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'Report
N O 1998
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., May 1999
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-fifth annual report of the Board of Governors
of the Federal Reserve System.
This report covers operations of the Board during calendar year 1998.
Sincerely,
Contents
Part 1
3
Monetary Policy and Economic Developments
MONETARY POLICY AND THE ECONOMY IN 1998
9
9
12
14
17
19
20
22
28
32
37
ECONOMIC AND FINANCIAL DEVELOPMENTS IN 1998
The household sector
The business sector
The government sector
The external sector
The labor market
Prices
U.S. financial markets
Debt and the monetary aggregates
International developments
Foreign exchange operations
39
39
65
MONETARY POLICY REPORTS TO THE CONGRESS
Report on February 24, 1998
Report on July 21, 1998
Part 2
Records, Operations, and Organization
95 THE BOARD OF GOVERNORS AND THE GOVERNMENT PERFORMANCE
95
95
97
AND RESULTS ACT
Strategic and performance plans
Goals and objectives
Interagency coordination
99 RECORD OF POLICY ACTIONS OF THE BOARD OF GOVERNORS
99 Regulation B (Equal Credit Opportunity)
99 Regulation C (Home Mortgage Disclosure)
99 Regulation D (Reserve Requirements of Depository Institutions)
101 Regulation E (Electronic Fund Transfers)
RECORD OF POLICY ACTIONS OF THE BOARD OF GOVERNORS—Continued
101 Regulation H (Membership of State Banking Institutions in the Federal
Reserve System)
102 Regulation H and Regulation P (Security Procedures)
102 Regulation H and Regulation Y (Bank Holding Companies and
Change in Bank Control)
103 Regulation I (Issue and Cancellation of Federal Reserve Bank Capital Stock)
103 Regulation J (Collection of Checks and Other Items by Federal Reserve Banks) and
Regulation CC (Availability of Funds and Collection of Checks)
104 Regulation K (International Banking Operations)
104 Regulation M (Consumer Leasing)
104 Regulation Y (Bank Holding Companies and Change in Bank Control)
105 Regulation Z (Truth in Lending)
106 Regulation DD (Truth in Savings)
106 Rules Regarding Delegation of Authority
107 Policy statements and other actions
109 1998 discount rates
113
113
115
115
117
118
118
135
143
153
164
174
184
197
MINUTES OF FEDERAL OPEN MARKET COMMITTEE MEETINGS
Authorization for Domestic Open Market Operations
Domestic Policy Directive
Authorization for Foreign Currency Operations
Foreign Currency Directive
Procedural Instructions with Respect to Foreign Currency Operations
Meeting held on February 3-4, 1998
Meeting held on March 31, 1998
Meeting held on May 19, 1998
Meeting held on June 30-July 1, 1998
Meeting held on August 18, 1998
Meeting held on September 29, 1998
Meeting held on November 17, 1998
Meeting held on December 22, 1998
207 CONSUMER AND COMMUNITY AFFAIRS
207 Applications
209 TILA and RESPA reform
210 Regulatory matters
212 HMD A data and lending patterns
214 Fair lending
215 Community development
218 Economic effects of the Electronic Fund Transfer Act
219 Compliance
220 Community Reinvestment Act
220 Agency reports on compliance with consumer regulations
224 Consumer complaints
226 Consumer policies
228 Consumer Advisory Council
229 Testimony and legislative recommendations
230 Recommendations of other agencies
230 Year 2000 initiatives
231
231
232
232
LITIGATION
Judicial review of Board orders under the Bank Holding Company Act
Litigation under the Financial Institutions Supervisory Act
Other actions
235
235
235
236
236
236
237
237
LEGISLATION ENACTED
Consumer Reporting Employment Clarification Act
Credit Union Membership Access Act
Examination Parity and Year 2000 Readiness for Financial Institutions Act
Federal Employees Health Care Protection Act
Homeowners Protection Act
Money Laundering and Financial Crimes Strategy Act
U.S. Holocaust Assets Commission Act
239
240
241
250
261
262
264
268
BANKING SUPERVISION AND REGULATION
Scope of responsibilities for banking supervision and regulation
Supervision for safety and soundness
Supervisory policy
Supervisory information technology
Staff training
Regulation of the U.S. banking structure
Recent regulatory changes
268
271
BANKING SUPERVISION AND REGULATION—Continued
Enforcement of other laws and regulations
Federal Reserve membership
273
273
274
274
REGULATORY SIMPLIFICATION
Comprehensive revisions adopted
Other revisions adopted
Comprehensive revisions proposed
275 FEDERAL RESERVE BANKS
275 Century date change
275 Developments in Federal Reserve priced services
281 Developments in currency and coin
282 Developments in fiscal agency and government depository services
287 Information technology
288 Financial examinations of Federal Reserve Banks
288 Income and expenses
289 Holdings of securities and loans
290 Volume of operations
290 Federal Reserve Bank premises
291 Pro forma financial statements for Federal Reserve priced services
295
FEDERAL RESERVE BANKS COMBINED FINANCIAL STATEMENTS
307
BOARD OF GOVERNORS FINANCIAL STATEMENTS
315
316
STATISTICAL TABLES
1. Statement of condition of each Federal Reserve Bank,
December 31, 1998 and 1997
2. Federal Reserve open market transactions, 1998
3. Federal Reserve Bank holdings of U.S. Treasury and federal agency securities,
December 31, 1996-98
4. Number and annual salaries of officers and employees of Federal Reserve Banks,
December 31, 1998
5. Income and expenses of Federal Reserve Banks, 1998
6. Income and expenses of Federal Reserve Banks, 1914-98
7. Acquisition costs and net book value of premises of Federal Reserve
Banks and Branches, December 31, 1998
8. Operations in principal departments of Federal Reserve Banks, 1995-98
9. Federal Reserve Bank interest rates on loans to depository institutions,
December 31, 1998
320
322
323
324
328
332
333
334
335
336
337
338
344
345
STATISTICAL TABLES—Continued
10. Reserve requirements of depository institutions, December 31, 1998
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, 1998 and 1997
13. Reserves of depository institutions, Federal Reserve Bank credit,
and related items—year-end 1918-98 and month-end 1998
14. Banking offices, and banks affiliated with bank holding companies
in the United States, December 31, 1997 and 1998
15. Mergers, consolidations, and acquisitions of assets or assumptions
of liabilities approved by the Board of Governors, 1998
365 FEDERAL RESERVE DIRECTORIES AND MEETINGS
366 Board of Governors of the Federal Reserve System
368 Federal Open Market Committee
369 Federal Advisory Council
370 Consumer Advisory Council
371 Thrift Institutions Advisory Council
372 Officers of Federal Reserve Banks and Branches
374 Conferences of chairmen, presidents, and first vice presidents
374 Directors
395
MAPS OF THE FEDERAL RESERVE SYSTEM
399
INDEX
Parti
Monetary Policy and
Economic Developments
Monetary Policy and the Economy in 1998
In 1998, the U.S. economy again performed impressively. Output expanded
rapidly, the unemployment rate fell to
its lowest level since 1970, and inflation
remained subdued. Transitory factors,
most recently falling prices for imports
and commodities, especially oil, have
helped produce the favorable outcomes
of recent years, but technological advances and increased efficiency, likely
reflecting in part heightened global competition and changes in business practices, suggest that some of the improvement will be more lasting.
Sound fiscal and monetary policies
have contributed importantly to the good
economic results of recent years: Budgetary restraint at the federal level has
bolstered national saving and permitted
the Federal Reserve to maintain lower
interest rates than would otherwise have
been possible. This policy mix and sustained progress toward price stability
have fostered clearer price signals, more
efficient resource use, robust business
investment, and sizable advances in the
productivity of labor and the real wages
of workers. The more rapid expansion
of productive potential has, in turn,
helped keep inflation low even as aggregate demand surged and labor markets
tightened.
Nonetheless, economic troubles
abroad posed a significant threat to the
economy's performance in 1998. Foreign economic growth slowed markedly,
NOTE. The discussion here and in the next
chapter is adapted from Monetary Policy Report to
the Congress pursuant to the Full Employment
and Balanced Growth Act of 1978 (Board of Governors, February 1999). The data cited in these
two chapters are those available as of mid-March
1999.
on average, as conditions in many countries deteriorated. The recession in
Japan deepened, and several emerging market economies in Asia, which
had started to weaken in the wake of
the financial crises of 1997, contracted
sharply. A worsening economic situation in Russia during the summer led to
a devaluation of the ruble and a moratorium by that country on a substantial
portion of its debt payments. As the year
progressed, conditions in Latin America
also weakened. Although some of the
troubled foreign economies were showing signs of improvement by the end of
the year, others either were not yet in
recovery or were still contracting.
The Russian crisis in mid-August precipitated a period of unusual volatility in
world financial markets. The losses
incurred in Russia and other emerging
market economies heightened investors'
and lenders' concerns about other potential problems and led them to become
substantially more cautious about taking
on risk. The resulting effects on U.S.
financial markets included a substantial
widening of risk spreads on debt instruments, a jump in measures of market
uncertainty and volatility, a drop in
equity prices, and a reduction in the
liquidity of many markets. To cushion
the U.S. economy from the effects of
financial strains here and abroad, and
potentially to help reduce the strains as
well, the Federal Reserve eased monetary policy on three occasions in the
fall. Global financial market stresses
lessened somewhat after mid-autumn,
reflecting, in part, these policy steps as
well as interest rate cuts in other industrial countries and international efforts
to provide support to troubled emerg-
85th Annual Report, 1998
ing market economies. Although some
U.S. financial flows were disrupted for
a time, most firms and households
remained able to obtain sufficient credit,
and the turbulence did not appear to
constrain spending significantly.
The foreign exchange value of the
dollar rose substantially against the currencies of the major foreign industrial
countries over the first eight months of
1998, but it subsequently fell sharply,
ending the year down a little on net. The
dollar's appreciation in the first half of
the year carried it to an eight-year high
against the Japanese yen. In June, this
strength prompted the first U.S. foreign exchange intervention operation
in nearly three years, an action that
appeared to slow the dollar's rise against
the yen over the following weeks. Later
in the summer, concerns about the possible impact on the U.S. economy of
increasing difficulties in Latin America
began to weigh on the dollar's exchange
value against major foreign currencies.
After peaking in mid-August, it fell
sharply over the course of several
weeks, reversing by mid-October the
appreciation that had occurred earlier in
the year. The depreciation during this
period was particularly sharp against the
yen. The reasons for this decline against
the yen are not clear, but repayment of
yen-denominated loans by international
investors and decisions by Japanese
investors to repatriate their assets in
light of increased volatility in global
markets seem to have contributed. The
dollar's exchange value fluctuated moderately against the major currencies over
the rest of the year. At year-end, the
launch of the third stage of European
Economic and Monetary Union fixed
the eleven participating countries' conversion rates and created a new common
currency, the euro.
With the U.S. economy expanding
rapidly, the economies of many U.S.
trading partners struggling, and the foreign exchange value of the dollar having
risen over 1997 and the first part of
1998, the U.S. trade deficit widened considerably in 1998. Some domestic industries were especially affected by lower
foreign demand or increased competition from imports. For example, a wide
range of commodity producers, notably
those in agriculture, oil, and metals,
experienced sharp price declines. Parts
of the manufacturing sector also suffered adverse consequences from the
shocks from abroad. Overall, real net
exports deteriorated sharply, as exports
stagnated and imports continued to
surge. The deterioration was particularly
marked in the first half of the year; the
second half brought a further, more
modest, net widening of the external
deficit.
Meanwhile, domestic spending continued to advance rapidly. Household
expenditures were bolstered by gains in
real income and a further rise in wealth,
while a low cost of capital and optimism
about future profitability spurred businesses to invest heavily in new capital
equipment. Although securities markets
were disrupted in late summer and early
fall, credit generally remained available
from alternative sources. Once the
strains on securities markets had eased,
businesses and households generally had
ready access to credit and other sources
of finance on relatively favorable terms,
although spreads in some markets
remained quite elevated, especially for
lower-rated borrowers. All told, household and business outlays rose even
more rapidly than in 1997, and that
acceleration kept the growth of real
GDP strong even as net exports were
slumping.
Deteriorating economic conditions
abroad, coupled with the strength of the
dollar over the first eight months of the
year, helped hold down inflation in
Monetary Policy and the Economy
the United States by trimming the prices
of oil and other imports. These declines
reduced both the prices paid by consumers and the costs of production in many
lines of business, and the competition
from abroad kept businesses from raising prices as much as they might have
otherwise. As a result of the reduced
rate of price inflation, workers enjoyed a
larger rise in real purchasing power even
as increases in nominal hourly compensation picked up only slightly on average. Because of increased gains in productivity, corporations in the aggregate
were able to absorb the larger real pay
increases without suffering a serious
diminution of profitability.
Monetary policy in 1998 needed to
balance two major risks to the economic
expansion. On the one hand, with the
domestic economy displaying considerable momentum and labor markets tight,
the Federal Open Market Committee
(FOMC) was concerned about the possible emergence of imbalances that
would lead to higher inflation and
thereby, eventually, put the sustainability of the expansion at risk. On the other
Selected Interest Rates
Percent
I i i
1997
1998
NOTE. The data are daily. Short ticks indicate days on
which the Federal Open Market Committee held a scheduled meeting or a policy action was announced. Vertical
lines mark days on which policy actions were announced:
March 25, 1997; and September 29, October 15, and
November 17, 1998.
hand, troubles in many foreign economies and resulting financial turmoil both
abroad and at home seemed, at times, to
raise the risk of an excessive weakening
of aggregate demand.
Over the first seven months of the
year, neither of these potential tendencies was sufficiently dominant to prompt
a policy action by the FOMC. Although
the incoming data gave no evidence of a
sustained slowing of output growth, the
Committee members believed that the
pace of expansion would likely moderate as businesses began to slow the rapid
rates at which they had been adding
to their stocks of inventories and other
investment goods, and as households
trimmed the large advances in their
spending on homes and consumer durable goods. Relatively firm real interest
rates, buoyed by a high real federal
funds rate resulting from the decline in
the level of expected inflation, were
thought likely to help restrain the growth
of spending by businesses and households. Another check on growth was
expected to come from the effects on
imports and exports of the economic
difficulties in emerging market economies in Asia and elsewhere. Indeed,
production in the manufacturing sector
slowed substantially in the first half
of the year, and capacity utilization
dropped noticeably. Moreover, inflation
remained subdued, and a pickup was not
expected in the near-to-intermediate
term because of declining oil prices
and because economic weakness abroad
and the appreciation of the dollar were
expected to trim the prices of imported
goods and to increase price competition for many U.S. producers. Nonetheless, with labor markets already quite
taut and aggregate demand growing
rapidly—a combination that often has
signaled the impending buildup of inflationary pressures—the Committee, at its
meetings from March through July,
85th Annual Report, 1998
judged conditions to be such that, if a
policy action were to be taken in the
period immediately ahead, it more likely
would be a tightening than an easing; its
directives to the Account Manager of
the Domestic Trading Desk at the Federal Reserve Bank of New York noted
that asymmetry.
By the time of the August FOMC
meeting, however, the situation was
changing. Although tight labor markets
and rapid output growth continued to
pose a risk of higher inflation, the damping influence of foreign economic developments on the U.S. economy seemed
likely to increase. The contraction of
the emerging market economies in Asia
appeared to be deeper than had been
anticipated, and the economic situation
in Japan had deteriorated. Financial
markets in some foreign economies also
had experienced greater turmoil, and,
the day before the Committee met,
Russia was forced to devalue the ruble.
These difficulties had been weighing
on U.S. asset markets. Stock prices had
fallen sharply in late July and into
August as investors became concerned
about the outlook for profits, and risk
spreads in debt markets had widened,
albeit from very low levels. Taking
account of these circumstances, the
Committee again left monetary policy
unchanged at the August meeting, but
it shifted to a symmetric directive,
reflecting its perception that the risks
to the economic outlook, at prevailing
short-term rates, had become roughly
balanced.
Over subsequent weeks, conditions in
financial markets and the economic outlook in many foreign countries deteriorated further, increasing the dangers
to the U.S. expansion. With investors
around the world apparently reevaluating the risks associated with various
credits and seemingly becoming less
willing or less able to bear such risks,
asset demands shifted toward safer and
more liquid instruments. These shifts
caused a sharp fall in yields on Treasury
securities. Spreads of yields on private debt securities over those on comparable Treasury instruments widened
considerably further, and issuance
slowed sharply. Measures of market
volatility increased, and liquidity in
many financial markets was curtailed.
Equity prices continued to slide lower,
with most broad indexes falling back by
early September to near their levels
at the start of the year. Reflecting the
weaker and more uncertain economic
outlook, some banks boosted interest
rate spreads and fees on new loans to
businesses and tightened their underwriting standards.
Against this backdrop, the FOMC at
its September meeting looked beyond
incoming data suggesting that the
economy was continuing to expand at a
robust pace, and it lowered the intended
level of the federal funds rate lA percentage point. The Committee noted that the
rate cut would cushion the effects on
prospective U.S. economic growth of
increasing weakness in foreign economies and of less accommodative conditions in domestic financial markets. The
directive adopted at the meeting suggested a bias toward further easing over
the intermeeting period. In the days following the policy move, disturbances in
financial markets worsened. Movements
in the prices of securities were exacerbated by a deterioration in market
liquidity, as some securities dealers cut
back on their market-making activities,
and by the increased anticipation of an
unwinding of positions by hedge funds
and other leveraged investors. In early
October, Treasury yields briefly tumbled to their lowest levels in many
years, reflecting efforts by investors to
exchange other instruments for riskless
and liquid Treasury securities.
Monetary Policy and the Economy
Although some measures of market
turbulence had begun to ease a bit
by mid-October, financial markets
remained extremely volatile, and risk
spreads were very wide. On October 15,
consistent with the directive from the
September meeting, the intended federal
funds rate was trimmed another lA percentage point, to 5 percent. This policy
move, which occurred between FOMC
meetings, came at the initiative of Chairman Greenspan and followed a conference call with Committee members. At
the same time, the Board of Governors
approved a lA percentage point reduction in the discount rate. These actions
were taken to buffer the domestic economy from the impact of the less accommodative conditions in domestic
financial markets, perhaps in part by
contributing to some stabilization of the
financial situation.
Following the October policy move,
strains in domestic financial markets
diminished considerably. As safe-haven
demands for Treasury securities ebbed,
Treasury yields generally trended
higher, and measures of financial market
volatility and illiquidity eased. Nonetheless, risk spreads remained very wide,
and liquidity in many markets continued
to be limited. Moreover, although pressures on some emerging market econo-
1
mies had receded a bit, partly reflecting concerted international efforts to
provide assistance to Brazil, the foreign
economic outlook remained uncertain.
With downside risks still substantial,
and in light of the cumulative effect
since August of the tightening in many
credit markets and the weakening of
economic activity abroad, the FOMC
reduced the intended federal funds
rate a further lA percentage point at its
November meeting, bringing the total
reduction during the autumn to 3A percentage point. The Board of Governors
also approved a second lA percentage
point cut in the discount rate. The Committee believed that, with this policy
action, financial conditions could reasonably be expected to be consistent
with fostering sustained economic
expansion while keeping inflationary
pressures subdued. The action provided
some insurance against an unexpectedly
severe weakening of the expansion, and
the Committee therefore established a
symmetrical directive. By the time of
the December meeting, the situation in
financial markets had changed little, on
balance, and the Committee decided that
no further change in rates was desirable
and that the directive should remain
symmetrical.
•
Economic and Financial Developments in 1998
The U.S. economy continued to display
great vigor in 1998, despite a sharp
slowing of growth in foreign economies
and an unsettled world financial environment. Real GDP increased more
than 4 percent over the four quarters of
the year, according to the Commerce
Department's preliminary estimate. The
economic difficulties facing many U.S.
trading partners, together with the
strength of the dollar through much of
the year, led to sluggishness in real
exports of goods and services. However,
the drag on the economy from that
source was more than offset by exceptional strength in the real expenditures of households and businesses,
which were powered by strong real
income growth, large gains in the value
of household wealth, ready access to
finance during most of the year, and
widespread optimism about the future of
the economy. Although turmoil in financial markets seemed to threaten the
economy for a time in late summer and
early autumn, that threat later receded,
in part because of the steps taken by the
Federal Reserve to prevent the tightenChange in Real GDP
Percent, Q4 to Q4
1992
1994
1996
1998
NOTE. The data are based on chained (1992) dollars
and come from the Department of Commerce.
ing of credit markets from impairing the
expansion of activity. The final quarter
of the year brought brisk expansion of
employment and income.
The increase in the general price level
in 1998 was smaller than that of the
preceding year, which had itself been
among the smallest in decades. The
chain-type price index for GDP rose
slightly less than 1 percent. The further
slowing of price increases was in large
part a reflection of sluggish conditions
in the world economy, which brought
declines in the prices of many imported
goods, including oil and other primary
commodities. In the domestic economy,
the nominal hourly compensation of
workers picked up only slightly despite
the tightness of the labor market, and
much of the compensation increase was
offset by gains in labor productivity.
As a result, unit labor costs, the most
important item in total business costs,
rose only modestly.
The Household Sector
Personal consumption expenditures
increased more than 5 percent in real
terms in 1998, the largest gain in a
decade and a half. Support for the large
spending increase came from a combination of circumstances that, on the
whole, were exceptionally favorable
to households. Strong gains in employment and real hourly pay gave another
appreciable boost to the growth of real
labor income. At the same time, household wealth again rose substantially,
bolstered in large part by the continued
rise in equity prices. Household net
worth at the end of 1998 was up more
10
85th Annual Report, 1998
than 10 percent from the level at the end
of 1997. The cumulative gain in household wealth from year-end 1994 to yearend 1998 was nearly 50 percent.
The rise in net worth probably
accounts for much of the decline in the
personal saving rate over the past few
years, to an annual average of Vi percent
in 1998. Households tend to increase
their saving from current income when
they feel that they must increase their
wealth to meet their longer-run objectives, but they are willing to reduce their
saving from current income when they
feel that their wealth is already at satisfactory levels. The low level of the
saving rate in 1998 is not so remarkable when gauged against a wealth-toincome ratio that has been running in a
range well above its longer-run historical average.
Personal consumption expenditures
in all three major categories—-durables,
nondurables, and services—recorded
gains in 1998 that were the largest of
the 1990s. Spending on durable goods
rose more than 12 percent over the year.
Within that category, expenditures on
home computers once again stood out,
rising nearly 75 percent in real terms, a
gain that reflected both an increase in
nominal outlays and a further substantial decline in computer prices. Consumer outlays on motor vehicles also
rose sharply, despite some temporary
limitations on supply from a midyear
strike at a major automaker. Spending
on most other types of durable goods
registered gains well above the average
annual increases of the past decade or
so. Because durable goods are not consumed all at once—but, rather, add to
stocks of such goods that will be yielding services to consumers for a number of years—they represent a form of
economic saving that is not captured in
the measure of the saving rate in the
national income accounts.
The increases in income and net
worth that led households to boost their
consumption expenditures in 1998 also
led them to invest heavily in additions to
the stock of housing. Declines in mortgage interest rates weighed in as well,
helping to maintain the affordability of
housing even as house prices moved up
somewhat faster than overall inflation.
These developments brought the objective of owning a home within the reach
of a greater number of households, and
the home-ownership rate, which has
been trending up over the decade, rose
to another new high.
In the single-family sector, sales of
new and existing homes surged, the
former rising more than 10 percent from
the preceding year and the latter about
13 percent. Construction of singlefamily houses strengthened markedly.
The number of units started during the
year was the largest since the late 1970s
and exceeded the 1997 total by about
12 percent. In the fourth quarter, unusually mild weather permitted builders to
maintain activity later into the season
than they normally would have and gave
an added kick to housing starts.
In contrast to the strength in the
single-family sector, the number of
multifamily units started in 1998 was
up only a little from 1997. After bottoming out at a very low level early in the
1990s, construction of these units had
been trending back up fairly briskly. But
with vacancy rates for multifamily rental
units running a touch higher in 1998,
builders and their creditors may have
become concerned about adding too
many new units to the stock. Financing
appeared generally to be in ample supply for promising projects; during the
period of financial turmoil, the flow
of credit was supported by substantial
purchases of multifamily mortgages and
mortgage-backed securities by Freddie
Mac and Fannie Mae.
Economic and Financial Developments
Total outlays for residential investment increased about \23A percent in
real terms during 1998, according to the
Commerce Department's preliminary
tally. The large increase reflected not
only the construction work on new residential units undertaken during the year
but also sizable advances in real outlays
for home improvements and in the volume of sales activity being carried on by
real estate brokers, which generated substantial gains in commissions.
The robust growth in household
expenditures in 1998 was accompanied
by an expansion of household debt of
nearly 9 percent, a larger rise than in
other recent years. Nonmortgage debt
increased 5!/2 percent, about 1 percentage point above the preceding year's
pace but down considerably from the
double-digit increases of 1994 and 1995.
Home mortgage debt jumped nearly
10 percent, its largest annual advance
since 1989, boosted in part by the strong
housing market. In addition, with mortgage rates reaching their lowest levels
in many years, many households refinanced existing mortgages, and some
likely took the opportunity to increase
the size of their mortgages, using the
extra funds to finance current expenditures or to pay down other debts.
The growth in household debt reflected both supply and demand influences. With wealth rising faster than
income over the year and with consumer
confidence remaining at historically
high levels, households were willing
to boost their indebtedness to finance
increased spending. In addition, lenders
generally remained accommodative toward all but the most marginal households, even after the turmoil in many
financial markets in the fall. After a
more general tightening of loan conditions between mid-1996 and mid-1997
in response to a rise in losses on such
loans, a smaller and declining fraction
11
of banks tightened consumer lending
standards and terms in 1998, according
to Federal Reserve surveys. However,
the availability of high loan-to-value and
subprime home equity loans likely was
reduced in the fall because of difficulties
in the market for securities backed by
such loans.
Despite the rapid increase in debt,
measures of household financial stress
were relatively stable in 1998, although
some remained at high levels. The delinquency rate for home mortgages has
stayed quite low in recent years, and
that for auto loans at domestic auto
finance companies has trended lower.
The delinquency rate for credit card
loans at banks fluctuated in a fairly
narrow range in 1997 and 1998, but it
remained elevated after having risen
substantially over the previous two
years. Personal bankruptcy filings have
followed a broadly similar pattern:
Growth ran at about a 3 percent annual
rate, on average, from the spring of 1997
to the autumn of 1998, down from
annual increases of roughly 25 percent
between early 1995 and early 1997. The
stability of these measures over the past
couple of years is likely due in part to
the earlier tightening of standards and
Delinquency Rates on Household Loans
Percent
Credit card accounts
at banks
Auto loans at domestic
auto finance companies
1988
1990
1992
1994
1996
1998
NOTE. The data are quarterly. Data on credit card
delinquencies are from bank Call Reports; data on auto
loan delinquencies are from the Big Three automakers;
data on mortgage delinquencies are from the Mortgage
Bankers Association and are through 1998:Q3.
12
85th Annual Report, 1998
terms on consumer loans. In addition,
lower interest rates and longer loan
maturities, which resulted from the shift
toward mortgage finance, have helped
mitigate the effects of increased borrowing on household debt-service burdens.
The Business Sector
Business fixed investment increased
about 12'/4 percent over 1998, with a
17 percent rise in equipment spending
accounting for the entire advance. The
strength of the economy and optimism
about its longer-run prospects provided
underpinnings for increased investment.
Outlays were also bolstered by the efficiencies obtainable with new technologies, by the favorable prices at which
many types of capital equipment could
be purchased, and, except during the
period of financial market turmoil, by
the ready availability and low cost of
finance, either through borrowing or
through the issuance of equity shares.
Real expenditures on office and computing equipment, after having risen at
an average rate of roughly 30 percent
in real terms from 1991 through 1997,
shifted into even higher gear in 1998,
climbing about 65 percent. The outsized
increase was likely due in part to the
efforts of some businesses to put new
computer systems in place before the
end of the millennium, in hopes of
avoiding difficulties associated with the
Y2K problem. Beyond that, investment
in computers was driven by the same
factors that have been at work throughout the expansion—namely, the introduction of machines that offer greater
computing power at increasingly attractive prices and that provide businesses
new and more efficient ways of organizing their operations. Price declines in
1998 were especially large because the
cost reductions associated with technical change were augmented by height-
ened international competition in the
markets for semiconductors and other
computer components and by price cutting to work down the stocks of some
assembled products.
Investment
in
communications
equipment—another high-tech category
that is an increasingly important part
of total equipment outlays—rose about
18 percent in 1998. After having traced
out an erratic pattern of ups and downs
through the latter part of the 1980s and
the early 1990s, real outlays for this
type of equipment began to record sustained large annual increases in 1994,
and the advance in 1998 was one of
the largest. Spending on other types of
equipment displayed varying degrees
of strength across different sectors but
recorded a sizable gain overall. Investment in transportation equipment was
strong across the board, spurred by the
need to move greater volumes of goods
or to carry more passengers in an
expanding economy. Spending on industrial machinery advanced about 4lA percent after having made larger gains in
most previous years of the expansion, a
pattern that mirrored a slowing of output
growth in the industrial sector.
