline in
such spending was moderated by sizable
outlays for aircraft in July and August.
New orders for nondefense capital
goods edged up in August but were still
well below their average for the second
quarter. Nonresidential construction
activity appeared to be falling appreciably further after a sharp downturn in the
second quarter.
Business inventory liquidation remained substantial in July, extending
the sizable declines since the start
of the year. Large drawdowns were
recorded in manufacturing and, excluding motor vehicles, in both wholesale
and retail trade. The limited data available for August indicated some reduction in dealer stocks of motor vehicles
and sizable further liquidation of durable goods by firms in the manufacturing sector. Nonetheless, the aggregate
inventory-sales ratio for producers of
durable goods edged up in August, led
by a further rise in the ratio for computers and electronic products. In the days
following the terrorist attacks, anecdotal
reports indicated that disruptions in
transportation facilities, including the
temporary suspension of air cargo service and lengthy trucking delays at
the nation's borders, caused some backups in inventories at some firms and
shortages at others, but these problems
generally seemed to ease within a few
days.
The U.S. trade deficit in goods and
services was about unchanged in July
from its June level, but both exports and
imports dropped sharply as weakness in
worldwide economic activity continued
to affect the nation's foreign trade. The
reduced value of exports in July was
spread among most trade categories but
was especially pronounced in machin


ery, industrial supplies, and automotive
products. The reduction in imports was
led by declines in oil, semiconductors,
other machinery, automotive products,
and consumer goods. Data for foreign
industrial economies confirmed earlier
indications of little or no growth in those
economies in the second quarter, and
more recent information for the period
prior to the terrorist attacks pointed to
further weakness, including evidence of
declining activity in Japan. Available
information on conditions in major
developing countries also suggested
slowing or negative growth in recent
months, in part as a consequence of
weakness in their exports to the United
States and, notably for some Asian
economies, the poor performance of the
global high-tech industry.
Consumer price inflation remained
relatively limited in July and August,
with core personal consumption expenditure (PCE) price inflation on an appreciably lower track than core consumer
price index (CPI) inflation. For the
twelve months ending in August, core
PCE prices rose a bit less, and core CPI
prices a bit more, than over the previous
twelve-month period. Consumer energy
prices fell sharply in July and August,
but a sizable rebound was anticipated in
September as prices of petroleum products moved higher after midsummer
in response to refinery disruptions and
tightening supplies. In electricity markets, upward price pressures dissipated
over the summer, while the sharp run-up
of natural gas prices continued to
unwind as inventories rose further in the
context of persisting high levels of production and sluggish demand. At the
producer level, core prices declined in
August, notably at the early stages of
processing. With regard to labor costs,
the rise in average hourly earnings of
production or nonsupervisory workers
diminished somewhat over July and

Minutes of FOMC Meetings, October 277
August, but the year-over-year advance
was still appreciably above that for the
previous twelve-month period. In addition, large increases in health insurance
costs were continuing to add to overall
employment costs.
At its meeting on August 21, 2001,
the Committee adopted a directive that
called for implementing conditions in
reserve markets consistent with a reduction of 25 basis points in the intended
level of the federal funds rate to a level
of about 3!/2 percent. The Committee
took this action in light of the absence
of firm evidence that the deceleration in
the economic expansion had run its
course or that a recovery in output was
imminent. With increasing slack in labor
and product markets and with inflation
expectations contained, the members
agreed that the balance of risks continued to be weighted toward conditions
that could generate economic weakness in the foreseeable future. Subsequently, on September 17, the Committee reduced its target for the federal
funds rate by a further Vi percentage
point. This action was taken against
the backdrop of heightened concerns
and uncertainty created by the recent
terrorist attacks and their potentially
adverse effects on asset prices and the
performance of the economy. In conjunction with this easing move, the Federal Reserve indicated that it would continue to supply unusually large volumes
of liquidity, and the Committee recognized that the federal funds rate might
fall below its new target until the normal
functioning of financial markets was
restored.
In the period before the terrorist
attacks, federal funds traded at rates near
the reduced target level established at
the August meeting. Most market interest rates edged lower over that period in
response to generally downbeat news on
the economy, and broad stock market



indexes fell appreciably. For a few days
after September 11, with federal funds
brokerage disrupted, banks generally
agreed to trade reserves at the 3Vi percent federal funds target rate then prevailing. As more normal functioning
resumed in the federal funds market, the
rate fell well below the Committee's
formal targets, including the reduced
rate set on September 17. By the latter
part of September and early October,
however, the effective rate was fluctuating around the new target level. After
the terrorist attacks, rates on short- and
intermediate-term Treasury securities
fell appreciably further, as did yields
on highly rated obligations such as federal agency debt. However, the yield
declines did not extend to long-term
Treasury bonds, which changed little
as investors apparently reacted to the
deteriorating outlook for the federal
budget surplus and prospectively larger
Treasury bond supplies. Yields on
investment-grade corporate bonds also
were little changed, but rates on highyield bonds, evidently reflecting
increased investor aversion to holding
risky securities, rose sharply in very thin
markets. In the stock market, broad
equity price measures fell considerably
further in volatile trading after the markets reopened on September 17, but part
of those losses had been recovered by
the time of this meeting.
The trade-weighted value of the dollar
against the other major foreign currencies was about unchanged on average
over the period since the August
meeting, as modest dollar appreciation early in the period was reversed
after September 11. The dollar ended
the period somewhat lower against the
yen and the euro but registered an
advance against the Canadian dollar.
The dollar rose over the period against
the currencies of other important trading
partners.

278 88th Annual Report, 2001
Growth of M2 remained relatively
robust in July and August, though below
the average pace in the first half of the
year, while the expansion of M3 weakened markedly over the two months.
More recently, a record surge in M2
components in the week ending September 17, which was largely reversed in
the following week, resulted in very
rapid growth in both aggregates on a
monthly average basis in September. In
the immediate aftermath of the terrorist
attacks, disruptions to the infrastructure
of financial markets, including communications and transportation facilities,
led to massive dislocations in the distribution of deposits and reserves. At the
same time, greatly heightened demand
for safe and liquid assets encouraged
shifts from equity markets into deposit
assets. These financial disturbances
called for and were accommodated by
record infusions of Federal Reserve
credit through open market operations,
the discount window, and other sources.
In addition, the Federal Reserve eased
its rules for lending securities to dealers and took a number of other steps to
facilitate the operation of financial markets. To a considerable extent, more normal functioning was restored to those
markets by the latter part of September,
and the unusual demand for reserves
abated.
In the presentation of its forecast to
the Committee, the staff indicated that
its downward revised outlook was subject to a very wide range of uncertainty
regarding the ongoing effects of the
tragic events of September 11. A mild
downturn in overall economic activity
probably was now under way and business conditions would continue to be
depressed for some uncertain period by
the sharp further deterioration in business and consumer confidence triggered
by the terrorist attacks. However, a
gradual recovery was anticipated during



the first half of 2002, especially against
the backdrop of a very accommodative
monetary policy and an increasingly
stimulative fiscal policy. The recovery
would gather momentum during 2002
to a pace late in the year near the staff's
current estimate of the growth in the
economy's potential. With long-term
trends in innovations and business
opportunities expected to remain favorable, business fixed investment after
the completion of ongoing adjustments
likely would return to robust rates of
growth, with favorable implications for
employment, labor productivity, and
consumer spending. The current and
prospective slack in resource use over
coming quarters, augmented by the
pass-through effects of lower oil prices,
would result in some modest deceleration in core PCE and CPI inflation.
In the Committee's discussion of current and prospective economic developments, the members focused on the
shock to consumer and business confidence occasioned by the events of September 11 and the adverse repercussions
on an already weak economy. The economy appeared to have been growing
very little, if at all, prior to the terrorist
attacks, and the dislocations arising
from the latter seemed to have induced
a downturn in overall economic activity against the backdrop of heightened
anxiety and uncertainty about economic
prospects and a sharp drop, at least
initially, in stock prices after the equity
markets reopened on September 17.
Looking ahead, the members generally
saw a relatively mild and short contraction followed by a gradual recovery next
year as a plausible forecast but one that
was subject to an unusually wide range
of uncertainty, notably in the direction
of a potentially much weaker outcome
in the nearer term. In the short period
since the attacks, anecdotal reports provided indications of a rebound from the

Minutes of FOMC Meetings, October 279
sharp cutback in spending that characterized the immediate aftermath of those
tragic events, but on balance business
activity seemed to be in the process of
moving lower. It was especially difficult
to assess the outlook for consumer sentiment and spending in the period immediately ahead, which likely would depend
to an important extent on the progress of
the war against terrorism and reactions
to any further terrorist activities. One
risk bearing on that outlook was the
possibility that prices in equity markets
might continue to decline and perhaps
even overadjust to lower earnings expectations. The confluence of worldwide economic weakness added to current uncertainties and concerns. In these
circumstances a substantial further drop
in consumer and business confidence
and spending could not be ruled out.
The members nonetheless saw favorable prospects for an upturn in business
activity next year, though the recovery
clearly would be more delayed than they
had anticipated before September 11.
Major reasons for optimism about the
outlook were the substantial easing in
monetary policy, whose lagged effects
would be felt increasingly in the year
ahead, and the fiscal stimulus measures that already had been enacted and
might well be supplemented over coming months. Other supportive elements
included a likely rebound in business
high-tech investment after its sharp
retrenchment and a gradual turnaround
in inventory investment as stocks
became better aligned with expected
sales. A sound banking system and low
inflation were seen as sources of underlying strength in the economy that
would contribute to the eventual pickup
in economic activity. Even with a
rebound in activity next year, however,
consumer price inflation appeared likely
to remain subdued or perhaps trend a bit
lower in association with reduced pres


sures on labor and other resources and
declining energy prices.
The Committee's review of recent
and prospective developments in key
sectors of the economy underscored the
uncertainty that surrounded the overall
economic outlook. The major question
at this point was the extent to which
the recent tragedies would continue to
weigh on consumer spending and business investment. In the consumer sector,
spending had with some exceptions held
up well through late summer, but confidence had begun to deteriorate even
before September 11. A factor that
seemed to be exerting an increasingly
depressing effect on consumer attitudes
was the persisting stream of worker
layoffs and rising unemployment. The
adverse wealth effects stemming from
the cumulative declines in stock market
prices were a further negative, though
one that had been cushioned by continued increases in the value of real estate.
Retail sales along with expenditures
associated with travel-related services
had fallen dramatically in the immediate
aftermath of the terrorist attacks. Very
recent anecdotal reports suggested some
improvement in consumer spending,
though not a total recovery, with mixed
indications ranging from a rebound to
levels near pre-attack norms to still
relatively depressed activity. Looking
ahead, many retailer contacts anticipated
sluggish sales over coming months.
There were no historical precedents for
judging the likely effects on consumer
confidence and spending of the unique
recent events, though it seemed likely
that prospects for added job losses and
the decline in equity wealth already
experienced would hold down consumer
expenditures over the months ahead.
Even so, the members did not rule out a
stronger-than-anticipated pickup later,
depending in part on the size of additional fiscal policy actions.

280 88th Annual Report, 2001
Housing demand had remained at a
relatively elevated level across much
of the nation, though signs of some softening were apparent prior to September 11, especially in the high-priced
segment of the housing market. The
near-term outlook suggested some further waning in housing demand in association with the prospective weakness
in employment and income. Some
members noted in this regard that they
sensed growing caution among homebuilders. However, the outlook for housing activity over the intermediate to
longer term remained fairly promising
against the backdrop of relatively low
mortgage interest rates and a prospective recovery in overall economic activity that would foster rising employment
and incomes.
The events of September 11 produced
a marked increase in uncertainty and
anxiety among contacts in the business
sector. Spending for equipment and software and for commercial structures had
been declining sharply through the
summer, with only a few tentative signs
that the pace of decline might be about
to ebb. According to contacts, intensified concerns about prospects for sales
and profits were depressing investment
further by fostering an increasingly
widespread wait-and-see attitude about
undertaking new investment expenditures. While nationwide statistics on
expenditures in the period since the
terrorist attacks were not yet available,
anecdotal reports pointed to especially
large cutbacks in planned spending
for commercial aircraft and rental cars
stemming from the sudden and sharp
deterioration of activity in the travel and
tourist industries. Reports from banking
contacts also indicated a substantial drop
in demand for business loans that was
attributed in part to the diminished willingness of small businesses in particular
to undertake new investments in capital



equipment and other production facilities. More generally, the increase in
uncertainty and the decline in business
confidence and corporate profits along
with the currently high levels of excess
capacity in many industries pointed to
the persistence of poor prospects for
capital spending over the short to intermediate term, with declines in outlays
for high-tech products expected to
remain especially pronounced. Looking
further ahead, however, a robust upturn
in business capital spending was still a
probable outcome. Businesses likely
would respond to profit opportunities
stemming not only from rising demand
resulting in part from fiscal and monetary stimulus but also from ongoing
technological improvements and the
need for new capital equipment as the
process of retrenchment from earlier
overinvestments was completed.
With a few short-lived exceptions,
production on the whole had not been
directly disrupted by the effects of the
terrorist attacks. Consequently, some
unintended accumulation of inventories
probably had occurred as a result of
sizable and unanticipated declines in the
demand for many products. Even so, the
pronounced downtrend in overall inventory spending appeared to be continuing, and with many business firms
evidently still trying to liquidate what
they viewed as excessive stocks, the
inventory adjustment process was likely
to persist for some time. Nonetheless,
as progress was made in reducing
unwanted stocks, the rate of inventory
liquidation would diminish and an eventual turn toward accumulation would
emerge, with positive implications for
economic activity. Indeed, this buildup
could be larger than previously anticipated if businesses now felt the need
to hold larger stocks against the contingency of supply-chain slowdowns and
disruptions.

Minutes of FOMC Meetings, October 281
The members saw the international
sector as contributing to weakness in the
domestic economy, especially over the
nearer term. Downshifts in the U.S.
economy were reinforcing more sluggish performance in many foreign
economies, which in association with
continued firmness in the dollar was
in turn depressing the outlook for U.S.
exports to those countries. In this regard,
several members cited anecdotal evidence of flagging foreign markets for a
variety of U.S. products. On the positive
side, weakness in world demand for oil
was fostering a significant downtrend in
energy prices, albeit with adverse effects
on energy producers in this country and
abroad.
Members viewed the outlook for
inflation as favorable. Expectations of
greater and longer-lasting slack in labor
and product markets than anticipated
earlier had led to downward revisions
to forecasts of wage and price inflation.
This outlook was abetted by substantial
declines in oil and other commodity
prices. On the negative side, increases in
spending on insurance and security and
continued upward pressure on costs in
the healthcare industry likely would
impinge on business margins, limiting
the downward adjustment of inflation.
In the discussion of policy for the
intermeeting period ahead, all the members endorsed a proposal calling for
some further easing of reserve conditions consistent with a 50 basis point
reduction in the federal funds rate to
a level of 2lA percent. While monetary
policy had already been eased substantially this year, the increased evidence of
a faltering economy and the decidedly
downside risks in the outlook called for
a further move at this meeting. Easing
would help limit the extent of the downturn and later provide impetus to the
eventual upturn in economic activity.
Further vigorous easing action would



tend to support business and household
confidence, which a number of members saw as especially important in
the current circumstances. Even after a
50 basis point reduction, the federal
funds rate would not reflect an unusually accommodative policy stance in
that, in real terms, it would still be positive by many measures and above its
typical level in most earlier periods
of economic weakness. Moreover, the
decline in stock market prices and the
widening of risk spreads had damped
the stimulative financial effects of the
Committee's earlier easing actions. The
relatively low level of inflation and
well-contained inflationary expectations
allowed the Committee flexibility to
focus on countering the downside risks
to the economy without incurring a significant threat of fostering expectations
of higher inflation. Monetary policy is
a flexible instrument and, with inflation
expectations likely to remain relatively
benign, policy could be reversed in a
timely manner later should stimulative policy measures and the inherent
resiliency of the economy begin to foster an unsustainable pace of economic
expansion.
In keeping with their views about the
risks to the economy, all the members
supported the retention of the sentence
in the press statement indicating that the
risks continued to be weighted toward
further weakness in the foreseeable
future.
At the conclusion of this discussion,
the Committee voted to authorize and
direct the Federal Reserve Bank of New
York, until it was instructed otherwise,
to execute transactions in the System
Account in accordance with the following domestic policy directive:
The Federal Open Market Committee
seeks monetary and financial conditions that
will foster price stability and promote sus-

282 88th Annual Report, 2001
tainable growth in output. To further its longrun objectives, the Committee in the immediate future seeks conditions in reserve
markets consistent with reducing the federal funds rate to an average of around
22/2 percent.

The vote encompassed approval of
the sentence below for inclusion in the
press statement to be released shortly
after the meeting.
Against the background of its long-run
goals of price stability and sustainable economic growth and of the information currently available, the Committee believes that
the risks continue to be weighted mainly
toward conditions that may generate economic weakness in the foreseeable future.
Votes for this action: Messrs. Greenspan,
McDonough, Ferguson, Gramlich, Hoenig, Kelley, Meyer, Ms. Minehan, Messrs.
Moskow and Poole. Votes against this
action: None.
It was agreed that the next meeting of
the Committee would be held on Tuesday, November 6, 2001.
The meeting adjourned at 12:30 p.m.
Donald L. Kohn
Secretary

Meeting Held on
November 6, 2001
A meeting of the Federal Open Market
Committee was held in the offices of
the Board of Governors of the Federal
Reserve System in Washington, D.C.,
on Tuesday, November 6, 2001, at
9:00 a.m.
Present:
Mr. Greenspan, Chairman
Mr. McDonough, Vice Chairman
Mr. Ferguson
Mr. Gramlich
Mr. Hoenig
Mr. Kelley
Mr. Meyer



Ms. Minehan
Mr. Moskow
Mr. Poole
Messrs. Jordan, McTeer, Santomero,
and Stern, Alternate Members
of the Federal Open Market
Committee
Messrs. Broaddus, Guynn, and Parry,
Presidents of the Federal Reserve
Banks of Richmond, Atlanta, and
San Francisco respectively
Mr. Kohn, Secretary and Economist
Mr. Bernard, Deputy Secretary
Mr. Gillum, Assistant Secretary
Ms. Smith, Assistant Secretary
Mr. Mattingly, General Counsel
Ms. Johnson, Economist
Mr. Reinhart, Economist
Mr. Stockton, Economist
Ms. Cumming, Messrs. Fuhrer, Hakkio,
Howard, Hunter, Lindsey,
Slifman, and Wilcox, Associate
Economists
Mr. Kos, Manager, System Open
Market Account
Mr. Winn, Assistant to the Board,
Office of Board Members,
Board of Governors
Messrs. Ettin and Madigan, Deputy
Directors, Divisions of Research
and Statistics and Monetary
Affairs respectively, Board of
Governors
Mr. Simpson, Senior Adviser, Division
of Research and Statistics,
Board of Governors
Messrs. Oliner and Struckmeyer,
Associate Directors, Division
of Research and Statistics,
Board of Governors
Messrs. Kamin and Whitesell,
Assistant Directors, Divisions
of International Finance and
Monetary Affairs respectively,
Board of Governors

Minutes of FOMC Meetings, November 283
Mr. Skidmore, Special Assistant to the
Board, Office of Board Members,
Board of Governors
Ms. Low, Open Market Secretariat
Assistant, Office of Board
Members, Board of Governors
Mr. Stewart, First Vice President,
Federal Reserve Bank of
New York
Messrs. Cox and Goodfriend,
Mses. Mester and Perlmutter,
Messrs. Rolnick and Sniderman,
Senior Vice Presidents, Federal
Reserve Banks of Dallas,
Richmond, Philadelphia,
New York, Minneapolis, and
Cleveland respectively
Mr. Thornton, Vice President, Federal
Reserve Bank of St. Louis
Mr. Robertson, Assistant Vice
President, Federal Reserve
Bank of Atlanta
Mr. Rudebusch, Senior Research
Advisor, Federal Reserve Bank
of San Francisco

By unanimous vote, the minutes of
the meeting of the Federal Open Market
Committee held on October 2, 2001,
were approved.
The Manager of the System Open
Market Account reported on recent
developments in foreign exchange markets. There were no open market operations in foreign currencies for the System's account in the period since the
previous meeting.
The Manager also reported on developments in domestic financial markets
and on System open market transactions
in government securities and securities
issued or fully guaranteed by federal
agencies during the period October 2,
2001, through November 5, 2001. By
unanimous vote, the Committee ratified
these transactions.



By notation vote circulated before
this meeting, the Committee members
unanimously approved the selection of
Michelle A. Smith to serve as an assistant secretary of the Committee for the
period until the first regularly scheduled
meeting in 2002.
The Committee then turned to a
discussion of the economic and financial outlook and the implementation of
monetary policy over the intermeeting
period ahead. A summary of the economic and financial information available at the time of the meeting and of
the Committee's discussion is provided
below.
The information reviewed at this
meeting indicated that economic activity, already weak in late summer, had
softened further after the terrorist
attacks. Overall consumer spending faltered, though purchases of motor vehicles reached a near-record level, and the
downward trajectory in business capital
expenditures steepened. With sales contracting and inventory imbalances still
substantial, the manufacturing sector
continued its sharp slide, and aggregate
employment plunged. Energy prices
were moderating somewhat in response
to lower worldwide demand, and core
price inflation remained subdued.
Conditions in the labor market deteriorated sharply further in October, with
private nonfarm payroll employment
suffering its worst monthly decline since
1975. The largest drop was in manufacturing, but nearly every major sector
experienced sizable job losses. Among
other job market indicators, the average
workweek edged down, initial claims
for unemployment insurance remained
very high, and the unemployment rate
jumped to 5.4 percent, an increase of
one-half percentage point.
Industrial
production
recorded
another large decrease in September
(latest data), and the weakness was

284 88th Annual Report, 2001
spread across most market groups and
industries. Motor vehicle assemblies
registered a further sharp contraction,
and output of high-technology goods
plunged still lower. The additional
decline in production in September
brought the rate of utilization of overall
manufacturing capacity to its lowest
reading since May 1983.
Personal consumption expenditures
fell sharply in September; purchases of
goods plummeted and consumption of
services, particularly transportation and
recreation services, declined as well. In
October, sales of light vehicles surged
to near-record levels in response to special financing packages offered by many
automakers, but available information
suggested that non-auto spending was
weak.
Residential building activity edged
down during the August-September
period, and signs of some further softness had emerged in recent weeks.
Nonetheless, in an environment of very
low mortgage rates, residential construction had been sustained at a comparatively high level despite a weakening
labor market and sluggish growth in personal income. Sales of new and existing
homes slipped in September but were
not far below the near-record levels of
last March.
Business capital spending on equipment and software fell sharply further
in the third quarter. Moreover, the
available information on orders and
shipments of nondefense capital goods
suggested another steep drop in such
spending in the latter part of this year in
the current environment of eroding corporate earnings and cash flows and a
very uncertain outlook for future sales
and earnings. The weakness in demand
for durable equipment was spread across
almost all categories of equipment but
was particularly prominent for high-tech
goods, aircraft, automobiles, and trucks.



Nonresidential construction activity also
declined in the spring and summer.
Total business inventories on a bookvalue basis decreased in July and August
(latest data for wholesalers and retailers) at a rate close to that of the second
quarter. At the manufacturing level,
stocks continued to run off at a brisk
pace through September; however, shipments weakened by more in the third
quarter, and the aggregate inventoryshipments ratio for the sector reached
its highest level in more than five years.
Wholesalers also experienced a sizable
decline in inventories over July and
August that resulted in a slight reduction
in their aggregate inventory-sales ratio,
but that ratio was still in the upper end
of its range for the past two years. Retail
inventories climbed somewhat in July
and August, but the sector's inventorysales ratio was little changed in August
and was in the lower end of its range for
the past year.
The U.S. trade deficit in goods and
services contracted slightly in August
after having changed little in July, and
the deficit for July and August combined was considerably smaller than
that for the second quarter. The value of
exports fell in the July-August period,
with most of the drop occurring in capital goods, consumer goods, and industrial supplies. The value of imports was
down appreciably more than that of
exports, with decreases occurring in
almost all major trade categories; automotive products, food, and aircraft were
the only exceptions. Recent information
indicated that foreign economic activity
had changed little in the third quarter,
and some forward indicators and anecdotal information pointed to reduced
activity later in the year. Economic
activity in the euro area and the United
Kingdom appeared to be reviving in the
summer months, but renewed softening
stemming from a downturn in business

Minutes of FOMC Meetings, November 285
and consumer confidence seemed to
have emerged in September and October. Japan remained the weakest of the
major foreign industrial economies; the
sharp contraction in economic activity
that began early in the year continued
in the third quarter, and the unemployment rate reached a record high in September. Most major emerging-market
economies, with the notable exception
of China, also were continuing to experience an economic slowdown that was
related at least in part to weakness in the
industrialized world.
Core consumer price inflation remained at a relatively subdued pace in
August and September; and with energy
prices having moderated over the past
year, total consumer price inflation had
moved down, on a year-over-year basis,
to the slower pace of its core component. Both the core consumer price
(CPI) index and the personal consumption expenditure (PCE) chain-type index
exhibited this general pattern. Core producer price inflation for finished goods
also held at a low rate in the AugustSeptember period and on a year-overyear basis. With regard to labor costs,
total hourly compensation of private
industry workers decelerated further in
the third quarter, despite a surge in benefit costs, and also slowed noticeably on
a year-over-year basis. Average hourly
earnings of production or nonsupervisory workers continued to rise in August
and September at the relatively moderate rate that had prevailed in earlier
months.
At its meeting on October 2, 2001,
the Committee adopted a directive that
called for maintaining conditions in reserve markets consistent with a decrease
of 50 basis points in the intended level
of the federal funds rate, to about
2l/i percent. The members recognized
that monetary policy already had been
eased substantially this year, but they



believed that the increased evidence of
a faltering economy and the decidedly
downside risks to the outlook called
for a further move. The additional rate
reduction would help limit the extent
of the downturn and later would contribute to an upturn. Moreover, the recent
declines in equity prices and widening
of risk spreads tended to offset some of
the stimulative effects of earlier easings,
and the relatively low level of inflation
and inflationary expectations provided
room to counter downside forces without incurring significant risks of higher
inflation. The members also believed
that the balance of risks remained
weighted toward conditions that could
generate economic weakness in the foreseeable future.
Federal funds traded at rates near the
Committee's target level over the intermeeting period. Most interest rates
declined significantly during the period
even though the reduction in the target
level for the federal funds rate had
been anticipated by market participants.
They apparently saw the Committee's
announcement and the subsequent
release of weaker-than-expected data as
portending further policy easing. With
yields on private debt securities down
sharply and investors perhaps becoming
more confident about long-term business prospects, major indexes of equity
prices moved higher over the intermeeting period.
In foreign exchange markets, the
trade-weighted value of the dollar in
terms of the major foreign currencies
had increased slightly on balance since
the October meeting. Incoming data for
the foreign industrial economies were
weaker than expected, and market interest rates abroad declined in response to
reductions in policy interest rates in
Canada and the United Kingdom and to
market expectations that the European
Central Bank would lower its policy

286 88th Annual Report, 2001
rates by year-end. The dollar moved
down slightly on balance in terms of an
index of the currencies of other important trading partners. The Brazilian real
was adversely affected by spillovers
from Argentina's financial difficulties,
while the Mexican peso rebounded from
its decline against the dollar in the wake
of the September terrorist attacks.
M2 changed little in October after a
surge in September that was related in
important measure to a temporary bulge
in transaction deposits stemming largely
from delayed settlements of security
trades in the aftermath of the terrorist
attacks. On balance, M2 grew rapidly
over the September-October period, reflecting the sharp drop in market interest
rates and perhaps the deposit of federal
tax rebates. M3 also increased rapidly
over September and October, largely in
conjunction with the expansion of M2.
The debt of domestic nonfinancial sectors grew at a moderate pace on balance
through August.
The staff forecast prepared for this
meeting emphasized the continuing
wide range of uncertainty surrounding
the outlook in the wake of the September attacks. The mild downturn in economic activity in the third quarter was
seen as likely to deepen over the remainder of the year and to continue for a time
next year. However, the cumulative easing that had occurred in the stance of
monetary policy, coupled with the fiscal
stimulus already in place and prospective additional measures, would provide
support for economic activity. Moreover, the ongoing liquidation of inventories would eventually abate and give
a sizable boost to production, while an
expected pickup in foreign economies
would provide some support for U.S.
exports. As a result, economic expansion was projected to resume and gradually gain strength through 2003, reaching a rate around the staff's current



estimate of the growth of the economy's
potential output. The period of subpar
expansion was expected to foster an
appreciable easing of pressures on
resources and some moderation in core
price inflation.
In the Committee's discussion of current and prospective economic conditions, members commented that widespread anecdotal reports supported
statistical indications that the economy
was contracting, and they saw no significant evidence that overall business
conditions were in the process of stabilizing prior to recovering. While the
members continued to see a fairly brief
and limited decrease in economic activity as the most likely outcome, they also
agreed that the risks to such a forecast were strongly tilted to the downside. Business investment expenditures
clearly seemed likely to continue to
decline over coming months. On the
other hand, consumer spending had held
up reasonably well thus far, but further
job losses could undermine consumer
confidence and spending. Looking further ahead, the longer-term prospects
for productivity and growth in the U.S.
economy remained bright and an upturn
during 2002 was a likely prospect. Such
a recovery would be fostered by the
lagged stimulus from both fiscal and
monetary policies interacting with
progress by business firms toward completing their adjustments to overhangs
in capital resources and excess inventories. However, the strength and timing
of the eventual recovery remained subject to question especially in light of the
marked degree of uncertainty that surrounded the prospects for further fiscal
policy legislation, developments in the
war against terrorism, and weakness
in foreign economies. In the context of
diminished pressures on labor and other
resources, the members expected underlying consumer price inflation to remain

Minutes of FOMC Meetings, November 287
benign and possibly to drift lower over
coming quarters, abetted by the indirect
effects of generally weaker energy
prices.
In their review of developments
in key sectors of the economy, members noted that surveys and anecdotal
commentary pointed to a considerable
decline in consumer confidence, though
in the view of some members the
decline seemed less than might have
been expected given prevailing circumstances. Retail sales, led by a surge in
motor vehicles, had improved considerably following a downturn in the weeks
after September 11. Even so, retail sales
were still generally below their levels
prior to the terrorist attacks, and overall
spending on consumer services had decelerated considerably, notably reflecting continuing weakness in expenditures on airline travel and related travel
activities. The extraordinary increase in
sales of light motor vehicles in October
clearly was propelled by exceptionally
attractive financing incentives, but such
inducements were temporary and many
of the resulting sales undoubtedly borrowed from the future. Still, the jump
in motor vehicle sales was a sign that
underlying consumer confidence and
willingness to spend had held up reasonably well in this period. Looking ahead,
reports from retailer contacts were
somewhat mixed; many anticipated relatively depressed holiday sales and where
possible were making efforts to limit
buildups of holiday merchandise, while
other retailers were confident that sales
would be reasonably well maintained,
albeit generally somewhat below levels
or growth rates experienced in previous
holiday seasons. Beyond the months
immediately ahead, members anticipated that, in addition to a drop in motor
vehicle sales to more sustainable levels,
consumer spending was likely to be held
back by the persistence of widespread



caution among households and by the
decline in stock market wealth over the
last year or so. Consumer confidence
was vulnerable to renewed terrorism and
to further weakness in labor markets.
Housing activity, though still at a
relatively elevated level, had displayed
signs of some slippage in recent months.
There were anecdotal reports of excess
inventories of unsold homes in some
areas, and members again cited indications of particular softness in the highprice segment of the housing market.
Weakness in employment and more generally the rise in uncertainty were having a depressing effect on homebuilding
activity, which likely would persist over
coming months. Nonetheless, low mortgage interest rates continued to provide
important support to homebuilding, and
in the absence of a much weaker economy than was currently anticipated or
of a further sizable shock to consumer
confidence, there appeared to be little
basis in ongoing trends and housing
finance conditions to expect substantial additional erosion in residential
construction.
Business fixed investment currently
seemed to be declining at an even faster
rate than earlier in the year, and the
sharp decrease in new orders of capital
goods in September pointed to marked
additional weakness over the months
ahead. According to widespread anecdotal reports, business confidence
appeared to have worsened considerably
further since late summer in the context
of a generally deteriorating outlook for
sales and earnings. In these circumstances, business firms were likely to
persist in their efforts to reduce what
they viewed as excess capacity, notably
in high-tech and travel-related industries. Some exceptions related to the
expansion of healthcare and securityenhancing facilities. However, the
longer-term attractiveness of efficiency-

288 88th Annual Report, 2001
inducing capital investment would at
some point promote a robust upturn in
such expenditures. The timing remained
uncertain, but a number of members saw
a reasonable prospect that the decline in
expenditures for capital equipment and
software would abate early next year
and that such spending probably would
turn up during the second half of the
year as businesses succeeded in better
aligning actual and desired capital
stocks. With regard to nonresidential
construction, widespread increases in
vacancy rates around the country suggested that the turnaround in overall
activity might be more delayed despite
some near-term stimulus from reconstruction activity in New York City. In
general and given prevailing wait-andsee business attitudes, members believed
that the risks over the forecast horizon
remained in the direction of a shortfall
in capital expenditures from what were
already weak expectations.
A key uncertainty in the outlook for
investment spending was the outcome
of the ongoing Congressional debate
relating to tax incentives for investment
in equipment and software. Both the
passage and the specific contents of such
legislation remained in question. Moreover, several members stressed the
difficulty of assessing the effectiveness
of temporary fiscal policy measures
directed at boosting investment expenditures. Though undoubtedly helpful in
fostering greater capital spending while
the tax incentives remained in place,
members expressed reservations about
the extent of the favorable effects in the
nearer term when marked disincentives
existed for many firms to make capital
expenditures in the context of excess
capacity, weak markets, and poor profit
opportunities. More generally, forecasts
of a reasonably vigorous rebound in the
economy over 2002 depended in part
on expectations of added fiscal stimulus,



but prospects appeared to have diminished for prompt passage of fiscal policy
initiatives that could significantly boost
economic activity in the next several
quarters.
Business firms were continuing to
cut back production in efforts to adjust
output to faltering demand and to pare
excess inventories. Even so, with
demand generally tending to be weaker
than expected, inventory-sales ratios
had remained on the high side for many
firms and strong efforts to reduce inventories were persisting, including efforts
by many retailers in light of their expectations that holiday sales would prove
disappointing. The pace of inventory
liquidation was thought likely to moderate in coming quarters and subsequently
turn to accumulation as inventories
came into better balance with sales,
with increasingly positive implications
for overall production and economic
activity.
Weakness in foreign economies was
continuing to foster declines in U.S.
exports in what appeared to be an
increasingly synchronous and mutually
reinforcing pattern of economic activity
among the world's nations. With recent
indications that on the whole foreign
economic activity was deteriorating
somewhat further and by more than
previously anticipated, members viewed
the risks for activity in foreign nations
and their related demand for U.S. goods
and services as tilted decidedly to the
downside.
The considerable slack in labor
markets, evidenced by both statistical
and widespread anecdotal reports, was
expected to exert appreciable downward
pressure on wage increases over the
forecast period. Concurrently, however,
the favorable impact of wage disinflation on business costs would be offset
in part by increasing costs of healthcare
insurance, slower gains in structural

Minutes of FOMC Meetings, November 289
productivity associated with reduced
business capital investment, and by
the necessity to divert some resources
to enhance security. The passthrough
effects of the substantial decline in
energy prices over the past year were a
favorable factor in the outlook for core
inflation. On balance, core consumer
price inflation was projected to remain
subdued and quite possibly edge lower.
In the Committee's discussion of policy for the intermeeting period ahead, all
the members indicated that they could
support a proposal calling for further
easing in reserve conditions consistent
with a 50 basis point reduction in the
federal funds rate to a level of 2 percent.
The heightened degree of uncertainty
and risk aversion following the terrorist
attacks seemed to be having a pronounced effect on business and household spending. The continued contraction in the economy and marking down
of most forecasts of inflation and
resource utilization going forward
strongly suggested the desirability of
further easing in the stance of policy.
Although policy had been eased substantially in 2001, the forces restraining
demand had been considerable, and a
variety of factors had limited the
passthrough of lower short-term interest
rates into long-term rates, equity prices,
bank lending rates, and the foreign
exchange value of the dollar. In circumstances in which inflation was already
reasonably low and pressures on
resources and prices were likely to abate
further in coming months, the risks were
quite small that additional monetary
stimulus aimed at bolstering the economy would foster a pickup in inflation.
A number of members noted that the
choice between 25 and 50 basis points
of easing was a close call. Three favored
a smaller move on balance, although
they could accept the larger decrease in
the current environment of substantial



uncertainty about the course of the
economy and the appropriate stance of
policy. These members noted that policy was already accommodative. Indeed,
policy had been eased substantially further in September and October, and the
effects of those actions and any added
easing at this meeting would be felt
mostly during the year ahead when fiscal stimulus and the inherent resilience
of the economy should already be boosting growth substantially. Some also
were concerned that the more sizable
action in combination with an announcement of the Committee's continuing
concern about further economic weakness would lead markets to build in
inappropriate expectations of even more
monetary stimulus.
Most members, however, favored a
50 basis point reduction in the Committee's target federal funds rate. These
members stressed the absence of evidence that the economy was beginning
to stabilize and some commented that
indications of economic weakness had
in fact intensified. Moreover, it was
likely in the view of these members that
core inflation, which was already modest, would decelerate further. In these
circumstances insufficient monetary policy stimulus would risk a more extended
contraction of the economy and possibly
even downward pressures on prices that
could be difficult to counter with the
current federal funds rate already quite
low. Should the economy display unanticipated strength in the near term, the
emerging need for a tightening action
would be a highly welcome development that could be readily accommodated in a timely manner to forestall any
potential pickup in inflation.
All the members indicated that with
the risks to the economy clearly tilted
toward further weakness, they could
vote in favor of retaining a statement to
that effect in the press statement to be

290

88th Annual Report, 2001

released shortly after today's meeting.
Several stressed that such a statement
did not constitute a commitment by the
Committee to ease policy further at the
next meeting. While the members
agreed that significant further weakness
in the economy might indeed warrant
additional easing, a decision in that
regard would depend entirely on the
nature of future economic and financial
developments.
At the conclusion of this discussion,
the Committee voted to authorize and
direct the Federal Reserve Bank of New
York, until it was instructed otherwise,
to execute transactions in the System
Account in accordance with the following domestic policy directive:
The Federal Open Market Committee
seeks monetary and financial conditions that
will foster price stability and promote sustainable growth in output. To further its longrun objectives, the Committee in the immediate future seeks conditions in reserve
markets consistent with reducing the federal
funds rate to an average of around 2 percent.
The vote encompassed approval of
the sentence below for inclusion in the
press statement to be released shortly
after the meeting.
Against the background of its long-run
goals of price stability and sustainable economic growth and of the information currently available, the Committee believes that
the risks continue to be weighted mainly
toward conditions that may generate economic weakness in the foreseeable future.
Votes for this action: Messrs. Greenspan,
McDonough, Ferguson, Gramlich, Hoenig, Kelley, Meyer, Ms. Minehan, Messrs.
Moskow and Poole. Votes against this
action: None.
It was agreed that the next meeting of
the Committee would be held on Tuesday, December 11, 2001.