Business investment in nonresidential
structures, which accounts for slightly
more than 20 percent of total business
fixed investment, was unchanged in
1998, according to the preliminary estimate. Sharply divergent trends were evident within nonresidential construction,
ranging from considerable strength in
the construction of office buildings to
marked weakness in the construction of
industrial buildings. The waxing and
waning of industry-specific construction
cycles appears to be the main explanation for the diverse outcomes of 1998.
Although some of the more-speculative
construction plans may have been
shelved because of a tightening of
lending terms and standards, partly in
Economic and Financial Developments
reaction to the financial turmoil, most
builders appear to have been able to
eventually obtain financing. Despite the
sluggishness of spending on structures,
the level of investment remained high
enough in 1998 to generate continued
moderate growth in the real stock of
structures.
Business inventories increased about
4!/2 percent in real terms in 1998 after
having risen more than 5 percent in
1997. Stocks grew at a 7 percent annual
rate in the first quarter, appreciably
faster than final sales, but inventory
growth over the remainder of the year
was considerably slower than in the first
quarter. At year-end, stocks in most nonfarm industries were at levels that did
not seem likely to cause firms to restrain
production going forward. Inventories
of vehicles may even have been a little
on the lean side, as a result of both a
strike that held down assemblies through
the middle part of the year and exceptionally strong demand, which prevented
the rebuilding of stocks later in the year.
By contrast, year-end inventories appear
to have been excessive in a few nonfarm
industries that have been hurt by the
sluggish world economy. Stocks of farm
commodities also appear to have been
excessive, having been boosted further
during the year by large harvests and
sluggish export demand.
The economic profits of U.S.
corporations—that is, book profits
adjusted so that inventories and fixed
capital are valued at their current
replacement cost—rose further, on net,
over the first three quarters of 1998, but
at a much slower pace than in most
other years of the current expansion.
Companies' earnings from operations in
the rest of the world fell back a bit, as
did the profits of private financial corporations from domestic operations. The
profits of nonfinancial corporations
from domestic operations increased at
13
an annual rate of about 13A percent.
Although the volume of output of the
nonfinancial companies continued to
rise rapidly, profits per unit of output
were squeezed a bit by companies' difficulties in raising prices in step with costs
in a competitive market environment.
With profits expanding more slowly
and investment spending still on the
upswing, businesses' external funding
needs increased substantially in 1998.
Aggregate debt of the nonfinancial business sector expanded 9!A percent from
the end of 1997 to the end of 1998, the
largest increase in ten years. The rise
reflected growth in all major types of
business debt. Business borrowing was
also boosted by substantial merger and
acquisition activity. Indeed, mergers and
acquisitions, share repurchases, and foreign purchases of U.S. firms in 1998
overwhelmed the high level of both initial and seasoned public equity issues,
and net equity retirements exceeded
$260 billion.
The financial market disruptions in
late summer and early fall appear to
have had little effect on total business
borrowing but prompted a substantial
temporary shift in the sources of credit.
With investors favoring high credit quality and liquidity, yields on lower-rated
corporate bonds rose despite declining
Treasury rates; the spread of yields on
junk bonds over those on comparable
Treasury securities roughly doubled
between mid-summer and mid-autumn
before falling back somewhat as conditions in financial markets eased. The
spread of rates on lower-tier commercial
paper over those on higher-quality paper
rose substantially during the fall but
retraced much of the rise by year-end.
Reflecting these adverse market conditions, nonfinancial corporate bond
issuance fell sharply in August and
remained low through mid-October,
with issuance of junk bonds virtually
14
85 th Annual Report, 1998
halted for a time. Commercial paper
issuance rose sharply in August and
September, as some firms apparently
decided to delay bond issues, turning
temporarily to the commercial paper
market instead. Bond issuance picked
up again in late October, however,
and issuance was extremely heavy in
November and remained strong in
December. In conjunction with this
rebound, commercial paper outstanding
fell back in the fourth quarter.
During the period when financial markets were strained, some borrowers
substituted bank loans—in some cases
under credit lines priced before the markets became volatile—for other sources
of credit, and business loans at banks
expanded very rapidly for a time before
tailing off late in the year. Federal
Reserve surveys indicate that banks
responded to the financial market turmoil by tightening their standards and
terms on new loans and credit lines,
especially on loans to larger customers
and those to finance commercial real
estate ventures; the tightening reflected
the less favorable or more uncertain economic outlook as well as a reduced
tolerance for risk at some banks.
Nonfinancial businesses remained
strong financially in 1998 despite the
Net Interest Payments of Nonfinancial
Corporations Relative to Cash Flow
Percent
I i I
11
1978
1983
i i
1988
1993
I I I 1
1998
NOTE. The data are quarterly and are through 1998:Q3.
rapid growth of debt and the relatively
small gain in profits. Interest rates for
many businesses fell, on balance, over
the year, and bond yields for investmentgrade firms reached their lowest level in
many years. Reflecting these low borrowing costs, the aggregate debt-service
burden for nonfinancial corporations,
measured as the ratio of net interest
payments to cash flow, remained about
9Vi percent, near its low of 9 percent in
1997 and less than half the peak level
reached in 1989. The delinquency rate
for commercial and industrial loans
extended by banks rose a bit from
the trough reached in late 1997 but
remained quite low, while that for commercial real estate loans fell a bit further, on net, from the already very low
level posted in 1997. Although Moody's
Investors Service downgraded more
nonfinancial firms than it upgraded over
the second half of the year, the downgraded firms were smaller on average,
so the debt of those upgraded about
equaled the debt of those downgraded.
Through November, business failures
remained at the low end of the range
seen over the past decade.
The Government Sector
In fiscal year 1998 the federal government recorded a surplus in the unified
budget for the first time in nearly three
decades. The surplus, amounting to
$69 billion, was equal to about 3A percent of GDP, a huge turnabout from the
deficits of the early 1990s, which in
some years were more than 4Vi percent
of GDP. The swing from deficit to surplus over the past few years was a result
partly of fiscal policies aimed at lowering the deficit and partly of the strength
of the economy and the stock market.
Excluding net interest payments—a
charge stemming from past deficits—the
Economic and Financial Developments
government recorded a surplus of more
than $300 billion in fiscal 1998.
Because of the improvement in
the government's saving position,
national saving—the combined gross
saving of households, businesses, and
governments—increased about 3 percentage points as a share of GDP from
1993 to 1998, even though the personal
saving rate was down sharply. The
increase in national saving over that
period helped facilitate the boom in
investment spending—in contrast to the
1980s and early 1990s, when persistent
large budget deficits tended to reduce
national saving, boost interest rates
higher than they otherwise would have
been, and thereby crowd out private
capital formation.
Federal receipts in the unified budget
in fiscal year 1998 were up 9 percent
from fiscal year 1997, with much of the
gain attributable to personal income tax
receipts, which rose more than 12 percent for a second consecutive year.
These receipts have been rising faster
than personal income in recent years, for
several reasons: Rates for high-income
taxpayers were raised by 1993 legislation intended to help reduce the deficit;
more taxpayers have moved into higher
brackets as their incomes have increased; and large increases in asset values have raised tax receipts from capital
gains. Social insurance tax receipts, the
second most important source of federal
revenue, increased 6 percent in fiscal
1998, just a touch more than the fiscal
1997 increase and roughly in step with
wage and salary growth. Receipts from
the taxes on corporate profits, which
account for about 10 percent of federal
revenues, rose less rapidly than in other
recent years, restrained by the slower
growth of corporate profits. In the first
three months of fiscal 1999, net receipts
from corporate taxes dipped below yearearlier levels, but gains in individual
15
income taxes and payroll taxes kept total federal receipts on a rising trajectory.
Unified outlays increased 3V4 percent
in fiscal year 1998 after having risen
2!/2 percent in fiscal 1997. Net interest
payments and nominal expenditures for
defense fell slightly, and outlays for
income security and Medicare rose only
a little; social security expenditures
increased moderately but somewhat less
than in other recent fiscal years. By contrast, the growth of Medicaid payments
picked up to about 6 percent after having increased less than 4 percent in each
of the preceding two fiscal years; however, even the fiscal 1998 rise was not
large compared with those in many earlier fiscal years when both medical costs
and Medicaid caseloads were increasing
rapidly and rates of federal reimbursement to the states were being raised.
Emergency legislation that was passed
in 1998, in an exception to statutory
spending restrictions, will boost federal
spending for a variety of functions in
fiscal 1999, including defense, embassy
security, disaster relief, preparation for
Y2K, and aid to agriculture.
Real federal outlays for consumption and investment, the part of federal spending that is counted in GDP,
increased about 1 percent, on net, from
the final quarter of calendar year 1997 to
the final quarter of 1998. A reduction in
real defense outlays over that period was
more than offset by a jump in nondefense spending.
With the budget balance shifting from
deficit to surplus, the stock of publicly
held federal debt declined in 1998 for
the first time since 1969. From year-end
1997 to year-end 1998, U.S. government
debt fell 1 Vi percent as the outstanding
stock of both bills and coupon securities
was reduced. Despite this reduction in
debt, the federal government continued
substantial gross borrowing to fund the
retirement of maturing securities. With
16
85th Annual Report, 1998
the need for funds trimmed substantially, however, the Treasury changed
its auction schedules, discontinuing the
three-year note auctions and moving to
quarterly, rather than monthly, auctions
of five-year notes. By reducing the number of coupon security issues, the Treasury is able to boost the size of each,
thereby contributing to their liquidity.
The decrease in the total volume of
coupon securities is intended to boost
the size of bill offerings over time,
increasing liquidity in that market and
also allowing, as the Treasury prefers,
for balanced issuance across the yield
curve. The Treasury also announced in
October that all future bill and coupon
security auctions would employ the
single-price format that had already
been adopted for the two-year and fiveyear note auctions and for auctions of
inflation-indexed securities. The Treasury judged that the single-price format
had reduced servicing costs and resulted
in broader market participation.
The Treasury continued to auction
inflation-indexed securities in substantial volume in 1998 in an effort to build
up that part of the Treasury market. In
April, the Treasury issued its first thirtyyear indexed bond, and in September it
announced a regular schedule of tenand thirty-year indexed security auctions. The Treasury also began offering inflation-indexed savings bonds in
September.
State and local governments recorded
further increases in their budget surpluses in 1998, both in absolute terms
and as a share of GDP. Revenue from
the taxes on individuals' incomes has
been growing very rapidly, keeping total
receipts, on a solid upward course. At
the same time, the growth of transfer
payments, which had threatened to overwhelm state and local budgets earlier in
the decade, has slowed substantially in
recent years. The growth of other types
of spending has been trending up moderately, on balance. The 1998 rise in
real expenditures for consumption and
investment amounted to about 2lA percent, according to the preliminary estimate; the annual gain has been in the
range of 2 percent to 23A percent in each
of the past seven years.
Despite the rising surpluses, state
and local government debt increased
1XA percent in 1998, a pickup of about
2 percentage points from growth in
1997. Somewhat more than half of the
long-term borrowing by state and local
governments in 1998 reflected new borrowing to fund current and anticipated
capital spending on utilities, transportation, educational facilities, and other
capital projects. The combination of
budget surpluses and relatively heavy
borrowing likely reflected several factors. First, some of these governments
may have spent the newly raised funds
on capital projects while at the same
time building up surpluses in "rainy day
funds" for later use. Second, because
state and local governments under some
circumstances are allowed to hold funds
raised in the markets for as long as five
years before spending them, some of
the money raised in 1998 may not have
been spent. Finally, there was a substantial volume of "advance refunding" in
1998. In an advance refunding, the borrower issues new bonds before existing higher-rate bonds may be called,
in anticipation of calling the old bonds
when that option becomes available.
While this sort of refinancing temporarily boosts total debt, it allows the
government entity to lock in a lower rate
even if municipal bond yields rise over
the period before the call date. The high
level of advance-refunding activity in
1998 was the result of lower borrowing
costs. Although yields on tax-exempt
municipal securities did not decline
nearly as much as those on compa-
Economic and Financial Developments
rable Treasury securities, they nonetheless reached their lowest levels in
many years. In addition, rating agencies
upgraded about five times as many state
and local government issues as they
downgraded, trimming borrowing costs
further for the upgraded entities.
17
U.S. external balances deteriorated further in 1998, largely because of the disparity between the rapid growth of the
U.S. economy and the sluggish growth
of the economies of many U.S. trading
partners. The nominal trade deficit for
goods and services was $169 billion,
considerably larger than the $110 billion
deficit in 1997. At $233 billion, the
current account deficit was also substantially larger than the 1997 deficit of
$155 billion. The large current account
deficits of recent years have been funded
with increased net foreign saving in the
United States. As a result, U.S. gross
domestic investment has exceeded the
level that could have been financed by
gross national saving alone, but at
the cost of a rise in net U.S. external
indebtedness.
The increase in the current account
deficit in 1998 was due to a decline
in net exports of goods and services
as well as a further weakening of net
investment income from abroad. Until
1997, net investment income had partly
offset persistent trade deficits. But as
the U.S. net external debt has risen in
recent years, net investment income has
become increasingly negative, moving
from a $14 billion surplus in 1996 to a
$5 billion deficit in 1997 and reaching a
deficit of more than $22 billion in 1998.
Net income from portfolio investment
became increasingly negative during
that period as the net portfolio liability position of the United States grew
larger. In addition, net income from
direct investment declined in 1998 because slower foreign economic growth
lowered U.S. earnings on investment
abroad and the appreciation of the dollar
reduced the value of those earnings,
while healthy U.S. growth supported foreigners' earnings on direct investment
in the United States.
The rise of the trade deficit reflected
an increase of about 10 percent in real
imports of goods and services during
1998, according to the preliminary
estimate from the Commerce Department. The increase was fueled by robust
U.S. Current Account
Change in Real Imports and Exports
of Goods and Services
The External Sector
Trade and the Current Account
Billions of dollars
Percent, Q4 to Q4
LJ Imports
1992
1994
1996
1998
NOTE. The data are from the Department of Commerce.
1992
1994
1996
1998
NOTE. The data are from the Department of Commerce.
18
85 th Annual Report, 1998
growth of U.S. domestic demand and by
continued declines in import prices,
which stemmed in part from the strength
of the dollar through mid-August and
in part from the effects of recessions
abroad. Of the major trade categories,
increases in imports were sharpest for
finished goods, especially capital equipment and automotive products. The
quantity of imported oil rose appreciably as demand increased in response to
the strength of U.S. economic activity
and lower oil prices, while domestic
production declined slightly. The price
of imported oil fell about $6.50 per
barrel over the four quarters of the
year. World oil prices fell in response
to reduced demand associated with
the economic slowdown in many foreign nations and with unusually warm
weather in the Northern Hemisphere;
an increase in supply from Iraq also
exerted downward pressure on oil
prices.
Real exports of goods and services
grew about 1 percent, on net, in 1998
after posting a 10 percent rise in 1997.
Declines during the first three quarters
(especially in machinery exports) were
offset by a rebound in the fourth quarter,
which was led by an increase in exports
of automotive products. The price competitiveness of U.S. products decreased,
reflecting the appreciation of the dollar
through mid-August. In addition,
economic activity abroad weakened
sharply; total average foreign growth
(weighted by shares of U.S. exports)
plunged from 4 percent in 1997 to an
estimated Vi percent in 1998. A moderate expansion of exports to Europe,
Canada, and Mexico was about offset
by a decline in exports associated
with deep recessions in Japan and the
emerging Asian economies (particularly in the first half of the year) and
in South America (in the second half
of the year).
Capital Flows
The financial difficulties in a number of
emerging market economies had several
noticeable effects on U.S. international
capital flows in 1998. Financial turmoil
put strains on official reserves in many
emerging market economies. Foreign
official assets in the United States fell
$22 billion. This decline, which began
in the fourth quarter of 1997, was
largest for developing countries, as
many of them drew down their foreign exchange reserves in response to
exchange rate pressures. OPEC nations'
foreign official reserves shrank in the
first three quarters of 1998, as oil
revenues dropped. Foreign official
assets in the United States, especially
those of industrial countries, generally
rebounded in the fourth quarter.
Private capital flows also were
affected by the widespread turmoil. On
a global basis, capital flows to emerging
market economies fell substantially in
the first half of 1998 and then dropped
precipitously in late summer and early
fall in the wake of the Russian crisis.
During the first half of the year, U.S.
residents acquired about $35 billion of
foreign securities. Net purchases virtually stopped in July, and in the AugustOctober period U.S. residents, on net,
sold about $40 billion worth of foreign
securities. In the final two months of
the year, as markets stabilized, U.S. residents resumed net purchases. (In addition, the financing of two large mergers
between U.S. firms and European firms
resulted in a surge in U.S. residents'
holdings of foreign securities in the
fourth quarter. When the foreign firms
acquired the U.S. entities, U.S. residents
received equity in the foreign firms.)
Foreign net purchases of U.S. securities,
which were substantial in the first half
of the year, likewise fell off markedly
in the July-October period but experi-
Economic and Financial Developments
enced a significant recovery in November and December. Thus, there is some
evidence that the contraction in gross
capital flows seen in late summer and
early fall waned somewhat in the fourth
quarter.
Private foreign purchases of U.S.
Treasury securities were only $48 billion in 1998, compared with $147 billion for 1997. Small net sales in the first
and third quarters partly offset large net
purchases in the second and fourth quarters. Private foreigners' purchases of
other U.S. securities shifted away from
equities and toward bonds, relative to
1997.
The contraction in private portfolio
capital flows, though large, was overshadowed by huge direct investment
capital flows, which resulted in part
from the above-mentioned and other
very large cross-border mergers. With
the effects of the mergers, foreign direct
investment into the United States totaled
more than twice the previous record of
$93 billion posted in 1997. Merger activity also buoyed U.S. direct investment
abroad, bringing the annual total to
$132 billion, surpassing the previous
record of $122 billion in 1997.
more than 3Vi percent. Stores selling
building materials and home furnishings expanded employment rapidly, as
did firms involved in computer services, communications, and managerial
services.
Output per hour in the nonfarm business sector rose 23A percent in 1998
after having increased about PA percent, on average, over the preceding two
years; by comparison, the average rate
of rise during the 1980s and the first half
of the 1990s was just over 1 percent per
year. Because productivity often picks
up to a pace above its long-run trend
when economic growth accelerates, the
results of the past three years might well
be overstating the rate of efficiency gain
that can be maintained in coming years.
However, reasons for thinking that the
trend may have picked up somewhat are
becoming more compelling in view of
incoming data. The 1998 gain in output
per hour was particularly impressive,
Labor Market Conditions
Thousands of jobs, average monthly change
Nonfarm payroll employment
400
llllll
The Labor Market
The rapid growth of output in 1998 was
associated with both increased hiring
and continued healthy growth in labor
productivity. The number of jobs on
nonfarm payrolls rose about 2VA percent
from the end of 1997 to the end of 1998,
a net increase of 2.8 million. Manufacturers reduced employment over the
year, but the demand for labor in other
parts of the economy continued to
rise rapidly. The construction industry
boosted employment about 6 percent
over the year, and both the services
industry and the finance, insurance, and
real estate industry posted increases of
19
200
Percent
Civilian unemployment rate
1990
1992
1994
1996
1998
NOTE. The data are from the Department of Labor.
The break in the unemployment rate data at January 1994
marks the introduction of a redesigned survey; data from
that point on are not directly comparable with those of
earlier periods.
20
85th Annual Report, 1998
in part because it came at a time
when many businesses were diverting
resources to correct the Y2K problem, a
move that likely imposed a bit of drag
on the growth of output per hour. Higher
rates of capital formation are raising the
growth of capital per worker, and workers are likely becoming more skilled in
using the new technologies. Businesses
not only are increasing their capital
inputs but also are continuing to implement changes to their organizational
structures and operating procedures that
may enhance efficiency and bolster
profit margins.
The rising demand for labor continued to strain supply in 1998. The civilian labor force rose just a bit more
than 1 percent from the fourth quarter of
1997 to the fourth quarter of 1998, and
with the number of persons holding jobs
rising somewhat faster than the labor
force, the civilian unemployment rate
fell still further. The unemployment rate
was 4.3 percent at the end of 1998; the
average for the full year—4.5 percent—
was the lowest of any year in almost
three decades. The percentage of the
working age population that was outside
the labor force and was interested in
obtaining work but not actively seeking
it edged down further in 1998 and was
in the lowest range since the collection
of these data began in 1970. With the
supply of labor so tight, businesses
reached further into the pool of individuals who do not have a history of strong
attachment to the labor force; persons
attempting to move from welfare to
work were among the beneficiaries.
Workers have realized large increases
in real wages and real hourly compensation over the past couple of years. The
increases have come partly through
faster gains in nominal pay than in the
mid-1990s but also though reductions in
the rate of price increase, which have
been enhancing the real purchasing
power of nominal earnings, perhaps to a
greater degree than workers might have
anticipated. According to the Labor
Department's employment cost index,
the hourly compensation of workers in
private nonfarm industries rose 3Vi percent in nominal terms during 1998, a
touch more than in 1997 and xh percentage point more than in 1996. Taking the
consumer price index as the measure of
price change, this increase in nominal
hourly compensation translated into a
2 percent increase in real hourly pay,
one of the largest on record in a series
that goes back to the early 1980s; the
gain was larger still if the chain-type
price index for personal consumption
expenditures is used as the measure of
consumer prices. Moreover, the employment cost index does not capture some
of the forms of compensation that
employers have been using to attract
and retain workers—stock options and
signing bonuses, for example.
Because of the rapid growth in labor
productivity, unit labor costs have been
rising much less rapidly than hourly
compensation in recent years. The
increase in unit labor costs in the nonfarm business sector was only 1V* percent in 1998. Businesses were unable to
raise prices sufficiently to recoup even
this small increase in costs, however.
Labor gained a greater share of the
income generated from production, and
the profit share, though still high, fell
back a little from its 1997 peak.
Prices
The broader measures of aggregate price
change showed inflation continuing
to slow in 1998. The consumer price
index moved up W2 percent over the
four quarters of the year after having
increased nearly 2 percent in 1997. A
steep decline in energy prices in the CPI
more than offset a small acceleration
Economic and Financial Developments
Change in Consumer Prices
Percent, Q4 to Q4
1990
IIIIlli •
1992
1994
1996
1998
NOTE. Consumer price index for all urban consumers.
Based on data from the Department of Labor.
in the prices of other goods and services. Only part of the deceleration in
the total CPI was attributable to technical changes in data collection and
aggregation.1
Measures of aggregate price change
from the national income and product
accounts, which draw heavily on data
from the CPI but also use data from
other sources, showed a somewhat more
pronounced deceleration of prices in
1998. The chain-type price index for
personal consumption expenditures, the
measure of consumer prices in the
national accounts, rose 3A percent after
increasing Wi percent in 1997. The
chain-type price index for gross domestic purchases—the broadest measure of
prices paid by U.S. households, businesses, and governments—increased
less than Vi percent after moving up
1. Since the end of 1994, the Bureau of Labor
Statistics has taken a number of steps to make the
consumer price index a more accurate price measure. The agency also introduced new weights into
the-CPI at the start of 1998. In total, these changes
probably reduced the 1998 rise in the CPI by
slightly less than Vi percentage point, relative to
the increase that would have been reported using
the methodologies and weights in existence at the
end of 1994. Without the changes that took effect
in 1998, the deceleration in the CPI in 1998 would
probably have been about half as large as was
reported.
21
1 lA percent over the preceding year. The
rise in the chain-type price index for
gross domestic product of slightly less
than 1 percent was about one-half the
1997 increase of \YA percent.
Developments in the external sector
helped bring about the favorable inflation outcome of 1998. Consumers
benefited directly from lower prices of
finished goods purchased from abroad.
Lower prices for imports probably
also held down the prices charged by
domestic producers, not only because
businesses were concerned about losing
market share to foreign competitors but
also because declines in commodity
prices in sluggish world markets helped
reduce domestic production costs to
some degree.
In manufacturing, one of the sectors
most heavily affected by the softness in
demand from abroad, the rate of plant
capacity utilization fell noticeably over
the year—even as the unemployment
rate continued to decline. The divergence of these two key measures of
resource use—the capacity utilization
rate and the unemployment rate—is
unusual: They typically exhibit similar
patterns of change over the course of the
business cycle. Because the unemployment rate applies to the entire economy,
it presumably should be a better indicator of the degree of pressure on
resources in general. In 1998, however,
slack in the goods-producing sector—
a reflection of the sizable additions
to capacity in this country and excess
capacity abroad—seemingly enforced a
discipline of competitive price and cost
control that affected the economy more
generally.
Prices in 1998 tended to be weakest
in the sectors most closely linked to the
external economy. The price of oil fell
almost 40 percent from December 1997
to December 1998. This drop triggered
steep declines in the prices of petroleum
22
85th Annual Report, 1998
products purchased directly by households. The retail price of motor fuel fell
about 15 percent over the four quarters
of the year, and the price of home heating fuel also plunged. With the prices of
natural gas and electricity also falling,
the CPI for energy was down about
9 percent over the year after having
slipped 1 percent in 1997.
Large declines in the prices of internationally traded commodities other
than oil pulled down the prices of many
domestically produced primary inputs.
The producer price index for crude materials other than energy, which reflects
the prices charged by domestic producers of these goods, fell more than 10 percent over the year. However, because
these non-oil commodities account for a
small share of total production costs, the
effect of their decline on inflation was
much less visible further down the chain
of production. Intermediate materials
prices excluding food and energy fell
about 1Vi percent over the four quarters
of the year, and the prices of finished
goods excluding food and energy rose
about 1V2 percent. The latter index was
boosted in part by an unusually large
hike in tobacco prices that followed the
settlement in the fall of states' litigation
against tobacco companies. In the food
sector as well, the effects of declining commodity prices became less visible further down the production chain;
the PPI for finished foods was about
unchanged, on net, over the year, and
price increases at the retail level, though
small, were somewhat larger than those
of the preceding year.
Consumer prices excluding those
for food and energy continued to rise
in 1998, but not very rapidly. The CPI
measure of these prices—the core CPI—
increased about 2!/2 percent from the
final quarter of 1997 to the final quarter
of 1998, a shade more than in 1997.
The chain-type price index for personal
Alternative Measures of Price Change
Percent
Price measure
1997
1998
Fixed-weight
Consumer price index
Excluding food and energy
1.9
2.2
1.5
2.4
Chain-type
Gross domestic product
Gross domestic purchases
Personal consumption expenditures ...
Excluding food and energy
1.7
1.3
1.5
1.6
.9
.4
.7
1.2
NOTE. Changes are based on quarterly averages and
are measured to the fourth quarter of the year indicated
from the fourth quarter of the previous year.
consumption expenditures excluding
food and energy—the core PCE price
index—decelerated a bit further, rising
at roughly half the pace of the core CPI.
Methodological differences between the
two measures are numerous; some of
the technical problems that have plagued
the CPI are less pronounced in the
PCE price measure, but the latter also
depends partly on imputations of prices
for which observations are not available.
Both measures, however, seem to suggest that the underlying trend of consumer price inflation remained low. A
similar message came from surveys of
consumers, which showed expectations
of future price increases easing a bit
further in 1998—although, as in other
recent years, the expected increases
remained somewhat higher than actual
increases.
U.S. Financial Markets
U.S. interest rates fluctuated in fairly
narrow ranges over the first half of 1998,
and most equity price indexes posted
substantial gains. However, after the
financial crisis in Russia in August and
subsequent difficulties in other emerging
market economies, investors appeared
to reassess the risks and uncertainties
facing the U.S. economy and concluded
Economic and Financial Developments
that more cautious postures were in
order. That sentiment was reinforced by
the prospect of an unwinding of positions by some highly leveraged investors. The resulting shift toward safe,
liquid investments led to a substantial
widening of risk spreads on debt instruments and to volatile changes in the
prices of many assets. Financial market
volatility and many risk spreads returned
to more normal levels later in the year,
as lower interest rates and robust economic data seemed to reassure market
participants that the economy would
remain sound, even in the face of additional adverse shocks from abroad.
However, lenders remained more cautious than they had been in the first part
of the year, especially in the case of
riskier credits.
Interest Rates
Over the first half of 1998, short-term
Treasury rates moved in a narrow range,
anchored by unchanged monetary policy, while yields on intermediate- and
long-term Treasury securities varied in
response to the market's shifting assessment of the likely impact of foreign
economic difficulties on the U.S. economy. In late 1997 and into 1998, spreading financial crises in Asia were associated with declines in U.S. interest rates,
as investors anticipated that weakness
abroad would constrain U.S. economic
growth and cushion the impact of tight
U.S. labor markets on inflation. However, interest rates moved back up later
in the first quarter of 1998, as the U.S.
economy continued to expand at a
healthy pace, fueled by hefty gains in
domestic demand. After a couple of
months of small changes, Treasury rates
fell in May and June, when concerns
about foreign economies, particularly in
Asia, once again led some observers to
expect weaker growth in the United
23
States and may also have boosted the
demand for safe Treasury securities relative to other instruments.