The meeting adjourned at 1:20 p.m.
Donald L. Kohn
Secretary

Meeting Held on
December 11, 2001
A meeting of the Federal Open Market
Committee was held in the offices of
the Board of Governors of the Federal
Reserve System in Washington, D.C.,
on Tuesday, December 11, 2001, at
9:00 a.m.
PresentMr. Greenspan, Chairman
Mr. McDonough, Vice Chairman
Ms. Bies
Mr. Ferguson
Mr. Gramlich
Mr. Hoenig
Mr. Meyer
Ms. Minehan
Mr. Moskow
Mr. Olson
Mr. Poole
Messrs. Jordan, McTeer, Santomero,
and Stern, Alternate Members
of the Federal Open Market
Committee
Messrs. Broaddus, Guynn, and Parry,
Presidents of the Federal Reserve
Banks of Richmond, Atlanta, and
San Francisco respectively
Mr. Kohn, Secretary and Economist
Mr. Bernard, Deputy Secretary
Mr. Gillum, Assistant Secretary
Ms. Smith, Assistant Secretary
Mr. Mattingly, General Counsel
Mr. Baxter, Deputy General Counsel
Ms. Johnson, Economist
Mr. Reinhart, Economist
Mr. Stockton, Economist
Ms. Cumming, Messrs. Fuhrer, Hakkio,
Howard, Lindsey, Rasche,
Slifman, and Wilcox, Associate
Economists

Minutes of FOMC Meetings, December 291
Mr. Kos, Manager, System Open
Market Account
Mr. Winn, Assistant to the Board,
Office of Board Members,
Board of Governors
Messrs. Ettin and Madigan, Deputy
Directors, Divisions of Research
and Statistics and Monetary
Affairs respectively, Board
of Governors
Mr. Simpson, Senior Adviser, Division
of Research and Statistics,
Board of Governors
Mr. Connors, Associate Director,
Division of International Finance,
Board of Governors
Messrs. Oliner and Struckmeyer,
Associate Directors, Division
of Research and Statistics,
Board of Governors
Mr. Whitesell, Assistant Director,
Division of Monetary Affairs,
Board of Governors
Mr. Skidmore, Special Assistant to the
Board, Office of Board Members,
Board of Governors
Ms. Low, Open Market Secretariat
Assistant, Office of Board
Members, Board of Governors
Mr. Rasdall, First Vice President,
Federal Reserve Bank of
Kansas City
Messrs. Eisenbeis and Goodfriend,
Mses. Krieger and Mester, and
Mr. Rosenblum, Senior Vice
Presidents, Federal Reserve Banks
of Atlanta, Richmond, New York,
Philadelphia, and Dallas
respectively
Messrs. Bryan, Judd, and Krane, Vice
Presidents, Federal Reserve Banks
of Cleveland, San Francisco, and
Chicago respectively



Mr. Weber, Senior Research Officer,
Federal Reserve Bank of
Minneapolis
Prior to this meeting, Ms. Susan Schmidt
Bies and Mr. Mark W. Olson had executed
their oaths of office as members of the Board
of Governors and the Federal Open Market
Committee.

By unanimous vote, the minutes of
the meeting of the Federal Open Market
Committee held on November 6, 2001,
were approved.
The Manager of the System Open
Market Account reported on recent
developments in foreign exchange markets. There were no open market operations in foreign currencies for the System's account in the period since the
previous meeting.
The Manager also reported on developments in domestic financial markets
and on System open market transactions
in government securities and securities
issued or fully guaranteed by federal
agencies during the period November 6,
2001, through December 10, 2001. By
unanimous vote, the Committee ratified
these transactions.
The Committee then turned to a discussion of the economic and financial
outlook and the conduct of monetary
policy over the intermeeting period
ahead. A summary of the economic and
financial information available at the
time of the meeting and of the Committee's discussion is provided below.
The information reviewed at this
meeting indicated that economic activity had continued to decline into the
fourth quarter, although some very
recent data suggested that the rate
of decline might be moderating. Labor
market conditions had worsened further,
especially in manufacturing and related
industries, and industrial production
had fallen in October and probably also
in November. However, purchases of

292 88th Annual Report, 2001
motor vehicles were very strong in both
months, and other household and business spending seemed to have recovered
somewhat from the sharp September
decline. Energy prices were moderating
noticeably in response to lower worldwide demand, and core price inflation
remained subdued.
The labor market deteriorated substantially in October and November.
Nonfarm payroll employment fell significantly in both months, with the largest job losses occurring in manufacturing, help supply services, and retail
trade. Steep cuts in employment also
occurred in industries directly affected
by the September attacks, notably transportation, lodging, and tourism. Among
the few industries that had not been
adversely affected were health services,
which continued to add workers, and
finance, insurance, and real estate,
which maintained stable employment on
balance. The heavy job losses boosted
the unemployment rate to 5.7 percent in
November.
Industrial production fell sharply further in October, and the cuts continued
to be spread widely across groups and
industries, reflecting weak demand for
business equipment, efforts by firms to
pare inventories, and foreign competition. Motor vehicle assemblies slowed
for a third straight month from the relatively high levels attained in the spring
and early summer, and the output of
high-technology goods remained on a
steep downward trajectory, though a few
positive signs had begun to emerge in
the semiconductor and computer industries. The rate of utilization of total
manufacturing capacity contracted further in October and was at a level substantially below the trough reached in
the 1990-91 recession.
Personal consumption expenditures
are estimated to have rebounded in
October, following the large Septem


ber decline, and were slightly above
the third-quarter average. Purchases of
motor vehicles surged in response to
aggressive zero-rate financing packages
offered by automakers, while spending
on other goods made a partial recovery
from the September drop. Outlays on
consumer services strengthened in October, but they remained below their thirdquarter average.
Residential building activity softened
somewhat further in October, but in an
environment of very low mortgage rates,
homebuilding remained at a relatively
high level despite the weak labor market
and sluggish growth in personal income.
Demand for single-family housing had
held up relatively well. Sales of new
single-family homes changed little in
October and had been relatively steady
since May, while sales of existing homes
partially retraced the sharp drop-off that
occurred in September.
Recent information suggested that
the downward trend in business spending on durable equipment and software
might be moderating somewhat. After
plunging during the spring and summer,
orders and shipments of nondefense
capital goods turned up in October. Of
particular note, both orders and shipments of office and computing equipment increased in October after having
declined sharply for most of the year.
For durable equipment in general, shipments had exceeded new orders since
the first of the year, and as a result the
backlog of unfilled orders was now
below its level of a year ago. Nonresidential construction also had been weak
during the spring and summer, reflecting an upward trend in vacancy rates
and uncertainties regarding rents and
property values. Although spending on
industrial structures dropped further in
October, outlays for ^office buildings and
other commercial structures picked up
noticeably.

Minutes of FOMC Meetings, December 293
The book value of business inventories fell steeply in the third quarter.
The bulk of the reduction occurred in
the manufacturing sector, but the sharp
drop in stocks was matched by a contraction in shipments and the aggregate stock-shipments ratio for the sector
remained at a very high level. In October, an additional sizable decline in
manufacturing stocks resulted in a
decrease in the sector's aggregate stockshipments ratio, though it remained
elevated. Wholesalers also experienced
a sizable drop in inventories in the third
quarter that produced a slight reduction
in their aggregate inventory-sales ratio,
but the latter was still in the upper portion of its range for the past two years.
Retail inventories and the sector's
inventory-sales ratio both edged up in
the third quarter. Nonetheless, the sector's ratio remained in the lower end of
its range for the past year.
The U.S. trade deficit in goods and
services narrowed significantly in September and the third quarter, though
most of those declines reflected estimated payments by foreign insurers
related to the events of September 11.
Abstracting from those payments, the
trade deficit fell only a little in the third
quarter as the value of exports fell by
less than the value of imports. The softness in exports was widespread, with
steep declines occurring in consumer
goods, capital goods, and industrial supplies. Reductions in imports also were
widespread, and as with exports, capital
goods and industrial supplies were down
sharply. The limited available information suggested a further weakening of
economic activity in the foreign industrial countries in the current quarter, but
there were some indications of a possible brightening of the economic outlook in the period ahead despite a sharp
decline in business confidence in the
aftermath of the September terrorist



attacks. Additional monetary easing
actions by the European Central Bank,
the Bank of England, and the Bank
of Canada contributed to that brighter
outlook. Japan remained the weakest of
the major foreign industrial economies,
and the available information suggested
further contraction in economic activity
and worsened labor market conditions
this quarter. Economic conditions in
the major emerging-market countries
remained weak, but there were signs
that the worst might be over in some
of the Asian economies most affected
by the global downdraft in the hightech sector. Economic growth in China
seemed to have slowed a little. In Latin
America, Argentina remained mired in
recession, and the global slowdown continued to depress the economies of other
nations in that region.
Core consumer price inflation remained at a relatively subdued pace in
September and October, and a renewed
decline in energy prices in October contributed to a sizable drop in total consumer price inflation during the twelve
months ended in October when compared with the previous twelve-month
period. The core personal consumption
expenditure (PCE) chain-type price
index also indicated that consumer inflation was significantly lower during the
year ended in October, while the core
consumer price index (CPI), with its
narrower range of spending categories,
had changed little over the past year.
Core producer prices for finished goods
edged up on balance during September
and October, but inflation as measured
by this index moderated slightly on a
year-over-year basis. With regard to
labor costs, growth of average hourly
earnings of production or nonsupervisory workers slowed in September
and October from the relatively moderate rate that had prevailed in earlier
months.

294 88th Annual Report, 2001
At its meeting on November 6, 2001,
the Committee adopted a directive that
called for implementing conditions
in reserve markets consistent with a
decrease of 50 basis points in the
intended level of the federal funds
rate, to about 2 percent. The members
referred to the heightened degree of
uncertainty and risk aversion following
the terrorist attacks that was having a
significant effect on business and household spending, and they noted that the
substantial easing of monetary policy
that had been put in place this year had
not shown through fully to long-term
interest rates, equity prices, bank lending rates, and the foreign exchange
value of the dollar. In these circumstances, with price inflation relatively
low and pressures on prices and
resources likely to ebb further, the members concluded that further monetary
stimulus would provide some added
insurance against a more extended contraction of the economy at little risk
of a pickup in inflation. The members
also believed that the balance of risks
remained weighted toward conditions
that could generate economic weakness
in the foreseeable future.
Federal funds traded at rates close to
the Committee's target level of 2 percent during the intermeeting period.
Against the background of better-thanexpected incoming economic data and
of favorable news on military operations
in Afghanistan, short-term interest rates
declined a little over the intermeeting
interval while intermediate- and longterm Treasury rates rose substantially.
With market concerns about the economic outlook diminishing, yields on
investment-grade corporate debt securities increased considerably less than
those on comparable-maturity Treasuries, rates on speculative-grade bonds fell
sharply, and major indexes of equity
prices moved significantly higher.



In foreign exchange markets, the
trade-weighted value of the dollar in
terms of the major foreign currencies
increased slightly on balance over the
intermeeting period; the release of
better-than-expected U.S. economic data
lifted the dollar early in the intermeeting
period, but subsequent data releases led
to some erosion of that gain. Abroad,
central bank policy rates were lowered
in the euro area, England, and Canada in
response to indications of flagging economic activity. In Japan, disappointing
economic news and comments by Japanese officials about possible intervention to weaken the yen contributed to a
decline in that currency. Meanwhile, the
dollar was about unchanged on balance
in terms of an index of the currencies
of other important trading partners. The
Mexican peso changed little on balance,
the Brazilian real firmed despite the
deepening problems of Argentina, and
the Korean won rose against the background of incoming data that suggested
the persistence of resilient domestic
demand.
M2 growth in November was robust
though well below the average pace of
the two previous months. Liquid deposits continued to increase rapidly, reflecting the sharp drop in market interest
rates this year, but inflows to retail
money funds slowed as the economic
outlook improved and the equity markets rallied. M3 expansion remained at a
very high rate in November, bolstered
by the growth of M2 and heavy bank
acquisitions of nondeposit liabilities.
The debt of domestic nonfinancial sectors grew at a moderate pace on balance
through October.
The staff forecast prepared for this
meeting suggested that economic activity would extend its decline for a time
in 2002 but then would begin to turn
upward. The recovery would be supported in part by the cumulative easing

Minutes of FOMC Meetings, December 295
that had occurred in the stance of monetary policy, along with the fiscal stimulus already in place and some assumed
additional measures not yet enacted.
The turnaround in the economy and the
gradual strengthening of the recovery
would also be fostered by the completion of downward adjustments to inventories, a marked slowing in the contraction of business capital investments, and
the added purchasing power arising
from the recent declines in oil prices.
Economic expansion was projected to
strengthen appreciably by the second
half of 2002 as the climate for business
fixed investment improved and a
strengthening of foreign economies led
to somewhat greater demand for U.S.
exports. Subpar expansion in the next
few quarters was expected to foster an
appreciable further easing of pressures
on resources and some moderation in
core price inflation.
In the Committee's discussion of current and prospective economic developments, members commented that the
economy clearly was continuing to contract, led by further inventory liquidation and ongoing reductions in capital
spending. The decline in inventories was
likely to abate before long, boosting production, but the course of a recovery
would depend on the behavior of final
demand. The recent statistical and anecdotal information was more mixed than
had been the case earlier and pointed on
balance toward some moderation in the
decline of overall final demand; for the
first time in a long while the incoming
data did not call for a downward revision to current forecasts. The members
agreed, however, that the evidence of
emerging stabilization in the economy
remained quite tentative and the timing
and strength of the eventual recovery
continued to be surrounded by a high
degree of uncertainty, with the risks to
the economy still clearly tilted toward



economic weakness. Among those risks,
members cited the apparently reduced
prospects for additional fiscal stimulus
legislation, the vulnerability of current
stock market valuations should forecasts
of a robust rebound in earnings fail to
materialize, the possibility of further
terrorist incidents, and especially the
potentially adverse effect on consumer
confidence and spending of additional
deterioration in labor market conditions.
Nonetheless, with the critical consumer
sector holding up relatively well thus
far, members continued to anticipate an
upturn in the economy during the year
ahead in light of the progress already
made by business firms in reducing
excess inventories and unwinding capital overhangs, and the beneficial effects
of the decline of energy prices. The
lagged effects of the substantial easing
in monetary policy this year and the
fiscal stimulus measures already enacted
into law were expected to buttress
demand and economic recovery over the
next year. The outlook for inflation was
viewed as favorable, given the slack in
labor and product markets, subdued
inflationary expectations, and the prospect that aggregate demand would
remain well below the economy's
potential output over the next several
quarters.
In the consumer sector, a major downside concern was the possibility that
substantial further deterioration in labor
market conditions, which was widely
anticipated, could have a significant
inhibiting effect on consumer confidence, incomes, and spending. Other
potentially adverse economic factors
cited by members included rising consumer debt burdens, the risk of a downturn in the stock market, and the recent
rise in mortgage interest rates. That
increase, among other things, would
impinge on the extraction of capital
gains from the turnover or refinancing

296 88th Annual Report, 2001
of existing homes, which had provided
important support for consumer spending. However, consumer expenditures
appeared to have been relatively well
sustained thus far, evidently in part the
result of widespread price discounting
and low interest rates, including zero
rates on many motor vehicle loans, that
were helping to overcome a currently
high degree of caution and price consciousness among consumers. Moreover, recent survey evidence suggested
that consumer confidence might be stabilizing after earlier declines. The significant decreases that had occurred in
the prices of fuel oil and gasoline were a
positive factor that would continue to
bolster household spending for a while.
Looking ahead, it was unclear how the
various factors affecting consumers
would interact, though apart from a
likely downward adjustment in sales
of motor vehicles to a more sustainable level following their recent surge,
members generally anticipated that solid
gains in consumer spending would
underpin the economic recovery.
Like consumer spending, new home
construction and sales had displayed
considerable resilience in recent months,
apparently in large part as a result of
relatively attractive mortgage interest
rates and perhaps to some extent as
a consequence of favorable weather
conditions in many parts of the country. Though overall housing activity
remained at a high level, members
reported softening activity in a few
areas of the nation, notably in apartment units in some major cities. Sales of
high-end houses also continued to be
relatively depressed. With regard to the
outlook, the recent rise in mortgage
interest rates could be expected to have
a retarding effect on housing activity.
Even so, in the absence of seriously
adverse shocks to confidence, housing
activity seemed likely to hold near cur


rent levels over the quarters immediately ahead.
Business capital spending appeared to
be continuing to decline at a rapid pace
as business firms persisted in their
efforts to bring production capacity into
better alignment with forecasts for the
growth of sales. With the near-term outlook for sales and profits remaining
relatively depressed, the prospects for a
significant pickup in spending for equipment and software did not seem favorable for the period immediately ahead.
Businesses were reported to be very cautious, with many business executives
awaiting concrete indications of improving markets before proceeding with
planned investment expenditures. Even
so, members referred to some tentative
indications, such as an uptick in orders
for durable goods and expectations of
improving sales of some high-tech products, that might be signaling a turnaround in overall capital spending over
coming quarters. Further progress in
adjusting capacity and strengthening
profit expectations would at some point
lead to an upturn in spending for new
equipment and software, but business
contacts indicated that the timing for
individual firms would vary considerably, with delays extending in some
cases into 2003. New construction of
nonresidential structures had declined
sharply over the past several quarters,
and with vacancy rates still rising in
many key markets a further sizable
decline was anticipated over the year
ahead. Some members reported that
higher insurance costs since the September 11 terrorist attacks were exerting an
inhibiting effect on some nonresidential
construction activity in their regions.
The liquidation of business inventories appeared to have accelerated in
the current quarter, fostered to an important extent by very large declines in
stocks of motor vehicles. Inventories

Minutes of FOMC Meetings, December 297
now seemed to be approaching levels
where firms would start to reduce their
rate of liquidation early next year and
perhaps turn to inventory accumulation
as the year ahead progressed, giving a
boost to production and incomes. Anecdotal reports provided some support
for such an outlook, including widespread indications that retail inventories
were already at quite lean levels, even
outside the motor vehicle sector. At
the same time, recent survey results
pointed to less discomfort with current
inventory levels though some further
inventory correction was anticipated in
manufacturing.
Further fiscal stimulus remained
under active debate in the Congress,
but with the rapid approach of the date
for adjourning the current session, it
was now questionable whether the legislation would be enacted this year.
Although an expansionary fiscal policy
was already in place as a result of earlier
legislation and more stimulus might be
legislated next year, especially if the
economy continued to deteriorate, members saw an additional boost to nearterm economic activity from new fiscal initiatives as increasingly unlikely.
Some members also commented on
mounting state and local government
deficits, largely the result of diminishing
income and sales tax receipts, and the
adverse implications for governmental
budgets and spending in various parts of
the country.
Reflecting unusually synchronous
global economic developments, foreign
nations also were experiencing sluggish
economic activity and in many instances
actual recessions. The weakness was
reflected in declining U.S. exports.
Members saw little prospect that foreign
economies would strengthen sufficiently
on their own to provide significant independent impetus to U.S. exports, at least
over the near term. Instead, an upturn in



foreign economic activity would depend
more on recovery in the United States.
Expectations that output would
remain below the economy's potential
for some time led many members to
believe that underlying inflation might
well edge lower from its currently modest levels. Reinforcing this outlook was
recent evidence of somewhat faster
than anticipated productivity growth, the
prospect that world economic conditions would hold down energy prices,
and a sharp drop in near-term inflation
expectations of households as reported
in recent surveys. Moreover, labor compensation appeared to be on a decelerating trend despite rapid increases in
the cost of healthcare and other worker
benefits. In these circumstances and
given the persistence of highly competitive conditions in domestic and
international markets, the ability of most
businesses to raise prices was likely
to remain quite limited or even nonexistent. While a number of members
referred to the possibility of further
disinflation, some also noted that the
risks of a deflationary spiral seemed
very limited, given the economy's selfcorrecting resilience and the ongoing
effects of stimulative fiscal and monetary policies.
In the Committee's discussion of
policy for the intermeeting period ahead,
all but one member indicated their support of a proposal to ease reserve conditions slightly further, consistent with
a 25 basis point reduction in the federal
funds rate to a level of \3A percent.
While there were signs that the weakness in aggregate demand might be abating, those signs were still quite limited
and tentative. For now, contractionary
forces continued to depress overall
economic activity, and subpar economic
performance seemed likely to persist, at
least for a time. Moreover, a number of
members saw substantial risks that eco-

298 88th Annual Report, 2001
nomic activity could even fall short
of a projection of stabilization in the
near term and moderate recovery later
next year. In these circumstances, the
consequences of inactivity at this
meeting could turn out to be considerable, and several members viewed
an easing action as a measure of insurance against the potential for greater or
more prolonged economic weakness
than they currently anticipated. If a
modest easing action taken today turned
out to be unneeded, the Committee
would have ample opportunity to
reverse its action without incurring any
real risk of allowing inflationary pressures to gather momentum, given the
projected degree of slack in resource use
and the current absence of significant
inflationary pressures. The risk that a
policy reversal, should it prove to be
needed in the near term, would foster
significant market unsettlement seemed
limited in light of widespread expectations of some further easing at this meeting to be followed by a policy turnaround next year.
At the same time, members emphasized that the stance of policy was
already quite accommodative, that much
of the effects of recent easings had yet
to be felt, and that tentative signs suggested the economy and the economic
outlook were beginning to stabilize. In
these circumstances several saw a decision to ease as a close call, but they
favored it on balance given their weighting of the possible consequences should
restraining forces in the economy persist
to a greater extent than they currently
expected. In the view of one member,
policy was already sufficiently stimulative and the outlook improved enough to
warrant a pause to assess further developments. In any event, members commented that the Committee's easing
cycle was likely to be approaching its
completion, and several suggested the



desirability of signaling that view to the
public.
Given their views about the risks to
the economy, the members supported
the retention of the sentence in the press
statement to be released shortly after
this meeting indicating that the risks
continued to be weighted mainly toward
conditions that could foster economic
weakness in the foreseeable future. Such
a statement was not intended to convey the impression that the Committee
necessarily contemplated further easing
actions. Members felt that the reduced
size of today's action along with a reference in the statement to the emergence
of signs that weakness in the economy
could be moderating would tend to mitigate such an interpretation.
At the conclusion of this discussion,
the Committee voted to authorize and
direct the Federal Reserve Bank of
New York, until it was instructed otherwise, to execute transactions in the System Account in accordance with the following domestic policy directive:
The Federal Open Market Committee
seeks monetary and financial conditions
that will foster price stability and promote
sustainable growth in output. To further its
long-run objectives, the Committee in the
immediate future seeks conditions in reserve
markets consistent with reducing the federal funds rate to an average of around
PA percent.

The vote encompassed approval of
the sentence below for inclusion in the
press statement to be released shortly
after the meeting:
Against the background of its long-run
goals of price stability and sustainable economic growth and of the information currently available, the Committee believes that
the risks continue to be weighted mainly
toward conditions that may generate economic weakness in the foreseeable future.

Minutes of FOMC Meetings, December 299
Votes for this action: Messrs. Greenspan,
and McDonough, Ms. Bies, Messrs. Ferguson, Gramlich, Meyer, Ms. Minehan,
Messrs. Moskow, Olson, and Poole. Votes
against this action: Mr. Hoenig. Absent
and not voting: Mr. Kelley.

Mr. Hoenig dissented because he
preferred to leave the federal funds rate
unchanged. He judged that a 2 percent
federal funds rate was already quite
stimulative and that a more stimulative
policy was not needed. Following the
rapid and aggressive policy actions
already taken, it would be prudent to




give the current policy more time to
work through the economy. It was also
his position that reducing the federal
funds rate at this meeting could increase
interest rate volatility by creating an
expectation of a faster or a more aggressive reversal of policy.
It was agreed that the next meeting
of the Committee would be held on
Tuesday-Wednesday, January 29-30,
2002.
The meeting adjourned at 1:20 p.m.
Donald L. Kohn
Secretary

301

Litigation
During 2001 the Board of Governors
was a party in seven lawsuits or appeals
filed that year and was a party in thirteen other cases pending from previous
years, for a total of twenty cases; in
2000, the Board had been a party in a
total of twenty-seven cases. None of the
lawsuits or appeals filed in 2001 raised
questions under the Bank Holding Company Act. As of December 31, 2001,
eight cases were pending.

Judicial Review of Board Orders
under the Bank Holding
Company Act
Dime Bancorp, Inc. v. Board of Governors, No. 00-4249 (2nd Circuit, filed
December 11, 2000), was a petition for
review of a Board order dated September 27, 2000, approving the applications of North Fork Bancorporation,
Inc., Melville, New York, to acquire
control of Dime Bancorp, Inc., and to
thereby acquire its wholly owned subsidiary, The Dime Savings Bank of New
York, FSB, both of New York, New
York (86 Federal Reserve Bulletin 767).
The petition was dismissed on the parties' stipulation on July 23, 2001.

Litigation under the Financial
Institutions Supervisory Act
Board of Governors v. Pharaon, No.
91-CIV-6250 (S.D. New York, filed
September 17, 1991), was an action
brought to recover assets of an individual subject to a civil money penalty
imposed by the Board. The case was
remanded from the U.S. Court of
Appeals for the Second Circuit for determination of the penalty amount follow


ing the court of appeals's determination
requiring a 10 percent surcharge and
prejudgment interest on the penalty
imposed. On January 29, 2001, the court
approved a settlement and terminated
the action.

Litigation under the
Gramm-Leach-Bliley Act
Trans Union LLC v. Federal Trade
Commission, et al, No. 01-5202 (D.C.
Circuit, filed June 4, 2001), is an appeal
of a district court order upholding challenged provisions of an interagency
rule regarding Privacy of Consumer
Financial Information (145 F. Supp.
2d 6, April 30, 2001). The action was
consolidated with Individual Reference
Services Group, Inc., v. Board of Governors, No. 01-5175 (D.C. Circuit, filed
May 25, 2001), Reed Elsevier, Inc. v.
Board of Governors, No. 00-1289 (D.C.
Circuit, filed June 30, 2000), and related
petitions for review filed against other
federal agencies challenging the same
rules. On August 1, 2001, all appeals
and petitions other than Trans Union
LLC were dismissed on the motion of
the appellants and petitioners.

Other Actions
Community Bank & Trust v. United
States, No. 01-571C (Court of Federal Claims, filed October 3, 2001),
is an action challenging on constitutional grounds the failure to pay interest
on reserve accounts held at Federal
Reserve Banks.
Emran
v.
Greenspan,
No.
l:01CV1992 (D. District of Columbia,
filed September 20, 2001), was an

302 88th Annual Report, 2001
employment discrimination claim. On
December 21, 2001, the case was dismissed by stipulation of the parties.
Laredo National Bancshares, Inc. v.
Whalen v. Board of Governors, No. 01CV-134 (S.D. Texas, removed on September 5, 2001, from Webb County,
Texas, district court), is a third-party
petition seeking indemnification or contribution from the Board in connection
with a claim asserted against defendant
Whalen alleging tortious interference
with a contract.
Radfar v. United States, No.
l:01CV1292 (D. District of Columbia,
filed June 11, 2001), is an action under
the Federal Tort Claims Act for injury
on Board premises.
Howe v. Bank for International Settlements, No. 00CV12485 RCL (D. Massachusetts, filed December 7, 2000), is
an action seeking damages in connection with gold market activities and the
repurchase by the Bank for International Settlements of its privately owned
shares.
Barnes v. Reno, No. l:00CV02900
(D. District of Columbia, filed December 4, 2000), was a civil rights action.
On June 13, 2001, the district court dismissed the action.
Guerrero v. United States, No. 996771 (E.D. California, service effected
November 21, 2000), was a suit brought
by a prisoner. On October 30, 2001, the
district court dismissed the action.
El Bey v. United States, No. 00-5293
(D.C. Circuit, filed August 31, 2000),
was an appeal of a district court order
dismissing a pro se action against the
Federal Reserve and other defendants
as lacking an arguable basis in law. On
January 11, 2001, the court dismissed
the appeal.
Sedgwick v. Board of Governors, No.
00-16525 (9th Circuit, filed August 16,



2000), was an appeal of the district
court's dismissal of an action under the
Federal Tort Claims Act alleging violation of bank supervision requirements.
On May 31, 2001, the court of appeals
affirmed the district court judgment.
A petition for certiorari (No. 01-5654,
filed August 6, 2001) was denied by the
U.S. Supreme Court on October 1, 2001.
Bettersworth v. Board of Governors,
No. 00-50262 (5th Circuit, filed
April 14, 2000), was an appeal of the
district court's dismissal of appellant's
Privacy Act claims. On April 12, 2001,
the court denied the petition for review.
A petition for certiorari (No. 01-444,
filed September 10, 2001) was denied
by the U.S. Supreme Court on November 13, 2001.
Albrecht v. Board of Governors,
No. 00-CV-317 (CKK) (D. District of
Columbia, filed February 18, 2000),
is an action challenging the method of
funding of the retirement plan for certain Board employees.
Artis v. Greenspan, No. l:99CV02073
(EGS) (D. District of Columbia, filed
August 3, 1999), is an employment discrimination action. An identical action,
No. l:00CV0400 (filed February 22,
2001), was consolidated with this action.
Nelson
v.
Greenspan,
No.
1-.99CV00215 (EGS) (D. District of
Columbia, filed January 28, 1999), was
an employment discrimination complaint. On August 15, 2001, the court
granted the Board's motion for summary judgment and dismissed the case.
In Fraternal Order of Police v. Board
of Governors, No. 98-3116 (D. District
of Columbia, filed December 22, 1998),
plaintiff seeks a declaratory judgment
regarding the Board's labor policy governing Federal Reserve Banks.
•

Federal Reserve System
Organization




Federal Reserve System Organization 305

Board of Governors
December 31,2001

Term expires January 31,

A L A N GREENSPAN, of New York, Chairman1
ROGER W. FERGUSON, JR., of Massachusetts, Vice Chairman1

2006
2014

LAURENCE H. MEYER, of Missouri
EDWARD W. KELLEY, JR., of Texas2
EDWARD M. GRAMLICH, of Virginia
MARK W. OLSON, of Maryland
SUSAN S. BIES, of Tennessee

2002
2004
2008
2010
2012

Officers
OFFICE OF BOARD MEMBERS

LEGAL

Lynn S. Fox, Assistant to the Board
Michelle A. Smith, Assistant to the Board
Donald J. Winn, Assistant to the Board
Donald L. Kohn, Adviser to the Board
Winthrop P. Hambley, Deputy
Congressional Liaison
Normand R.V. Bernard, Special Assistant
to the Board
John Lopez, Special Assistant
to the Board
Bob Stahly Moore, Special Assistant
to the Board
Rosanna Pianalto-Cameron, Special
Assistant to the Board
David Skidmore, Special Assistant
to the Board

Cary K. Williams, Assistant General
Counsel

LEGAL DIVISION

J. Virgil Mattingly, Jr., General Counsel
Scott G. Alvarez, Associate General
Counsel
Richard M. Ashton, Associate
General Counsel
Kathleen M. O'Day, Associate General
Counsel
Stephanie Martin, Assistant General
Counsel
Ann Misback, Assistant General Counsel
Stephen L. Siciliano, Assistant General
Counsel
Katherine H. Wheatley, Assistant General
Counsel
1. The designations as Chairman and Vice Chairman
expire on June 20, 2004, and October 5, 2003, respectively, unless the service of these members of the Board
shall have terminated sooner.

2. Resigned December 31, 2001.



DIVISION—Continued

OFFICE OF THE SECRETARY

Jennifer J. Johnson, Secretary
Robert deV. Frierson, Deputy Secretary
Margaret M. Shanks, Assistant Secretary
DIVISION OF INTERNATIONAL FINANCE

Karen H. Johnson, Director
David H. Howard, Deputy Director
Thomas A. Connors, Associate Director
Dale W. Henderson, Associate Director
Richard T. Freeman, Deputy Associate
Director
William L. Helkie, Deputy Associate
Director
Steven B. Kamin, Deputy Associate
Director
Jon W. Faust, Assistant Director
Joseph E. Gagnon, Assistant Director
Michael P. Leahy, Assistant Director
D. Nathan Sheets, Assistant Director
Ralph W. Tryon, Assistant Director
DIVISION OF MONETARY AFFAIRS

Vincent R. Reinhart, Director
David E. Lindsey, Deputy Director
Brian F. Madigan, Deputy Director
William C. Whitesell, Deputy Associate
Director
James A. Clouse, Assistant Director
William B. English, Assistant Director
Richard D. Porter, Senior Adviser

306 88th Annual Report, 2001

Board of Governors—Continued
DIVISION OF RESEARCH
AND STATISTICS

David J. Stockton, Director
Edward C. Ettin, Deputy Director
David W. Wilcox, Deputy Director
Myron L. Kwast, Associate Director
Stephen D. Oliner, Associate Director
Patrick M. Parkinson, Associate Director
Lawrence Slifman, Associate Director
Charles S. Struckmeyer, Associate Director
Joyce K. Zickler, Deputy
Associate Director
J. Nellie Liang, Assistant Director
Stuart Wayne Passmore, Assistant Director
David L. Reifschneider, Assistant Director
Janice Shack-Marquez, Assistant Director
William L. Wascher III, Assistant Director
Alice Patricia White, Assistant Director
Glenn B. Canner, Senior Adviser
David S. Jones, Senior Adviser
Thomas D. Simpson, Senior Adviser

DIVISION OF BANKING SUPERVISION
AND REGULATION

Richard Spillenkothen, Director
Stephen C. Schemering, Deputy Director
Herbert A. Biern, Senior Associate
Director
Roger T. Cole, Senior Associate Director
William A. Ryback, Senior Associate
Director
Gerald A. Edwards, Jr., Associate Director
Stephen M. Hoffman, Jr., Associate
Director
James V. Houpt, Associate Director
Jack P. Jennings, Associate Director
Michael G. Martinson, Associate Director
Molly S. Wassom, Associate Director
Howard A. Amer, Deputy Associate
Director
Norah M. Barger, Deputy Associate
Director
Betsy Cross-Jacowski, Deputy Associate
Director
Deborah P. Bailey, Assistant Director



Barbara J. Bouchard, Assistant Director
Angela Desmond, Assistant Director
James A. Embersit, Assistant Director
Charles H. Holm, Assistant Director
Heidi Willmann Richards, Assistant
Director
William G. Spaniel, Assistant Director
David M. Wright, Assistant Director
William C. Schneider, Jr., Project Director,
National Information Center
DIVISION O F CONSUMER
AND COMMUNITY AFFAIRS

Dolores S. Smith, Director
Glenn E. Loney, Deputy Director
Sandra F. Braunstein, Assistant Director
Maureen P. English, Assistant Director
Adrienne D. Hurt, Assistant Director
Irene Shawn McNulty, Assistant Director
DIVISION OF FEDERAL RESERVE B A N K
OPERATIONS AND PAYMENT SYSTEMS

Louise L. Roseman, Director
Paul W. Bettge, Associate Director
Jeffrey C. Marquardt, Associate Director
Kenneth D. Buckley, Assistant Director
Joseph H. Hayes, Jr., Assistant Director
Edgar A. Martindale III, Assistant Director
Marsha W. Reidhill, Assistant Director
Jeff J. Stehm, Assistant Director
Jack K. Walton II, Assistant Director
OFFICE OF STAFF DIRECTOR
FOR M A N A G E M E N T

Stephen R. Malphrus, Staff Director for
Management
Sheila Clark, Equal Employment
Opportunity Programs Director
MANAGEMENT DIVISION

William R. Jones, Director
Stephen J. Clark, Associate Director
Darrell R. Pauley, Associate Director
David L. Williams, Associate Director
Christine M. Fields, Assistant Director