Treasury rates changed little, on net,
in the early summer, but they slipped
lower in August, reflecting increased
concern about the Japanese economy
and financial problems in Russia. The
default by Russia on some government
debt obligations and the devaluation
of the ruble in mid-August not only
resulted in sizable losses for some investors but also undermined confidence in
other emerging market economies. The
currencies of many of these economies
came under substantial pressure, and the
market value of the international debt
obligations of some countries declined
sharply. U.S. investors shared in the
resulting losses, and U.S. economic
growth and the profits of U.S. companies were perceived to be vulnerable. In
these circumstances, many investors,
both here and abroad, appeared to reassess the riskiness of various counterparties and investments and to become less
willing to bear risk. The resulting shift
of demand toward safety and liquidity
led to declines of 40 to 75 basis points
Spreads of Corporate Bond Yields
over Treasury Security Yields
Percentage points
High-yield
J
F
M
A M
J J
1998
A
S
O
N
D
NOTE. The data are daily. The spread of high-yield
bonds compares the yield on the Merrill Lynch Master II
index with that on a seven-year Treasury; the other two
spreads compare yields on the appropriate Merrill Lynch
indexes with that on a ten-year Treasury.
24
85th Annual Report, 1998
in Treasury coupon yields between midAugust and mid-September. In contrast,
yields on higher-quality private securities fell much less, and those on issues
of lower-rated firms increased sharply.
As a result, spreads of private rates over
Treasury rates rose substantially, reaching levels not seen for many years,
and the issuance of corporate securities
dropped sharply.
Investors' desire to limit risk-taking
as markets became troubled in the late
summer showed up clearly in mutual
fund flows. High-yield bond funds,
which had posted net inflows of more
than $1 billion each month from May
through July, saw a $3.4 billion outflow in August and inflows of less than
$400 million in September and October
before rebounding sharply in November.
By contrast, inflows to government bond
funds jumped from less than $1 billion
in July to more than $2 billion a month
in August and September. Equity mutual
funds posted net outflows totaling nearly
$12 billion in August, the first monthly
outflow since 1990, and inflows over the
rest of the year were well below those
earlier in the year.
In part, the foreign difficulties were
transmitted to U.S. markets by losses
incurred by leveraged investors—
including banks, brokerage houses, and
hedge funds—as the prospects for distress sales of riskier assets by such
investors weighed on market sentiment,
depressing prices. Many of these entities
did reduce the scale of their operations
and trim their risk exposures, responding to pressures from more cautious
counterparties. As a result, liquidity in
many markets declined sharply, with
bid-asked spreads widening and large
transactions becoming more difficult
to complete. Even in the market for
Treasury securities, investors showed
an increased preference for the liquidity
offered by the most recent issues at each
maturity, and the yields on these more
actively traded "on-the-run" securities
fell noticeably relative to those available
on "off-the-run" issues, the ones that
had been outstanding longer.
Conditions in U.S. financial markets
deteriorated further following revelations in mid-September of the magnitude of the positions and the extent of
the losses of a major hedge fund, LongTerm Capital Management. LTCM indicated that it sought high rates of return
mostly by identifying small discrepancies in the prices of different instruments relative to historical norms and
then taking highly leveraged positions
in those instruments in the expectation
that market prices would revert to such
norms over time. In pursuing its strategy, LTCM took very large positions,
some of which were in relatively small
and illiquid markets.
LTCM was quite successful between
1995 and 1997, but the shocks hitting
world financial markets in August of
1998 generated substantial losses for the
firm. Losses mounted in September, and
before new investors could be found, the
firm encountered difficulties meeting
liquidity demands arising from its collateral agreements with its creditors
and counterparties. With world financial
markets already suffering from heightened risk aversion and illiquidity, officials of the Federal Reserve Bank of
New York judged that the precipitous
unwinding of LTCM's portfolio that
would follow the firm's default would
compound market difficulties by distorting market prices and imposing potentially large losses, not just on LTCM's
creditors and counterparties but also on
other market participants not directly
involved with LTCM.
In an effort to avoid these difficulties,
the Federal Reserve Bank of New York
contacted the major creditors and counterparties of LTCM to see if an alterna-
Economic and Financial Developments
tive to forcing LTCM into bankruptcy
could be found. At the same time,
Reserve Bank officials informed some
of their colleagues at the Federal
Reserve Board, the Treasury, and other
financial regulators of their activities.
Subsequent discussions among LTCM's
creditors and counterparties led to an
agreement by the private-sector parties
to provide an additional $3!/2 billion of
capital to LTCM in return for a 90 percent equity stake in the firm.
Because of the potential for firms
such as LTCM to have a large influence
on U.S. financial markets, Treasury
Secretary Robert Rubin asked the
President's Working Group on Financial
Markets to study the economic and regulatory implications of the operations
of firms like LTCM and their relationships with their creditors. In addition,
the extraordinary degree of leverage that
LTCM was able to amass led the federal
agencies responsible for the prudential
oversight of the fund's creditors and
counterparties to undertake reviews of
the practices those firms employed in
managing their risks. These reviews
suggested significant weaknesses in the
risk-management practices of many
firms in their dealings with LTCM
and—albeit to a lesser degree—in their
dealings with other highly leveraged
entities. Few counterparties seem to
have had a complete understanding of
LTCM's risk profile, and their credit
decisions were heavily influenced by the
firm's reputation and strong past performance. Moreover, LTCM's counterparties did not impose sufficiently tight limits on their exposures to LTCM, in part
because they relied on collateral agreements requiring frequent marking to
market to limit the risk of their exposures. Although these agreements generally provided for collateral with a value
sufficient to cover current credit exposures, they did not deal adequately with
25
the potential for future increases in
exposures from changes in market values. This shortcoming was especially
important in dealings with a firm like
LTCM, which had such large positions
in illiquid markets that its liquidation
would likely have moved prices sharply
against its creditors. In such cases, creditors need to take further steps to limit
their potential future exposures, which
might include requiring additional collateral or simply scaling back their activity with such firms.
The private-sector agreement to
recapitalize LTCM allowed its positions
to be reduced in an orderly manner over
time, rather than in an abrupt fire sale.
Nonetheless, the actual and anticipated
unwinding of LTCM's portfolio, as well
as actual and anticipated sales by other
similarly placed leveraged investors,
likely contributed materially to the tremendous volatility of financial markets
in early October. Market expectations of
asset price volatility going forward, as
reflected in options prices, rose sharply,
as bid-asked spreads and the premium
for on-the-run securities widened. Longterm Treasury yields briefly dipped to
their lowest levels in more than thirty
years, in part because of large demand
Implied Volatilities
Percent
Percent
13 -
-
m
40
-
S&PSOO I
12 -
35
-
30
25
Jfi 2 0
10 ~j
\f
9
%
8
-
-
15
7
-
-
10
-*•— Long-term Treasury bond
i
J
l
l
i
I
i
F M A M J
t
i
i
i
t
J A S O N D
1998
NOTE. The data are daily. Implied volatilities are calculated from options prices.
26
85th Annual Report, 1998
shifts resulting from concerns about
the safety and liquidity of private and
emerging market securities. Spreads of
rates on corporate bonds over those
on comparable Treasury securities rose
considerably, and issuance of corporate
bonds, especially by lower-rated firms,
remained very low.
By mid-October, however, market
conditions had stopped deteriorating,
and they began to improve somewhat in
the days and weeks following the cut in
the federal funds rate on October 15,
between Federal Open Market Committee meetings. Internationally coordinated efforts to help Brazil cope with its
financial difficulties, culminating in the
announcement of an IMF-led support
package in mid-November, contributed
to the easing of market strains. In the
Treasury market, bid-asked spreads narrowed a bit and the premium for on-therun issues declined. With the earlier
flight to quality and liquidity unwinding,
Treasury rates backed up considerably.
Corporate bond spreads reversed a part
of their earlier rise, and investmentgrade bond issuance rebounded sharply.
In the high-yield bond market, investors
appeared to be more hesitant, especially
in regard to all but the best-known issuers, and the volume of junk bond
issuance picked up less. In the commercial paper market, yields on higherquality paper declined; yields on
lower-quality paper remained elevated,
however, and some lower-tier firms reportedly drew on their bank lines for
funding, giving a further boost to bank
business lending, which had begun to
pick up during the summer.
Market conditions improved a bit
further immediately after the Federal
Reserve's November rate cut, but some
measures of market stress rose again in
late November and in December. The
deterioration reflected in part widespread warnings of lower-than-expected
corporate profits, a weakening economic
outlook for Europe, and renewed concerns about the situation in Brazil. In
addition, with risk a greater-than-usual
concern, some market participants were
likely less willing to hold lower-rated
securities over year-end, when they
would have to be reported in annual
financial statements. As a result, liquidity in some markets appeared to be curtailed, and price movements were exaggerated. These effects were particularly
noticeable in the commercial paper
market: The spread between rates on
top-tier and lower-tier thirty-day paper
jumped almost 40 basis points on
December 2, when that maturity crossed
year-end, and then reversed the rise late
in the month.
Equity Prices
Most equity indexes rose strongly, on
balance, in 1998, with the Nasdaq Composite Index up nearly 40 percent, the
S&P 500 Composite Index rising more
than 25 percent, and the Dow Jones
Industrial Average and the NYSE
Composite Index advancing more than
15 percent. Small capitalization stocks
underperformed the stocks of larger
firms, with the Russell 2000 Index off
3 percent over the year. The variation in
stock prices over the course of the year
was extremely wide. Prices increased
substantially over the first few months,
as concerns eased that Asian economic
problems could lead to a slowdown in
the United States and to a consequent
decline in profits. The major indexes
declined, on balance, over the following
couple of months before rising sharply,
in some cases to new records, in late
June and early July, on increasing confidence about the outlook for earnings.
The main exception was the Russell
2000; small capitalization stocks fell
Economic and Financial Developments
Major Stock Price Indexes
Index, January 2, 1998 = 100
Nasdaq
90
1997
1998
NOTE. The data are daily.
more substantially in the spring, and
their rise in July was relatively muted.
Rising concerns about the outlook for
Japan and other Asian economies, as
well as the deepening financial problems in Russia, caused stock prices to
retrace their July gains by early August.
After Russia devalued the ruble and
defaulted on some debts in mid-August,
prices fell further, reflecting the general
turbulence in global financial markets.
By the end of the month, most equity
indexes had dropped back to roughly
their levels at the start of the year. Commercial bank and investment bank
stocks fell particularly sharply, as investors became concerned about the effect
on these institutions' profits of emerging
market difficulties and of substantial
declines in the values of some assets.
Equity prices rose for a time in September but then fell back by early October
before rebounding as market dislocations eased and interest rates on many
private obligations fell. By December,
most major indexes were back near their
July highs, although the Russell 2000
remained below its earlier peak.
The increase in equity prices in 1998,
coupled with the slowing of earnings
growth, left many valuation measures
beyond their historical ranges. After
ticking higher in late summer and early
autumn, the ratio of consensus estimates
27
of earnings over the coming twelve
months to prices in the S&P 500 fell
back, ending the year below its level
at the end of 1997. The decline in this
measure likely reflected in part lower
real long-term bond yields. For example,
as measured by the difference between
the ten-year nominal Treasury yield and
inflation expectations reported in the
Philadelphia Federal Reserve Bank's
survey of professional forecasters, real
yields fell appreciably between late
1997 and late 1998. (The yield on
ten-year inflation-indexed Treasury
securities actually rose somewhat over
1998. However, the increase may have
reflected the securities' lack of liquidity
and the substantial rise in the premium
investors were willing to pay for liquidity.) From mid-1998 on, the real interest
rate declined somewhat more than the
forward earnings yield on stocks, and
the spread between the two consequently increased a bit, perhaps reflecting the greater sense of risk in financial markets. Nonetheless, the spread
remained quite small relative to historical norms: Investors may have been
Equity Valuation and Long-Term
Real Interest Rate
Percent
T e n - y e a r real interest rate
I I I 1 1 I I 1 I I 1 I I i I 1 1I
1980 1983 1986 1989 1992 1995 1998
NOTE. The data are monthly. The earnings-price ratio
is based on the I/B/E/S International, Inc., consensus
estimate of earnings over the coming twelve months. The
real interest rate is the yield on the ten-year Treasury note
less the ten-year inflation expectations from the Federal
Reserve Bank of Philadelphia Survey of Professional
Forecasters.
28
85th Annual Report, 1998
anticipating rapid long-term earnings
growth—consistent with the expectations of securities analysts—and they
may still have been satisfied with a
lower risk premium for holding stocks
than they have demanded historically.
Debt and the
Monetary Aggregates
substantially expanded their lending
to financial firms through repurchase
agreements and loans to purchase and
carry securities. As a result, the growth
of total bank credit, adjusted to remove
the effects of mark-to-market accounting rules, accelerated to 10^2 percent on
a fourth-quarter to fourth-quarter basis,
the largest annual increase in more than
a decade.
Debt and Depository Intermediation
From the fourth quarter of 1997 to the
fourth quarter of 1998, the total debt
of the U.S. household, government, and
nonflnancial business sectors increased
about 6 percent, in the top half of the
3 percent to 7 percent range established
by the FOMC and considerably faster
than nominal GDP. Buoyed by strong
spending on durable goods, housing,
and business investment, as well as by
merger and acquisition activity that substituted debt for equity, nonfederal debt
expanded about 8V2 percent in 1998,
more than 2 percentage points faster
than in 1997. By contrast, federal debt
declined 1 lA percent, following a rise of
3
/4 percent over the preceding year.
Credit market instruments on the
books of depository institutions rose at a
somewhat faster pace than did the debt
aggregate, posting a 6V2 percent rise
in 1998, about one-quarter percentage
point higher than in 1997. Growth in
depository credit picked up in the second half of the year, as the turbulence
in financial markets apparently led
many firms to substitute bank loans for
funds raised in the markets. Banks also
added considerably to their holdings of
securities in the third and fourth quarters, in part reflecting the attractive
spreads available on non-Treasury debt
instruments.
Financial firms also appeared to turn
to banks for funding when the financial
markets were volatile, and U.S. banks
The Monetary Aggregates
The broad monetary aggregates expanded very rapidly in 1998. From the
fourth quarter of 1997 to the fourth
quarter of 1998, M2 increased SV2 percent, placing it well above the upper
bound of the 1 percent to 5 percent
range established by the FOMC. However, as the Committee noted in February 1998, this range was intended as
a benchmark for money growth under
conditions of stable prices, real economic growth near trend, and historical
velocity relationships. Part of the excess
of M2 above its range was the result of
faster growth in nominal spending than
would likely be consistent with sustained price stability. In addition, the
velocity of M2 (defined as the ratio of
nominal GDP to M2) fell 3 percent.
Some of the decline resulted from the
decrease in short-term market interest
rates in 1998—as usual, rates on deposits fell more slowly than market rates,
reducing the opportunity cost of holding
M2 (defined as the difference between
the rate on Treasury bills and the average return on M2 assets).
However, the bulk of the decline
cannot be explained on the basis of
the historical relationship between the
velocity of M2 and this measure of its
opportunity cost. Three factors not captured in that relationship likely contributed to the drop in velocity. First,
households seem to have allocated an
Economic and Financial Developments
29
Growth of Money and Debt
Percent
M2
M3
Domestic
nonfinancial debt
4.2
.6
5.6
5.2
6.4
4.1
9.1
7.5
1990
1991
1992
1993
1994
4.2
8.0
14.3
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
4.9
1995
1996
1997
1998
-1.6
-4.5
-1.2
1.8
3.9
4.6
5.8
8.5
6.1
6.8
8.8
11.0
5.4
5.3
4.9
6.1
Quarterly (annual rate)2
1998:1
2
3
4 .. .
3.2
1.0
-2.0
5.0
7.6
7.5
6.9
11.0
10.3
10.1
8.6
13.3
5.8
6.0
5.9
6.3
Period
Annual'
1988
1989
Ml
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.
increased share of savings flows to
monetary assets rather than equities following several years of outsized gains in
stock market wealth. Second, some evidence suggests that in the 1990s the
demand for M2 assets has become more
sensitive to longer-term interest rates
and to the slope of the yield curve; the
decline in long-term Treasury yields in
1998, and the consequent flattening
of the yield curve, may thereby have
increased the relative attractiveness of
M2 assets. Finally, a critical source of
the especially rapid M2 expansion in the
fourth quarter likely was an increased
demand for safe, liquid assets as investors responded to the heightened financial market volatility.
M3 expanded even faster than M2 in
1998, posting an 11 percent rise on a
fourth-quarter to fourth-quarter basis.
Growth over the year was the fastest
since 1981 and left the aggregate well
above the top end of its 2 percent to
6 percent growth range. As with M2,
however, the FOMC established the M3
M2 Velocity and M2 Opportunity Cost
Ratio scale
1978
Percentage points, ratio scale
1983
1988
1993
1998
NOTE. The data are quarterly. The velocity of M2 is
the ratio of nominal gross domestic product to the stock
of M2. The opportunity cost of M2 is a two-quarter
moving average of the three-month Treasury bill rate less
the weighted average return on assets included in M2.
30
85 th Annual Report, 1998
range as a benchmark for growth under
conditions of stable prices, sustainable
output growth, and the historical behavior of velocity. The rapid growth of M3
in part simply reflected the rise in M2.
In addition, the non-M2 components of
M3 increased 18!/2 percent over the year,
following an even larger advance in
1997. The substantial rise in these components in 1998 was partly the result of
the funding of the robust growth in bank
credit with managed liabilities, many of
which are in M3. However, M3 growth
was boosted to an even greater extent by
flows into institution-only money funds,
which have been expanding rapidly
in recent years as such funds have
increased their share of the corporate
cash management business. Because
investments in these money funds substitute for business holdings of shortterm assets that are not in M3, their rise
has generated an increase in M3 growth.
In addition, institution-only funds pay
rates that tend to lag movements in market rates; thus, their relative attractiveness was temporarily enhanced—and
their growth rate boosted—by declines
in short-term market interest rates late in
1998.
Ml increased 1%. percent over the
four quarters of 1998, its first annual
increase since 1994. Currency expanded
at an 8V4 percent pace, its largest rise
since 1994. The increase apparently
reflected continued strong foreign shipments, though at a slower pace than in
1997, and a sharp acceleration in domestic demand. Deposits in Ml declined
further in 1998, reflecting the continued
introduction of retail "sweep" programs. Growth of Ml deposits has been
depressed for a number of years by these
programs, which shift—or "sweep"—
balances from household transactions
accounts, which are subject to reserve
requirements, into savings accounts,
which are not. Because the funds are
shifted back to transactions accounts
when needed, depositors' access to their
funds is not affected by these programs.
However, banks benefit from the reduction in holdings of required reserves,
which do not pay interest. Over 1998,
sweep programs for demand deposit
accounts became more popular, contributing to a 4V4 percent decline in such
balances. By contrast, new sweep programs for other checkable deposits,
which had driven double-digit declines
in such deposits over the previous
three years, were less important in 1998,
and, with nominal spending strong and
interest rates lower, other checkable
deposits were about unchanged on the
year.
As a result of the introduction of
retail sweep accounts, the average level
of required reserve balances (balances
that must be held at Reserve Banks to
meet reserve requirements) has trended
lower over the past few years. The
decline has been associated with an
increase in banks' required clearing balances, which are balances that banks
agree in advance to hold at their Federal
Reserve Bank to facilitate the clearing of their payments. Unlike required
reserve balances, banks earn credits on
their required clearing balances that can
be applied to the use of Federal Reserve
priced services. Despite the increase
in required clearing balances, required
operating balances, which are the sum
of required reserve balances and required clearing balances, have declined
over the past few years and in late 1998
reached their lowest level in several
decades.
The decline in required operating balances has generated concerns about a
possible increase in the volatility of the
federal funds rate. Because a bank's
required level of operating balances
must be met only on average over a
two-week maintenance period, banks are
Economic and Financial Developments
free to allocate their reserve holdings
across the days of a maintenance period
in order to minimize their reserve costs.
However, banks must also manage their
reserves in order to avoid overdrafts,
which the Federal Reserve discourages
through administrative measures and
financial penalties. Thus, as required
operating balances decline toward the
minimum level needed to clear banks'
transactions, banks are less and less able
to respond to fluctuations in the federal
funds rate by lending funds when the
rate is high and borrowing when the rate
is low. As a result, when required operating balances are low, the federal funds
rate is likely to rise further than it otherwise would when demands for reserves
are unexpectedly strong or supplies
weak; conversely, the federal funds
rate is likely to fall more in the event
of weaker-than-expected demand or
stronger-than-expected supply. One way
to ease this difficulty would be to pay
interest on required reserve balances,
which would reduce banks' incentives
to expend resources on sweeps and other
efforts to minimize these balances.
Despite the low level of required
operating balances, the federal funds
rate did not become noticeably more
volatile over the spring and summer of
1998. This result reflected in part more
frequent overnight open market operations by the Federal Reserve to better
match the daily demand for and supply
of reserves. Banks also likely improved
the management of their accounts at the
Federal Reserve Banks. Moreover, large
banks apparently became more willing
to borrow at the discount window. The
Federal Reserve's decision to return to
lagged reserve accounting at the end of
July also likely contributed to reduced
volatility in the federal funds market by
enhancing somewhat the ability of both
banks and the Federal Reserve to forecast reserve demand.
31
In the latter part of 1998, however,
the federal funds rate was more volatile.
The increase may have been due partly
to further reductions in required operating balances resulting from new sweep
programs, but other factors were probably more important, at least for a time.
Market participants were scrutinizing
borrowing banks more closely, and in
some cases lenders pared or more tightly
administered their counterparty credit
limits, or shifted more of their placements from term to overnight maturities. The heightened attention to credit
quality also made banks less willing to
borrow at the discount window, out of
concern that other market participants
might detect their borrowing and interpret it as a sign of financial weakness.
As a result, many banks that were net
takers of funds in short-term markets
attempted to lock in their funding earlier
in the morning. On net, these forces
boosted the demand for reserves and
put upward pressure on the federal
funds rate early in the day. To buffer the
effect of these changes on volatility in
the federal funds market, the Federal
Reserve increased the supply of reserves
and, at times, responded to the level of
the federal funds rate early in the day
when deciding on the need for market
operations. Because demand had shifted
to earlier in the day, however, the federal funds rate often fell appreciably
below its target level by the end of the
day.
At its November meeting, the FOMC
amended the Authorization for Domestic Open Market Operations to extend
the permitted maturity of System repurchase agreements from fifteen to sixty
days. Over the remainder of 1998, the
Domestic Trading Desk made use of
this new authority on three occasions,
arranging System repurchase agreements with maturities of thirty to fortyfive days to meet anticipated seasonal
32
85th Annual Report, 1998
reserve demands over year-end. While
the Desk had in the past purchased
inflation-indexed securities when rolling over holdings of maturing nominal
securities, it undertook its first outright
open market purchase devoted solely to
inflation-indexed Treasury securities in
1998, thereby according those securities
the same status as other Treasury securities in open market operations.
International Developments
Emerging Economies
Developments in international financial markets in 1998 continued to be
dominated by the unfolding crises in
emerging markets that had begun in
Thailand in 1997. Financial market turbulence spread to other emerging markets around the globe, spilling over from
Korea, Indonesia, Malaysia, Singapore,
the Philippines, and Hong Kong in late
1997 and the first part of 1998 to Russia
in the summer, and to Latin America,
particularly Brazil, shortly thereafter.
The Asian crisis contributed to a deepening recession in Japan, and as the
year progressed, growth in several other
major foreign industrial economies
slowed as well.
Exchange Value of Selected Asian
Currencies versus the Dollar
Index, December 1996 = 100
80
40
Indonesian rupiah
[ I 1 [ 1
1997
M
1998
NOTE. Dollars per unit of foreign currency. The data
are monthly.
At the beginning of 1998, many Asian
currencies were declining or were under
pressure. The Indonesian rupiah dropped
sharply in January, amid widespread
rioting and talk of a coup, and fell again
in May and June, as the deepening
recession prompted more social unrest
and, ultimately, the ouster of President
Suharto. Some of the rupiah's losses
were reversed in the second half of the
year, following the relatively orderly
transition of power to President Habibie.
Tighter Indonesian monetary policy,
which pushed short-term interest rates
as high as 70 percent by July, contributed to the rupiah's recovery. On
balance, between December 1997 and
December 1998 the rupiah depreciated
more than 35 percent against the dollar.
In contrast, the Thai baht and Korean
won, which had declined sharply in
1997, gained more than 20 percent
against the dollar over the course of
1998. Policy reforms and stable political
environments helped boost these currencies. The currencies of the Philippines,
Malaysia, Singapore, and Taiwan fluctuated in a narrower range and ended the
year little changed against the dollar. In
September, Malaysia imposed capital
and exchange controls, fixing the ringgit's exchange rate against the dollar.
The Hong Kong dollar came under pressure at times during the year, but its
peg to the U.S. dollar remained intact,
although at the cost of interest rates that
were at times considerably elevated.
Short-term interest rates in Asian economies other than Indonesia declined in
1998, and as some stability returned to
Indonesian markets near the end of the
year, short-term rates in that nation
began to retreat from their highs.
As the year progressed, the financial
storm moved from Asia to Russia. At
first the Russian central bank was able
to defend the ruble's peg to the dollar
with interest rate increases and sporadic
Economic and Financial Developments
intervention. By midyear, however, the
government's failure to reach a new
assistance agreement with the International Monetary Fund, reported shortfalls in tax revenues, and the disruption
of rail travel by striking coal miners
protesting late wage payments brought
to the fore the deep structural and political problems faced by Russia. In addition, declining oil prices were lowering
government revenues and worsening
the current account. As a result of
these difficulties, the ruble came under
renewed pressure, forcing Russian interest rates sharply higher, and Russian
equity prices fell abruptly. A disbursement of $4.8 billion from the IMF in
July was quickly spent to keep the currency near its level of 6.2 rubles per
dollar, but the lack of progress on fiscal
reform put the next IMF tranche in
doubt.
On August 17, Russia announced a
devaluation of the ruble and a moratorium on servicing official short-term
debt. Subsequently, the ruble depreciated more than 70 percent against the
dollar, the government imposed conditions on most of its foreign and domestic debt that implied substantial losses
for creditors, and many Russian financial institutions became insolvent. The
events in Russia precipitated a global
increase in financial market turbulence,
including a pullback of credit to highly
leveraged investors and a widening of
credit spreads in both emerging market
economies and many industrial countries. The turmoil did not abate until
after the central banks of a number of
industrial countries eased policy in the
fall.
Latin American financial markets
were only moderately disrupted by the
Asian and Russian problems during
the first half of 1998. The reaction to the
Russian default was swift and strong,
however, and the prices of Latin Ameri
33
can assets fell precipitously. The spreads
between yields on Latin American
Brady bonds and comparable U.S. Treasuries widened considerably (with increases ranging from 900 basis points
in Argentina to 1500 basis points in
Brazil), peaking in early September
before retracing part of the rise. Latin
American equity prices plunged 25 percent or more. Several currencies came
under pressure despite sharp increases
in short-term interest rates.
Anticipation of an IMF-led financial
assistance package for Brazil helped
spur a partial recovery in Latin American asset markets in late September and
October. The details of the $41.5 billion loan package were announced in
November. After the IMF approved the
package in early December, however,
Brazil's Congress rejected a part of
the government's fiscal austerity plan,
sparking renewed financial turmoil. In
mid-December, $9.3 billion of the loan
package was disbursed, but continuing
pressure from investors seeking to take
funds out of Brazil put the long-term
viability of the real's crawling exchange
rate peg in doubt. Brazil's central bank
defended the peg through the end of the
year, drawing down a substantial portion
of the $75 billion in foreign exchange
reserves it had amassed as of April
1998.2
The Mexican peso, which was also
weakened by the effects of falling oil
prices, depreciated 18 percent against
the dollar over the year. The Colombian
peso and the Ecuadorian sucre were
devalued, but Argentina's currency
board arrangement survived.
The fallout from the financial crises
that hit several Asian emerging market
economies in late 1997 triggered a further decline in output in the region in
2. In mid-January 1999, the real was devalued
and soon after was allowed to float.
34
85th Annual Report, 1998
early 1998. In the countries most heavily
affected—Thailand, Korea, Malaysia,
and Indonesia—output dropped at
double-digit annual rates in the first half
of the year, as credit disruptions, widespread failures in the financial and corporate sectors, and a resulting high degree of economic uncertainty depressed
activity severely. Output in Hong Kong
also dropped in early 1998, as interest
rates rose sharply amid pressure on its
currency peg. Later in the year, with
financial conditions in most of the Asian
crisis countries stabilizing somewhat,
output started to bottom out.