Federal Reserve System Organization 307

Board of Governors—Continued
DIVISION OF INFORMATION
TECHNOLOGY
Richard C. Stevens, Director
Marianne M. Emerson, Deputy Director
Maureen T. Hannan, Associate Director
Tillena G. Clark, Assistant Director
Geary L. Cunningham, Assistant Director
Wayne A. Edmondson, Assistant Director
Po Kyung Kim, Assistant Director

Susan F. Marycz, Assistant Director
Sharon L. Mowry, Assistant Director
Robert F. Taylor, Assistant Director
OFFICE OF THE INSPECTOR GENERAL
Barry R. Snyder, Inspector General
Donald L. Robinson, Deputy Inspector
General

Federal Open Market Committee
December 31, 2001

Members
ALAN GREENSPAN, Chairman, Board of Governors
WILLIAM J. McDoNOUGH, Vice Chairman, President, Federal Reserve Bank of New York
SUSAN SCHMIDT BIES, Board of Governors

ROGER W. FERGUSON, JR., Board of Governors
EDWARD M. GRAMLICH, Board of Governors

THOMAS M. HOENIG, President, Federal Reserve Bank of Kansas City
EDWARD W. KELLEY, JR., Board of Governors
LAURENCE H. MEYER, Board of Governors

CATHY E. MlNEHAN, President, Federal Reserve Bank of Boston
MICHAEL H. MOSKOW, President, Federal Reserve Bank of Chicago
MARK W. OLSON, Board of Governors

WILLIAM POOLE, President, Federal Reserve Bank of St. Louis

Alternate Members
JERRY L. JORDAN, President, Federal Reserve Bank of Cleveland
ROBERT D. MCTEER, JR., President, Federal Reserve Bank of Dallas
ANTHONY M. SANTOMERO, President, Federal Reserve Bank of Philadelphia
GARY H. STERN, President, Federal Reserve Bank of Minneapolis
JAMIE B. STEWART, JR., First Vice President, Federal Reserve Bank of New York

Officers
DONALD L. KOHN,

Secretary and Economist
NORMAND R.V BERNARD,

Deputy Secretary
GARY P. GILLUM,

Assistant Secretary
MICHELLE A. SMITH,

Assistant Secretary




J. VIRGIL MATTINGLY, JR.,

General Counsel
THOMAS C. BAXTER, JR.,

Deputy General Counsel
KAREN H. JOHNSON,

Economist
VINCENT R. REINHART,

Economist

308 88th Annual Report, 2001

Federal Open Market Committee—Continued
DAVID J. STOCKTON,

Economist
CHRISTINE M. CUMMING,

Associate Economist
JEFFREY C. FUHRER,

Associate Economist
CRAIG S. HAKKIO,

Associate Economist
DAVID H. HOWARD,

WILLIAM C. HUNTER,

Associate Economist
DAVID E. LINDSEY,

Associate Economist
ROBERT H. RASCHE,

Associate Economist
LAWRENCE SLIFMAN,

Associate Economist
DAVID W. WILCOX,

Associate Economist
Associate Economist
DINO Kos, Manager, System Open Market Account
During 2001 the Federal Open Market Committee held eight regularly scheduled meet-

ings (see "Minutes of Federal Open Market
Committee Meetings" in this volume.)

Federal Advisory Council
December 31,2001

Members
District 1—LAWRENCE K. FISH, Chairman, President, and Chief Executive Officer,
Citizens Financial Group, Inc., Providence, Rhode Island
District 2—DOUGLAS A. WARNER III, Chairman, J.P. Morgan Chase & Co., Incorporated,
New York, New York
District 3—RONALD L. HANKEY, Chairman and Chief Executive Officer,
Adams County National Bank, Gettysburg, Pennsylvania
District 4—DAVID A. DABERKO, Chairman and Chief Executive Officer,
National City Corporation, Cleveland, Ohio
District 5—L.M. BAKER, JR., Chairman and Chief Executive Officer,
Wachovia Corporation, Winston Salem, North Carolina
District 6—L. PHILLIP HUMANN, Chairman, President, and Chief Executive Officer,
SunTrust Banks, Inc., Atlanta, Georgia
District 7—ALAN G. MCNALLY, Chairman and Chief Executive Officer,
Harris Bancorp, Inc., Chicago, Illinois
District 8—KATIE S. WINCHESTER, President and Chief Executive Officer,
First Citizens National Bank, Dyersburg, Tennessee
District 9—R. SCOTT JONES, President and Chief Executive Officer,
Signal Financial Corporation, Mendota Heights, Minnesota
District 10—CAMDEN R. FINE, President and Chief Executive Officer,
Midwest Independent Bank, Jefiferson City, Missouri
District 11—RICHARD W. EVANS, JR., Chairman and Chief Executive Officer,
Frost National Bank, San Antonio, Texas
District 12—STEVEN L. SCHEID, Vice Chairman and President,
Charles Schwab Corporation, San Francisco, California

Officers
DOUGLAS A. WARNER III, President
LAWRENCE K. FISH, Vice President
JAMES E. ANNABLE, Co-Secretary

WILLIAM J. KORSVIK, Co-Secretary



Federal Reserve System Organization 309

Federal Advisory Council—Continued
The Federal Advisory Council met on February 1-2, May 3-4, September 6-7, and
December 13-14, 2001. The Board of Governors met with the council on February 2, May 4, September 7, and December 14, 2001. The council, which is composed of one representative of the banking

industry from each of the twelve Federal
Reserve Districts, is required by the Federal
Reserve Act to meet in Washington at least
four times each year and is authorized by the
act to consult with, and advise, the Board
on all matters within the jurisdiction of the
Board.

Consumer Advisory Council
December 31, 2001

Members
ANTHONY ABB ATE, President and Chief Executive Officer, Interchange Bank, Saddle
Brook, New Jersey
TERESA A. BRYCE, General Counsel, Nexstar Financial Corporation, St. Louis, Missouri
MALCOLM BUSH, President, Woodstock Institute, Chicago, Illinois
MANUEL CASANOVA, JR., Executive Vice President, International Bank of Commerce,
Brownsville, Texas
CONSTANCE CHAMBERLIN, President and Chief Executive Officer, Housing Opportunities
Made Equal, Richmond, Virginia
ROBERT M. CHEADLE, Legislative Counsel, The Chickasaw Tribal Legislature, Ada,
Oklahoma
MARY ELLEN DOMEIER, President, State Bank and Trust Company of New Ulm,
New Ulm, Minnesota
LESTER WM. FIRSTENBERGER, Attorney, Pittsfield, New Hampshire
JOHN C. GAMBOA, Executive Director, The Greenlining Institute, San Francisco, California
EARL JAROLIMEK, Vice President and Corporate Compliance Officer, Community First
Bankshares, Fargo, North Dakota
WILLIE JONES, Senior Vice President, The Community Builders, Inc., Boston,
Massachusetts
ANNE S. LI, Former Executive Director, New Jersey Community Loan Fund, Trenton,
New Jersey
J. PATRICK LIDDY, Director of Compliance, Fifth Third Bancorp, Cincinnati, Ohio
OSCAR MARQUIS, Attorney, Hunton and Williams, Park Ridge, Illinois
JEREMY NOWAK, Chief Executive Officer, The Reinvestment Fund, Philadelphia,
Pennsylvania
MARTA RAMOS, Vice President and Community Reinvestment Act Officer, Banco Popular
de Puerto Rico, San Juan, Puerto Rico
RONALD REITER, Supervising Deputy Attorney General, California Department of Justice,
San Francisco, California
ELIZABETH RENUART, Staff Attorney, National Consumer Law Center, Boston,
Massachusetts
RUSSELL W. SCHRADER, Senior Vice President and Assistant General Counsel,
Visa U.S.A., San Francisco, California
FRANK TORRES III, Legislative Counsel, Consumers Union, Washington, District of
Columbia



310 88th Annual Report, 2001

Consumer Advisory Council—Continued
GARY S. WASHINGTON, Senior Vice President, ABN AMRO, Chicago, Illinois
ROBERT L. WYNN II, Financial Education Officer, Wisconsin Department of Financial
Institutions, Madison, Wisconsin

Officers
LAUREN ANDERSON, Chair

Executive Director,
Neighborhood Housing Services
of New Orleans, Inc.,
New Orleans, Louisiana
The Consumer Advisory Council met with
members of the Board of Governors on
March 22, June 28, and October 25, 2001.
The council is composed of academics, state
and local government officials, representatives of the financial industry, and represen-

DOROTHY BROADMAN, Vice Chair

Director of Corporate Citizenship,
Capital One Financial Corporation,
Falls Church, Virginia
tatives of consumer and community interests. It was established pursuant to the 1976
amendments to the Equal Credit Opportunity
Act to advise the Board on consumer financial services.

Thrift Institutions Advisory Council
December 31,2001

Members
TOM R. DORETY, President and Chief Executive Officer, Suncoast Schools Federal Credit
Union, Tampa, Florida
RONALD S. ELIASON, President and Chief Executive Officer, Utah Community Federal
Credit Union, Provo, Utah
D.R. GRIMES, Vice Chairman and Chief Executive Officer, NetBank, Alpharetta, Georgia
THOMAS S. JOHNSON, Chairman and Chief Executive Officer, GreenPoint Bank,
New York, New York
CORNELIUS D. MAHONEY, Chairman, President, and Chief Executive Officer, Woronco
Savings Bank, Westfield, Massachusetts
KAREN L. MCCORMICK, President and Chief Executive Officer, First Federal Savings and
Loan Association, Port Angeles, Washington
JAMES F. MCKENNA, President and Chief Executive Officer, North Shore Bank, FSB,
Brookfield, Wisconsin
CHARLES C. PEARSON, JR., Co-Chairman and Chief Executive Officer, Waypoint Bank,
Harrisburg, Pennsylvania
HERBERT M. SANDLER, Chairman and Chief Executive Officer, World Savings Bank, FSB,
Oakland, California
EVERETT STILES, President and Chief Executive Officer, Macon Bank, Franklin,
North Carolina




Federal Reserve System Organization 311

Thrift Institutions Advisory Council—Continued
MARK H. WRIGHT, President and Chief Executive Officer, USAA Federal Savings Bank,
San Antonio, Texas
CLARENCE ZUGELTER, President, Chief Executive Officer, and Chairman, First Federal
Bank, FSB, Kansas City, Missouri

Officers
THOMAS S. JOHNSON, President
The members of the Thrift Institutions
Advisory Council met with the Board of
Governors on February 23, July 13, and
November 9, 2001. The council, which is
composed of representatives from credit

MARK H. WRIGHT, Vice President
unions, savings and loan associations, and
savings banks, consults with, and advises,
the Board on issues pertaining to the thrift
industry and on various other matters within
the Board's jurisdiction.

Officers of Federal Reserve Banks and Branches
December 31, 2001

Chairman1
Deputy Chairman

President
First Vice President

BOSTON2

William C. Brainard
William O. Taylor

Cathy E. Minehan
Paul M. Connolly

NEW YORK2

Peter G. Peterson
Gerald M. Levin
Bal Dixit

William J. McDonough
Jamie B. Stewart, Jr.

PHILADELPHIA

Charisse R. Lillie
Glenn A. Schaeffer

Anthony M. Santomero
William H. Stone, Jr.

CLEVELAND2

David H. Hoag
Robert W. Mahoney
George C. Juilfs
Charles E. Bunch

Jerry L. Jordan
Sandra Pianalto

Jeremiah J. Sheehan
Wesley S.
Williams, Jr.
George L. Russell, Jr.
James F. Goodmon

J. Alfred Broaddus, Jr.
Walter A. Varvel

John F. Wieland
Paula Lovell
Catherine Sloss
Crenshaw
Julie K. Hilton
Mark T. Sodders
Whitney Johns Martin
Ben Tom Roberts

Jack Guynn
Patrick K. Barron

BANK or Branch

Buffalo

Cincinnati
Pittsburgh
RICHMOND2
Baltimore
Charlotte
ATLANTA
Birmingham
Jacksonville
Miami
Nashville
New Orleans




Vice President
in charge of Branch

Barbara L. Walter3

Barbara B. Henshaw
Robert B. Schaub

William J. Tignanelli3
Dan M. Bechter3
James M. McKee 3
Andre T. Anderson
Robert J. Slack3
James T. Curry III
Melvyn K. Purcell3
Robert J. Musso 3

312 88th Annual Report, 2001

Officers of Federal Reserve Banks and BranchesContinued
Chairmanl
Deputy Chairman

President
First Vice President

CHICAGO2

Arthur C. Martinez
Robert J. Darnall

Michael H. Moskow
Gordon R.G.
Werkema

Detroit

Timothy D. Leuliette

ST. LOUIS

Charles W. Mueller
Walter L.
Metcalfe, Jr.
Vick M. Crawley
Roger Reynolds
Gregory M. Duckett

William Poole
W. LeGrande Rives

James J. Howard
Ronald N. Zwieg
Thomas 0. Markle

Gary H. Stern
James M. Lyon

BANK or Branch

Little Rock
Louisville
Memphis
MINNEAPOLIS
Helena
KANSAS CITY
Denver
Oklahoma City
Omaha
DALLAS
El Paso
Houston
San Antonio
SAN FRANCISCO
Los Angeles
Portland
Salt Lake City
Seattle

Vice President
in charge of Branch

David R. Allardice3

Robert A. Hopkins
Thomas A. Boone
Martha Perine Beard

Samuel H. Gane

Terrence P. Dunn
Thomas M. Hoenig
Jo Marie Dancik
Richard K. Rasdall
Kathryn A. Paul
Patricia B. Fennell
Gladys Styles Johnston

Maryann F. Hunter3
Dwayne E. Boggs
Steven D. Evans

H.B. Zachry, Jr.
Robert D. McTeer, Jr.
Patricia M.
Helen E. Holcomb
Patterson
Beauregard Brite White
Edward O. Gaylord
Patty P. Mueller

Sammie C. Clay
Robert Smith III3
James L. Stull3

Nelson C. Rising
George M. Scalise
William D. Jones
Nancy Wilgenbusch
H. Roger Boyer
Richard R. Sonstelie

Mark L. Mullinix4
Raymond H. Laurence3
Andrea P. Wolcott
David K. Webb 3

NOTE. A current list of these officers appears each
month in the Federal Reserve Bulletin.
1. The Chairman of a Federal Reserve Bank serves, by
statute, as Federal Reserve Agent.
2. Additional offices of these Banks are located at
Windsor Locks, Connecticut; Utica at Oriskany, New




Robert T. Parry
John F. Moore

York; East Rutherford, New Jersey; Columbus, Ohio;
Charleston, West Virginia; Columbia, South Carolina;
Indianapolis, Indiana; Milwaukee, Wisconsin; Des
Moines, Iowa; and Peoria, Illinois.
3. Senior Vice President
4. Executive Vice President

Federal Reserve System Organization 313

Conference of Chairmen
The chairmen of the Federal Reserve Banks
are organized into the Conference of Chairmen, which meets to consider matters of
common interest and to consult with, and
advise, the Board of Governors. Such meetings, attended also by the deputy chairmen,
were held in Washington on May 30 and 31,
and on November 28 and 29, 2001.
The members of the Executive Committee of the Conference of Chairmen during
2001 were John F. Wieland, chair; Peter G.
Peterson, vice chair; and Charisse R. Lillie,
member.
On November 29, 2001, the Conference
elected its Executive Committee for 2002;
it named Peter G. Peterson as chair,
Charisse R. Lillie as vice chair, and Robert J.
Darnall as the third member.

Conference of Presidents
The presidents of the Federal Reserve Banks
are organized into the Conference of Presidents, which meets periodically to consider
matters of common interest and to consult
with, and advise, the Board of Governors.
J. Alfred Broaddus, Jr., President of the
Federal Reserve Bank of Richmond, served
as chair of the conference in 2001, and
Michael H. Moskow, President of the Federal Reserve Bank of Chicago, served as its
vice chair. Betty M. Fahed, of the Federal
Reserve Bank of Richmond, served as its
secretary, and Valerie J. Van Meter, of the
Federal Reserve Bank of Chicago, served as
its assistant secretary.

Conference of First
Vice Presidents
The Conference of First Vice Presidents of
the Federal Reserve Banks was organized in
1969 to meet periodically for the consideration of operations and other matters.
Richard K. Rasdall, Jr., First Vice President of the Federal Reserve Bank of Kansas City, served as chair of the conference
in 2001, and Paul M. Connolly, First Vice
President of the Federal Reserve Bank of
Boston, served as its vice chair. Leesa M.
Guy ton, of the Federal Reserve Bank of



Kansas City, served as its secretary, and
David K. Park, of the Federal Reserve Bank
of Boston, served as its assistant secretary.
On October 16, 2001, the conference
elected Paul M. Connolly as its chair for
2002-2003, and Walter A. Varvel, First Vice
President of the Federal Reserve Bank of
Richmond, as its vice chair.

Directors
The following list of directors of Federal
Reserve Banks and Branches shows for each
director the class of directorship, the director's principal organizational affiliation, and
the date the director's term expires. Each
Federal Reserve Bank has a nine-member
board: three Class A and three Class B directors, who are elected by the stockholding
member banks, and three Class C directors,
who are appointed by the Board of Governors of the Federal Reserve System.
Class A directors represent the stockholding member banks in each Federal Reserve
District. Class B and Class C directors represent the public and are chosen with due, but
not exclusive, consideration to the interests
of agriculture, commerce, industry, services,
labor, and consumers; they may not be officers, directors, or employees of any bank or
bank holding company. In addition, Class C
directors rriay not be stockholders of any
bank or bank holding company.
For the election of Class A and Class B
directors, the Board of Governors classifies
the member banks of each Federal Reserve
District into three groups. Each group, which
comprises banks with similar capitalization,
elects one Class A director and one Class B
director. Annually, the Board of Governors
designates one of the Class C directors as
chair of the board and Federal Reserve Agent
of each District Bank, and it designates
another Class C director as deputy chair.
Federal Reserve Branches have either five
or seven directors, a majority of whom are
appointed by the parent Federal Reserve
Bank; the others are appointed by the Board
of Governors. One of the directors appointed
by the Board is designated annually as chair
of the board of that Branch in a manner

314 88th Annual Report, 2001
prescribed by the parent Federal Reserve
Bank.
For the name of the chair and deputy chair
of the board of directors of each Reserve

Bank and of the chair of each Branch, see
the preceding table, "Officers of Federal
Reserve Banks and Branches."

Directors of Federal Reserve Banks and Branches
Term expires
Dec. 31
DISTRICT l — B O S T O N

Class A
Terrence Murray

David S. Outhouse

Richard C. White
Class B
Robert R. Glauber
Orit Gadiesh
Sherwin Greenblatt
Class C
William C. Brainard
William O. Taylor
James J. Norton

Chairman and Chief Executive Officer,
FleetBoston Financial Corporation,
Boston, Massachusetts
President and Chief Executive Officer,
First & Ocean National Bank,
Newburyport, Massachusetts
Chairman, President, and Chief Executive Officer,
Community National Bank, Derby, Vermont

2001

President and Chief Executive Officer,
National Association of Securities Dealers, Inc.,
Washington, D.C.
Chairman, Bain & Company, Inc.,
Boston, Massachusetts
President and Chief Operating Officer,
Bose Corporation, Framingham, Massachusetts

2001

Professor of Economics, Yale University,
New Haven, Connecticut
Chairman Emeritus, The Boston Globe,
Boston, Massachusetts
Vice President, AFL-CIO, Washington, D.C.

2001

Vice Chairman, FleetBoston Financial,
Princeton, New Jersey
President and Chief Executive Officer,
The Canandaigua National Bank and
Trust Company, Canandaigua, New York
Chairman and Chief Executive Officer,
Citigroup Inc., New York, New York

2001

2002

2003

2002
2003

2002
2003

DISTRICT 2 — N E W YORK

Class A
T. Joseph Semrod
George W Hamlin IV

Sanford I. Weill




2002

2003

Federal Reserve System Organization 315
Term expires
Dec. 31

DISTRICT 2, NEW YORK—Continued
Class B
Ronay Menschel
Ann M. Fudge

Jerry I. Speyer

Class C
Peter G. Peterson
Albert J. Simone
Gerald M. Levin

Chairman, Phipps Houses, New York, New York
Retired Executive Vice President, Kraft Foods,
Inc., and Retired President, Coffee & Cereals
Division, Tarrytown, New York,
Westport, Connecticut
President and Chief Executive Officer,
Tishman Speyer Properties,
New York, New York

2001
2002

Chairman, The Blackstone Group,
New York, New York
President, Rochester Institute of Technology,
Rochester, New York
Chief Executive Officer, AOL Time Warner, Inc.,
New York, New York

2001

2003

2002
2003

BUFFALO BRANCH

Appointed by the Federal Reserve Bank
Kathleen R. Whelehan
Executive Vice President, Consumer Finance
Division, HSBC, Buffalo, New York
Geraldine C. Ochocinska ....Director, Region 9, UAW, Buffalo, New York
Peter G. Humphrey
President and Chief Executive Officer,
Financial Institutions, Inc.,
Warsaw, New York
Maureen Torrey Marshall ...Co-Owner, Torrey Farms, Inc., Elba, New York
Appointed by the Board of Governors
Bal Dixit
President and Chief Executive Officer,
Newtex Industries, Inc., Victor, New York
Patrick P. Lee
Chairman and Chief Executive Officer,
International Motion Control, Inc.,
Buffalo, New York
John E. Friedlander
President and Chief Executive Officer,
Kaleida Health, Buffalo, New York

2001
2002
2003

2003
2001
2002

2003

DISTRICT 3 — P H I L A D E L P H I A

Class A
Rufus A. Fulton, Jr

Frank Kaminski, Jr.




Chairman and Chief Executive Officer,
Fulton Financial Corporation,
Lancaster, Pennsylvania
Chairman, Atlantic Central Bankers Bank,
Camp Hill, Pennsylvania

2001

2002

316 88th Annual Report, 2001
Term expires
Dec. 31

DISTRICT 3, Class A—Continued
Robert J. Vanderslice

Class B
Howard E. Cosgrove
Robert E. Chappell

Doris M. Damm

Class C
Charisse R. Lillie
Ronald J. Naples

Glenn A. Schaeffer

DISTRICT

President and Chief Operating Officer,
Pennsville National Bank,
Pennsville, New Jersey

2003

Chairman and Chief Executive Officer,
Conectiv, Wilmington, Delaware
Chairman and Chief Executive Officer,
Penn Mutual Life Insurance Co.,
Horsham, Pennsylvania
President and Chief Executive Officer,
Accu Staffing Services,
Cherry Hill, New Jersey

2001

Partner, Ballard Spahr Andrews & Ingersoll,
Philadelphia, Pennsylvania
Chairman and Chief Executive Officer,
Quaker Chemical Corporation,
Conshohocken, Pennsylvania
President, Pennsylvania Building and
Construction Trades Council,
Harrisburg, Pennsylvania

2001

2002

2003

2002

2003

A—CLEVELAND

Class A
John R. Cochran
Tiney M. McComb
Stephen P. Wilson

Class B
Wayne R. Embry
David L. Nichols
Cheryl L. Krueger-Horn




Chairman and Chief Executive Officer,
FirstMerit Corporation, Akron, Ohio
Chairman and President, Heartland BancCorp,
Gahanna, Ohio
President and Chief Executive Officer,
Lebanon Citizens National Bank,
Lebanon, Ohio
Retired President and Chief Operating Officer,
Cleveland Cavaliers, Cleveland, Ohio
President and Chief Operating Officer,
Rich's/Lazarus/Goldsmith's, Atlanta, Georgia
President and Chief Executive Officer,
Cheryl&Co., Westerville, Ohio

2001
2002
2003

2001
2002
2003

Federal Reserve System Organization 317
Term expires
Dec. 31

DISTRICT 4, CLEVELAND—Continued
Class C
David H. Hoag
Phillip R. Cox
Robert W. Mahoney

Former Chairman, The LTV Corporation,
Cleveland, Ohio
President and Chief Executive Officer,
Cox Financial Corporation, Cincinnati, Ohio
Retired Chairman and Chief Executive Officer,
Diebold Incorporated, Canton, Ohio

2001
2002
2003

CINCINNATI BRANCH

Appointed by the Federal Reserve Bank
Jean R. Hale
Vice Chairman, President, and
Chief Executive Officer,
Community Trust Bancorp, Inc.,
Pikeville, Kentucky
Mary Ellen Slone
Chief Executive Officer and Chairman,
Meridian Communications,
Lexington, Kentucky
V. Daniel Radford
Executive Secretary-Treasurer,
Cincinnati AFL-CIO Labor Council,
Cincinnati, Ohio
Bick Weissenrieder
Chairman, President, and Chief Executive Officer,
Hocking Valley Bank, Athens, Ohio
Appointed by the Board of Governors
Thomas Revely III
President and Chief Executive Officer,
CBS Technologies, LLC, Cincinnati, Ohio
George C. Juilfs
Chairman and Chief Executive Officer,
SENCORP, Newport, Kentucky
Charles Whitehead
President, Ashland Inc. Foundation,
Covington, Kentucky

2001

2002

2002

2003

2001
2002
2003

PITTSBURGH BRANCH

Appointed by the Federal Reserve Bank
Edward V. Randall, Jr.
Management Advisor and Consultant,
Babst, Calland, Clements, & Zomnir, P C ,
Pittsburgh, Pennsylvania
Georgia Berner
President, Berner International Corp.,
New Castle, Pennsylvania
Peter N. Stephans
Chairman and Chief Executive Officer,
Trigon Incorporated, McMurray, Pennsylvania
Kristine N. Molnar
President, Upper Ohio Valley Region,
WesBanco Bank, Inc.,
Wheeling, West Virginia



2001

2002
2002
2003

318

88th Annual Report, 2001
Term expires
Dec. 31

DISTRICT 4, PITTSBURGH BRANCH—Continued

Appointed by the Board of Governors
Gretchen R. Haggerty
Vice President, Accounting and Finance,
U.S. Steel Group, Pittsburgh, Pennsylvania
Charles E. Bunch
Executive Vice President, PPG Industries, Inc.,
Pittsburgh, Pennsylvania
James I. Mitnick
Senior Vice President, Turner Construction
Company, Pittsburgh, Pennsylvania

2001
2002
2003

DISTRICT 5 — R I C H M O N D

Class A
James M. Culberson, Jr.
Fred L. Green III

William W. Duncan, Jr.
Class B
Craig A. Ruppert
W. Henry Harmon

James E. Haden

Class C
Irwin Zazulia
Jeremiah J. Sheehan
Wesley S. Williams, Jr

Chairman Emeritus, First National Bank and
Trust Company, Asheboro, North Carolina
Chairman, President and Chief Executive Officer,
The National Bank of South Carolina,
Columbia, South Carolina
President/Chief Executive Officer,
St. Michaels Bank, St. Michaels, Maryland

2001

President, Ruppert Nurseries Inc.,
Laytonsville, Maryland
President and Chief Executive Officer,
Triana Energy, LLC,
Charleston, West Virginia,
Union Drilling, Inc.,
Bridgeville, Pennsylvania
President/Chief Executive Officer,
Martha Jefferson Hospital,
Charlottesville, Virginia

2001

Retired President and Chief Executive Officer,
Hecht's, Arlington, Virginia
Retired Chairman, Reynolds Metals Company,
Richmond, Virginia
Partner, Covington & Burling, Washington, D.C.

2001

2002

2003

2002

2003

2002
2003

BALTIMORE BRANCH

Appointed by the Federal Reserve Bank
Jeremiah E. Casey
Director and Former Chairman,
Allfirst Financial, Inc., Baltimore, Maryland
Dyan Brasington
President, Technology Council of Maryland,
Rockville, Maryland



2001
2002

Federal Reserve System Organization 319
Term expires
Dec. 31
DISTRICT 5, BALTIMORE BRANCH

Appointed by the Federal Reserve Bank—Continued
William L. Jews

Kenneth C. Lundeen

President and Chief Executive Officer,
CareFirst BlueCross BlueShield,
Owings Mills, Maryland
President, C. J. Langenfelder & Son, Inc.,
Baltimore, Maryland

Appointed by the Board of Governors
Owen E. Herrnstadt
Director, International Department, International
Association of Machinists and Aerospace
Workers, AFL-CIO, Upper Marlboro, Maryland
George L. Russell, Jr.
Law Offices of Peter G. Angelos,
Baltimore, Maryland
William C. Handorf
Professor of Finance, School of Business and
Public Management,
The George Washington University,
Washington, D.C.

2003

2003

2001

2002
2003

CHARLOTTE BRANCH

Appointed by the Federal Reserve Bank
William H. Nock
President and Chief Executive Officer,
Sumter National Bank, Sumter, South Carolina
Lucy J. Reuben
Dean, School of Business, South Carolina
State University, Orangeburg, South Carolina
Elleveen T. Poston
President, Quality Transport, Inc.,
Lake City, South Carolina
Cecil W Sewell, Jr.
Chairman and Chief Executive Officer Emeritus,
RBC Centura Banks, Inc.,
Raleigh, North Carolina
Appointed by the Board of Governors
James F. Goodmon
President and Chief Executive Officer,
Capitol Broadcasting Company, Inc.,
Raleigh, North Carolina
Michael A. Almond
President and Chief Executive Officer,
Charlotte Regional Partnership,
Charlotte, North Carolina
Jim Lowry
President, High Point Chevrolet Jeep,
High Point, North Carolina

2001
2002
2003
2003

2001

2002

2003

DISTRICT 6 — A T L A N T A

Class A
Waymon L. Hickman



Chairman and Chief Executive Officer,
First Farmers and Merchants National Bank,
Columbia, Tennessee

2001

320 88th Annual Report, 2001
Term expires
Dec. 31

DISTRICT 6, Class A—Continued
Richard G Hickson
William G. Smith, Jr.

Class B
Suzanne E. Boas
Juanita P. Baranco
John Dane III
Class C
Maria Camila Leiva
John F. Wieland

Paula Lovell

President and Chief Executive Officer,
Trustmark Corporation, Jackson, Mississippi
President and Chief Executive Officer,
Capital City Bank Group, Inc.,
Tallahassee, Florida

2002

President, Consumer Credit Counseling
Service, Inc., Atlanta, Georgia
Executive Vice President, Baranco
Automotive Group, Morrow, Georgia
President and Chief Executive Officer,
Trinity Yachts, Inc., New Orleans, Louisiana

2001

Executive Vice President, MFZ Management
Corporation, Coral Gables, Florida
Chief Executive Officer and Chairman,
John Wieland Homes and Neighborhoods, Inc.,
Atlanta, Georgia
President, Lovell Communications, Inc.,
Nashville, Tennessee

2001

2003

2002
2003

2002

2003

BIRMINGHAM BRANCH

Appointed by the Federal Reserve Bank
Robert M. Barrett
Chairman, President, and Chief Executive Officer,
First Community Bank of Central Alabama,
Wetumpka, Alabama
W. Charles Mayer III
Senior Executive Vice President,
Alabama Banking Group Head, and
Commercial Banking Group Head,
AmSouth Bank, Birmingham, Alabama
James A. Vickery
International Representative, Laborers'
International Union of North America,
Gadsden, Alabama
Hundley Batts, Sr
Owner and Managing General Agent,
Hundley Batts & Associates,
Huntsville, Alabama
Appointed by the Board of Governors
Catherine Sloss Crenshaw ...President, Sloss Real Estate Group, Inc.,
Birmingham, Alabama
V. Larkin Martin
Managing Partner, Martin Farm,
Courtland, Alabama
W. Miller Welborn
Chairman, Welborn & Associates, Inc.,
Tuscaloosa, Tennessee



2001

2002

2003

2003

2001
2002
2003

Federal Reserve System Organization 321
Term expires
Dec. 31

DISTRICT 6, ATLANTA—Continued
JACKSONVILLE BRANCH

Appointed by the Federal Reserve Bank
Harvey R. Heller
President, Heller Brothers Packing Corp.,
Winter Garden, Florida
Jerry M. Smith
Chairman and President, First National Bank
of Alachua, Alachua, Florida
Robert L. Fisher
President and Chief Executive Officer,
MacDill Federal Credit Union,
Tampa, Florida
Michael W. Poole
Poole Carbone Eckbert, Winter Park, Florida
Appointed by the Board of Governors
Julie K. Hilton
Vice President and Co-Owner, Hilton Inc.,
Panama City Beach, Florida
Marsha G. Rydberg
Partner, The Rydberg Law Firm, Tampa, Florida
William E. Flaherty
Former Chairman, Blue Cross and Blue Shield
of Florida, Inc., Jacksonville, Florida

2001
2002
2003

2003
2001
2002
2003

MIAMI BRANCH

Appointed by the Federal Reserve Bank
Rudy E. Schupp
Chairman, Florida Banking, Wachovia, N.A.,
West Palm Beach, Florida
D. Keith Cobb
Managing Director, Cobb Consulting Group,
Ft. Lauderdale, Florida
James W. Moore
Managing Partner, Riverside Capital, LLC,
Fort Myers, Florida
Miriam Lopez
President and Chief Executive Officer,
TransAtlantic Bank, Miami, Florida
Appointed by the Board of Governors
Rosa Sugranes
Chairman, Iberia Tiles Corp., Miami, Florida
Mark T. Sodders
President, Lakeview Farms, Inc.,
Pahokee, Florida
Brian E. Keeley
President and Chief Executive Officer,
Baptist Health Systems of South Florida,
Coral Gables, Florida




2001
2002
2002
2003

2001
2002
2003

322 88th Annual Report, 2001
Term expires
Dec. 31
DISTRICT 6, NASHVILLE BRANCH

Appointed by the Federal Reserve Bank
Dale W. Polley
Past President, First American Corporation,
Nashville, Tennessee
L.A. Walker, Jr.
Chairman, BB&T McMinn/Monroe Counties,
Tennessee, Athens, Tennessee
James W. Spradley, Jr.
President, Standard Candy Company, Inc.,
Nashville, Tennessee
Emil Hassan
Senior Vice President, North America
Manufacturing, Purchasing, Quality and
Logistics, Nissan North America, Inc.,
Smyrna, Tennessee
Appointed by the Board of Governors
Frances F. Marcum
General Partner, Marcum Capital, L.L.C.,
Tullahoma, Tennessee
Beth Dortch Franklin
President and Chief Executive Officer,
Star Transportation, Inc., Nashville, Tennessee
Whitney Johns Martin
Chairman and Chief Executive Officer,
Capital Across America, Nashville, Tennessee

2001
2002
2003
2003

2001
2002
2003

NEW ORLEANS BRANCH

Appointed by the Federal Reserve Bank
David E. Johnson
Chairman and Chief Executive Officer,
The First Bancshares, Inc., and
The First National Bank of South Mississippi,
Hattiesburg, Mississippi
C.R. Cloutier
President and Chief Executive Officer,
MidSouth Bank, Lafayette, Louisiana
Teri G. Fontenot
President and Chief Executive Officer,
Woman's Hospital, Baton Rouge, Louisiana
David Guidry
President and Chief Executive Officer,
Guico Machine Works, Inc., Harvey, Louisiana
Appointed by the Board of Governors
Dave Dennis
President, Specialty Contractors & Assoc, Inc.,
Gulfport, Mississippi
R. Glenn Pumpelly
President and Chief Executive Officer,
Pumpelly Oil Inc., Sulphur, Louisiana
Ben Tom Roberts
Senior Executive Vice President,
Roberts Brothers, Inc., Realtors,
Mobile, Alabama




2001

2002
2003
2003

2001
2002
2003

Federal Reserve System Organization 323
Term expires
Dec. 31

DISTRICT 7—CHICAGO
Class A
Alan R. Tubbs
William A. Osborn

Robert R. Yohanan
Class B
James H. Keyes
Connie E. Evans
Jack B. Evans
Class C
Arthur C. Martinez
Robert J. Darnall
W. James Farrell

President, Maquoketa State Bank and Ohnward
Bancshares Inc., Maquoketa, Iowa
Chairman and Chief Executive Officer,
Northern Trust Corporation and
The Northern Trust Company,
Chicago, Illinois
Managing Director and Chief Executive Officer,
First Bank & Trust, Evanston, Illinois

Chairman and Chief Executive Officer,
Johnson Controls, Inc., Milwaukee, Wisconsin
President and Chief Executive Officer,
WSEP Ventures, Chicago, Illinois
President, The Hall-Perrine Foundation,
Cedar Rapids, Iowa
Retired Chairman and Chief Executive Officer,
Sears, Roebuck and Co., Chicago, Illinois
Chairman, Prime Advantage Chicago,
Chicago, Illinois
Chairman and Chief Executive Officer,
Illinois Tool Works Inc., Glenview, Illinois

2001
2002

2003

2001
2002
2003

2001
2002
2003

DETROIT BRANCH

Appointed by the Federal Reserve Bank
Richard M. Bell
Retired President and Chief Executive Officer,
The First National Bank of Three Rivers,
Three Rivers, Michigan
Mark T. Gaffney
President, Michigan State AFL-CIO,
Lansing, Michigan
Irma B. Elder
President, Elder Ford, Troy, Michigan
David J. Wagner
Chairman, Fifth Third Bank,
Grand Rapids, Michigan
Appointed by the Board of Governors
Stephen R. Polk
Chairman and Chief Executive Officer,
R. L. Polk & Co., Southfield, Michigan
Edsel B. Ford II
Board Director, Ford Motor Company,
Dearborn, Michigan
Timothy D. Leuliette
President and Chief Executive Officer,
Metaldyne, Plymouth, Michigan




2001

2002
2002
2003

2001
2002
2003

324 88th Annual Report, 2001
Term expires
Dec. 31

DISTRICT 8—ST. LOUIS
Class A
Thomas H. Jacobsen
Lunsford W. Bridges

Bradley W. Small

Class B
Bert Greenwalt
Joseph E. Gliessner, Jr.
Robert L. Johnson
Class C
Charles W. Mueller
Gayle P.W. Jackson
Walter L. Metcalfe, Jr.