The Asian crisis had a relatively moderate effect on China. Growth remained
fairly strong throughout the year despite
a dramatic slowdown in the growth of
exports. A salutary effect of the crisis
may have been the encouragement that
it seemed to give authorities in China to
move ahead more quickly with various
financial sector reforms.
Inflation in the Asian developing
economies rose only moderately on
average in 1998, as the inflationary
effects of currency depreciations in the
region were largely offset by the deflationary influence of very weak domestic
activity. The current account balances of
the Asian crisis countries swung into
substantial surplus. These countries
experienced a significant improvement
in their competitive positions after the
substantial depreciations of their currencies in late 1997 and early 1998. In
addition, their imports fell sharply with
the falloff in domestic demand.
In Russia, economic activity declined
in 1998 as interest rates were pushed
up in an attempt to fend off pressure on
the ruble. After the August debt moratorium and ruble devaluation, output
dropped sharply, ending the year down
about 10 percent from its year-earlier
level. The ruble collapse triggered
a surge in inflation to a triple-digit
annual rate during the latter part of the
year.
In Latin America, the pace of economic activity slowed only moderately
in the first half of 1998, as the spillover
from the Asian financial turbulence was
limited. The Russian financial crisis in
August, in contrast, had a strong impact
on real activity in Latin America, particularly in Brazil and Argentina, where
interest rates moved sharply higher in
response to exchange rate pressures.
Output in both countries is estimated
to have declined in the second half of
the year at annual rates of about 5 percent. Activity in Mexico and Venezuela
was also depressed by lower oil export
revenues. Inflation rates in Latin American countries were little changed in
1998 and ranged from 1 percent in
Argentina and 3 percent in Brazil to
31 percent in Venezuela.
Industrial Economies
The dollar's value, measured on a tradeweighted basis against the currencies of
a broad group of important U.S. trading
partners, rose almost 7 percent during
the first eight months of 1998 but then
Nominal Dollar Exchange Rate Indexes
Index
Broad
110
90
Major currencies
i
1994
1995
1996
i
1997
1998
NOTE. The data are monthly. Indexes are tradeweighted averages of the exchange value of the dollar in
terms of major currencies (March 1973 = 100) and in
terms of a broad group of important U.S. trading partners
(January 1997= 100).
Economic and Financial Developments
fell, returning by December to a level
about 2 percent above that of a year
earlier. (When adjusted for changes in
U.S. and foreign consumer price levels,
the value of the dollar in December
1998 was about 1 percent below its level
in December 1997.) Before the Russian
default, the dollar was supported by the
robust pace of U.S. economic activity,
which at times generated expectations
that monetary policy would be tightened. Healthy U.S. growth also contrasted with weakening economic activity abroad, especially in Japan. Occasionally, however, the positive influence
of the strong economy was countered
by worries about growing U.S. external
deficits. From August through October,
in the aftermath of the Russian financial
meltdown, concerns that increased difficulties in Latin America might affect
the U.S. economy disproportionately, as
well as expectations of lower U.S. interest rates, weighed on the dollar's value,
and it fell sharply. The broad index of
the dollar's exchange value eased a bit
further during the fourth quarter of the
year.
Against the currencies of the major
foreign industrial countries, the dollar
declined 2 percent in nominal terms over
1998, on balance, reversing some of its
10 percent appreciation over the preceding year. Among these currencies, the
dollar's value fluctuated most widely
against the Japanese yen. The dollar rose
against the yen during the first half of
the year as a result of concerns about the
effects of the Asian crisis on the alreadyweak Japanese economy and further
signs of deepening recession and persistent banking system problems in that
country. It reached a level of almost
147 yen per dollar in mid-June, prompting coordinated intervention by U.S. and
Japanese authorities in foreign exchange
markets that helped to contain further
downward pressure on the yen. The dol
35
lar resumed its appreciation against the
yen, albeit at a slower pace, in July and
early August.
The turning point in the dollar-yen
rate came after the Russian collapse,
amid the global flight from risk that
caused liquidity to dry up in the markets
for many assets. During the first week
of October, the dollar dropped nearly
14 percent against the yen in extremely
illiquid trading conditions. Although
fundamental factors in Japan, such as
progress on bank reform, fiscal stimulus, and the widening trade surplus may
have helped boost the yen against the
dollar, market commentary at the time
focused on reports that some international investors were buying large
amounts of yen. These large purchases
reportedly were needed to unwind positions in which investors had used yen
loans to finance a variety of speculative investments. On balance, the dollar
depreciated almost 10 percent against
the yen in 1998, reversing most of its
net gain over 1997.
Japanese economic activity contracted in 1998, as the country remained
in its most protracted recession of the
postwar era. Business and residential
investment plunged, and private consumption stagnated, more than offsetting positive contributions from governUS. Exchange Rate with Japan
Yen per dollar
140
120
100
1994
1995
1996
NOTE. The data are monthly.
1997
1998
36
85 th Annual Report, 1998
ment spending and net exports. Core
consumer prices declined slightly, while
wholesale prices fell almost 4*/2 percent. In April, the Japanese government
announced a large fiscal stimulus package. During the final two months of the
year, the government announced another
set of fiscal measures slated for implementation during 1999, which included
permanent personal and corporate
income tax cuts, incentives for investment, and further increases in public
expenditures.
Against the German mark, the dollar
depreciated about 6 percent, on net, over
1998. Late in the year the dollar moved
up against the mark, as evidence of a
slowdown of European growth raised
expectations of easier monetary conditions in Europe. In the event, monetary
policy was eased sooner than market
participants had expected, with a coordinated European interest rate cut coming
in early December.
A major event at the turn of the year
was the birth of the euro, which marked
the beginning of Stage Three of European Economic and Monetary Union
(EMU). On December 31, the rates locking the euro with the eleven legacy
currencies were determined; based on
these rates, the value of the euro at the
moment of its creation was $1.16675.
In the eleven European countries
whose currencies were fixed against the
euro, output growth slowed moderately
over the course of 1998, as net exports
weakened and business sentiment worsened. Unemployment rates came down
slightly, but on average these rates
remained in the double-digit range. Consumer price inflation continued to slow,
helped by lower oil prices. In December,
the harmonized CPI for the eleven countries stood 3/4 percent above its yearearlier level, meeting the European
Central Bank's primary objective of
inflation below 2 percent.
Between December 1997 and December 1998, the average value of the dollar
changed little against the British pound
but rose 8 percent against the Canadian
dollar. Weakness in primary commodity
prices, including oil, likely depressed
the value of the Canadian dollar. The
Bank of Canada raised official rates in
January 1998 and again in August, in
response to currency market pressures.
The Bank of England raised official rates
in June 1998 to counter inflation pressures. Tighter monetary conditions in
both countries, as well as a decline in
net exports associated with global difficulties, contributed to a slowing of output growth in the second half of the
year. The deceleration was sharper in
the United Kingdom than in Canada.
U.K. inflation eased slightly to near its
target rate, while Canadian inflation
remained near the bottom of its target
range. In response to weaker economic
activity as well as to the expected effects
of the global financial turmoil, both the
Bank of Canada and the Bank of
England lowered official interest rates in
the latter part of the year.
The general trend toward easier
monetary conditions was reflected in
declines in short-term interest rates in
almost all the G-10 countries during
1998. Interest rates in the euro area converged to relatively low German levels
in anticipation of the launch of the third
stage of EMU. Yields on ten-year government bonds in the major foreign
industrial countries declined significantly over the course of the year, as
economic activity slowed, inflation continued to moderate, and investors sought
safer assets. Between December 1997
and December 1998, ten-year interest
rates fell 180 basis points in the United
Kingdom and 150 basis points in
Germany. The ten-year rate fell only
30 basis points in Japan, on balance,
declining about 90 basis points over the
Economic and Financial Developments
first ten months of the year but backing
up in November and December, at least
in part because of market participants'
concerns that the demand for bonds
would be insufficient to meet the surge
in debt issuance associated with the
latest fiscal stimulus package.
Share prices on European stock exchanges again posted strong advances
in 1998, with price indexes rising 8 percent in the United Kingdom, about
15 percent in Germany, nearly 29 percent in France, and 41 percent in Italy.
In contrast, Japanese equity prices fell
more than 9 percent over the year, and
Canadian share prices declined 4 percent. After a considerable run-up earlier
in the year, share prices around the globe
fell sharply in late summer, but they
subsequently rebounded as the Federal
Reserve and several other central banks
eased monetary policy.
Foreign Exchange Operations
On June 17, the U.S. monetary authorities intervened in foreign exchange markets, selling a total of $833 million
for Japanese yen. The sales were split
evenly between the Federal Reserve
System and the U.S. Treasury. No other
foreign exchange intervention operations for the accounts of the System or
the Treasury were conducted during the
year. Reported net sales of dollars by
major central banks were $29 billion in
1998, versus $10 billion in 1997.
At the end of the year, the Federal
Reserve held the equivalent of $19,769
million, valued at current exchange
rates, in marks and yen.3 With the dollar's depreciation versus both currencies
in 1998, the cumulative gains on System
foreign currency holdings increased
$1,870 million, to $2,228 million.
Absent sales of foreign currencies, the
3. At the beginning of 1999, the System's holdings of marks were converted to euros.
37
U.S. and Foreign Interest Rates
Percent
Three-month
„ German/euro-area interbank
Ten-year
1992
1994
1996
1998
NOTE. The data are monthly.
System did not realize any gains or
losses.
On November 17, the FOMC voted
unanimously to reauthorize Federal
Reserve participation in the North
American
Framework
Agreement
(NAFA), established in 1994, and in the
associated bilateral reciprocal currency
swap arrangements with the Bank of
Canada and the Bank of Mexico. On
December 7, the Secretary of the Treasury authorized renewal of the Treasury's participation in the NAFA and of
the associated Exchange Stabilization
Agreement with Mexico. Other bilateral
swap arrangements with the Federal
Reserve—those with the Bank for International Settlements, the Bank of Japan,
and many European central banks—
were allowed to lapse in light of their
disuse over the past fifteen years and in
the presence of other well-established
arrangements for international monetary cooperation. The swap arrangement
between the Treasury's Exchange Stabilization Fund and the German Bundesbank was also allowed to lapse.
•
39
Monetary Policy Reports to the Congress
The reports in this chapter were submitted to the Congress on February 24
and July 21, 1998, pursuant to the Full
Employment and Balanced Growth Act
of 1978.
Report on February 24, 1998
Monetary Policy and the
Economic Outlook
The U.S. economy turned in another
excellent performance in 1997. Growth
was strong, the unemployment rate
declined to its lowest level in nearly a
quarter-century, and inflation slowed
further. Impressive gains were also
made in other important respects: The
federal budget moved toward balance
much more quickly than almost anyone
had anticipated; capital investment, a
critical ingredient for long-run growth,
rose sharply further; and labor productivity, the ultimate key to rising living
standards, displayed notable vigor.
Among the influences that have
brought about this favorable performance are the sound fiscal and monetary
policies that have been pursued in recent
years. Budgetary restraint at the federal
level has raised national saving, easing
the competition for funds in our capital
markets and thereby encouraging greater
private investment. Monetary policy, for
its part, has sought to foster an environment of subdued inflation and sustainable growth. The experience of recent
years has provided additional evidence
that the less households and businesses
need to cope with a rising price level, or
worry about the sharp fluctuations in
employment and production that usually
accompany inflationary instability, the
more long-term investment, innovation,
and enterprise are enhanced.
The circumstances that prevailed
through most of 1997 required that the
Federal Reserve remain especially attentive to the risk of a pickup in inflation.
Labor markets were already tight when
the year began, and nominal wages had
started to rise faster than previously.
Persistent strength in demand over the
year led to economic growth in excess
of the expansion of the economy's
potential, intensifying the pressures on
labor supplies. In earlier business expansions, such developments had usually
produced an adverse turn in the inflation trend that, more often than not,
was accompanied by a worsening of
economic performance on a variety of
fronts, culminating in recession.
Robust growth of spending early in
the year heightened concerns among
members of the Federal Open Market
Committee (FOMC) that growing
strains on productive resources might
touch off a faster rate of cost and price
rise that could eventually undermine
the expansion. Financial market participants seemed to share these concerns:
Intermediate- and long-term interest
rates began moving up in December
1996, effectively anticipating Federal
Reserve action. When the FOMC firmed
policy slightly at its March meeting by
raising the intended federal funds rate
from 5V4 percent to 5XA percent, the
market response was small.
The economy slowed a bit during the
second and third quarters, and inflation
moderated further. In addition, the
progress being made by the federal government in reducing the size of the defi-
40
85th Annual Report, 1998
cit was becoming more apparent. As a
consequence, by the end of September,
longer-term interest rates fell 3A percentage point from their peaks in mid-April,
leaving them about lA percentage point
below their levels at the end of 1996.
The decline in interest rates, along with
continued reports of brisk growth in
corporate profits, sparked increases in
broad indexes of equity prices of 20 percent to 35 percent between April and
September.
Even with a more moderate pace of
growth, labor markets continued to
tighten, generating concern among the
FOMC members over this period that
rising costs might trigger a rise in inflation. Consequently, at its meetings from
May through November, the Committee
adopted directives for the conduct of
policy that assigned greater likelihood
to the possibility of a tightening of policy than to the possibility of an easing
of policy. Even though the Committee
kept the nominal federal funds rate
unchanged, it saw the rise in the real
funds rate resulting from declining inflation expectations, together with the
increase in the exchange value of the
dollar, as providing some measure of
additional restraint against the possible
emergence of greater inflation pressures.
In the latter part of the year, developments in other parts of the world began
to alter the perceived risks attending the
U.S. economic outlook. Foreign economies generally had seemed to be on
a strengthening growth path when the
Federal Reserve presented its midyear
monetary policy report to the Congress
last July. But over the remainder of the
summer and during the autumn, severe
financial strains surfaced in a number of
advanced developing countries in Asia,
weakening somewhat the outlook for
growth abroad and thus the prospects
for U.S. exports. Although the circumstances in individual countries varied,
the problems they encountered generally resulted in severe downward pressures on the foreign exchange values of
their currencies; in many cases, steep
depreciations occurred despite substantial upward movement of interest rates.
Asset values in Asia, notably equity and
real estate prices, also declined appreciably in some instances, leading to losses
by financial institutions that had either
invested in those assets or lent against
them; nonfinancial firms began to
encounter problems servicing their obligations. In many instances the debts of
nonfinancial and financial firms were
denominated in dollars and unhedged.
Concerted international efforts to bring
economic and financial stability to the
region are under way, and some progress
has been made, but it is evident that in
several of the affected economies the
process of adjustment will be painful.
Meanwhile, economic activity in Japan
stagnated, in part because of the developments elsewhere in East Asia, and the
weaknesses in the Japanese financial
system became more apparent.
The steep depreciations of many
Asian currencies contributed to a substantial further appreciation of the U.S.
dollar. Measured against a broad set
of currencies that includes those of
the advanced developing countries of
Asia, the exchange value of the dollar,
adjusted for relative consumer prices,
has moved up about 8 percent since
October and has increased about 16 percent from its level at the end of 1996.
The dollar has also appreciated, on balance, against an index of currencies of
the G-10 (Group of Ten) industrial countries; this G-10 trade-weighted index of
dollar exchange rates is up about 13 percent in nominal terms since the end of
1996.
The difficulties in Asia contributed to
additional declines of lA to Vi percentage point in the yields on intermediate-
Monetary Policy Reports, February
and long-term Treasury securities in
the United States between mid-autumn
and the end of the year. These decreases
were due in part to an international
flight to the safe haven of dollar assets,
but they also reflected expectations that
these difficulties would exert a moderating influence on the growth of aggregate
demand and inflation in the United
States. Equity prices were quite volatile
but showed little trend in the fourth
quarter. In light of the ongoing difficulties in Asia and the possible effects on
the United States, the FOMC not only
left interest rates unchanged in December, but shifted its instructions to the
Manager of the System Open Market
Account to symmetry between ease and
tightening in the near term.
Some spillover from the problems in
Asia has recently begun to appear in
reports on business activity in the United
States. Customers in the advanced
developing countries reportedly have
canceled some of the orders they had
previously placed with U.S. firms, and
companies more generally are expressing concerns about the possibilities of
both reduced sales to Asia and more
intense price competition here as the
result of the sharp changes in exchange
rates. Nonetheless, the available statistics suggest on balance that overall
growth of output and employment has
remained brisk in the early part of 1998.
Confronted with the marked crosscurrents described above—involving both
upside and downside risks to the growth
of output and prospects for inflation—
the FOMC earlier this month once again
chose to hold its federal funds rate
objective unchanged. In credit markets,
interest rates have fallen further this
year as the effects of the Asian turmoil
seemed even more likely to restrain any
tendencies toward unsustainable growth
and greater inflation in the United
States. With interest rates lower and the
41
negative effects of the Asian problems
seen by market participants as mostly
limited to particular sectors, broad
indexes of equity prices have risen
appreciably, many to new highs.
Economic Projections for 1998
The outlook for 1998 is clouded with a
greater-than-usual degree of uncertainty.
Part of that uncertainty is a reflection of
the financial and economic stresses that
have developed in Asia, the full consequences of which are difficult to judge.
But there are some other significant
question marks as well, many of them
growing out of the surprising performance of the U.S. economy in 1997:
Growth was considerably stronger and
inflation considerably lower than Federal Reserve officials and most private
analysts had anticipated.
Some of the key forces that gave rise
to this favorable performance can be
readily identified. An ongoing capital
spending boom, encouraged in part
by declining prices of high-technology
equipment, provided stimulus to aggregate demand and at the same time created the additional capacity to help meet
that demand. A further jump in labor
productivity that was fueled partly by
the buildup of capital helped firms overcome the production and pricing challenges posed by tight labor markets. A
surprisingly robust stock market bolstered the finances of households and
enabled them to spend more freely. Falling world oil prices reduced the prices
of petroleum products and helped
hold down the prices of other energyintensive goods. Finally, a rising dollar
imposed additional restraint on inflation,
as prices of imported goods fell appreciably. Circumstances as favorable as
those of 1997 are not likely to persist,
although several elements in the recent
mix could help maintain, for some time,
42
85 th Annual Report, 1998
a more favorable economic performance
than historical relationships would
suggest.
In assessing the situation, the members of the Board of Governors and the
Reserve Bank presidents, all of whom
participate in the deliberations of the
FOMC, think that the most likely outcome for 1998 will be one of moderate
growth, low unemployment, and low
inflation. Most of them have placed their
point estimates of the rise in real gross
domestic product from the fourth quarter of 1997 to the fourth quarter of 1998
in the range of 2 percent to 23/4 percent.
The civilian unemployment rate in the
fourth quarter of 1998 is expected to be
at about its recent level. For the most
part, the forecasts have the total consumer price index for all urban consumers rising between P/4 percent and
2lA percent this year. These predictions
do not differ appreciably from those
recently put forth by the Administration.
Although developments in Asia over
the past few months have not yet
affected aggregate U.S. economic performance in a measurable way, these
influences will likely become more visible in coming months. Growth of U.S.
exports is expected to be restrained by
weaknesses in Asian economies and by
the lagged effects of the appreciation
of the dollar since 1995. Moreover, with
the rise in the dollar's value making
imports less expensive, some U.S. businesses and consumers will likely switch
from domestic to foreign sources for
some of their purchases. But the timing
and magnitude of these developments
are hard to predict.
In contrast to the slower growth that
seems to be in prospect for exports,
domestic spending seems likely to maintain considerable strength in coming
quarters. Households as a group are
quite upbeat in their assessments of their
personal finances—as might be expected
in conjunction with expanding job
opportunities, rising incomes, and huge
gains in wealth. Recently, many households have taken advantage of lower
long-term interest rates by refinancing
their home mortgages, and this will provide a little additional wherewithal for
spending. Moreover, the decline in mortgage rates is also bolstering housing
construction.
Business outlays for fixed investment
seem likely to advance at a relatively
brisk pace in the coming year, although
gains as large as those of the past couple
Economic Projections for 1998
Percent
Federal Reserve governors
and Reserve Bank presidents
Indicator
Administration
Range
Central
tendency
Change, fourth quarter
to fourth quarter1
Nominal GDP
Real GDP 2
Consumer price index3
3'/2-5
13/4-3
l'/2-2'/2
33/4-4 V2
2-23/4
13/4-2'/4
4.0
2.0
2.2
Average level,
fourth quarter
Civilian unemployment rate
4'/2-5
about 43/4
5.0
1. Change from average for fourth quarter of 1997 to
average for fourth quarter of 1998.
2. Chain-weighted.
3. All urban consumers.
Monetary Policy Reports, February
of years may be difficult to match. Outlays for computers, which have dominated the investment surge of the past
few years, should climb substantially
further as businesses press ahead with
new investment in the latest technologies, encouraged in part by ongoing
price declines. With labor markets tight,
firms continue to see capital investment
as the key in efforts to increase efficiency and maintain competitiveness.
Internally generated funds remain adequate to cover the bulk of businesses'
investment outlays, and those firms turning to the debt and equity markets are
most often finding financing generously
available on good terms. Inventory
growth will likely put less pressure on
business cash flow this year; after adding to stocks at a substantial clip in
1997, businesses seem likely to scale
back such investment somewhat, especially as they perceive a moderation in
sales increases.
The Federal Reserve policymakers'
forecasts of the average unemployment
rate in the fourth quarter of 1998 are
mostly around 43A percent. The persistence for another year of this degree of
tightness in the labor market means that
firms will likely continue to face difficulties in finding workers and that hiring
and retaining workers could become
more costly. Indeed, there are indications that wage inflation picked up further at the end of last year. Improvements in labor productivity have become
more sizable in the past couple of years,
and if such gains can be extended, wage
increases of the magnitude of those of
1997 need not translate into greater price
inflation. The more rapid growth in productivity is consistent with the high
level of capital investment in recent
years, but the extent to which the trend
in productivity has picked up is still
uncertain. Furthermore, if momentum in
nominal wages continues to build, the
43
pay increases will eventually squeeze
profit margins and place upward pressures on prices, even with exceptional
productivity gains. The strains in labor
markets therefore constitute an ongoing
inflationary risk that will have to be
monitored closely.
In the near term, however, there are
several factors that should lessen the
risk of a step-up in inflation. Manufacturing capacity remains ample, and
bottlenecks are not hampering production. The recent appreciation of the dollar should damp inflation both because
of falling import prices and because the
added competition from imports may
induce domestic producers to hold down
prices. Oil prices have weakened considerably since the latter part of 1997 in
response to abundant supplies, the softening of demand in Asia, and a mild
winter. Ample supplies and the prospect
of softer global demand have been
depressing the prices of many other
commodities, both in agriculture and in
industry. Perhaps most important, as the
low level of inflation that has prevailed
in recent years gets built into wage
agreements, other contracts, and individuals' inflation expectations, it will
provide an inertial force helping sustain
the favorable price performance for a
time.
Although many of the factors currently placing restraint on inflation are
not necessarily long lasting, the Committee judged that their effect in 1998
would about offset the pressures from
tight labor markets. Consequently, the
Board members and Reserve Bank
presidents anticipate that the rate of
price inflation will change little this
year. Again in 1998, the FOMC will be
monitoring a variety of price measures
in addition to the CPI for indications of
changes in inflation and will be assessing movements in the CPI in the context
of ongoing technical improvements by
44
85 th Annual Report, 1998
the Bureau of Labor Statistics that are
likely to damp the reported 1998 rise in
that index.
Money and Debt Ranges for 1998
In establishing the ranges for growth of
broad measures of money over 1998, the
Committee recognized the considerable
uncertainty that still exists about the
behavior of the velocities of these aggregates. The velocity of M3 (the ratio of
nominal GDP to the monetary aggregate) in particular has proved difficult
to predict. Last year, the growth of this
aggregate relative to spending was
affected by the rapid increase in depository credit and by the way in which that
increase was funded, as well as by the
changing cash management practices of
corporations, which have been using the
services of institution-only money funds
in M3. These factors boosted M3 growth
last year to 83/4 percent, 3 percentage
points faster than nominal GDP—an
unusually large decline in M3 velocity.
Going forward, it seems likely that M3
growth will continue to be buoyed by
robust credit growth at depositories and
continuing shifts in cash management.
Thus, its velocity is likely to decline
further, though the amount of decline is
difficult to predict.
The relationship of M2 to spending in
recent years has come back more into
line with historical patterns in which the
velocity of M2 tended to be fairly constant, except for the effects of the changing opportunity cost of M2—the spread
between yields that savers could earn
holding short-term market instruments
and those that they could earn holding
M2. In the early 1990s, M2 velocity
departed from this pattern, rising substantially and atypically. Even after the
unusual shift of the early 1990s died
out, M2 velocity continued to drift
somewhat higher from 1994 into 1997.
That drift probably reflected some continued, albeit more moderate, redirection of savings into bond and equity
markets, especially through the purchase
of mutual funds. However, last year the
drift abated. There was little change, on
balance, in the opportunity cost of holding M2, and M2 velocity also was about
unchanged, as M2 grew 5Vi percent,
nearly the same as nominal GDP. Nevertheless, the upward drift could resume in
the years ahead as financial innovations
or perceptions of attractive returns lead
households to further shift their savings
away from M2 balances. Or velocity
might be pushed downward if volatility
or setbacks in bond and stock markets were to lead investors to seek the
safety of M2 assets, which have stable
principal.
In light of the uncertainties about the
behavior of velocities, the Committee
followed its practice of recent years and
established the ranges for 1998 not as
expectations for actual money growth,
but rather as benchmarks for M2 and
M3 behavior that would be consistent
with sustained price stability, assuming
velocity change in line with pre-1990
historical experience. Thus, the ranges
for fourth-quarter to fourth-quarter
growth are unchanged from those in
1997: 1 percent to 5 percent for M2, and
2 percent to 6 percent for M3. Given the
central tendency of the Committee's
forecast for growth of nominal GDP of
Ranges for Growth of Monetary
and Debt Aggregates
Percent
Aggregate
M2
M3 .
Debt
1996
1997
1998
1-5
2-6
3-7
1-5
2-6
3-7
1-5
2-6
3-7
NOTE. Change from average for fourth quarter of
preceding year to average for fourth quarter of year
indicated.
Monetary Policy Reports, February
33A percent to 4]/2 percent, M2 is likely
to be in the range, perhaps in the upper
half, if short-term interest rates do not
change much and velocity continues
recent patterns. For M3, however, a continuation of recent velocity behavior
could imply growth around the upper
end of, if not above, the price-stability
range.
Debt of the nonfinancial sectors grew
43/4 percent in 1997, near the middle of
the range of 3 percent to 7 percent established by the Committee last February.
As with the monetary aggregates, the
Committee has left the range for debt
unchanged for 1998. The range it has
chosen encompasses the likely growth
of debt given Committee members'
forecasts of nominal GDP. Except for
the 1980s, the growth of debt has tended
to be reasonably in line with the growth
of nominal GDP.
Although the ranges for money and
debt are not set as targets for monetary
policy in 1998, the behavior of these
variables, interpreted carefully, can at
times provide useful information about
the economy and the workings of the
financial markets. The Committee will
continue to monitor the movements of
money and debt—along with a wide
variety of other financial and economic indicators—to inform its policy
deliberations.
Economic and Financial
Developments in 1997 and
Early 1998
The past year has been an exceptionally
good one for the U.S. economy. Initial
estimates indicate that real GDP
increased nearly 4 percent over the four
quarters of 1997. Household and business expenditures continued to rise
rapidly, owing in part to supportive
financial conditions, including a strong
stock market, ample availability of
45
credit, and, from April onward, declining intermediate- and long-term interest
rates. In the aggregate, private domestic
spending on consumption and investment rose nearly 5 percent on an
inflation-adjusted basis. The strength of
spending, along with a further sizable
appreciation of the foreign exchange
value of the U.S. dollar, brought a surge
of imports, the largest in many years.
Export growth, while lagging that of
imports, also was substantial despite the
appreciation of the dollar and the emergence after midyear of severe financial
difficulties in several foreign economies,
particularly among the advanced developing countries in Asia.
Meanwhile, inflation slowed from the
already reduced rates of the previous
few years. Although wages and total
hourly compensation accelerated in a
tight labor market, the inflationary
impulse from that source was more than
offset by other factors, including rising
competition from imports, the price
restraint from increased manufacturing
capacity, and a sizable gain in labor
productivity.
The Household Sector
Consumption Spending, Income,
and Saving
Bolstered by increases in income and
wealth, personal consumption expenditures rose substantially during 1997—
about 33/4 percent, according to the initial estimate. Expenditures strengthened
for a wide variety of durable goods.
Real outlays on home computers continued to soar, rising even faster than
they did over the previous few years.
Strength also was reported in purchases
of furniture and home appliances—
products that tend to do well when home
sales are strong. Consumer expenditures
on motor vehicles rose moderately, on
46
85th Annual Report, 1998
net, more than reversing the small
declines of the previous two years. Real
expenditures on services increased more
than 4 percent in 1997, the largest gain
of recent years. Personal service categories such as recreation, transportation,
and education recorded large increases.
Consumers also boosted their outlays
for business services, including outlays
related to financial transactions.