Chairman Emeritus, Firstar Corporation
(now U.S. Bancorp), St. Louis, Missouri
President and Chief Executive Officer,
Metropolitan National Bank,
Little Rock, Arkansas
President and Chief Executive Officer,
The Farmers and Merchants National Bank,
Nashville, Illinois

2001

Partner, Greenwalt Company, Hazen, Arkansas
Executive Director, New Directions Housing Corp.,
Louisville, Kentucky
Chairman and Chief Executive Officer,
Johnson Bryce, Inc., Memphis, Tennessee

2001
2002

Chairman and Chief Executive Officer,
Ameren Corporation, St. Louis, Missouri
Managing Director, Fond Elec Group, Inc.,
St. Louis, Missouri
Chairman, Bryan Cave LLP, St. Louis, Missouri

2001

2002

2003

2003

2002
2003

LITTLE ROCK BRANCH

Appointed by the Federal Reserve Bank
Lawrence A. Davis, Jr.
Chancellor, University of Arkansas at Pine Bluff,
Pine Bluff, Arkansas
Everett Tucker III
Chairman, Moses Tucker Real Estate, Inc.,
Little Rock, Arkansas
David R. Estes
President and Chief Executive Officer,
First State Bank, Lonoke, Arkansas
Raymond E. Skelton
Regional President, U.S. Bank,
Little Rock, Arkansas
Appointed by the Board of Governors
Vick M. Crawley
Plant Manager, Baxter Healthcare Corporation,
Mountain Home, Arkansas
A. Rogers Yarnell II
President, Yarnell Ice Cream Co., Inc.,
Searcy, Arkansas
Cynthia J. Brinkley
President, Arkansas Southwestern Bell
Telephone Company,
Little Rock, Arkansas




2001
2002
2002
2003

2001
2002
2003

Federal Reserve System Organization 325
Term expires
Dec. 31
DISTRICT 8, LOUISVILLE BRANCH

Appointed by the Federal Reserve Bank
Orson Oliver
President, Mid-America Bank of Louisville,
Louisville, Kentucky
Marjorie Z. Soyugenc
Executive Director and Chief Executive Officer,
Welborn Foundation, Evansville, Indiana
Thomas W. Smith
President and Chief Executive Officer,
Ephraim McDowell Health,
Danville, Kentucky
Frank J. Nichols
Chairman, President, and Chief Executive Officer,
Community Financial Services, Inc.,
Benton, Kentucky
Appointed by the Board of Governors
Roger Reynolds
President and Chief Executive Officer,
Interlink Logistics LLC, Louisville, Kentucky
J. Stephen Barger
Executive Secretary-Treasurer, Kentucky State
District Council of Carpenters, AFL-CIO,
Frankfort, Kentucky
Norman E. Pfau, Jr.
President and Chief Executive Officer,
Geo. Pfau's Sons Company, Inc.,
Jeffersonville, Indiana

2001
2002
2002

2003

2001
2002

2003

MEMPHIS BRANCH

Appointed by the Federal Reserve Bank
Walter L. Morris, Jr.
President, H&M Lumber Co., Inc.,
West Helena, Arkansas
James A. England
Chairman, President, and Chief Executive Officer,
Decatur County Bank, Decaturville, Tennessee
John C. Kelley, Jr.
President, Business Financial Services,
First Tennessee Bank, Memphis, Tennessee
E.C. Neelly III
Management Consultant, First American
National Bank, Iuka, Mississippi
Appointed by the Board of Governors
Gregory M. Duckett
Senior Vice President and Corporate Counsel,
Baptist Memorial Health Care Corporation,
Memphis, Tennessee
Mike P. Sturdivant, Jr.
Partner, Due West, Glendora, Mississippi
Russell Gwatney
President, Gwatney Companies,
Memphis, Tennessee




2001
2002
2002
2003

2001

2002
2003

326

88th Annual Report, 2001
Term expires
Dec. 31

DISTRICT 9—MINNEAPOLIS
Class A
W.W. LaJoie

Roger N. Berglund
Dan M. Fisher

Class B
Jay F. Hoeschler
Rob L. Wheeler
D. Greg Heineman
Class C
James J. Howard
Linda Hall Whitman
Ronald N. Zwieg

Chief Executive Officer and Chairman,
Central Savings Bank,
Sault Ste. Marie, Michigan
Chairman and President, Dakota Western Bank,
Bowman, North Dakota
Chief Information Officer,
Community First Bankshares, Inc.,
Fargo, North Dakota

2001

President and Owner, Hoeschler Corporation,
La Crosse, Wisconsin
Vice President, Wheeler Mfg. Co., Inc.,
Lemmon, South Dakota
Chairman, Williams Insurance Agency,
Sioux Falls, South Dakota

2001

Chairman Emeritus, Xcel Energy, Inc.,
Minneapolis, Minnesota
Former President, Ceridian,
Minneapolis, Minnesota
President, United Food & Commercial Workers,
Local 653, Plymouth, Minnesota

2002
2003

2002
2003

2001
2002
2003

HELENA BRANCH

Appointed by the Federal Reserve Bank
Richard E. Hart
President, Senior Lender, and Director,
Mountain West Bank, Kalispell, Montana
Emil W. Erhardt
Chairman and President, Citizens State Bank,
Hamilton, Montana
Marilyn F. Wessel
Dean and Director, Museum of the Rockies,
Bozeman, Montana
Appointed by the Board of Governors
Thomas O. Markle
President and Chief Executive Officer,
Markle's Inc., Glasgow, Montana
William P. Underriner
President, Selover Buick Inc.,
Billings, Montana




2001
2002
2002

2001
2002

Federal Reserve System Organization 327
Term expires
Dec. 31

DISTRICT 10—KANSAS CITY
Class A
Jeffrey L. Gerhart

Dennis E. Barrett
Bruce A. Schriefer

President and Chief Executive Officer,
First National Bank,
Newman Grove, Nebraska
Vice Chairman, FirstBank Holding
Company of Colorado, Lakewood, Colorado
President, Bankers' Bank of Kansas,
Wichita, Kansas

Class B
Frank A. Potenziani
M&T Trust, Albuquerque, New Mexico
Paula Marshall-Chapman ....Chief Executive Officer, The Bama Companies, Inc.,
Tulsa, Oklahoma
Hans C. Helmerich
President and Chief Executive Officer,
Helmerich & Payne, Inc., Tulsa, Oklahoma
Class C
Jo Marie Dancik
Rhonda Holman

Terrence P. Dunn

Regional Managing Partner, Ernst & Young LLP,
Minneapolis, Minnesota
Vice President, Kauffman Center for
Entrepreneurial Leadership at the
Ewing Marion Kauffman Foundation,
Kansas City, Missouri
President and Chief Executive Officer,
J. E. Dunn Construction Company,
Kansas City, Missouri

2001

2002
2003

2001
2002
2003

2001
2002

2003

DENVER BRANCH

Appointed by the Federal Reserve Bank
Albeit C. Yates
President, Colorado State University,
Ft. Collins, Colorado
Virginia K. Berkeley
President, Colorado Business Bank N.A.,
Denver, Colorado
Robert M. Murphy
President, Sandia Properties Ltd., Co.,
Albuquerque, New Mexico
John W. Hay III
President, Rock Springs National Bank,
Rock Springs, Wyoming
Appointed by the Board of Governors
James A. King
Chief Executive Officer, BT, Inc.,
Riverton, Wyoming
Kathleen Avila
Partner and Chief Executive Officer,
Avila Retail, Albuquerque, New Mexico
Kathryn A. Paul
President, Delta Dental Plan of Colorado,
Denver, Colorado



2001
2002
2003
2003

2001
2002
2003

328 88th Annual Report, 2001
Term expires
Dec. 31
DISTRICT 10, OKLAHOMA CITY BRANCH

Appointed by the Federal Reserve Bank
Betty Bryant Shaull
President-Elect and Director,
Bank of Cushing and Trust Company,
Cushing, Oklahoma
W. Carlisle Mabrey III
President and Chief Executive Officer,
Citizens Bank & Trust Co.,
Okmulgee, Oklahoma
Robert A. Funk
Chairman and Chief Executive Officer,
Express Personnel Services International,
Oklahoma City, Oklahoma
Russell W. Teubner
Founder and Director, Esker, Inc.,
Stillwater, Oklahoma
Appointed by the Board of Governors
Vacancy
J. Clifford Hudson
Chairman and Chief Executive Officer,
Sonic Corp., Oklahoma City, Oklahoma
Patricia B. Fennell
Executive Director, Latino Community
Development Agency,
Oklahoma City, Oklahoma

2001

2001

2002

2003

2001
2002
2003

OMAHA BRANCH

Appointed by the Federal Reserve Bank
Vacancy
Judith A. Owen
President and Chief Executive Officer,
Wells Fargo Bank Nebraska, N.A.,
Omaha, Nebraska
Frank L. Hayes
President, Hayes & Associates, L.L.C., CPAs,
Omaha, Nebraska
H.H. Kosman
Chairman, President, and Chief Executive Officer,
Platte Valley National Bank,
Scottsbluff, Nebraska
Appointed by the Board of Governors
Gladys Styles Johnston
Chancellor, University of Nebraska at Kearney,
Kearney, Nebraska
Bob L. Gottsch
Vice President, Gottsch Feeding Corporation,
Hastings, Nebraska
A.F. Raimondo
Chairman and Chief Executive Officer,
Behlen Mfg. Co., Columbus, Nebraska




2001
2002

2003
2003

2001
2002
2003

Federal Reserve System Organization 329
Term expires

Dec. 31

DISTRICT 11—DALLAS
Class A
Dudley K. Montgomery
Kenneth T. Murphy

Matthew T. Doyle
Class B
Julie Spicer England
Malcolm Gillis
Judy Ley Allen
Class C
Ray L. Hunt
Patricia M. Patterson
H.B. Zachry, Jr.

Director, The Security State Bank of Pecos,
Pecos, Texas
Chairman, President, and Chief Executive Officer,
First Financial Bankshares, Inc.,
Abilene, Texas
Vice Chairman and Chief Executive Officer,
Texas First Bank, Texas City, Texas

2001

Vice President, Texas Instruments, Dallas, Texas
President, Rice University, Houston, Texas
Owner, Allen Investments, Houston, Texas

2001
2002
2003

Chairman and Chief Executive Officer,
Hunt Consolidated, Inc., Dallas, Texas
President, Patterson Investments, Inc.,
Dallas, Texas
Chairman and Chief Executive Officer,
H. B. Zachry Company, San Antonio, Texas

2001

2002

2003

2002
2003

EL PASO BRANCH

Appointed by the Federal Reserve Bank
Lester L. Parker
President and Chief Executive Officer,
United Bank of El Paso del Norte,
El Paso, Texas
James D. Renfrow
President and Chief Executive Officer,
The Carlsbad National Bank,
Carlsbad, New Mexico
Melissa W. O'Rourke
President, Charlotte's Inc., El Paso, Texas
Ron C. Helm
Owner, Helm Cattle Company, El Paso, Texas
Appointed by the Board of Governors
Beauregard Brite White
Rancher, J. E. White, Jr. & Sons, Marfa, Texas
James Haines
Chief Executive Officer and President,
El Paso Electric Company, El Paso, Texas
Gail S. Darling
President, Gail Darling Inc., El Paso, Texas




2001

2002

2002
2003
2001
2002
2003

330 88th Annual Report, 2001
Term expires
Dec. 31
DISTRICT 11, HOUSTON BRANCH

Appointed by the Federal Reserve Bank
Richard W. Weekley
Chairman, Weekley Development Company,
Houston, Texas
Priscilla D. Slade
President, Texas Southern University,
Houston, Texas
Ray B. Nesbitt
President (Retired), Exxon Chemical Company,
Houston, Texas
Alan R. Buckwalter III
Chairman and Chief Executive Officer,
J.P. Morgan Chase Bank, Texas Region,
Houston, Texas
Appointed by the Board of Governors
Edward O. Gaylord
Chairman, Jacintoport Terminal Company,
Houston, Texas
Lupe Fraga
President and Chief Executive Officer,
Tejas Office Products, Inc.,
Houston, Texas
Jeffrey K. Skilling
President and Chief Executive Officer,
Veld Interests, Inc., Houston, Texas

2001
2002
2002
2003

2001
2002

2003

SAN ANTONIO BRANCH

Appointed by the Federal Reserve Bank
R. Tom Roddy
Chairman, Clear Lake National Bank,
San Antonio, Texas
Mary Rose Cardenas
Executive Vice President, Cardenas Motors, Inc.,
Brownsville, Texas
Daniel B. Hastings, Jr.
President and Owner, Daniel B. Hastings, Inc.,
Laredo, Texas
Arthur R. Emerson
Chairman and Chief Executive Officer,
Groves Rojas Emerson, San Antonio, Texas
Appointed by the Board of Governors
Ron R. Harris
President and Chief Executive Officer,
Pervasive Software Inc., Austin, Texas
Patty P. Mueller
Vice President, Mueller Energetics Corp.,
Corpus Christi, Texas
Marvin L. Ragsdale
President, Iron Workers District Council of
the State of Texas, Austin, Texas




2001
2002
2002
2003

2001
2002
2003

Federal Reserve System Organization 331
Term expires
Dec. 31

DISTRICT 12—SAN

FRANCISCO

Class A
Warren K.K. Luke
E. Lynn Caswell

Richard C. Hartnack
Class B
Jack McNally

Robert S. Attiyeh

Barbara L. Wilson

Class C
Sheila D. Harris
George M. Scalise
Nelson C. Rising

Chairman, President, and Chief Executive Officer,
Hawaii National Bank, Honolulu, Hawaii
Chairman and Managing Director,
Zurich American Trust Co., AG,
Laguna Niguel, California
Vice Chairman, Union Bank of California,
Los Angeles, California

2001
2002

2003

Business Manager, IBEW, Local Union 1245,
and Principal, JKM Consulting,
Sacramento, California
Senior Vice President, Chief Financial Officer
(Retired), and Consultant, Amgen, Inc.,
Thousand Oaks, California
Idaho and Regional Vice President (Retired)
and Consultant, Qwest Corporation,
Boise, Idaho

2001

Director, Governor's Office of Housing
Development, Phoenix, Arizona
President, Semiconductor Industry Association,
San Jose, California
Chairman and Chief Executive Officer,
Catellus Development Corporation,
San Francisco, California

2001

2002

2003

2002
2003

Los ANGELES BRANCH

Appointed by the Federal Reserve Bank
Russell Goldsmith
Chairman and Chief Executive Officer,
City National Bank, Beverly Hills, California
John H. Gleason
Regional President, California and Texas,
Del Webb Corporation, Phoenix, Arizona
D. Linn Wiley
President and Chief Executive Officer,
Citizens Business Bank, Ontario, California
Linda Griego
Managing Partner, Engine Co. No. 28,
Los Angeles, California
Appointed by the Board of Governors
William D. Jones
Chairman, President, and Chief Executive Officer,
CityLink Investment Corporation,
San Diego, California
Lori R. Gay
President, Los Angeles Neighborhood Housing
Service, Inc., Los Angeles, California
Lonnie Kane
President, Karen Kane, Inc.,
Los Angeles, California




2001
2002
2003
2003

2001

2002
2003

332 88th Annual Report, 2001
Term expires

Dec. 31
DISTRICT 12, PORTLAND BRANCH

Appointed by the Federal Reserve Bank
George J. Passadore
President, Oregon Wells Fargo Bank,
Portland, Oregon
Phyllis A. Bell
President, Oregon Coast Aquarium,
Newport, Oregon
Martin Brantley
President and General Manager (Retired),
Oregon's 12-KPTV, Portland, Oregon
Guy L. Williams
President and Chief Executive Officer,
Security Bank, Coos Bay, Oregon
Appointed by the Board of Governors
Karla S. Chambers
Vice President and Co-Owner,
Stahlbush Island Farms, Inc.,
Corvallis, Oregon
Nancy Wilgenbusch
President, Marylhurst University,
Marylhurst, Oregon
Patrick Borunda
Principal, The Navigator Group,
Yacolt, Washington

2001
2002
2002
2003

2001

2002
2003

SALT LAKE CITY BRANCH

Appointed by the Federal Reserve Bank
Curtis H. Harris
Chairman, President, and Chief Executive Officer,
Barnes Banking Company, Kaysville, Utah
J. Pat McMurray
President and Chief Executive Officer,
Idaho Region, Wells Fargo Bank,
Boise, Idaho
Maria Garciaz
Executive Director, Salt Lake Neighborhood
Housing Services, Inc.,
Salt Lake City, Utah
Peggy A. Stock
President, Westminster College,
Salt Lake City, Utah
Appointed by the Board of Governors
Gary L. Crocker
Chairman, ARUP Laboratories,
Salt Lake City, Utah
H. Roger Boyer
Chairman, The Boyer Company, Salt Lake City, Utah
William C. Glynn
President, Intermountain Industries, Inc.,
Boise, Idaho




2001
2002
2002

2003

2001
2002
2003

Federal Reserve System Organization 333
Term expires
Dec. 31
DISTRICT 12, SEATTLE BRANCH

Appointed by the Federal Reserve Bank
Peter H. van Oppen
Chairman and Chief Executive Officer,
Advanced Digital Information Corp.,
Redmond, Washington
Mary E. Pugh
President, Pugh Capital Management, Inc.,
Seattle, Washington
James C. Hawkanson
Chairman (Retired), The Commerce Bank of
Washington, N.A., Seattle, Washington
Betsy Lawer
Vice Chair and Chief Operating Officer,
First National Bank of Alaska,
Anchorage, Alaska
Appointed by the Board of Governors
Helen M. Rockey
Chief Executive Officer and President (Retired),
Just for Feet, Inc., Seattle, Washington
Boyd E. Givan
Senior Vice President and Chief Financial
Officer (Retired), The Boeing Company,
Seattle, Washington
Richard R. Sonstelie
Chairman (Retired), Puget Sound Energy, Inc.,
Bellevue, Washington




2001

2002
2002
2003

2001
2002

2003

334 88th Annual Report, 2001

Membership of the Board of Governors, 1913-2001
Appointed Members
Federal Reserve
District

Date initially took
oath of office

Charles S. Hamlin

Boston

Paul M. Warburg
Frederic A. Delano
W.P.G. Harding
Adolph C. Miller

New York
Chicago
Atlanta
San Francisco

Albert Strauss
Henry A. Moehlenpah
Edmund Platt

New York
Chicago
New York

David C.Wills
John R. Mitchell
Milo D. Campbell
Daniel R. Crissinger
George R. James

Cleveland
Minneapolis
Chicago
Cleveland
St. Louis

Edward H. Cunningham
Roy A. Young
Eugene Meyer

Wayland W. Magee
Eugene R. Black
M.S. Szymczak

Chicago
Minneapolis
New York
Kansas City
Atlanta
Chicago

J.J. Thomas
Marriner S. Eccles

Kansas City
San Francisco

Joseph A. Broderick
John K. McKee
Ronald Ransom
Ralph W. Morrison
Chester C. Davis

New York
Cleveland
Atlanta
Dallas
Richmond

Ernest G. Draper
Rudolph M. Evans
James K. Vardaman, Jr.
Lawrence Clayton
Thomas B. McCabe
Edward L. Norton
Oliver S. Powell
Wm. McC. Martin, Jr.