Real disposable personal income—
after-tax
income
adjusted
for
inflation—is estimated to have increased
about 33/4 percent during 1997, a gain
that was exceeded on only one occasion
in the previous decade. Income was
boosted this past year by sizable gains in
wages and salaries and by another year
of large increases in dividends.
Measured in terms of annual averages, the personal saving rate fell further
in 1997, according to current estimates.
The 1997 average of 3.8 percent was
about V2 percentage point below the
1996 average and roughly a full percentage point below the 1995 average.
It also was the lowest annual reading
in several decades. Various surveys of
households show consumers to have
become increasingly optimistic about
prospects for the economy, and this rising degree of optimism may have led
them to spend more freely from current
income. Support for additional spending
came from the further rise in the stock
market, as the capital gains accruing to
households increased the chances of
their meeting longer-run net worth
objectives even as they consumed a
larger proportion of current income.
Residential Investment
Preliminary data indicate that real residential investment increased nearly
6 percent during 1997. Real outlays for
the construction of new single-family
structures rose moderately, and outlays
for the construction of multifamily units
continued to recover from the extreme
lows that were reached earlier in the
decade. Real outlays for home improvements and brokers' commissions, categories that have a combined weight of
more than 35 percent in total residential
investment, moved up substantially from
the final quarter of 1996 to the final
quarter of 1997. Spending on mobile
homes, a small part of the total, also
advanced.
The indicators of single-family housing activity were almost uniformly
strong during the year. Sales of houses
surged, driven by declines in mortgage
interest rates and the increasingly
favorable economic circumstances of
households. Annual sales of new singlefamily houses were up about 5Vi percent from the number sold in the preceding year, and sales of existing homes
moved up about 3 percent. House prices
moved up more quickly than prices
in general. Responding to the strong
demand, starts of new single-family
units remained at a high level, only a
touch below that of 1996; the annual
totals for single-family units have now
exceeded 1 million units for six consecutive years, putting the current
expansion in single-family housing construction nearly on a par with that of
the 1980s in terms of longevity and
strength. In January of this year, starts of
and permits for single-family units were
both quite strong.
Starts of multifamily units increased
in 1997 for the fourth year in a row and
were about double the record low of
1993. The increased construction of
these units was supported by a firming
of rents, abundant supplies of credit, and
a reduction in vacancy rates in some
markets. The national vacancy rate came
down only slightly, however, and it has
reversed only a portion of the sharp
run-up that took place in the 1980s. This
Monetary Policy Reports, February
January, starts of multifamily units fell
back to about the 1997 average after
having surged to an exceptionally high
level in the fourth quarter.
The home-ownership rate—the number of households that own their dwellings divided by the total number of
households—moved up further in 1997,
to about 653/4 percent, a historical high.
The rate had fallen in the 1980s but has
risen almost 2 percentage points in this
decade.
Household Finance
Household net worth appears to have
grown roughly $3J/2 trillion during 1997,
ending at its highest multiple relative to
disposable personal income on record.
Most of this increase in net worth was
the result of upward revaluations of
household assets rather than additional
saving. In particular, capital gains on
corporate equities accounted for about
three-fourths of the increase in net
worth. Flows of household assets into
mutual funds, pensions, and other vehicles for holding equities indirectly were
exceeded by outflows from directly held
equities.
Household borrowing not backed by
real estate, including credit card balances, auto loans, and other consumer
credit, increased 43A percent in 1997.
These obligations grew at double-digit
rates in 1994 and 1995, but their growth
has slowed fairly steadily since then.
Mortgage borrowing, by contrast, has
experienced relatively muted swings in
growth during the current expansion.
Home mortgages are estimated to have
grown 7 percent last year, only a bit
slower than in 1996. Within this category of credit, however, home equity
loans have advanced sharply, reflecting
in part the use of these loans in refinancing and consolidating credit card and
other consumer obligations.
47
An element in the slowing of consumer credit growth may have been
assessments by some households that
they were reaching the limits of their
capacity for carrying debt and by some
lenders that they needed to tighten selectively their standards for granting new
loans. In the mid-1990s, the percentage
of household income required to meet
debt obligations rose to the upper end of
its historical range, in large part because
of a sharp rise in credit card debt.
Between 1994 and 1996 personal bankruptcies grew at more than a 20 percent
annual rate, to some extent because
of households' rising debt burden; a
change in the federal bankruptcy law
and a secular trend toward associating
less social stigma with bankruptcy also
may have contributed. Over the same
period, delinquency and charge-off
rates on consumer loans increased
significantly.
Last year, however, because the
growth of household debt only slightly
outpaced that of income while interest
rates drifted lower, the household debtservice burden did not change. Reflecting in part the stability of the aggregate
household debt burden, delinquency
rates on many segments of consumer
credit plateaued, although charge-off
rates generally continued to rise somewhat. Personal bankruptcies advanced
again last year but showed some signs
of leveling off in the third quarter.
Some of the apparent leveling out of
household debt-repayment problems
may also have resulted from efforts by
lenders to stem the growth of losses on
consumer loans. For the past two years,
a large percentage of the respondents to
the Federal Reserve's quarterly Senior
Loan Officer Opinion Survey on Bank
Lending Practices have reported tightened standards on consumer loans. But
the percentages reporting tightening
have fallen a bit in the last few surveys,
48
85th Annual Report, 1998
suggesting that many banks feel that
they have now altered their standards
sufficiently.
Although banks pulled back a bit
from consumer lending, most households had little trouble obtaining credit
in 1997. Bank restraint has most commonly taken the form of imposing lower
credit limits or raising finance charges
on outstanding balances; credit card
solicitations continued at a record pace.
Furthermore, many respondents to the
Federal Reserve's January 1998 survey
of loan officers said their banks had
eased terms and standards on home
equity loans, providing consumers easier
access to an alternative source of
finance.
Mortgage rates fell last month to levels that led many households to apply
for loan refinancing. When households
refinance, they may choose among
options that have differing implications
for cash flow, household balance sheets,
and spending. Some households may
decide to reduce their monthly payments, keeping the size of their mortgages unchanged. Others may keep their
monthly payments unchanged, either
speeding up their repayments or increasing their mortgages and taking out cash
in the process, perhaps to augment current expenditures. In any case, the wave
of refinancings is likely having only a
small effect on the overall economy
because the current difference between
the average rate on outstanding mortgages and the rate on new ones is not
very large.
The Business Sector
Investment Expenditures
Adjusted for inflation, businesses' outlays for fixed investment rose about
8 percent during 1997 after gaining
about 12 percent during 1996. Spending
continued to be spurred by rapid growth
of the economy, favorable financial conditions, attractive purchase prices for
new equipment, and optimism about the
future. Business outlays for equipment,
which account for more than threefourths of total business fixed investment, moved up about 12 percent this
past year, making it the fourth year of
the last five in which the annual gains
have exceeded 10 percent. As in previous years of the expansion, real investment rose fastest for computers, the
power of which continued to advance
rapidly at the same time their prices
continued to decline. Spending also
moved up briskly for many other types
of equipment, including communications equipment, commercial aircraft,
industrial machinery, and construction
machinery.
Real outlays for nonresidential construction, the remaining portion of business fixed investment, declined somewhat in 1997 after moving up in each of
the four previous years. Construction of
office buildings continued to increase in
1997, but sluggishness was apparent in
the expenditure data for many other
types of structures. Nonetheless, a tone
of underlying firmness was apparent in
other indicators of market conditions.
Vacancy rates declined, for example,
and rents seemed to be picking up. In
some areas of the country, more builders
have been putting up new office buildings on "spec"—that is, undertaking
new construction before occupants have
been lined up. The new projects are
apparently being spurred to some degree
by the ready availability of financing.
Business inventory investment picked
up considerably in 1997. According to
the initial estimate, the level of inventories held by nonfarm businesses rose
about 5 percent in real terms over the
course of the year after increasing
roughly 2 percent in 1996. Accumula-
Monetary Policy Reports, February
tion was especially rapid in the commercial aircraft industry, in which production has been ramped up in response to
a huge backlog of orders for new jets.
With the rate of inventory growth outpacing the growth of final sales last year,
the stock-to-sales ratio in the nonfarm
sector ticked up slightly, after a small
decline in the preceding year. Although
inventory accumulation does not seem
likely to persist at the pace of 1997,
businesses in general do not appear to
be uncomfortable with the levels of
stocks they have been carrying.
Corporate Profits
and Business Finance
The economic profits of U.S. corporations (book profits after inventory
valuation and capital consumption
adjustments) increased at more than a
14 percent annual rate over the first three
quarters of 1997, and the profits of nonfinancial corporations from their domestic operations grew at a W/i percent
annual rate. In the third quarter, nonfinancial corporate profits amounted to
nearly 14 percent of that sector's nominal output, up from 1XA percent in 1982
and the highest share since 1969. The
elevated profit share reflects both the
high level of cash flow before interest
costs, which also stands at a multiyear
peak relative to output, and the reductions in interest costs that have taken
place in the 1990s. Fourth-quarter profit
announcements indicate that year-overyear growth in earnings was fairly
strong; few corporations reported that
they had experienced much fallout yet
from the events in Asia, but many
warned that profits in the first half of
1998 will be significantly affected.
Despite the rapid growth in profits,
the financing gap for nonfinancial
corporations—capital expenditures less
internal cash flow—widened, reflecting
49
the strong expansion of spending on
capital equipment and inventories. Furthermore, on net, firms continued to
retire a large volume of equity, adding
further to borrowing needs, as substantial gross issuance was swamped by
stock repurchases and merger-related
retirements. Given these financing
requirements, the growth of nonfinancial corporate debt picked up to more
than a 7 percent rate last year.
With the debt of nonfinancial corporations advancing briskly, the ratio of their
interest payments to cash flow was about
unchanged last year, after several years
of decline that had left it at quite a low
level. Consequently, measures of debtrepayment difficulties also were very
favorable last year: The default rate on
corporate bonds remained extremely
low, and the number of upgrades of debt
about equaled the number of downgrades. Similarly, only small percentages of business loans at banks were
delinquent or charged off. The rate of
business bankruptcies increased a bit but
was still fairly low.
Businesses continued to find credit
amply supplied at advantageous terms
last year. The spread between yields on
investment-grade bonds and yields on
Treasury securities of similar maturities
remained narrow, varying only a little
during the year. The spreads on belowinvestment-grade bonds fell over the
year, touching new lows before widening a bit in the fall and early this year;
the widening occurred in large part
because these securities benefited less
from the flight to U.S. assets in response
to events in Asia than did Treasury securities. Banks also appeared eager to lend
to businesses. Large percentages of the
respondents to the Federal Reserve's
surveys, citing stiff competition as the
reason, said they had eased terms—
particularly spreads—on business loans
last year. Much smaller percentages
50
85 th Annual Report, 1998
reported having eased standards on these
loans. The high ratios of stock prices to
earnings suggest that equity finance was
also quite cheap last year. Nevertheless,
the market for initial public offerings of
equity was cooler than in 1996—new
issues were priced below the expected
range more often than above it, and
first-day trading returns were smaller on
average.
The pickup in business borrowing
was widespread across funding sources.
Outstanding commercial paper, which
had declined a bit in 1996, posted strong
growth in 1997, as did bank business
loans. Gross issuance of bonds was
extremely high, particularly bonds with
ratings below investment grade. Such
lower-rated bonds made up nearly half
of all issuance, a new record. Although
sales of new investment-grade bonds
slowed a bit in the fall, corporations
were apparently waiting out the market volatility at that time, and issuance picked back up in January. Banks,
real estate investment trusts, and
commercial-mortgage-backed securities
were the most significant sources of
funds for income properties—residential
apartments and commercial buildings—
the financing of which expanded further
last year.
The Government Sector
Federal Expenditures, Receipts,
and Finance
Nominal outlays in the unified budget
increased about IVi percent in fiscal
year 1997 after moving up 3 percent in
fiscal 1996. Fiscal 1997 was the sixth
consecutive year that the growth of
spending was less than the growth of
nominal GDP. During that period,
spending as a percentage of nominal
GDP fell from about 22Vi percent to just
over 20 percent. The set of factors that
have combined to bring about this result
includes implementation of fiscal policies aimed at reducing the deficit, which
has helped slow the growth of discretionary spending and spending on some
social and health services programs, and
the strength of the economy, which has
reduced outlays for income support.
In nominal terms, small to moderate
increases were recorded in most major
expenditure categories in fiscal 1997.
Net interest outlays, which have been
accounting for about 15 percent of total
unified outlays in recent years, rose only
a small amount in 1997, as did nominal
outlays for defense and those for income
security. Expenditures on Medicaid rose
moderately for a second year after having grown very rapidly for many years;
spending in this category has been
restrained of late by the strong economy,
the low rate of inflation in the medical
area, and policy changes in the Medicaid program. Policy shifts and the
strong economy also cut into outlays for
food stamps, which fell about 10 percent
in fiscal 1997. By contrast, spending on
Medicare continued to rise at about three
times the rate of total federal outlays.
Growth of outlays for social security
also exceeded the rate of rise of total
expenditures.
Real federal outlays for consumption
and gross investment, the part of federal
spending that is counted in GDP, were
unchanged, on net, from the last quarter
of 1996 to the final quarter of 1997.
Real outlays for defense, which account
for about two-thirds of the spending for
consumption and investment, declined
slightly, offsetting a small increase in
nondefense outlays. Because of much
larger declines in most other recent
years, the level of real defense outlays at
the end of 1997 was down about 22 percent from its level at the end of the
1980s; total real outlays for consump-
Monetary Policy Reports, February
tion and investment dropped about
14 percent over that period.
Federal receipts rose faster than nominal GDP for a fifth consecutive year in
fiscal 1997; receipts were 193/4 percent
of GDP last year, up from \13A percent
in fiscal 1992. The ratio tends to rise
during business expansions, mainly
because of cyclical increases in the share
of profits in nominal GDP. In the past
couple of years, the ratio also has been
boosted by the tax increases included
in the Omnibus Reconciliation Act of
1993, by a rising income share of highincome taxpayers, and by receipts from
surging capital gains realizations, which
raise the numerator of the ratio but not
the denominator because capital gains
realizations are not part of GDP. In fiscal 1997, combined receipts from individual income taxes and social insurance taxes, which account for about
80 percent of total receipts, moved up
about 9Vi percent, even more than in
fiscal 1996. Receipts from the taxes on
corporate profits were up about 6 percent in fiscal 1997 after increasing about
9!/2 percent in the preceding fiscal year.
The total rise in receipts in fiscal 1997,
coupled with the subdued rate of
increase in nominal outlays, resulted in
a budget deficit of $22 billion, down
from $107 billion in the preceding fiscal
year.
With the budget moving close to balance, federal borrowing slowed sharply
last year. The Treasury responded to the
smaller-than-expected borrowing need
by reducing sales of bills in order to
keep its auctions of coupon securities
predictable and of sufficient volume to
maintain the liquidity of the secondary
markets. The result was an unusually
large net redemption of bills, which at
times pushed yields on short-term bills
down relative to yields on other Treasury securities and short-term private
obligations.
51
Last year saw the first issuance by the
Treasury of inflation-indexed securities.
The Treasury sold indexed ten-year
notes in January and April of last year
and again this January, and sold fiveyear notes in July and October; it also
announced that it would sell indexed
thirty-year bonds this April. Investor
interest in the securities at those auctions was substantial, with the ratios of
received bids to accepted bids resembling those for nominal securities. As
expected, most of the securities were
quickly acquired by final investors, and
the trading volume as a share of the
outstanding amount has been much
smaller than for nominal securities.
An important macroeconomic implication of the reduced federal deficit is
that the federal government has ceased
to be a negative influence on the level of
national saving. The improvement in the
federal government's saving position in
recent years has more than accounted
for a rise in the total gross saving of
households, businesses, and governments, from about \AVi percent of gross
national product earlier in the decade,
when federal government saving was at
a cyclical low and highly negative, to
more than 17 percent in the first three
quarters of 1997. This rise in domestic
saving, along with increased borrowing
from abroad, has financed the rise in
domestic investment in this expansion.
Still higher rates of saving and investment were the norm a couple of decades
ago, when the personal saving rate was
a good bit above its level in recent
years.
State and Local Governments
The real outlays of state and local governments for consumption and investment moved up about 2 percent over
the four quarters of 1997, similar to
the average since the start of the 1990s.
52
85th Annual Report, 1998
Investment expenditures, which have
grown about 2Vi percent per annum this
decade, rose at only half that pace in
1997, according to the initial estimate.
However, real consumption expenditures increased 2lA percent last year,
a touch above the average for the
decade. Compensation of government
employees, which accounts for about
three-fifths of real consumption and
investment expenditures, rose about
PA percent in 1997 and has increased at
an annual rate of only about 1 lA percent
since the end of the 1980s.
The efforts of state and local governments to hold down their labor expenses
are also reflected in the recent data on
nominal wages and hourly compensation. According to the employment cost
indexes, hourly compensation of the
workers employed by state and local
governments increased 2lA percent in
1997, a little less than in 1996 and
the smallest annual increase in the
seventeen-year history of the series. The
increase in the average hourly wage of
state and local employees amounted to
about 23/4 percent in 1997, roughly the
same as the gain in 1996. The average
hourly cost of the benefit packages provided to state and local employees rose
only 1 lA percent, a percentage point less
than the increase in 1996.
With costs contained and receipts
continuing to rise with the growth of the
economy, financial pressures that were
evident among state and local governments earlier in the expansion have
diminished. The increased breathing
room in the budgets of recent years is
apparent in the consolidated current
account of these governments: Surpluses
in that account, excluding those that are
earmarked for social insurance funds,
had dipped to a low of about 1 Vi percent
of nominal receipts in 1991, but they
have been larger than 3 percent of
receipts in each of the past three years.
State and local debt expanded about
53/4 percent last year after changing little
in 1996 and declining in the two preceding years. In those earlier years, municipal debt outstanding had been held down
by the retirement of bonds that were
"advance refunded" in the early 1990s.
In such operations, funds that had earlier
been raised and set aside were used to
refund debt as it became callable. By the
end of 1996, however, the stock of such
debt had apparently been largely worked
down.
External Sector
Trade and the Current Account
The nominal trade deficit for goods and
services was $114 billion in 1997, little
changed from the $111 billion deficit in
1996. For the first three quarters of the
year, the current account deficit reached
$160 billion at an annual rate, somewhat wider than the 1996 deficit of
$148 billion. This deterioration of the
current account largely reflects continued declines in net investment income,
which for the first time recorded deficits
in each of the first three quarters of the
year.
The quantity of imports of goods and
services expanded strongly during
1997—about 13 percent according to
preliminary estimates—as the very rapid
growth experienced during the first half
of the year moderated slightly during
the second half. The expansion was
fueled by continued vigorous growth of
U.S. GDP. Additional declines in nonoil import prices—related in large part
to the appreciation of the dollar—
contributed as well. Of the major trade
categories, increases in imports were
sharpest for capital goods and consumer
goods.
Export growth was also strong in
1997, particularly during the first half
Monetary Policy Reports, February
of the year. The quantity of exports of
goods and services rose nearly 11 percent, after a rise of 9lA percent the preceding year. Despite further appreciation of the dollar, exports accelerated
in response to the strength of economic
activity abroad. Output growth in most
of our industrial-country trading partners firmed in 1997 from the moderate
rates observed in 1996. Among our
developing-country trading partners,
robust growth continued through much
of the year, but the onset of crises in
several Asian economies late in 1997
led to abrupt slowdowns in economic
activity. Growth of exports to Latin
American countries and to Canada was
particularly strong. Exports to Western
Europe also increased at a healthy pace.
53
stocks were a record $55 billion. In
addition, foreign direct investment in the
United States also posted a new high of
$78 billion, as the strong pace of acquisitions of U.S. companies by foreigners
continued.
U.S. direct investment abroad in
the first three quarters of 1997 also
exceeded the 1996 pace, with a record
net outflow of $88 billion. U.S. net purchases of foreign securities in the first
three quarters of 1997 were $74 billion,
a little below the pace for 1996. However, net purchases of stocks in Japan
and bonds in Latin America were up
substantially. Banks in the United States
reported a large increase in net claims
on foreigners in the first quarter but only
a modest increase in the next two quarters combined.
Capital Flows
In the first three quarters of 1997, large
increases were reported in both foreign
ownership of assets in the United States
and U.S. ownership of assets abroad,
reflecting the continued trend toward the
globalization of both financial markets
and the markets for goods. Little evidence of the gathering financial storm in
Asia was apparent in the data on U.S.
capital flows through the end of September. Foreign official assets in the
United States rose $46 billion in the first
three quarters of 1997. The increases
were concentrated in the holdings of
certain industrial countries and members of OPEC. Although substantial,
these increases were below the pace for
the first three quarters of 1996.
In contrast, increases in assets held by
other foreigners in the first three quarters of 1997 surpassed those recorded in
1996. In particular, net purchases of US.
Treasury securities by private foreigners
rose to $130 billion, net purchases of
U.S. corporate and other bonds reached
$96 billion, and net purchases of US.
The Labor Market
Employment, Productivity,
and Labor Supply
More than 3 million jobs were added to
nonfarm payrolls in 1997—a gain of
nearly 23A percent, measured from
December to December. Patterns of
hiring mirrored the broadly based gains
in output and spending. Manufacturing, construction, trade, transportation,
finance, and services all exhibited appreciable strength. In manufacturing, the
1997 rise in the job count followed two
years of little change. Elsewhere, the
gains in 1997 came on top of substantial
increases in other recent years. Especially rapid increases were posted this
past year in some of the services industries, including computer services,
management services, education, and
recreation. Employment at suppliers of
personnel, a category that includes the
agencies that supply help on a temporary basis, also increased appreciably in
1997, but the gains in this category fell
54
85th Annual Report, 1998
considerably short of those seen in
previous years of the expansion. Helpsupply firms reported that shortages of
workers were limiting the pace of their
expansion.
Labor productivity has risen rapidly
over the past two years. Revised data
show the 1996 gain in output per hour
in the nonfarm business sector to have
been about \3A percent, and the increase
in 1997 was larger still—about 2lA percent, according to the first round of estimates. Although the average rate of productivity increase since the end of the
1980s still is only a little above 1 percent per year, the data for the past two
years provide hopeful indications that
sustained high levels of investment in
new technologies may finally be translating into a stronger trend.
The civilian unemployment rate fell
more than Vi percentage point from the
fourth quarter of 1996 to the fourth
quarter of 1997, to an average of just
under 43/4 percent. The rate held steady
at this level in January of this year. For
most of the past year, the rate has been
running somewhat below the minimum
that was reached in the expansion of the
1980s. A variety of survey data indicate
that firms have had increased difficulty
filling jobs.
After moving up a step in 1996, the
labor force participation rate continued to edge higher in 1997. Without
the increment to labor supply from
increased participation over these two
years, the unemployment rate would
have fallen to an even lower level.
Changes in the welfare system perhaps
contributed to some extent to the small
rise in participation in 1997, although
this effect is difficult to disentangle from
the normal tendency of participation to
rise when the labor market is tight. Even
though one-third of the adult population remained outside the labor force
in 1997, the vast majority of those
individuals likely were in pursuits that
tended to preclude their workforce participation, such as retirement, schooling,
or housework. The percentage of the
working age population interested in
work but not actively seeking it moved
down further in 1997, to 2lA percent in
the fourth quarter, a record low in the
history of the series, which began in
1970.
Wages and Hourly Compensation
According to the employment cost
indexes, hourly compensation in private industry increased 3.4 percent from
December of 1996 to December of
1997. This rise exceeded that of the
previous year by 0.3 percentage point
and was 0.8 percentage point greater
than the increase of 1995. Although the
patterns of change in hourly pay have
varied quite a bit by industry and occupation over the past two years, the
overall step-up seems to have been
prompted, in large part, by the tightening of labor markets. The implementation of a higher minimum wage also
seems to have been a factor in some
industries and occupations, although its
impact is difficult to assess precisely.
The wage and salary component of
hourly compensation rose faster in 1997
than in any previous year of the expansion. Annual increases in the employment cost index for wages and salaries in private industry amounted to
2.8 percent in both 1994 and 1995, but
the increases of 1996 and 1997 were
3.4 percent and 3.9 percent respectively.
Wages and salaries in the serviceproducing industries accelerated nearly
a full percentage point in 1997, pushed
up, especially, by sharp pay increases in
the finance, insurance, and real estate
sector, in which commissions and
bonuses have recently been boosted
by high levels of mortgage refinancing
Monetary Policy Reports, February
and trading activity. By contrast, hourly
wages in the goods-producing industries
slowed a couple of tenths of a percentage point in 1997; the annual gains in
these industries have been around 3 percent, on average, in each of the past six
years.
Although the costs of the fringe benefits that companies provide to their
employees also picked up in 1997, the
yearly increase of 2.3 percent was not
large by historical standards. As in other
recent years, benefit costs in 1997 were
restrained by a variety of influences.
Most notably, the price of health care
continued to rise at a subdued pace, and
the ongoing strength of the economy
limited the need for payments by firms
to state unemployment trust funds. Even
though some firms reported seeing
renewed sharp increases in health care
costs during the year, the employment
cost data suggest that most firms still
were keeping those costs under fairly
tight control.
With nominal hourly compensation in
almost all industries moving ahead at a
faster pace than inflation, workers' pay
generally increased in real terms, and
the real gains were substantial in many
occupations. Indeed, the employment
cost index does not capture some of the
forms of compensation that employers
have been using to attract and retain
workers—stock options and signing
bonuses, for example.
Prices
Indications of a slowing of inflation in
1997 were widespread in the various
measures of aggregate price change. The
consumer price index, which had picked
up to more than a 3 percent rate of rise
over the four quarters of 1996, increased
slightly less than 2 percent over the four
quarters of 1997 as energy prices turned
down and increases in food prices
55
slowed. The CPI excluding food and
energy—a widely used gauge of the
underlying trend of inflation—rose only
2lA percent in 1997 after increases of
3 percent in 1995 and 2Vi percent in
1996. The CPI for commodities other
than food and energy rose about Vi percent over the four quarters of 1997 after
moving up slightly more than 1 percent
in 1996. Price increases for non-energy
services, which have a much larger
weight than commodities in the core
CPI, also slowed a little in 1997; a 3 percent rise during the year was about
l
A percentage point less than the
increase during 1996. Only small portions of the slowdowns between 1996
and 1997 in the total CPI and in the CPI
excluding food and energy were the
result of technical changes implemented
by the Bureau of Labor Statistics.1
Other measures of aggregate price
change also decelerated in 1997. The
chain-type price index for gross domestic purchases—the broadest measure of
prices paid by U.S. households, businesses, and governments—increased
about Wi percent during 1997 after
moving up 2lA percent in 1996. The
chain-type price index for gross domestic product, a measure of price change
for the goods and services produced in
this country (rather than the goods and
services purchased), increased PA per1. Over the past three years, the Bureau of
Labor Statistics has introduced a number of technical changes in its procedures for compiling the
CPI, with the aim of obtaining a more accurate
measure of price change. Typically, the changes
have only a small effect on the results for any
particular year, but their cumulative effects are
somewhat larger and are tending to hold down the
reported increases of recent years relative to what
would have been reported with no changes in
procedures. Apart from the procedural changes,
the reported rate of rise from 1998 forward will
also be affected by an updating of the CPI market
basket, an action that the BLS undertakes approximately every ten years.
56
85th Annual Report, 1998
Alternative Measures of Price Change
Percent
Price measure
1996
1997
Fixed-weight
Consumer price index
Excluding food and energy ...
3.2
2.6
1.9
2.2
Chain-type
Personal consumption
expenditures
Excluding food and energy ...
Gross domestic purchases
Gross domestic product
2.7
2.3
2.3
2.3
1.5
1.6
1.4
1.8
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.
cent in the latest year after rising
2XA percent in 1996. The steeper slowing of the price index for aggregate purchases relative to that for aggregate production was largely a reflection of the
prices of imports, which fell faster in
1997 than in 1996. Falling computer
prices were an important influence on
many of these measures of aggregate
price change—more so than on the CPI,
which gave small weight to computers
through 1997 but has started weighting
them more heavily this year.
In real terms, imports of goods and
services account for approximately
15 percent of the total purchases of
households, businesses, and governments located in the United States. But
that figure probably understates the
degree of restraint that falling import
prices have imposed on domestic inflation, because the lower prices for
imports also make domestic producers
of competing products less likely to
raise prices. Prices have also been
restrained by large additions to manufacturing capacity in this country,
amounting to more than 5 percent in
each of the past three years; this capacity growth helped to stave off the bottlenecks that so often have developed
in the more advanced stages of other
postwar business expansions. A gain in
manufacturing production of more than
6 percent this past year was accompanied by only a moderate increase in the
factory operating rate, which, at yearend, remained well below the highs
reached in other recent expansions and
the peak for this expansion, which was
recorded about three years ago.
Reflecting the ample domestic supply
and the effects of competition from
goods produced abroad, the producer
price index for finished goods declined
about 3/4 percent from the fourth quarter
of 1996 to the fourth quarter of 1997;
excluding food and energy, it rose only
fractionally. Prices of domestically produced materials (other than food and
energy) also rose only slightly, on net.
The prices of raw industrial commodities, many of which are traded in international markets, declined over the year;
the weakness of prices in these markets
was especially pronounced in late 1997,
when the crises in Asia were worsening.
Industrial commodity prices fell further
in the first couple of weeks of 1998,
but they since have changed little, on
balance. The producer price index fell
sharply in January of this year; the index
excluding food and energy declined
slightly.
After moving up more than 4 percent
in 1996, the consumer price index for
food increased only \3A percent in 1997.
Impetus for the large increase of 1996
had come from a surge in the price of
grain, which peaked around the middle
of that year; since then, grain prices
have dropped back considerably. An
echo of the up-and-down price pattern
for grains appeared at retail in the form
of sharp price increases for meats, poultry, and dairy products in 1996 followed
by small to moderate declines for most
of those products in 1997. Moderate
price increases were posted at retail for
most other food categories last year.
Monetary Policy Reports, February
The CPI for energy has traced out an
even bigger swing than the price of food
over the past two years—a jump of
IV2 percent over the four quarters of
1996 was followed by a decline of about
1 percent over the four quarters of 1997.
As is usually the case in this sector, the
key to these developments was the price
of crude oil, which in 1997 more than
reversed the run-up of the preceding
year. Prices of oil have been held down
in recent months by ample world supplies, the economic problems in Asia,
and a mild winter.
Survey data on inflation expectations
mostly showed moderate reductions during 1997 in respondents' views of the
future rate of price increase, and some
of the survey data for early 1998 have
shown a more noticeable downward
shift in inflation expectations. A lowering of inflation expectations has long
been viewed as an essential ingredient
in the pursuit of price stability, and the
recent data are a sign that progress is
still being made in that regard.
Credit, Money, Interest Rates,
and Equity Prices
Credit and Depository Intermediation
The debt of the domestic nonfinancial
sectors grew at a 43A percent rate last
year, somewhat below the midpoint of
the range established by the FOMC and
less than in 1996, when it grew 5]A percent. The deceleration was accounted
for entirely by the federal component,
which, because of the reduced budget
deficit, rose less than 1 percent last year
after having risen 33A percent in 1996.
Nonfederal debt grew 6 percent, a bit
more than in 1996, as the pickup in
business borrowing more than offset the
deceleration of household debt.
Depository institutions increased their
share of credit flows in 1997, with credit
57
on their books expanding 53A percent,
up appreciably from growth in 1996.
The growth of bank credit, adjusted to
remove the effects of mark-to-market
accounting rules, accelerated to an
8lA percent pace, the largest rise in ten
years; and banks' share of domestic nonfinancial debt outstanding climbed to its
highest level since 1988. Bank credit
accelerated in part because banks' holdings of securities—which had run off
in 1995 and had been flat in 1996—
expanded at a brisk pace last year; securities account for one-fourth of total
bank credit. Loans, which make up the
remainder of bank credit, also advanced
a bit more quickly last year than in
1996, though more slowly than in 1995.
The increase in bank loans occurred
despite a net decline in consumer loans
on banks' books resulting both from
sharply slower growth in loans originated by banks and from continued
securitization of those loans. Real estate
loans at banks, by contrast, posted solid
growth last year. This category of credit
benefited from a pickup in home mortgages, the rapid growth in home equity
loans, which were substituting in part
for consumer loans, an acceleration
in commercial real estate lending, and
the acquisition of thrift institutions by
banks. Commercial and industrial loans
expanded considerably last year, reflecting both the general rise in the demand
by businesses for funds and an increase
in banks' share of the nonmortgage business credit market as they competed
vigorously for business loans by easing
terms.
The rapid growth of banks' assets was
facilitated by their continued high profitability and abundance of capital; at the
end of the third quarter, nearly 99 percent of bank assets were at wellcapitalized institutions. Problems with
the repayment performance of consumer
loans—which, while not deteriorating
58
85 th Annual Report, 1998
further, remained elevated by historical
standards—hurt some banks; however,
overall loan delinquency and charge-off
rates stayed quite low, and measures of
banks' profitability persisted at the elevated levels they have occupied for several years. Profits at a few large bank
holding companies were reduced in the
fourth quarter by trading losses resulting
from the events in Asia. Nonetheless,
the profits of the industry as a whole
remained robust.
The profits and capital levels of thrift
institutions, like those of banks, were
high last year, and the thrifts also were
aggressive lenders. The outstanding
amount of credit extended by thrifts
grew at about a l!/2 percent pace last
year, but this sluggishness reflected
entirely the acquisitions of thrifts by
commercial banks; among thrifts not
acquired during the year, asset growth
was similar to that of banks.
The Monetary Aggregates
Boosted in part by the need to fund
substantial growth in depository credit,
M3 shot up last year, expanding $3A percent; this growth was well above the
2 percent to 6 percent annual range,
which was intended to suggest the rate
of growth over the long run consistent
with price stability. M3 was augmented
by a shift in sources of funding—mostly
at U.S. branches and agencies of foreign
banks—from borrowings from related
offices abroad, which are not included in
M3, to large time deposits issued in the
United States, which are. Also contributing to the strength in M3 was rapid
growth in institution-only money funds,
which reflected gains by these funds in
the provision of corporate cash management services. Corporations that manage their own cash often keep their
funds in short-term assets that are not
included in M3.
Although growth of M2 did not match
that of M3, it increased at a brisk
5*/2 percent rate last year. As the Committee had anticipated, the aggregate
was somewhat above the upper bound
of its 1 percent to 5 percent annual
range, which also had been chosen to
be consistent with expected M2 growth
under conditions of price stability. Because short-term interest rates responded
only slightly to System tightening in
March, the opportunity cost of holding
M2—the interest earnings forgone by
owning M2 assets rather than money
Growth of Money and Debt
Percent
Ml
Period
M2
M3
Domestic
nonfinancial
debt
Annual'
1987
1988
1989
6.3
4.3
.5
4.2
5.7
5.2
5.8
6.3
4.0
9.9
8.9
7.8
1990
1991
1992
1993
1994 .
4.2
7.9
14.4
10.6
25
4.1
3.1
1.8
1.3
.6
1.8
1.2
.6
1.1
1.7
6.8
4.5
4.7
5.1
5 1
1995
1996
1997
-1.6
-4.5
-1.2
3.9
4.6
5.6
6.1
6.9
8.7
5.4
5.2
4.7
Quarterly
(annual rate)2
1997:Q1
Q2
Q3
Q4
-1.4
-4.5
.3
.8
5.1
4.4
5.4
6.8
8.0
7.7
8.1
9.8
4.3
4.7
4.1
5.2
. .
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.
Monetary Policy Reports, February
market instruments such as Treasury
bills—was about unchanged over the
year. As M2 grew at about the same rate
as nominal GDP, velocity was also
essentially unchanged. The ups and
downs of M2 growth last year mirrored
those of the growth in nominal output.
M2 expanded much more slowly in the
second quarter than in the first, consistent with the cooling of nominal GDP
growth and almost unchanged opportunity costs. In the second half of the year,
M2 growth picked up, again pacing the
growth of nominal GDP. In the fall, M2
may also have been boosted a little by
the volatility in equity markets, which
may have led some households to seek
the relative safety of M2 assets.
For several decades before 1990, M2
velocity responded positively to changes
in its opportunity costs and otherwise
showed little net movement over time.
This pattern was disturbed in the early
1990s in part by households' apparent
decision to shift funds out of loweryielding M2 deposits into higheryielding stock and bond mutual funds,
which raised M2 velocity even as opportunity costs were declining. The movements in the velocity of M2 from 1994
into 1997 appear to have again been
explained by changes in opportunity
costs, along with some residual upward
drift. This drift suggests that some
households may still have been in the
process of shifting their portfolios
toward non-M2 assets. There was no
uptrend in velocity over the second half
of last year, perhaps because of the
declining yields on intermediate- and
long-term debt and the greater volatility
and lower average returns posted by
stock mutual funds. However, given the
aberrant behavior of velocity during the
1990s in general, considerable uncertainty remains about the relationship
between the velocity and opportunity
cost of M2 in the future.
59
Ml fell VA percent last year. As has
been true for the past four years, the
growth of this aggregate was depressed
by the adoption by banks of retail sweep
programs, whereby balances in transactions accounts, which are subject to
reserve requirements, are "swept" into
savings accounts, which are not. Sweep
programs benefit depositories by reducing their required reserves, which earn
no interest. At the same time, they do
not restrict depositors' access to their
funds for transactions purposes, because
the funds are swept back into transactions accounts when needed. The initiation of programs that sweep funds out
of NOW accounts—until last year the
most common form of retail sweep
programs—appears to be slowing, but
sweeps of household demand deposits
have picked up, leaving the estimated
total amount by which sweep account
balances increased last year similar
to that in 1996. Adjusted for the initial
reduction in transactions accounts
resulting from the introduction of new
sweep programs, Ml expanded 6lA percent, a little above its sweep-adjusted
growth in 1996.
The drop in transactions accounts
caused required reserves to fall 1XA percent last year. Despite this decline, the
monetary base grew 6 percent, boosted
by a hefty advance in currency. Currency again benefited from foreign
demand, as overseas shipments continued at the elevated levels seen in recent
years. Moreover, domestic demand for
currency expanded sharply in response
to the strong domestic spending.
The Federal Reserve has been concerned that as the steady decline in
required reserves of recent years is
extended, the federal funds rate may
become significantly more volatile.
Required reserves are fairly predictable
and must be maintained on only a twoweek average basis. As a result, the
60
85th Annual Report, 1998
unavoidable daily mismatches between
reserves made available through open
market operations and desired reserves
typically have been fairly small, and
their effect on the federal funds rate has
been muted. However, banks also hold
reserve balances at the Federal Reserve
to avoid overdrafts after making payments for themselves and their customers. This component of the demand for
reserves is difficult to predict, varies
considerably from day to day, and must
be fully satisfied each day. As required
reserves have declined, the demand for
balances at the Federal Reserve has
become increasingly dominated by these
more changeable daily payment-related
needs. Nonetheless, federal funds volatility did not increase noticeably last
year. In part this was because the Federal Reserve intervened more frequently
than in the past with open market operations of overnight maturity in order to
better match the supply of and demand
for reserves each day. In addition, banks
made greater use of the discount window, increasing the supply of reserves
when the market was excessively tight.
Significant further declines in reserve
balances, however, do risk increased
federal funds rate volatility, potentially
complicating the money market operations of the Federal Reserve and of the
private sector. One possible solution to
this problem is to pay banks interest on
their required reserve balances, reducing
their incentive to avoid holding such
balances.
Interest Rates and Equity Prices
Interest rates on intermediate- and longterm Treasury securities moved lower,
on balance, last year. Yields rose early
in the year as market participants became concerned that strength in demand
would further tighten resource utilization margins and increase inflation
unless the Federal Reserve took countervailing action. Over the late spring and
summer, however, as growth moderated
some and inflation remained subdued,
these concerns abated significantly, and
longer-term interest rates declined. Further reductions came in the latter part of
the year as economic problems mounted
in Asia. On balance, between the end of
1996 and the end of 1997, the yields on
ten-year and thirty-year Treasury bonds
fell about 70 basis points. Early this
year, with the economic troubles in Asia
continuing, the desire of investors for
less risky assets, along with further
reductions in the perceived risk of strong
growth and higher inflation, pushed
yields on intermediate- and long-term
Treasury securities down an additional
25 to 50 basis points, matching their
levels of the late 1960s and the early
1970s, when the buildup of inflation
expectations was in its early stages.
Survey measures of expectations for
longer-horizon inflation generally did
move lower last year, but by less than
the drop in nominal yields. As a result,
estimates of the real longer-term interest
rate calculated by subtracting these
measures of expected inflation from
nominal yields indicate a slight decline
in real rates over the year. In contrast,
yields on the inflation-indexed ten-year
Treasury note rose about a quarter
percentage point between mid-March
(when market participants seem to have
become more comfortable with the new
security) and the end of the year. The
market for the indexed securities is sufficiently small that their yields can fluctuate temporarily as a result of moderate
shifts in supply or demand. Indeed,
much of the rise in the indexed yield
came late in the year, when, in an, uncertain global economic environment,
investors' heightened desire for liquidity may have made nominal securities
relatively more attractive.
Monetary Policy Reports, February
With real interest rates remaining low
and corporate profits growing strongly,
equities had another good year in 1997,
and major stock indexes rose 20 percent
to 30 percent. Although stocks began
the year well, they fell with the upturn
in interest rates in February. As interest
rates subsequently declined and earnings reports remained quite upbeat, the
markets again advanced, with most
broad indexes of stock prices reaching
new highs in the spring. Advances were
much more modest, on balance, over
the second half of the year. Valuations
seemed already to have incorporated
very robust earnings growth, and in
October, deepening difficulties in Asia
evidently led investors to lower their
expectations for the earnings of some
U.S. firms, particularly high-technology
firms and money center banks. More
rapid price advances have resumed of
late, as interest rates fell further and
investors apparently came to see the
earnings consequences of Asian difficulties as limited.
Despite the strong performance of
earnings and the slower rise of stock
prices since last summer, valuations
seem to reflect a combination of expectations of quite rapid future earnings
growth and a historically small risk
premium on equities. The gap between
the market's forward-looking earningsprice ratio and the real interest rate,
measured by the ten-year Treasury rate
less a survey measure of inflation expectations, was at the smallest sustained
level last year in the eighteen-year
period for which these data are available. Declines in this gap generally
imply either that expected real earnings
growth has increased or that the risk
premium over the real rate investors use
when valuing those earnings has fallen,
or both. Survey estimates of stock analysts' expectations of long-term nominal
earnings growth are, in fact, the highest
61
observed in the fifteen years for which
these data are available. Because inflation has trended down over the past
fifteen years, the implicit forecast of the
growth in real earnings departs even
further from past forecasts. However,
even with this forecast of real earnings
growth, the current level of equity valuation suggests that investors are also
requiring a lower risk premium on equities than has generally been the case in
the past, a hypothesis supported by the
low risk premiums evident in corporate
bond yields last year.
International Developments
The foreign exchange value of the dollar
rose during 1997 in terms of the currencies of most of the United States' trading partners. From the end of December
1996 through the end of December
1997, the dollar on average gained
13 percent in nominal terms against the
currencies of the other G-10 countries
when those currencies are weighted by
multilateral trade shares. In terms of a
broader index of currencies that includes
those of most industrial countries and
several developing countries, the dollar
on balance rose nearly 14 percent in real
terms during 1997.2 The trading desk of
the New York Federal Reserve Bank did
not intervene in foreign exchange markets during 1997.
During the first half of 1997, the dollar appreciated in terms of the currencies of the other industrial countries, as
the continuing strength of U.S. economic
activity raised expectations of further
tightening of U.S. monetary conditions.
Concerns about the implications of the
transition to European Monetary Union
2. This index weights currencies in terms of the
importance of each country in determining the
global competitiveness of U.S. exports and adjusts
nominal exchange rates for changes in relative
consumer prices.
62
85 th Annual Report, 1998
and perceptions that monetary policy
was not likely to tighten significantly in
prospective member countries also contributed to the tendency for the dollar
to rise in terms of the mark and other
continental European currencies. In
response to varying indicators of the
strength of the Japanese expansion, the
dollar rose against the yen early in the
year but then moved back down through
midyear.
The crises in Asian financial markets
dominated developments during the second half of the year and resulted in
substantial appreciation of the dollar in
terms of the currencies of Korea and
several countries in Southeast Asia. The
dollar also appreciated against the yen
in response to evidence of financial sector fragility in Japan and faltering Japanese economic activity, which were
likely to be exacerbated by the negative
impact of the Asian situation on Japan.
During the first weeks of 1998, the dollar has changed little, on average, in
terms of the currencies of most other
industrial countries, but it has moved
down in terms of the yen.
Pronounced asset-price fluctuations
in Southeast Asia began in early July
when the Thai baht dropped sharply
immediately following the decision by
authorities to no longer defend the
baht's peg. Downward pressure soon
emerged on the currencies and equity
prices of other southeast Asian countries, in particular Indonesia and Malaysia. Weakening balance sheet positions
of nonfinancial firms and financial institutions, rising debt-service burdens, and
financial market stresses that resulted
in part from policies of pegging local
currencies to the appreciating dollar
prompted closer scrutiny of Asian
economies. As foreign creditors came
to realize the extent to which these
Asian financial systems were undercapitalized and inadequately supervised,
they became less willing to continue to
lend, making it even more difficult for
the Asian borrowers to meet their foreign currency obligations. Turbulence
spread to Hong Kong in October. The
depreciation of currencies elsewhere in
Asia, in particular the decision by Taiwanese authorities to allow some downward adjustment of the Taiwan dollar,
led market participants to question the
commitment of Hong Kong authorities
to the peg of the Hong Kong dollar to
the U.S. dollar. In response, the Hong
Kong Monetary Authority raised domestic interest rates substantially to defend
the peg, driving down equity prices as a
consequence. Near the end of the year,
the crisis spread to Korea, whose economy and financial system were already
vulnerable as a result of numerous bankruptcies of corporate conglomerates
starting in January 1997; these bankruptcies of major nonfinancial firms further
undermined Korean financial institutions and, combined with the depreciations in competitor countries, contributed to a loss of investor confidence. On
balance, during 1997 the dollar appreciated significantly in terms of the Indonesian rupiah (139 percent), the Korean
won (100 percent), and the Thai baht
(82 percent), while it moved up somewhat less in terms of the Taiwan dollar
(19 percent) and was unchanged in
terms of the Hong Kong dollar, which
remains pegged to the U.S. dollar. Since
year-end, the dollar has appreciated significantly further, on balance, in terms
of the Indonesian rupiah and is little
changed in terms of the Korean won.
The emergence of the financial crisis
is causing a marked slowdown in economic activity in these Asian economies. During the first half of last year,
real output continued to expand in most
of these countries at about the robust
rates enjoyed in 1996. Since the onset of
the crisis, domestic demand in these
Monetary Policy Reports, February
countries has been greatly weakened by
disruption in financial markets, substantially higher domestic interest rates,
sharply reduced credit availability, and
heightened uncertainty. In addition,
macroeconomic policy has been tightened somewhat in Thailand, the Philippines, Indonesia, and Korea in connection with international support packages
from the International Monetary Fund
(IMF) and other international financial institutions, and in connection with
bilateral aid from individual countries.
Announcement of agreement with the
IMF on the support packages temporarily buoyed asset markets in each
country, but concerns about the willingness or ability of governments to undertake difficult reforms and to achieve the
stated macroeconomic goals remained.
Additional measures to tighten the
Korean program were announced in
mid-December and included improved
reserve management by the Bank of
Korea, removal of certain interest rate
ceilings, and acceleration of capital
account liberalization and financial
sector restructuring. With the encouragement of the authorities of the G-7
and other countries, banks in industrial
countries have generally rolled over
the majority of their foreign-currencydenominated claims on Korean banks
during early 1998, as a plan for financing the external obligations of Korean
financial institutions was being formulated. After the announcement on
January 28 of an agreement in principle
for the exchange of existing claims on
Korean banks for restructured loans carrying a guarantee from the Korean government, the won stabilized. In the case
of Indonesia, the support package was
renegotiated and reaffirmed with the
IMF in mid-January, though important
elements of the approach of the Indonesian authorities remain in question as
this report is submitted.
63
Signs that adjustment is proceeding within these Asian economies are
already evident. For example, Thailand
and Korea have registered strong
improvements in their trade balances
in recent months. Equity prices have
recovered in Thailand, Indonesia, and
Korea as well. At the same time, signs
of rising inflation are beginning to
emerge. In particular, consumer prices
have accelerated in recent months in
these three countries.
Spillover of the financial crisis to the
economies of China, Hong Kong, and
Taiwan has been limited to date. Steps
to maintain the peg in Hong Kong
have resulted in elevated interest rates,
sharply lower equity prices, and
increased uncertainty. However, in
Taiwan, equity prices on balance rose
nearly 18 percent in 1997 and have risen
somewhat further so far this year. Real
output growth in these three economies
remained robust early in 1997 but may
have slowed somewhat in China and
Hong Kong in recent months.
Financial markets in some Latin
American countries also came under
pressure in reaction to the intensification
of the crises in Asia in late 1997. After
remaining quite stable earlier in the year,
the Mexican peso dropped about 8 percent in terms of the U.S. dollar in late
October; since then, it has changed little,
on balance. In Brazil, exchange market
turbulence abroad lowered market confidence in the authorities' ability to maintain that country's managed exchange
rate regime; in response, short-term
interest rates were raised 20 percentage
points. The Brazilian exchange rate
regime and the peg of the Argentine
peso to the dollar have held. Real output growth in Mexico and Argentina
remained healthy during 1997. In Brazil,
growth fluctuated sharply during the
year, with the high domestic interest
rates and tighter macroeconomic policy
64
85 th Annual Report, 1998
stance that were put in place late in
the year weakening domestic demand.
During 1997, consumer price inflation
slowed significantly in Mexico and Brazil and remained very low in Argentina.
In Japan, the economic expansion
faltered in the second quarter as the
effects on domestic demand of the
April increase in the consumption tax
exceeded expectations; in addition, crises in many of Japan's Asian trading
partners late in the year weakened
external demand and heightened concerns about the fragility of Japan's
financial sector. The dollar rose about
10 percent against the yen during the
first four months of 1997 as economic
activity in the United States strengthened relative to that in Japan and as
interest rate developments, including the
FOMC policy move in March, favored
dollar assets. These gains were temporarily reversed in May and June as market attention focused on the growing
Japanese external surplus and tentative
indications of improving real activity.
However, subsequent evidence of disappointing output growth, revelations of
additional problems in the financial sector, and concerns about the implications
of turmoil elsewhere in Asia for the
Japanese economy contributed to a rise
in the dollar in terms of the yen during
the second half of the year. On net, the
dollar appreciated nearly 13 percent
against the yen during 1997; so far in
1998, it has moved back down slightly,
on balance.
In Germany and France, output
growth rose in 1997 from its modest
1996 pace, boosted in both countries by
the strong performance of net exports.
Nevertheless, the dollar rose in terms
of the mark and other continental
European currencies through midyear,
responding not only to stronger U.S.
economic activity but also to concerns
about the timetable for launching Euro
pean Monetary Union (EMU), the process of the transition to a single currency, and the policy resolve of the
prospective members. Later in the year
the dollar moved back down slightly
and then fluctuated narrowly in terms
of the mark, as investors concluded
that the transition to EMU was likely
to be smooth, with the euro introduced
on time on January 1, 1999, and with
a broad membership. On balance, the
dollar rose about 17 percent against the
mark during 1997 and has varied little
since then.
In the United Kingdom and Canada,
real output growth was vigorous in
1997. All the components of U.K.
domestic demand continued to expand
strongly. In Canada, more robust private
consumption spending and less fiscal
restraint boosted real GDP growth from
its moderate 1996 pace. Central bank
official lending rates were raised in both
countries during the year to address the
threat of rising inflation. The value of
the pound eased slightly in terms of the
dollar over the year, whereas the Canadian dollar fell more than 4 percent in
terms of the U.S. dollar. Much of the
movement in the Canadian dollar came
during the fourth quarter, as the crisis in
Asia contributed to a weakening of
global commodity prices and thus a
likely lessening of Canadian export
earnings. The Canadian dollar depreciated further early in 1998, reaching
historic lows against the U.S. dollar in
January, but it has rebounded with the
tightening by the Bank of Canada in late
January.
Long-term interest rates have generally declined in the other G-10 countries
since the end of 1996. Japanese longterm rates have dropped about 90 basis
points, with most of the decrease coming in the second half of last year as
evidence of sluggish economic activity
became more apparent. German long-
Monetary Policy Reports, July
term rates have also fallen about
80 basis points as expectations of tightening by the Bundesbank diminished,
especially toward the end of the year.
The turbulence in Asian asset markets
likely contributed to inflows into bond
markets in several of the industrial countries, including the United States. Longterm rates in the United Kingdom have
declined about 150 basis points. Legislation to increase the independence of the
Bank of England and repeated tightening of monetary policy during the year
reassured markets that some slowing of
the very rapid pace of economic growth
was likely and that the Bank would be
aggressive in resisting inflation in the
future. Three-month market interest
rates generally have risen in the other
G-10 countries, although there have
been exceptions. Rates have moved up
the most in Canada (more than 180 basis
points) and the United Kingdom
(120 basis points), in response to several
increases in official lending rates. German rates have risen about 40 basis
points. Short-term rates in the countries
that are expected to adopt a single currency on January 1 of next year converged toward the relatively low levels
of German and French rates, with Italian
rates declining more than 100 basis
points over the year.
Equity prices in the foreign G-10
countries other than Japan moved up
significantly in 1997. Despite some
volatility in these markets, particularly
in the fourth quarter following severe
equity price declines in many Asian
markets, increases in equity price
indexes over 1997 ranged from 17 percent in the United Kingdom to almost
60 percent in Italy. In contrast, equity
prices fell 20 percent in Japan. To date
this year, equity prices in the industrial
countries generally have risen.
The price of gold declined more than
20 percent in 1997 and fell further in
65
early 1998, reaching lows not seen since
the late 1970s. Open discussion and,
in some cases, confirmation of central
bank sales of gold contributed to the
price decline. Downward adjustment of
expectations of inflation in the industrial
countries in general may have added
to the selling pressure on gold. More
recently, the price of gold has moved up
slightly, on net.
Report on July 21, 1998
Monetary Policy and the
Economic Outlook
The U.S. economy posted significant
further gains in the first half of 1998.
The unemployment rate dropped to
its lowest level in nearly thirty years,
and inflation remained subdued. Real
output rose appreciably, on balance,
although much of the advance apparently occurred early in the year. Household spending and business fixed investment, supported by the ongoing rise
in equity prices and the continued
low level of long-term interest rates,
appear to have maintained considerable
momentum this year. The sizable
advance in capital spending and the
resulting additions to the capital stock
should help bolster labor productivity—
the key to rising living standards.
Yet the news this year has not been
uniformly good. The turmoil that
erupted in some Asian countries last
year has generated major concerns about
the outlook for those economies and the
repercussions for other nations, including the United States. Several Asian
countries have had sharp contractions
in economic activity, and others have
experienced distinctly subpar growth.
Heightened uneasiness among international investors has induced portfolio
shifts away from Asia and, to some
66
85 th Annual Report, 1998
extent, from other emerging market
economies.
These difficulties have created considerable uncertainty and risk for the U.S.
economy, but they have also helped
to contain potential inflationary pressures in the near term by reducing
import prices and restraining aggregate
demand. In particular, the substantial
rise in the foreign exchange value of the
dollar has boosted our real imports
and—together with the slower growth in
Asia—depressed our real exports. At the
same time, the run-up in the dollar and
slack economic conditions in Asia have
helped produce a sharp drop in the dollar prices of oil and other commodities
and have pushed down other import
prices. Shifts in preferences toward
dollar-denominated assets in combination with downward revisions to forecasts of inflation and demand have
helped to reduce our interest rates; the
lower interest rates have boosted household and business spending, offsetting a
portion of the damping of demand from
the foreign sector.
The Asian crisis is likely to continue
to restrain U.S. economic activity in
coming quarters. The size of the effect
will depend in large part on how quickly
the authorities in the Asian nations can
put their troubled financial systems on
a sounder footing and carry out other
essential economic reforms. Deteriorating conditions in many countries during
the past few months created added pressures for reform, and they underscored
the depth and scope of the problems that
must be addressed.
Despite the pronounced weakening of
our trade balance, the already tight U.S.
labor market has come under further
strain this year owing to robust growth
of domestic demand. As a result, the
outlook for inflation has taken on a
greater degree of risk. Consumer prices
actually rose a bit less rapidly in the first
half of 1998 than they did in 1997, but
transitory factors—the drop in oil prices,
the run-up in the dollar, and weak economic activity in Asia—exerted considerable downward pressure on domestic
prices. These factors will not persist
indefinitely. Meanwhile, the pool of
individuals interested in working but
who are not already employed has
continued to shrink. The extraordinary
tightness in labor markets has generated
a rising trend of increases in wages and
related costs, although faster productivity growth has damped the effect on
business costs so far.
In conducting monetary policy in the
first half of 1998, the Federal Open Market Committee (FOMC) closely scrutinized incoming information for signs
that the strength of the economy and the
taut labor market were likely to boost
inflation and threaten the durability of
the expansion. However, despite slightly
larger increases in the consumer price
index (CPI) in some months, inflation
remained moderate on the whole. Moreover, the FOMC expected that aggregate demand would slow appreciably
because of a rising trade deficit and
a considerable slackening in domestic
spending. Although the Committee was
acutely aware of the uncertainties in the
economic outlook, it believed that the
deceleration in demand—and the associated modest easing of pressures on
resources—could well be sufficient to
limit any deterioration in underlying
price performance. On balance, the
FOMC chose to keep the intended federal funds rate at 5 Vi percent.