New York
Richmond
St. Louis
Boston
Philadelphia
Atlanta
Minneapolis
New York

A.L. Mills, Jr.

San Francisco

J.L. Robertson

Kansas City

C. Canby Balderston
Paul E. Miller

Philadelphia
Minneapolis

Aug. 10, 1914 Reappointed in 1916 and 1926. Served
until Feb. 3, 1936.2
Aug. 10, 1914 Term expired Aug. 9,1918.
Aug. 10, 1914 Resigned July 21, 1918.
Aug. 10, 1914 Term expired Aug. 9,1922.
Aug. 10, 1914 Reappointed in 1924. Reappointed in 1934
from the Richmond District. Served
until Feb. 3, 1936.2
Oct. 26,1918 Resigned Mar. 15, 1920.
Nov. 10, 1919 Term expired Aug. 9, 1920.
Reappointed in 1928. Resigned Sept. 14,
June 8,1920
1930.
Sept. 29,1920 Term expired Mar. 4, 1921.
May 12, 1921 Resigned May 12,1923.
Mar. 14, 1923 Died Mar. 22, 1923.
Resigned Sept. 15, 1927.
May 1, 1923
May 14, 1923 Reappointed in 1931. Served until Feb. 3,
1936.3
May 14, 1923 Died Nov. 28, 1930.
Resigned Aug. 31, 1930.
Oct. 4, 1927
Sept. 16,1930 Resigned May 10, 1933.
May 18, 1931 Term expired Jan. 24, 1933.
May 19, 1933 Resigned Aug. 15, 1934.
June 14, 1933 Reappointed in 1936 and 1948. Resigned
May 31, 1961.
June 14, 1933 Served until Feb. 10, 1936.2
Nov. 15, 1934 Reappointed in 1936, 1940, and 1944.
Resigned July 14, 1951.
Feb. 3, 1936
Resigned Sept. 30, 1937.
Feb. 3, 1936
Served until Apr. 4, 1946.2
Feb. 3,1936
Reappointed in 1942. Died Dec. 2, 1947.
Feb. 10, 1936 Resigned July 9, 1936.
June 25, 1936 Reappointed in 1940. Resigned Apr. 15,
1941.
Mar. 30, 1938 Served until Sept. 1,1950.2
Mar. 14,1942 Served until Aug. 13, 1954.2
Resigned Nov. 30, 1958.
Apr. 4, 1946
Feb. 14,1947 Died Dec. 4, 1949.
Apr. 15, 1948 Resigned Mar. 31, 1951.
Sept. 1, 1950 Resigned Jan. 31, 1952.
Sept. 1, 1950 Resigned June 30, 1952.
April 2, 1951 Reappointed in 1956. Term expired
Jan. 31, 1970.
Feb. 18,1952 Reappointed in 1958. Resigned Feb. 28,
1965.
Feb. 18, 1952 Reappointed in 1964. Resigned Apr. 30,
1973.
Aug. 12, 1954 Served through Feb. 28, 1966.
Aug. 13, 1954 Died Oct. 21, 1954.

Name




Other dates1

Membership of the Board of Governors, 1913-2000

335

Appointed Members—Continued
Federal Reserve
District

Date initially took
oath of office

Chas. N. Shepardson
G.H. King, Jr.

Dallas
Atlanta

Mar. 17, 1955
Mar. 25, 1959

George W. Mitchell

Chicago

Aug. 31, 1961

J. Dewey Daane
Sherman J. Maisel
Andrew F. Brimmer
William W. Sherrill

Richmond
San Francisco
Philadelphia
Dallas

Nov. 29, 1963
Apr. 30, 1965
Mar. 9, 1966
May 1, 1967

Arthur F. Burns

New York

Jan. 31, 1970

John E. Sheehan
Jeffrey M. Bucher
Robert C. Holland
Henry C. Wallich
Philip E. Coldwell
Philip C. Jackson, Jr.
J. Charles Partee
Stephen S. Gardner
David M. Lilly
G. William Miller
Nancy H. Teeters
Emmett J. Rice
Frederick H. Schultz
Paul A. Volcker
Lyle E. Gramley
Preston Martin
Martha R. Seger
Wayne D. Angell
Manuel H. Johnson
H. Robert Heller
Edward W.Kelley, Jr.
Alan Greenspan
John P. LaWare
David W. Mullins, Jr.
Lawrence B. Lindsey
Susan M. Phillips
Alan S. Blinder
Janet L. Yellen
Laurence H. Meyer
Alice M. Rivlin
Roger W. Ferguson, Jr.
Edward M. Gramlich
Susan S. Bies
Mark W. Olson

St. Louis
San Francisco
Kansas City
Boston
Dallas
Atlanta
Richmond
Philadelphia
Minneapolis
San Francisco
Chicago
New York
Atlanta
Philadelphia
Kansas City
San Francisco
Chicago
Kansas City
Richmond
San Francisco
Dallas
New York
Boston
St. Louis
Richmond
Chicago
Philadelphia
San Francisco
St. Louis
Philadelphia
Boston
Richmond
Chicago
Minneapolis

Jan. 4, 1972
June 5, 1972
June 11, 1973
Mar. 8, 1974
Oct. 29, 1974
July 14, 1975
Jan. 5, 1976
Feb. 13, 1976
June 1, 1976
Mar. 8, 1978
Sept. 18, 1978
June 20, 1979
July 27, 1979
Aug. 6, 1979
May 28, 1980
Mar. 31, 1982
July 2, 1984
Feb. 7, 1986
Feb. 7, 1986
Aug. 19, 1986
May 26, 1987
Aug. 11, 1987
Aug. 15, 1988
May 21, 1990
Nov. 26, 1991
Dec. 2, 1991
June 27, 1994
Aug. 12, 1994
June 24, 1996
June 25, 1996 Resigned July 16, 1999.
Nov. 5, 1997
Reappointed in 2001.
Nov. 5, 1997
Dec. 7, 2001
Dec. 7, 2001

Name

NOTE. Under the original Federal Reserve Act, the
Federal Reserve Board was composed of five appointed
members, the Secretary of the Treasury (ex-officio chairman of the Board), and the Comptroller of the Currency.
The original term of office was ten years; the five original
appointed members had terms of two, four, six, eight, and
ten years. In 1922 the number of appointed members was
increased to six, and in 1933 the term of office was raised




Other dates1

Retired Apr. 30, 1967.
Reappointed in 1960. Resigned Sept. 18,
1963.
Reappointed in 1962. Served until
Feb. 13, 1976.2
Served until Mar. 8, 1974.2
Served through May 31, 1972.
Resigned Aug. 31, 1974.
Reappointed in 1968. Resigned Nov. 15,
1971.
Term began Feb. 1, 1970. Resigned
Mar. 31, 1978.
Resigned June 1, 1975.
Resigned Jan. 2, 1976.
Resigned May 15, 1976.
Resigned Dec. 15, 1986.
Served through Feb. 29, 1980.
Resigned Nov. 17, 1978.
Served until Feb. 7, 1986.2
Died Nov. 19, 1978.
Resigned Feb. 24, 1978.
Resigned Aug. 6, 1979.
Served through June 27, 1984.
Resigned Dec. 31, 1986.
Served through Feb. 11, 1982.
Resigned August 11, 1987.
Resigned Sept. 1, 1985.
Resigned April 30, 1986.
Resigned March 11, 1991.
Served through Feb. 9, 1994.
Resigned August 3, 1990.
Resigned July 31, 1989.
Resigned Dec. 31,2001.
Reappointed in 1992.
Resigned April 30, 1995.
Resigned Feb. 14, 1994.
Resigned Feb. 5, 1997.
Served through June 30, 1998.
Term expired Jan. 31, 1996.
Resigned Feb. 17, 1997.

to twelve years. The Banking Act of 1935 changed the
name to the Board of Governors of the Federal Reserve
System and provided that the Board be composed of
seven appointed members; that the Secretary of the Treasury and the Comptroller of the Currency continue to
serve until Feb. 1, 1936; that the appointed members in
office on Aug. 23, 1935, continue to serve until Feb. 1,
1936, or until their successors were appointed and had

336 88th Annual Report, 2001
CHAIRMEN 3
Charles S. Hamlin
W.P.G. Harding
Daniel R. Crissinger
Roy A. Young
Eugene Meyer
Eugene R. Black
Marriner S. Eccles
Thomas B. McCabe
Wm. McC. Martin, Jr.
Arthur F. Burns
G.William Miller
Paul A. Volcker
Alan Greenspan

Aug. 10, 1914-Aug. 9, 1916
Aug. 10, 1916-Aug. 9, 1922
May 1,1923-Sept. 15,1927
Oct. 4, 1927-Aug.31,1930
Sept. 16,1930-May 10, 1933
May 19,1933-Aug. 15, 1934
Nov. 15, 1934-Jan. 31, 19484
Apr. 15, 1948-Mar. 31, 1951
Apr. 2,1951-Jan.31, 1970
Feb. 1,1970-Jan. 31, 1978
Mar. 8, 1978-Aug. 6, 1979
Aug. 6,1979-Aug. 11, 1987
Aug. 11, 1987- 5

VICE CHAIRMEN 3
Frederic A. Delano
Paul M. Warburg
Albert Strauss
Edmund Platt
J.J. Thomas
Ronald Ransom
C. Canby Balderston
J.L. Robertson
George W. Mitchell
Stephen S. Gardner
Frederick H. Schultz
Preston Martin
Manuel H. Johnson
David W. Mullins, Jr.
Alan S. Blinder
Alice M. Rivlin
Roger W. Ferguson, Jr.

Aug. 10,1914-Aug. 9,1916
Aug. 10,1916-Aug. 9, 1918
Oct. 26, 1918-Mar. 15, 1920
July 23,1920-Sept. 14,1930
Aug. 21,1934-Feb. 10,1936
Aug. 6, 1936-Dec. 2,1947
Mar. 11, 1955-Feb. 28, 1966
Mar. 1,1966-Apr. 30,1973
May 1,1973-Feb. 13, 1976
Feb. 13, 1976-Nov. 19, 1978
July 27,1979-Feb. 11,1982
Mar. 31, 1982-Apr. 30, 1986
Aug. 4, 1986-Aug. 3, 1990
July 24, 1991-Feb. 14, 1994
June 27, 1994-Jan. 31, 1996
June 25, 1996-July 16, 1999
Oct. 5, 1999-

Ex-Officio Members
SECRETARIES OF THE TREASURY
Dec. 23, 1913-Dec. 15, 1918
W.G. McAdoo
Carter Glass
Dec. 16,1918-Feb. 1, 1920
David F. Houston
Feb. 2,1920-Mar. 3,1921
Andrew W. Mellon
Mar. 4, 1921-Feb. 12, 1932
Ogden L. Mills
Feb. 12, 1932-Mar. 4, 1933
William H. Woodin
Mar. 4,1933-Dec. 31,1933
Henry Morgenthau, Jr. Jan. 1, 1934-Feb. 1,1936

COMPTROLLERS OF THE CURRENCY
John Skelton Williams
Daniel R. Crissinger
Henry M. Dawes
Joseph W. Mclntosh
J.W. Pole
J.F.T. O'Connor

Feb. 2,1914-Mar. 2,1921
Mar. 17,1921-Apr. 30,1923
May 1, 1923-Dec. 17, 1924
Dec. 20, 1924-Nov. 20, 1928
Nov. 21, 1928-Sept. 20, 1932
May 11,1933-Feb. 1, 1936

qualified; and that thereafter the terms of members be
fourteen years and that the designation of Chairman and
Vice Chairman of the Board be for four years.
1. Date following "Resigned" and "Retired" denotes
final day of service.
2. Successor took office on this date.




3. Before Aug. 23, 1935, Chairmen and Vice Chairmen were designated Governor and Vice Governor.
4. Served as Chairman Pro Tempore from February 3,
1948, to April 15,1948.
5. Served as Chairman Pro Tempore from March 3,
1996, to June 20,1996.

Statistical Tables




338 88th Annual Report, 2001
1. Statement of Condition of the Federal Reserve Banks,
by Bank, December 31, 2001 and 2000
Millions of dollars
Total

Boston

Item
2001

2000

11,045
2,200
1,047

11,046
2,200
949

34
0

110
0

2001

2000

ASSETS

Gold certificate account
Special drawing rights certificate account
Coin
Loans
To depository institutions
Other
Securities purchased under agreements
to resell (triparty)

546
115
54

535
115
46

50,250

43,375

Federal agency obligations
Bought outright
Held under repurchase agreements

10
0

130
0

1
0

7
0

US. Treasury securities
Bought outright1
Held under repurchase agreements
Total loans and securities

551,675
0
601,969

511,703
0
555,318

33,146
0
33,149

29,376
0
29,385

3,829
1,512

8,019
1,460

317
91

473
93

14,559
20,819

15,670
19,769

757
1,076

703
955

0

0

-2,362

2,782

656,980

614,431

33,743

35,088

611,757

563,450

31,806

31,891

17,478
6,645
61
828
25,012

19,045
5,149
216
1,390
25,800

626
0
2
40
668

1,645
0
1
63
1,709

3,131
2,395

7,225
4,165

283
149

521
249

42,295

600,640

32,906

34,371

7,373
7,312
0

6,997
6,794
0

418
418
0

358
358
0

656,980

614,431

33,743

35,088

751,540
139,783
611,757

751,714
188,264
563,450

35,614
3,808
31,806

36,707
4,816
31,891

11,045
2,200
0
598,512

11,046
2,200
0
550,205

611,757

563,450

Items in process of collection
Bank premises
Other assets
Denominated in foreign currencies 2
Other3
Interdistrict settlement account
Total assets
LIABILITIES

Federal Reserve notes
Deposits
Depository institutions
U.S. Treasury, general account
Foreign, official accounts
Other4
Total deposits
Deferred credit items
Other liabilities and accrued dividends5
Total liabilities
CAPITAL ACCOUNTS

Capital paid in
Surplus
Other capital accounts
Total liabilities and capital accounts
FEDERAL RESERVE NOTE STATEMENT

Federal Reserve notes outstanding (issued to Bank)
Less: Held by Bank
Federal Reserve notes, net
Collateral for Federal Reserve notes
Gold certificate account
Special drawing rights certificate account
Other eligible assets
U.S. Treasury and federal agency securities

DigitizedTotalFRASER
for collateral


Statistical Tables 339
1.—Continued

Philadelphia

N e w York
2001

2001

2000

Richmond

Cleveland

2000

2001

2000

2001

2000

4,451

4,428

874
63

874
74

454
83
44

414
83
52

538
104
61

520
104
67

741
147
165

750
147
117

0
0

0
0

0
0

2
0

0
0

0
0

1
0

5
0

50,250

43,375

4
0

50
0

0
0

5
0

1
0

7
0

1
0

8
0

225,984
0
276,239

197,518
0
240,944

22,659
0
22,660

21,313
0
21,320

32,298
0
32,298

28,635
0
28,643

32,957
0
32,958

30,038
0
30,051

473
177

893
166

526
49

384
51

218
152

282
154

174
132

658
128

3,099
9,787

3,230
8,577

481
810

486
769

996
1,087

1,083
964

3,544
1,231

4,121
1,689

-29,004

-3,255

-2,239

1,353

-2,008

2,260

13,211

2,402

266,158

255,930

22,868

24,911

33,448

34,078

52^4

40,063

251,766

240,061

21,773

23,114

30,620

31,183

45,208

34,048

3,092
6,645
37
447
10,221

4,570
5,149
192
646
10,556

413
0
1
29
443

702
0
1
46
749

1,103
0
2
30
1,135

1,249
0
2
112
1,363

3,191
0
7
70
3,269

1,641
0
8
42
1,691

381
782

943
1,435

100
110

404
188

224
139

349
239

109
205

683
283

263,150

252,995

22,425

24,456

32,118

33,134

48,790

36,706

1,504
1,504

1,468
1,468

221
221

228
228

665
665

472
472

0

0

0

0

0

0

1,757
1,757
0

1,679
1,679
0

266,158

255,930

22,868

24,911

33,448

34,078

52304

40,063

293,294
41,528
251,766

300,366
60,305
240,061

28,335
6,562
21,773

31,820
8,706
23,114

34,936
4,316
30,620

36,272
5,089
31,183

55,438
10,230
45,208

50,845
16,797
34,048




340 88th Annual Report, 2001
1. Statement of Condition of the Federal Reserve Banks,
by Bank, December 31, 2001 and 2000—Continued
Millions of dollars
Chicago

Atlanta
Item
2001

2001

2000

1,028
212
117

1,064
212
114

15
0

2000

25
0

ASSETS

Gold certificate account
Special drawing rights certificate account
Coin

871
166
113

802
166
83

Loans
To depository institutions
Other
Securities purchased under agreements
to resell (triparty)
Federal agency obligations
Bought outright
Held under repurchase agreements

1
0

9
0

1
0

16
0

US. Treasury securities
Bought outright1
Held under repurchase agreements
Total loans and securities

37,935
0
37,943

34,060
0
34,075

62,482
0
62,497

61,207
0
61,248

149
281

514
251

526
105

1,119
104

Other assets
Denominated in foreign currencies2
Other3

1,046
1,278

1,122
1,147

1,333
2,005

1,409
1,953

Interdistrict settlement account

7,088

4,499

6,071

-770

48,934

42,658

73,895

66,453

46,323

39,286

68,119

61,206

1,169
0
2
37
1,208

1,097
0
2
86
1,185

3,498
0
3
44
3,544

2,796
0
3
134
2,933

138
196

877
320

386
258

575
476

7,864

41,668

7238

65,190

535
535
0

495
495
0

793
793
0

632
632
0

48,934

42,658

73^95

66,453

Federal Reserve notes outstanding (issued to Bank)
Less: Held by Bank

65,085
18,763

60,948
21,662

74,543
6,424

70,685
9,479

Federal Reserve notes, net

46323

39086

68,119

61,206

Items in process of collection
Bank premises

Total assets
LIABILITIES

Federal Reserve notes
Deposits
Depository institutions
U.S. Treasury, general account
Foreign, official accounts
Other4
Total deposits
Deferred credit items
Other liabilities and accrued dividends5
Total liabilities
CAPITAL ACCOUNTS

Capital paid in
Surplus
Other capital accounts
Total liabilities and capital accounts
FEDERAL RESERVE NOTE STATEMENT

NOTE. Components may not sum to totals because of
rounding
1. Includes securities loaned—fully guaranteed