Monetary Policy, Financial
Markets, and the Economy
over the First Half of 1998
Output grew rapidly in the first quarter,
with real gross domestic product (GDP)
Monetary Policy Reports, July
estimated to have risen 5l/i percent at an
annual rate. Business fixed investment
soared after a weak fourth quarter, and
consumption and housing expenditures
expanded at a strong clip. In addition,
contrary to the expectations of many
forecasters, inventory investment rose
substantially from its already hefty
fourth-quarter pace, with the rise contributing more than IV2 percentage
points to overall GDP growth. At the
same time, the cumulative effect of the
appreciation of the dollar and the faster
growth of demand here than abroad
resulted in a sharp drop in real net
exports, with both rapid import growth
and the first quarterly drop in exports
in four years. Employment continued
to advance briskly, and the unemployment rate held steady at 43/4 percent.
Hourly compensation accelerated somewhat when measured on a year-overyear basis, but impressive productivity
growth once again helped to restrain
the increase in unit labor costs. The CPI
rose only lA percent at an annual rate
over the first three months of the year, as
a sharp drop in energy prices offset price
increases elsewhere.
Falling long-term interest rates and
rising equity prices over the previous
year provided substantial impetus to
household and business spending in
the first quarter. Interest rates dropped
sharply further in early January, and
although they moved up a little over the
remainder of the quarter, nominal yields
on long-term Treasury securities were
among the lowest in decades. Interest
rates continued to benefit from the improvement in the federal budget and the
prospect of reduced federal borrowing
in the future; rates were also restrained
to a significant extent by the effects of
the Asian crisis. Equity prices increased
sharply in the first quarter, extending
their remarkable gains of the previous
three years in spite of disappointing
67
news on corporate profits. Households
and firms borrowed at a vigorous pace
in the first quarter, and growth in the
debt of domestic nonfinancial sectors
picked up from the fourth quarter of
1997, as did the growth of the monetary
aggregates.
At their March meeting, the members
of the FOMC confronted unusual crosscurrents in the economic outlook. On
the price side, the FOMC noted that,
although the incoming data were quite
favorable, transitory factors were possibly masking underlying tendencies
toward higher inflation. Moreover, the
available data on household and business spending confirmed the impressive
strength of domestic demand and highlighted the possibility that developments
in the external sector might not provide
sufficient offset in coming quarters to
avoid a buildup of inflation pressures.
At the same time, the FOMC noted the
substantial uncertainty surrounding the
prospects for the Asian economies. Balancing these considerations, the FOMC
kept its policy stance unchanged but
noted that recent information had altered
the inflation risks enough to make tightening more likely than easing in the
period ahead.
The second quarter brought both a
marked further deterioration in the outlook for Asia and some indications that
the U.S. economy might be cooling. In
Asia, evidence of steep output declines
in several countries was combined with
mounting concern that economic and
financial problems in Japan were not
likely to be resolved as quickly as many
observers had hoped or expected. One
result was a further rise in the exchange
value of the dollar and a decline in
long-term U.S. interest rates. Increasing
investor concern about emerging market
economies raised risk spreads on external debts in Asia, Russia, and Latin
America.
68
85 th Annual Report, 1998
The higher value of the dollar and the
depressed income in many Asian countries continued to take their toll on U.S.
exports and to boost imports in the second quarter. In addition, a marked slackening in the pace of inventory accumulation, which was amplified by the effects
of a strike in the motor vehicle industry,
was reflected in a sharp slowing in
domestic demand. Nonetheless, the utilization of labor resources remained very
high: In the second quarter, the unemployment rate averaged a bit less than
AVi percent, its lowest quarterly reading
in nearly thirty years. The twelve-month
change in average hourly earnings indicated that wages were rising somewhat
more rapidly than they had a year
earlier. And the CPI rose faster in the
second quarter than in the first, mainly
reflecting a smaller drop in energy
prices.
Financial conditions in the second
quarter and into July remained supportive of domestic spending. Yields on private securities declined, although less
than Treasury yields, as quality spreads
widened a bit. Equity prices rose further in early April before falling back
over the next two months in response
to renewed earnings disappointments.
Prices then rebounded substantially,
with most major indexes hitting record
highs in July. The growth of money and
credit slowed a little on balance from
the first-quarter pace but remained buoyant. Banks and other lenders continued
to compete vigorously, extending credit
on generally favorable terms as they
responded in part to the sustained
healthy financial condition of most businesses and households.
The FOMC left the intended federal
funds rate unchanged at its May and
June-July meetings. At the May meeting, the FOMC reiterated its earlier concern that the robust expansion of domestic final demand, supported by very
positive financial conditions, had raised
labor market pressures to a point that
might precipitate an upturn in inflation
over time. Yet the FOMC believed that
the growth of economic activity would
slow. It also judged that the risk of
significant further deterioration in Asia,
which could disrupt global financial
markets and impair economic activity in
the United States, was rising somewhat.
Economic Projections
for 1998 and 1999
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 activity to expand moderately, on
average, over the next year and a half.
For 1998 as a whole, the central tendency of their forecasts for real GDP
growth spans a range of 3 percent to
VA percent. For 1999, these forecasts
center on a range of 2 percent to 2 Vi percent. The civilian unemployment rate,
which averaged a bit less than 4!/2 percent in the second quarter of 1998, is
expected to stay near this level through
the end of this year and to edge higher
in 1999. With labor markets remaining
tight and some of the special factors that
helped restrain inflation in the first half
of 1998 unlikely to be repeated, inflation
is anticipated to run somewhat higher in
the second half of 1998 and in 1999.
The economy is entering the second
half of 1998 with considerable strength
in household spending and business
fixed investment. Consumers are enjoying expanding job opportunities, rising
real incomes, and high levels of wealth,
all of which are providing them with the
confidence and wherewithal to spend.
These factors, in conjunction with low
mortgage interest rates, are also bolstering housing demand. Business fixed
investment appears robust as well:
Monetary Policy Reports, July
Financial conditions remain conducive
to capital spending, and firms no doubt
are continuing to seek out opportunities
for productivity gains in an environment
of rapid technological change, falling
prices for high-tech equipment, and tight
labor markets.
Nonetheless, a number of factors are
expected to exert some restraint on the
expansion of activity in the quarters
ahead. The demand for U.S. exports will
continue to be depressed for a while
by weak activity abroad, on average,
and by the strong dollar, which will also
likely continue to boost imports. The
effects of these external sector developments on employment and income
growth have yet to materialize fully. In
addition, although financial conditions
are generally expected to be supportive,
real outlays on housing and business
equipment have reached such high levels that gains from here are expected to
be more moderate.
With the plunge in energy prices in
early 1998 unlikely to be repeated, most
FOMC participants expect the CPI for
all urban consumers to rise more rapidly
in the second half of 1998 than it did in
the first half, resulting in an increase in
the CPI of l3/4 percent to 2 percent
for 1998 as a whole. The pickup in the
second half should be limited, however,
by further decreases in non-oil import
prices, ample domestic manufacturing
capacity, and low expected inflation.
Looking ahead to next year, the central
tendency is for an increase in the CPI of
2 percent to 2Vi percent. Absent a further rise in the dollar, the fall in non-oil
import prices should have run its course.
Moreover, even with the expected edg-
Economic Projections for 1998 and 1999
Percent
Federal Reserve governors
and Reserve Bank presidents
Administration
Indicator
Range
Central
tendency
1998
Change, fourth quarter
to fourth quarter'
Nominal GDP
Real GDP
Consumer price index2
4'/4-5
23/4-3»/4
l'/4-2'/4
4'/2-5
3 - 3 «/4
1-V4-2
4.2
2.4
1.6
Average level
in the fourth quarter
Civilian unemployment rate
41/4-41/2
41/4-41/2
4.8
1999
Change, fourth quarter
to fourth quarter'
Nominal GDP
Real GDP
Consumer price index2
4-5'/2
2-3
l'/ 2 -3
4'/4-5
2-2'/2
2-2'/ 2
4.1
2.0
2.1
Average level
in the fourth quarter
Civilian unemployment rate
41/4-43/4
4'/2-43/4
5.0
1. Change from average for fourth quarter of previous
year to average for fourth quarter of year indicated.
69
2. All urban consumers.
70
85th Annual Report, 1998
ing higher of the unemployment rate
next year, the labor market will remain
tight, suggesting potential ongoing pressures on available resources that would
tend to raise inflation a bit. The FOMC
will remain alert to the possibility of
underlying imbalances in the economy
that could generate a persisting pickup
in inflation, which would threaten the
economic expansion.
As noted in past monetary policy
reports, the Bureau of Labor Statistics is
in the process of implementing a series
of technical adjustments to make the
CPI a more accurate measure of price
change. These adjustments and the regular updating of the market basket are
estimated to have trimmed CPI inflation
somewhat over 1995-98, and a significant further adjustment is scheduled for
1999. All told, the published figures for
CPI inflation in 1999 are expected to
be more than Vi percentage point lower
than they would have been had the
Bureau retained the methods and formulas in place in 1994. In any event, the
FOMC will continue to monitor a variety of price measures besides the CPI as
it attempts to gauge progress toward the
long-run goal of price stability.
Federal Reserve officials project
somewhat faster growth in real GDP
and slightly higher inflation in 1998 than
does the Administration. The Administration's projections for the growth in
real GDP and inflation in 1999 are
around the lower end of the FOMC participants' central tendencies.
the domestic nonfinancial sectors. The
FOMC set these same ranges for 1999
on a provisional basis.
Once again, the FOMC chose the
growth ranges for the monetary aggregates as benchmarks for growth under
conditions of price stability and historical velocity behavior. For several
decades before 1990, the velocities of
M2 and M3 (defined as the ratios of
nominal GDP to the aggregates) behaved in a fairly consistent way over
periods of a year or more. M2 velocity
showed little trend but varied positively
from year to year with changes in a
traditional measure of M2 opportunity
cost, defined as the interest forgone by
holding M2 assets rather than short-term
market instruments such as Treasury
bills. M3 velocity moved down a bit
over time, as depository credit and the
associated elements in M3 tended to
grow a shade faster than GDP. In the
early 1990s, these patterns of M2 and
M3 behavior were disrupted, and the
velocities of both aggregates climbed
well above the levels that were predicted by past relationships. However,
since 1994 the velocities of M2 and M3
have again moved roughly in accord
with their pre-1990 experience, although
their levels remain elevated.
The recent return to historical patterns does not imply that velocity will
be fully predictable or even that all
Ranges for Growth of Monetary
and Debt Aggregates
Percent
Money and Debt Ranges
for 1998 and 1999
At its most recent meeting, the FOMC
reaffirmed the ranges for 1998 growth of
money and debt that it had established
in February: 1 percent to 5 percent for
M2, 2 percent to 6 percent for M3, and
3 percent to 7 percent for the debt of
Aggregate
M2
M3
Debt
1997
1998
Provisional
for
1999
1-5
2-6
3-7
1-5
2-6
3-7
1-5
2-6
3-7
NOTE. Change from average for fourth quarter of
preceding year to average for fourth quarter of year
indicated.
Monetary Policy Reports, July
movements in velocity can be completely explained in retrospect. Some
shifts in velocity arise from household
and business decisions to adjust their
portfolios for reasons that are not captured by simple measures of opportunity
cost. Some shifts in velocity arise from
decisions of depository institutions to
create more or less credit or to fund
credit creation in different ways. All
these decisions are shaped by the rapid
pace of innovation in financial institutions and instruments. Between 1994
and early 1997, M2 velocity drifted
somewhat higher, probably owing to
some reallocation of household savings
into bond and equity markets. But M2
velocity has declined over the past year
despite little change in its traditionally
defined opportunity cost. One explanation may be that the flatter yield curve
has reduced the return on longer-term
investments relative to the bank deposits
and money market mutual funds in
M2. Another part of the story may be
the booming stock market, which has
reduced the share of households' financial assets represented by monetary
assets and may have encouraged households to rebalance their portfolios by
increasing their M2 holdings. M3 velocity has dropped more sharply over the
past year, with strong growth in large
time deposits and in institutional money
funds that are increasingly used by businesses for cash management.
If the velocities of M2 and M3 follow
their average historical patterns over
the remainder of 1998 and the growth
of nominal GDP matches the expectations of Federal Reserve policymakers,
these aggregates will finish this year
above the upper ends of their respective ranges. Part of this relatively rapid
money growth reflects nominal GDP
growth in excess of that consistent with
price stability and sustainable growth of
real output; the rest represents a decline
71
in velocity. Absent unusual changes in
velocity in 1999, policymakers' expectations of nominal GDP growth imply that
M2 and M3 will be in the upper ends of
their price-stability growth ranges next
year. The debt of the domestic nonfinancial sectors is expected to remain near
the middle of its range this year and in
1999.
In light of the apparent return of
velocity changes to their pre-1990
behavior, some FOMC members have
been giving the aggregates greater
weight in assessing overall financial
conditions and the thrust of monetary
policy. However, velocity remains
somewhat unpredictable, and all FOMC
members monitor a wide variety of other
financial and economic indicators to
inform their policy deliberations. The
FOMC decided that the money and debt
ranges are best used to emphasize its
commitment to achieving price stability,
so it again set the ranges as benchmarks
for growth under price stability and historical velocity behavior.
Economic and Financial
Developments in 1998
The U.S. economy continued to perform
well in the first half of the year. The
economic difficulties in Asia and the
strong dollar reduced the demand for
our exports and intensified the pressures
on domestic producers from foreign
competition. But these effects were
outweighed by robust domestic final
demand, owing in part to supportive
financial conditions, including a higher
stock market, ample availability of
credit, and long-term interest rates that
in nominal terms were among the lowest
in many years. Sharp swings in inventory investment were mirrored in considerable unevenness in the growth of
real GDP, which appears to have slowed
markedly in the second quarter after
72
85 th Annual Report, 1998
having soared to nearly 51/2 percent at
an annual rate in the first quarter. Nonetheless, over the first half as a whole, the
rise in real output was large enough to
support sizable gains in employment and
to push the unemployment rate down to
the range of AXA percent to AVi percent,
the lowest in decades.
The further tightening of labor markets in recent quarters has been reflected
in a more discernible uptilt to the trend
in hourly compensation. But price
inflation remained subdued in the first
half of the year, held down in part by a
sharp decline in energy prices and lower
prices for non-oil imports. Intense competition in product markets, ample plant
capacity, ongoing productivity gains,
and damped inflation expectations also
helped to restrain inflation pressures in
the face of tight labor markets.
The Household Sector
Consumer Spending
The factors that fueled the sizable
increase in household expenditures in
1997 continued to spur spending in the
first half of 1998: Growth in employment and real disposable income remained very strong, and households in
the aggregate enjoyed significant further
gains in net worth. Reflecting these
developments, sentiment indexes suggest that consumers continued to feel
extraordinarily upbeat about the current
and prospective condition of the economy and their own financial situations.
In total, real consumer outlays rose at
an annual rate of 6 percent in the first
quarter, and the available data point
to another large increase in the second
quarter. Increases in spending were
broad-based, but outlays for durable
goods were especially strong. Declining
prices and ongoing product innovation
continued to stimulate demand for per
sonal computers and other home electronic equipment. In addition, purchases
of motor vehicles were sustained by a
combination of solid fundamentals and
attractive pricing. Indeed, since 1994,
sales of light vehicles have been running at a brisk pace of 15 million units
(annual rate), and in the second quarter,
a round of very attractive manufacturers' incentives helped lift sales to a pace
of 16 million units.
Spending on services also remained
robust in the first half of the year, with
short-run variations reflecting in part the
effects of weather on household energy
use; outlays on personal business services, including those related to financial transactions, and on recreation
services continued to exhibit remarkable strength. In addition, real outlays
for nondurable goods, which rose
only moderately last year, grew about
6!/2 percent at an annual rate in the first
quarter, and they appear to have posted
another sizable increase in the second
quarter.
Real disposable income—that is,
after-tax income adjusted for inflation—
remained on a strong uptrend in early
1998: It rose about 4 percent at an
annual rate between the fourth quarter
of 1997 and May 1998. This increase in
part reflected a sharp rise in aggregate
wages and salaries, which were boosted
by sizable gains in both employment
and real wage rates; dividends and
nonfarm proprietors' incomes also rose
appreciably. However, growth in aftertax income (as measured in the national
income and product accounts) was
restrained by large increases in personal
income tax payments—likely owing
in part to taxes paid on realized capital
gains; capital gains—whether realized
or not—are not included in measured
income. Reflecting the movements in
spending and measured income, the personal saving rate fell from an already
Monetary Policy Reports, July
low level of about 4 percent in 1997 to
3V2 percent during the first five months
of 1998.
Residential Investment
Housing activity continued to strengthen
in the first half of 1998, especially in the
single-family sector, where starts rose
noticeably and sales of both new and
existing homes soared. Indeed, the average level of single-family starts over the
first five months of the year—VA million units at an annual rate—was 9 percent above the pace for 1997 as a whole.
Moreover, surveys by the National
Association of Homebuilders suggested
that housing demand remained vigorous
at midyear, and the Mortgage Bankers
Association reported that loan applications for home purchases have been
around all-time highs of late.
The strong demand for homes has
contributed to some firming of house
prices, which are now rising in the
neighborhood of 3 percent to 5 percent
per year, according to measures that
control for shifts in the regional composition of sales and attempt to minimize
the effects of changes in the mix of the
structural features of houses sold. In
nominal terms, these increases are well
within the range of recent years; however, in real terms, they are among the
largest since the mid-1980s—a development that should reinforce the investment motive for homeownership. Of
course, rising house prices may make
purchasing homes more difficult for
some families. But, with income growth
strong and mortgage rates around 7 percent (thirty-year conventional fixed-rate
loans), homeownership is as affordable
as it has been at any time in the past
thirty years. Moreover, innovative
programs that relax the standards for
mortgage qualification are helping
low-income families to finance home
73
purchases. Also, stock market gains
have probably boosted demand among
higher-income groups, especially in the
trade-up and second-home segments of
the market.
After having surged in the fourth
quarter of 1997, multifamily starts
settled back to about 325,000 units
(annual rate) over the first five months
of 1998, a pace only slightly below that
recorded over 1997 as a whole. Support
for multifamily construction continued
to come from the overall strength of the
economy, which undoubtedly has stimulated more individuals to form households, as well as from low interest rates
and an ample supply of financing. In
addition, real rents picked up over the
past year, and the apartment vacancy
rate appears to be edging down.
Household Finance
Household net worth rose sharply in
the first quarter, pushing the wealth-toincome ratio to another record high.
Although the flow of new personal
saving was quite small, the revaluation
of existing assets added considerably to
wealth, with much of these capital gains
accumulated on equities held either
directly or indirectly through mutual
funds and retirement accounts. Of
course, these gains have been distributed quite unevenly: The 1995 Survey
of Consumer Finances reported that
41 percent of U.S. families own equities
in some form, but that families with
higher wealth own a much larger share
of total equities.
In the first quarter of this year, the
run-up in wealth, together with low
interest rates and high levels of confidence about future economic conditions,
supported robust household spending
and borrowing. The expansion of household debt, at an annual rate of 13A percent, was above last year's pace and
74
85th Annual Report, 1998
once again outstripped growth in disposable income. The consumer credit component of household debt grew 4V2 percent at an annual rate in the first quarter,
a pace roughly double that for the
fourth quarter of last year but near the
1997 average. Preliminary data for April
and May point to a somewhat smaller
advance in the second quarter.
Mortgage debt increased 8!/4 percent
at an annual rate in the first quarter, the
same as its fourth-quarter advance and
a little above its 1997 growth rate.
Fixed-rate mortgage interest rates were
15 basis points lower in the first quarter
than three months earlier and 75 basis
points lower than a year earlier, which
encouraged both new home purchases
and a surge of refinancing of existing
mortgages. Within total gross mortgage
borrowing, the flattening of the yield
curve made adjustable-rate mortgages
less attractive relative to fixed-rate mortgages, and their share of originations
reached the lowest point in recent years.
Net borrowing can be boosted by refinancings if households "cash out" some
housing equity, but the magnitude of
this effect is unclear. In any event, continued expansion of bank real estate
lending and a high level of mortgage
applications for home purchases suggest
a further solid gain in mortgage debt in
the second quarter. Home equity credit
at banks increased only 2 percent at an
annual rate from the fourth quarter of
1997 through June 1998 after having
posted a 15!/2 percent gain last year; this
slowdown may reflect a diminished substitution of mortgage debt for consumer
debt or simply the increase in mortgage
refinancings, which allowed households
to pay down more expensive home
equity debt or to convert housing equity
into cash in a more advantageous
manner.
Despite the further buildup of household indebtedness, financial stress
among households appears to have
stabilized after several years of deterioration. In the aggregate, estimated
required payments of loan principal and
interest have held about steady relative
to disposable personal income—albeit
at a high level—since 1996. Over this
period, the effect on debt burdens of
faster growth of debt than income has
been roughly offset by declining interest
rates and the associated refinancing of
higher interest-rate debt, as well as by a
shift toward mortgage debt (which has a
longer repayment period). Various measures of delinquency rates on consumer
loans leveled off or declined in 1997,
and delinquency rates on mortgages
have been at very low levels for several years. Personal bankruptcy filings
reached a new record high in the first
quarter of 1998, but this represented
only 6 percent more filings than four
quarters earlier, which is the smallest
such change in three years.
These developments have apparently
suggested to banks that they have sufficiently tightened terms and standards
on consumer loans. In the Federal
Reserve's May Senior Loan Officer
Opinion Survey on Bank Lending Practices, relatively few banks, on net,
reported tightening standards on credit
card or other consumer loans. Little
change was reported in the terms of
consumer loans.
The Business Sector
Fixed Investment
Real business fixed investment appears
to have posted another hefty gain over
the first half of 1998 as spending continued to be boosted by positive sales
expectations in many industries; favorable financial conditions; and a perceived opportunity, if not a necessity,
Monetary Policy Reports, July
for firms to install new technology in
order to remain competitive. The exceptional growth of investment since the
early 1990s has been facilitated in part
by the increase in national saving associated with the elimination of the federal
budget deficit. It has resulted in considerable modernization and expansion of
the nation's capital stock, which have
been important in the improved performance of labor productivity over the
past few years and which should continue to lift productivity in the future.
Moreover, rapid investment in the manufacturing sector in recent years has
resulted in large additions to productive
capacity, which have helped keep factory operating rates from rising much
above average historical levels in the
face of appreciable increases in output.
Real outlays for producers' durable
equipment, which have been rising more
than 10 percent per year, on average,
since the early 1990s, moved sharply
higher in the first half of 1998. All
major categories of equipment spending
recorded sizable gains in the first quarter; but, as has been true throughout the
expansion, outlays for computers rose
especially rapidly. Real computer outlays received particular impetus in early
1998 from extensive price-cutting. Purchases of communications equipment
have also soared in recent quarters; the
rise reflects intense pressures to add
capacity to accommodate the growth
of networking; the rapid pace of technological advance, especially in wireless communications; and regulatory
changes. As for the second quarter, data
on shipments, coupled with another
steep decline in computer prices, point
to a further substantial increase in
real computer outlays. Spending on
motor vehicles apparently continued to
advance as well while demand for other
types of capital equipment appears to
have remained brisk.
75
In total, real outlays on nonresidential
construction flattened out in 1997 after
four years of gains, and they remained
sluggish in early 1998. Construction of
office buildings remained robust in the
first half of this year, after having risen
at double-digit rates in 1996 and 1997,
and outlays for institutional buildings
continued to trend up. However, expenditures for other types of structures were
lackluster. Nonetheless, the economic
fundamentals for the sector as a whole
remain quite favorable: Vacancy rates
for office and retail space have continued to fall; real estate prices, though still
well below the levels of the mid-1980s
in real terms, have risen appreciably in
recent quarters; and funding for new
projects remains abundant.
Inventory Investment
The pace of stockbuilding by nonfarm
businesses picked up markedly in 1997
and is estimated to have approached
$100 billion (annual rate) in the first
quarter of 1998—equal to an annual rate
increase of 8!/2 percent in the level of
inventories and accounting for more
than 1 !/2 percentage points of that quarter' s growth in real GDP. The firstquarter accumulation was heavy almost
across the board. Among other things,
it included a large increase in stocks
of petroleum as the unusually warm
weather reduced demand for refined
products and low prices provided an
incentive for refiners and distributors to
accumulate stocks. However, overall
sales were also very strong, and with
only a few exceptions—notably, semiconductors, chemicals, and textiles—
stocks did not seem out of line with
sales. In any event, fragmentary data
for the second quarter point to a considerable slowing in inventory investment that is especially evident in the
motor vehicle sector, where stocks were
76
85th Annual Report, 1998
depleted by the combination of strong
sales and General Motors production
shortfalls. In addition, petroleum stocks
appear to have grown less rapidly than
they did in the first quarter, and stockbuilding elsewhere slowed sharply in
April and May.
Corporate Profits and
Business Finance
Businesses have financed a good part of
their investment this year through continued strong cash flow, but they have
also increased their reliance on financial
markets. Economic profits (book profits
after inventory valuation and capital
consumption adjustments) have run at
12 percent of national income over the
past year, well above the 1980s peak of
roughly 9 percent. However, the strength
in profits has resulted partly from the
low level of net interest payments, leaving total capital income at roughly the
same share of national income as at the
1980s peak. Overall, a major portion of
the increase in profits between the 1980s
and the 1990s represents a realignment
of returns from debt-holders to equityholders.
Although their level remains high, the
growth of profits has slowed: Economic
profits rose A3A percent at an annual
rate in the first quarter, compared with
9Vi percent between the fourth quarter
of 1996 and the fourth quarter of 1997.
This slowdown may have resulted
from various causes, including rising
employee compensation and the Asian
financial crisis. Quantifying the effect of
the Asian turmoil is difficult: Although
only a small share of the profits of U.S.
companies is earned in the directly
affected Asian countries, the crisis has
reduced the prices of U.S. imports and
thereby put downward pressure on
domestic prices.
Nonfinancial businesses realized
annualized economic profit growth of
only VA percent in the first quarter.
Because capital expenditures (including
inventory investment) grew much faster,
the financing gap—the excess of capital
expenditures over retained earnings—
widened. As a result, these businesses
used less of their cash flow to retire
outstanding equity and continued to borrow at the rapid pace of the fourth quarter of 1997, with debt expanding at
an annual rate of 9 percent in the first
quarter of 1998. Outstanding amounts of
both bonds and commercial paper rose
especially sharply. The decline in longterm interest rates around year-end
encouraged companies to lock in those
yields, and gross bond issuance reached
a record high in the first quarter of 1998.
Borrowing by nonfinancial businesses
increased at a slightly slower but still
rapid clip in the second quarter, with
little change in outstanding commercial
paper but very strong net bond issuance
and some rebound in bank loans.
Despite persistent high borrowing,
external funding for businesses remained readily available on favorable
terms. The spreads between yields on
investment-grade bonds and yields on
Treasury bonds widened a little from
low levels, with investors favoring Treasury securities over corporate securities
as a haven from Asian turmoil and, perhaps, with disappointing profits leading to some minor reassessment of the
underlying risk of private obligations.
The spreads on high-yield bonds also
increased, in part because of heavy issuance of these bonds this spring, but they
remain narrow by historical standards.
In the Federal Reserve's May survey on
bank lending practices, banks reported
negligible change in business loan standards; moreover, yield spreads on bank
loans remained low for both large and
Monetary Policy Reports, July
small firms. Surveys by the National
Federation of Independent Business suggest that small firms have been facing
little difficulty in obtaining credit.
The ready availability of credit has
stemmed importantly from the healthy
financial condition of many businesses,
which have enjoyed an extended period
of economic expansion and robust profits. The aggregate debt-service burden
for nonfinancial corporations, measured
as the ratio of net interest payments
to cash flow, dropped substantially
between 1990 and 1996 and remains
modest, despite edging up in the first
quarter of this year. In addition, most
measures of financial distress have
shown favorable readings. The delinquency rate on commercial and industrial bank loans has stayed very low
since 1995, preserving the dramatic
decline that occurred in the first half of
the decade. After moving up a little
in 1996 and 1997, business failures
decreased in the first five months of
1998; the liabilities of failed businesses
as a share of total liabilities was less
than one-quarter the value reached in
the early 1990s. At the same time,
Moody's upgraded significantly more
debt than it downgraded, and the rate of
junk bond defaults stayed close to its
low 1997 level.
Net equity issuance was less negative
in the first quarter of this year than
in the fourth quarter of last year, but
nonfinancial corporations still retired,
on net, about $100 billion of equity at
an annual rate. The wave of merger
announcements this spring will likely
generate strong share retirements over
the remainder of the year. Gross equity
issuance in the first half of 1998 was
close to its pace of the past several years, although investors seemed
somewhat cautious about initial public
offerings.
11
The Government Sector
Federal
The incoming news on the federal budget continues to be very positive. Over
the twelve months ending in May 1998,
the unified budget registered a surplus
of $60 billion, compared with a deficit
of $65 billion during the twelve months
ending in May 1997. Soaring receipts
continued to be the main force driving
the improvement in the budget, but subdued growth in outlays also played a
key role. If the latest projections from
the Office of Management and Budget
(OMB) and the Congressional Budget
Office (CBO) are realized, the unified
budget for fiscal year 1998 as a whole
will show a surplus of roughly $40 billion to $65 billion.
With the federal budget having
shifted into surplus, the federal government is now augmenting, rather than
drawing on, the pool of national saving.
In fact, the improvement in the government's budget position over the past
several years has been large enough
to generate a considerable rise in gross
domestic saving despite a decline in the
private saving rate; all told, gross saving
by households, businesses, and governments increased from about \AVi percent of gross national product in the
early 1990s, when federal saving was at
a cyclical low, to more than 17 percent
of GNP in recent quarters. This increase
in domestic saving, along with increased
borrowing from abroad, has financed
the surge in domestic investment in this
expansion. Moreover, this year's budgetary surplus will continue to pay benefits in future years because it allows the
government to reduce its outstanding
debt, which implies smaller future interest payments and, all else equal, makes
it easier to keep the budget in surplus.
78
85th Annual Report, 1998
If, in fact, the budget outcome over the
next several years is as favorable as the
OMB and the CBO now anticipate
under current policies, the reduction
in the outstanding debt could be
substantial.
Federal receipts in the twelve months
ending in May 1998 were 10 percent
higher than in the same period a year
earlier—roughly twice the percentage
increase for nominal GDP over the past
year. Individual income tax receipts,
which have been rising at double-digit
rates since the mid-1990s, continued to
do so over the past year as the surge in
capital gains realizations likely persisted
and sizable gains in real income raised
the average tax rates on many households (the individual income tax structure being indexed for inflation but not
for growth in real incomes). In contrast
to the ongoing strength in individual
taxes, corporate tax payments increased
only moderately over the past year, echoing the deceleration in corporate profits.
Federal expenditures in the twelve
months ending in May 1998 were only
1 xh percent higher in nominal terms than
during the twelve months ending in
May 1997, with restraint evident in most
categories. Outlays for defense were
about unchanged, as were those for
income security programs. In the latter
category, outlays for low-income support fell as economic activity remained
robust, welfare reform capped outlays
for family assistance, and enrollment
rates in other programs dropped. In the
health area, spending on Medicaid
picked up somewhat after a period of
extraordinarily small increases, whereas
growth in spending for Medicare
slowed, in part because of the programmatic changes that were legislated in
1997. And, with interest rates little
changed and the stock of outstanding
federal debt no longer rising, net interest
payments stabilized.
Real federal outlays for consumption
and gross investment, the part of federal
spending that is counted in GDP, fell
about 2 percent between the first quarters of 1997 and 1998. The decrease was
concentrated in real defense spending,
which fell about 23A percent, roughly
the same as over the preceding four
quarters; real nondefense spending was
unchanged, on balance. In the first quarter, real federal outlays fell at a 10 percent annual rate; the drop reflected
a plunge in defense spending, which
appears to have been reversed in the
second quarter.
With debt held by the public close to
$4 trillion, the government will continue
to undertake substantial gross borrowing to redeem maturing securities. The
government will also continue to adjust
its issuance of short-term debt to accommodate seasonal swings in receipts and
spending. The surplus during the first
half of calendar year 1998—boosted by
the huge inflow of individual income
tax receipts—enabled the Treasury to
reduce its outstanding debt $57 billion
while augmenting its cash balance
$40 billion. The reduction in debt
included net paydowns of coupon securities and bills.
Looking ahead to projected surpluses
for coming years, the Treasury announced that it will no longer issue
three-year notes and will auction fiveyear notes quarterly rather than monthly.
Over the past several years, the Treasury has accommodated the surprising
improvement in federal finances by
substantially reducing both bill and
coupon issuance. The Treasury hopes
that concentrating future coupon offerings in larger, less-frequent auctions
will maintain the liquidity of these securities while still allowing for sufficient
issuance of bills to maintain their liquidity as well. These changes are also
intended to prevent further upcreep in
Monetary Policy Reports, July
the average maturity of the outstanding debt held by private investors,
now standing at sixty-five months. The
Treasury continues to work on encouraging the market for inflation-indexed
securities, issuing a thirty-year indexed
bond in April to complement the
existing five-year and ten-year indexed
notes.
State and Local
The fiscal position of state and local
governments in the aggregate has also
remained quite favorable. Strong growth
of household income and consumer
spending has continued to lift revenues,
despite numerous small tax cuts, and
governments have continued to hold the
line on expenditures. As a result, the
consolidated current account of the sector, as measured by the surplus (net of
social insurance funds) of receipts over
current expenditures in the national
income and product accounts, held
steady in the first quarter at around
$35 billion (annual rate), roughly where
it has been since 1995. State governments, which have reaped the main
benefits of rising income taxes, have
fared especially well: Indeed, all of the
forty-seven states whose fiscal years
ended by June 30 appear to have
achieved balance or to have run surpluses in their general funds budgets in
fiscal year 1998.
Real expenditures for consumption
and gross investment by states and
localities have been rising about 2 percent per year, on average, since the early
1990s, and the increase in spending for
the first half of 1998 appears to have
been a bit below that trend. These governments added jobs over the first half
of the year at about the same rate as they
did over 1997 as a whole. However, real
construction outlays, which have been
drifting down since early 1997, posted
79
a sizable decline in the first quarter,
and monthly data suggest that spending
dropped further in the spring. The weakness in construction spending over the
past year has cut across the major categories of construction and is puzzling in
light of the sector's ongoing infrastructure needs and the good financial shape
of most governments.
State and local governments responded to the low interest rates during
the first half of the year by borrowing
at a rapid rate, both to refinance outstanding debt and to fund new capital
projects. Because debt retirements eased
in the first quarter relative to the fourth
quarter of 1997, net issuance increased
substantially. Meanwhile, credit quality
of state and local debt continued to
improve, with much more debt upgraded
than downgraded in the first half of the
year.
External Sector
Trade and the Current Account
The nominal trade deficit on goods and
services widened to $140 billion at an
annual rate in the first quarter from
$114 billion in the fourth quarter of last
year. The current account deficit for the
first quarter reached $ 189 billion (annual
rate), 2VA percent of GDP, compared
with $155 billion for the year 1997. A
larger deficit on net investment income
as well as the widening of the deficit on
trade in goods and services contributed
to the deterioration in the first quarter of
the current account balance. In April
and May, the trade deficit increased
further.
The quantity of imports of goods and
services again grew vigorously in the
first quarter. The annual rate of expansion at 17 percent exceeded that for
1997 and reflected the continued
strength of U.S. economic activity and
80
85th Annual Report, 1998
the effects of past dollar appreciation.
Imports of consumer goods, automotive
products, and machinery were particularly robust. Preliminary data for April
and May suggest that real import growth
remained strong. Non-oil import prices
fell sharply through the second quarter,
reflecting the rise in the exchange value
of the dollar over the past year.
The quantity of exports of goods and
services declined at an annual rate of
1 percent in the first quarter, the first
such absolute drop since the first quarter
of 1994. The weakness of economic
activity in a number of our trading partners, with absolute declines in several
economies in Asia, and the strength of
the dollar, which also partly resulted
from the Asian financial crises, largely
account for the abrupt halt in the growth
of real exports after a 10 percent rise
last year. Declines were recorded for
machinery, industrial supplies, and agricultural products. Exports to the emerging market economies in Asia, particularly Korea, as well as exports to Japan
were down sharply while exports to
western Europe and Canada rose moderately. Preliminary data for April and
May suggest that real exports declined
further.
The Capital Account
Foreign direct investment in the United
States and U.S. direct investment abroad
continued at near record levels in the
first quarter of 1998, spurred by strong
merger and acquisition activity across
national borders.
In the first quarter, the booming U.S.
stock market continued to attract large
foreign interest. Net purchases by private foreigners were $29 billion, following record net purchases of $66 billion
in the year 1997. Foreign net purchases
of U.S. corporate bonds remained sub
stantial, and net purchases of U.S. government agency bonds reached a record
$21 billion. In contrast, net sales of U.S.
Treasury securities by private foreigners, particularly large net sales booked
at a Caribbean financial center, were
recorded in the first quarter. U.S. net
purchases of foreign stocks and bonds
were modest.
Foreign official assets in the United
States increased $10 billion in the first
quarter. However, the net increase in the
second quarter was limited by large
dollar sales by Japan.
The Labor Market
Employment and Labor Supply
Labor demand remained robust during
the first half of 1998. Growth in payroll employment averaged 243,000 per
month, only a little less than in 1997 and
well above the rate consistent with the
growth in the working-age population.
The unemployment rate held steady
in the first quarter at 43/4 percent but
dropped to the range of 4lA percent to
4!/2 percent in the second quarter.
The services industry, which accounts
for about 30 percent of nonfarm employment, continued to be the mainstay of
employment growth over the first half of
1998, posting increases of 115,000 per
month, on average. Within services, hiring remained brisk at computer and
data-processing firms and at firms
providing engineering and managerial
services, but payrolls at temporary help
agencies rose much less rapidly than
they had over the preceding few years—
apparently in part reflecting difficulties
in finding workers, especially for highly
skilled and technical positions. Sizable
increases were also posted at wholesale
and retail trade establishments and in
the finance, insurance, and real estate
Monetary Policy Reports, July
category. Construction payrolls were
bounced around by unusual winter
weather but, on average, rose a brisk
21,000 per month—about the same as in
1997.
In contrast to the robust gains elsewhere, manufacturing firms curbed their
hiring in the first half of 1998 in the face
of slower growth in factory output. After
having risen a torrid 6lA percent in
1997, factory output increased at an
annual rate of about 2Vi percent between
the fourth quarter of last year and May
1998; the deceleration reflected the
effects of the Asian crisis as well as a
downshift in motor vehicle assemblies
and the completion of the 1996-97
ramp-up in aircraft production. In June,
factory output is estimated to have fallen
V2 percent; the GM strike accounted for
the decline.
The labor force participation rate—
which measures the percentage of the
working-age population that is either
employed or looking for work—trended
up mildly over the past couple of years
and stood at 67.1 percent, on average,
in the first half of 1998, slightly above
the previous cyclical highs achieved in
late 1989 and early 1990. Participation
among adult women has picked up
noticeably in recent years, after having
risen only slowly in the first half of
the 1990s, and participation among
adult men, which had been on a gradual
downtrend through mid-decade, appears
to have leveled out. In contrast, participation rates for teenagers, for whom
school enrollment rates have risen, have
continued to sag after having dropped
sharply in the early 1990s. Strong labor
demand clearly contributed importantly
to the rise in overall participation over
the past several years, but the expansion
of the earned income tax credit and
changes in the welfare system probably
provided added stimulus.
81
Labor Costs and Productivity
Firms no doubt are continuing to rely
heavily on targeted pay increases and
incentives like stock options and
bonuses to attract and retain workers.
But the tightness of the labor market
also appears to be exerting some upward
pressure on traditional measures of
hourly compensation, which have exhibited a somewhat more pronounced
uptrend of late. Indeed, the twelvemonth change in the employment cost
index (ECI) for private industry workers picked up to 3l/i percent in March,
compared with 3 percent for the twelve
months ending in March 1997 and
23A percent for the twelve months ending in March 1996. Hourly compensation accelerated especially rapidly for
employees of finance, insurance, and
real estate firms, some of whom received sizable bonuses and commissions. However, the acceleration was
fairly widespread across industries and
occupations and, given the relatively
small rise in consumer prices over the
past year, implies a solid increase in real
pay for many workers.
The acceleration in hourly compensation costs over the past year resulted
mainly from faster growth of wages and
salaries, which rose 4 percent over the
twelve months ending in March; this
increase was about Vi percentage point
larger than the one recorded over the
preceding twelve months. Separate data
on average hourly earnings of production or nonsupervisory workers also
show an ongoing acceleration of wages:
The twelve-month change in this series
was 4.1 percent in June, V2 percentage
point above the reading for the preceding twelve months.
Benefits costs have generally remained subdued, with the increase over
the year ending in March amounting to
82
85 th Annual Report, 1998
only about 2!A percent. According to the
ECI, employer payments for health
insurance have picked up moderately in
recent quarters after having been essentially flat over the previous couple of
years, and indications are that further
increases may be in the offing. Insurers
whose profit margins had been squeezed
in recent years by pricing strategies
designed to gain market share reportedly are raising premiums, and many
managed care plans are adding innovations that, while offering greater flexibility and protections to consumers, may
boost costs. Additional upward pressure
on premiums apparently has come from
higher spending on prescription drugs.
Among other major components of
benefits, rising equity prices have reduced the need for firms to pay into
defined benefit plans, and costs for state
unemployment insurance and workers'
compensation have fallen sharply.
Labor productivity in the nonfarm
business sector posted another sizable
advance in the first quarter of 1998,
bringing the increase over the year ending in the first quarter to an impressive
2 percent.3 Taking a slightly longer
perspective, productivity has risen a bit
more than 1V2 percent per year, on average, over the past three years, after having risen less than 1 percent per year, on
average, over the first half of the decade.
At least in part, the recent strong productivity growth has likely been a cyclical response to the marked acceleration
of output. But it is also possible that the
high levels of business investment over
the past several years—and the associated rise in the amount of capital per
worker—are translating into a stronger
underlying productivity trend. In addition, productivity apparently is being
buoyed by the assimilation of new technologies into the workplace. In any
event, the faster productivity growth
of late is helping to offset the effects
of higher hourly compensation on unit
labor costs and prices, thereby allowing
wages to rise in real terms.
Prices
Price inflation remained quiescent in the
first half of this year. After having
increased l3/4 percent in 1997, the consumer price index slowed to a crawl in
early 1998 as energy prices plummeted,
and it recorded a rise of only about
IV2 percent at an annual rate over the
first six months of the year. The increase
in the CPI excluding food and energy—
the so-called "core CPI"—picked up to
2I/2 percent (annual rate) over the first
half of the year. However, this pickup
follows some unusually small increases
in the second half of 1997, and the
Alternative Measures of Price Change
3. According to the published data, productivity rose 1.1 percent at an annual rate in the first
quarter. However, these data are distorted by
inconsistencies in the measurement of hours associated with varying lengths of pay periods across
months. Although the Bureau of Labor Statistics
has already revised the monthly hours and earnings data to account for these inconsistencies,
it will not update the productivity statistics until
August. All else being equal, adjusting the productivity data to reflect the Bureau's revisions
to hours would substantially raise productivity
growth in the first quarter, but it would have little
effect on the change over the four quarters ending
in the first quarter.
Percent
1996:Q1
to
1997:Q1
1997:Q1
to
1998-.Q1
Fixed-weight
Consumer price index
Excluding food and energy ...
2.9
2.5
1.5
2.3
Chain-type
Personal consumption
expenditures
Excluding food and energy . . .
Gross domestic product
2.6
2.3
2.2
1.0
1.4
1.4
Price measure
NOTE. Changes are based on quarterly averages.
Monetary Policy Reports, July
twelve-month change has held fairly
steady at about 2V4 percent since late
last summer. The chain-type price index
for personal consumption expenditures
on items other than food and energy
rose only 1V2 percent over the year ending in the first quarter of 1998—the
most recent information available; this
measure typically rises less rapidly than
does the core CPI, in part because it is
less affected by so-called "substitution
bias."
The relatively favorable price performance in the first half of 1998 reflected
a number of factors that, taken together,
continued to exert enough restraint to
offset the upward pressures from strong
aggregate demand and high levels of
labor utilization. One was the drop in oil
prices. In addition, non-oil import prices
continued to fall, thus further lowering
input costs for many domestic industries
and limiting the ability of firms facing
foreign competition to raise prices for
fear of losing sales to producers abroad.
Prices of manufactured goods were also
held in check by the sizable increase
in domestic industrial capacity in recent
years and by developments in Asia,
which, among other things, led to a considerable softening of commodity prices.
Moreover, the various surveys of consumers and forecasters suggest that
inflation expectations stayed low—even
declined in some measures. For example, according to the Michigan survey,
median one-year inflation expectations
dropped a bit further this year, after having held fairly steady over 1996 and
1997, and inflation expectations for the
next five to ten years edged down from
about 3 percent, on average, in 1996 and
1997 to 23/4 percent in the second quarter of 1998.
The CPI for goods other than food
and energy rose at an annual rate of
1 percent over the first six months of
1998, only a bit above the meager
83
Vi percent rise over 1997 as a whole. In
the main, the step-up reflected a turnaround in prices of used cars and trucks,
and prices of tobacco products and prescription drugs also rose considerably
faster than they had in 1997. More generally, prices continued to be restrained
by the effect of the strong dollar on
prices of import-sensitive goods. For
example, prices of new vehicles fell
slightly over the first half of the year,
while prices of other import-sensitive
goods—such as apparel and audio-video
equipment—were flat or down. In the
producer price index, prices of capital
equipment were little changed, on balance, over the first half of 1998; they,
too, were damped by the competitive
effects of falling import prices.
The CPI for non-energy services
increased 3 percent over the first six
months of 1998, about the same as last
year's pace. After having fallen somewhat last year, airfares picked up in
the first half of the year, and owner's
equivalent rent seems to be rising a bit
faster than it did in 1997. In addition,
increases in prices of medical services,
which had slowed to about 3 percent per
year in 1996-97, have been running
somewhat higher so far this year. Price
changes for most other major categories
of services were similar to or smaller
than those recorded in 1997.
Energy prices fell sharply in early
1998, as the price of crude oil came
under severe downward pressure from
weak demand in Asia, a decision by key
OPEC producers to increase output, and
a relatively warm winter in the Northern Hemisphere. After having averaged
about $20 per barrel in the fourth quarter of 1997, the spot price of West Texas
intermediate dropped to a monthly average of $15 per barrel in March, where
it more or less remained through the
spring. Crude prices dropped sharply in
June following reports of high levels
84
85th Annual Report, 1998
of inventories and revised estimates of
oil consumption in Asia but have since
firmed in response to an agreement by
major oil producers to restrict supply
in the months ahead; they now stand at
$ 141/2 per barrel. Reflecting the decline
in crude prices, retail energy prices fell
at an annual rate of 12 percent over the
first half of the year, led by a steep drop
in gasoline prices.
Developments in the agricultural sector also helped to restrain overall inflation in the first half of this year. Excluding the prices of fruits and vegetables—
which tend to be bounced around by
short-term swings in the weather—food
prices have been rising a scant 0.1 percent per month, on average, since late
1997. Although farmers in some regions
of the country are experiencing more
prolonged weather problems, conditions
in the major crop-producing areas of the
Midwest still look relatively favorable,
and it appears that aggregate farm
production will be sufficient to maintain
ample supplies over the coming year,
especially in the context of sluggish
export demand.
Credit and the
Monetary Aggregates
Credit and Depository Intermediation
The total debt of U.S. households, governments, and nonfinancial businesses
increased at an annual rate of 53A percent from the fourth quarter of 1997
through May of this year. Domestic nonfinancial debt now stands a little above
the midpoint of the 3 percent to 7 percent range established by the FOMC for
1998. Debt growth has picked up since
1997, as an acceleration of private credit
associated with strong domestic demand
and readily available supply has more
than offset reduced federal borrowing.
Indeed, federal debt declined VA per
cent at an annual rate between the fourth
quarter of 1997 and May 1998, whereas
nonfederal debt increased 8!/4 percent
annualized over the same period. The
growth of nonfederal debt has slowed
only slightly over the past several
months.
Credit on the books of depository
institutions rose at roughly the same
pace as total credit in the first half of the
year. Commercial bank credit advanced
rapidly in the first quarter and at a more
subdued rate in the second. This slowdown was especially acute in securities
holdings, which had surged in both the
fourth quarter of 1997 and the first quarter of this year. Responses to the Federal
Reserve's May survey on bank lending
practices suggest that the earlier run-up
in securities reflected the efforts of
banks to boost returns on equity by
increasing leverage; much of the rise in
securities holdings was concentrated at
banks that were constrained by recent
mergers from using their profits to
repurchase shares. Loan growth also
slowed in the second quarter, although
the various loan categories behaved
quite differently: Real estate lending
expanded most slowly in May and June,
whereas business lending rebounded in
those months after having stalled out in
March and April. Outstanding loans at
branches and agencies of foreign banks
declined in the second quarter, and
survey responses identified an actual or
expected weakening in the capital position of the parent banks as the primary
impetus for a tightening of loan terms
and standards.
The Report of Condition and Income
(the Call Report) showed that banks'
return on equity was about unchanged in
the first quarter, staying in the elevated
range it has occupied since 1993. Call
Report data also indicated that delinquency and charge-off rates on commercial and industrial loans and on real
Monetary Policy Reports, July
estate loans remain quite low, while
delinquency and charge-off rates on
consumer loans have leveled off after
their previous rise. Indeed, bank profits
have benefited importantly in recent
years from a low level of provisioning for loan losses. Nevertheless, bank
supervisors have been concerned that
intense competition and favorable
economic conditions might be leading
banks to ease standards excessively.
They reminded depositories that credit
assessments should take account of the
possibility of less positive economic
circumstances in the future.
The trend toward consolidation in the
banking industry continued in the first
half of the year. Some of the announced
mergers involve combinations of banks
and nonbank financial institutions, such
as thrifts and insurance companies.
Many of the mergers were designed to
capitalize on the economies of scale and
diversification of risk in nationwide
banking; other mergers were undertaken
to expand the range of services offered
to customers. Although some observers
are concerned that consolidation might
raise banks' market power, greater
national concentration in banking over
the past several years has not increased
banking concentration in most local
markets.
The Monetary Aggregates
The broad monetary aggregates grew
more rapidly in the first half of 1998
than they did in 1997, although the pace
of their expansion has slowed noticeably in recent months. M2 grew IV* percent at an annual rate between the fourth
quarter of last year and June of this year,
placing it well above the top of its 1 percent to 5 percent growth range. When
the FOMC established this range in February, it noted that annual ranges represented benchmarks for money growth
85
under conditions of stable prices and
velocity behavior in accordance with its
pre-1990 historical experience. In fact,
nominal spending and income have
grown more rapidly than is consistent
with price stability and sustainable real
growth, and the velocity of M2 (defined
as the ratio of nominal GDP to M2) has
fallen relative to the behavior predicted
by the pre-1990 experience.
For several decades before 1990, M2
velocity showed little overall trend but
varied positively from year-to-year with
changes in M2 opportunity cost, which
is generally defined as the interest forgone by holding M2 assets rather than
short-term market instruments such as
Treasury bills. The relationship was disturbed in the early 1990s by a sharp
increase in velocity; however, since
mid-1994, M2 velocity and opportunity
Growth of Money and Debt
Percent
Period
Ml
M2
M3
Domestic
nonfinancial
debt
Annual^
1988
1989
4.3
.5
5.7
5.2
6.3
4.0
9.1
7.5
1990
1991 .
1992
1993
1994
4.2
7.9
14.4
10.6
2.5
4.1
3.1
1.8
1.3
.6
1.8
1.2
.6
1.1
1.7
6.7
4.5
4.5
4.9
4.9
1995
1996 .
1997
-1.6
-4.5
-1 2
3.9
4.6
5.7
6.1
6.8
8.8
5.4
5.3
5.0
Quarterly
(annual rate)2
1998:Q1
Q2
3.0
.3
8.0
7.3
11.0
9.6
6.2
n.a.
Year-to-date3
1998
.9
7.3
9.8
5.8
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.
3. From average for fourth quarter of 1997 to average
for June (May in the case of domestic nonfinancial debt).
n.a. Not available.
86
85th Annual Report, 1998
cost have again been moving roughly
together, though not in lockstep. Indeed,
velocity has declined recently despite
almost no change in the standard measure of opportunity cost. The dip in
velocity may be partly attributable to the
flatter yield curve, which has reduced
the return on longer-term investments
relative to M2 assets—bank deposits
and money market mutual funds. Money
demand may also be bolstered by the
efforts of households to rebalance their
portfolios in the face of a booming stock
market. By the end of 1997, households'
monetary assets had ebbed to the smallest share of their total financial assets
in many years, and households may
want to reduce the concentration of their
assets in relatively risky equities and
increase their holdings of less volatile
M2 assets. However, in spite of both the
flatter yield curve and the rebalancing
motive, flows into both bond mutual
funds and stock mutual funds have been
quite heavy this year.
M2 increased 7 lA percent at an annual
rate in the second quarter, compared
with 8 percent in the first quarter. A
buildup in household liquid accounts in
preparation for individual income tax
payments substantially boosted money
growth in April; the clearing of these
payments depressed May growth by a
roughly equal amount. At an annual rate,
M2 increased about 6 percent on average over April and May and about 5 percent in June, suggesting a larger deceleration than is shown by the quarterly
average figures.
M3 grew 93A percent at an annual rate
between the fourth quarter of last year
and June, placing it far above the top of
its 2 percent to 6 percent growth range.
As with M2, the FOMC chose the
growth range for M3 as a benchmark for
growth under conditions of price stability and historical velocity behavior. The
components of M3 not included in M2
increased 17!/2 percent at an annual rate
over the first half of the year, following
an even faster run-up in 1997. Rapid
expansion of large time deposits in the
first quarter was driven importantly by
strong credit growth at depository institutions. More recently, gains in this category have diminished as bank credit
growth has slowed. Holdings of institutional money market mutual funds
climbed more than 20 percent in each of
the past three years, and that strength
has mounted in 1998 as businesses'
interest in outsourcing their cash
management evidently has intensified.
Because in-house management often
involves short-term assets that are not
included in M3, the shift to mutual funds
boosts M3 growth.
Ml rose 1 percent at an annual rate
between the fourth quarter of 1997 and
June of this year. Currency expanded
6V2 percent annualized over that period,
a bit below its increase last year. Foreign demand for U.S. currency apparently weakened substantially in the first
five months of the year, with an especially large decline in shipments to
Russia. Deposits in Ml declined in the
first half of the year owing to the continued introduction of "sweep" programs.
Ml growth has been depressed for several years by the spread of these programs, which sweep balances out of
transactions accounts, which are subject
to reserve requirements, and into savings accounts, which are not. Depositors
are unaffected by this arrangement
because the funds are swept back when
needed; banks benefit because they can
reduce their holdings of reserves, which
earn no interest. New sweeps of other
checkable deposits have slowed sharply,
but sweeps of demand deposits into
savings deposits—an activity that has
become popular more recently—
continue to spread. Because many banks
have already reduced their required
Monetary Policy Reports, July
reserves to minimal levels, the total flow
of new sweep programs is tapering off,
although it remains considerable.
The drop in transactions accounts in
the first half of the year caused required
reserves to fall 33A percent at an annual
rate, a much slower decline than in
1997. The monetary base grew 5Vi percent over the same period, as the runoff
in required reserves was more than
offset by the increased demand for
currency.
The substantial decline in required
reserves over the past several years has
raised concern that the federal funds rate
might become more volatile. Required
reserves are fairly predictable and must
be maintained on only a two-week
average basis. As a result, the Federal
Reserve has generally been able to supply a quantity of reserves that is close to
the quantity demanded at the federal
funds rate intended by the FOMC, and
banks have accommodated many unanticipated imbalances in reserve supply
by varying the quantity demanded
across days. Banks also hold reserve
balances to avoid overdrafts after making payments to other banks. But this
precautionary demand is more variable
and difficult to predict than requirementrelated demand, and it cannot be substituted across days. As required reserves
drop, more banks will hold deposits
at the Federal Reserve only to meet
these day-to-day demands, reducing the
potential for rate-smoothing behavior.
So far, however, the federal funds
rate has not become noticeably more
volatile on a maintenance-period average basis. This outcome has occurred
partly because the Federal Reserve has
responded to the changing nature of
reserve demand by conducting open
market operations on more days than
had been customary and by arranging
more operations with overnight maturity, thereby bringing the daily reserve
87
supply more closely in line with
demand. At the same time, banks have
borrowed more reserves at the discount
window and have improved the management of their accounts at Reserve Banks.
Between 1995 and 1997, banks also significantly increased their required clearing balances, which they precommit to
hold and which earn credits that can be
applied to Federal Reserve priced services. Like required reserve balances,
required clearing balances are predictable by the Federal Reserve and can be
substituted across days within the twoweek maintenance period. Going forward, the Federal Reserve's recent decision to use lagged reserve accounting
rather than contemporaneous reserve
accounting will increase somewhat the
predictability of reserve demand by both
banks and the Federal Reserve. Still,
further declines in required reserves
might increase funds-rate volatility.
Moreover, one-third of the banks responding to the Federal Reserve's recent
Senior Financial Officer Survey report
that reserve management is more difficult today than in the past. One way to
diminish these problems would be to
pay interest on reserve balances, which
would reduce banks' incentives to minimize those balances.
Financial Markets
Interest Rates
Yields on intermediate- and long-term
Treasury securities moved in a fairly
narrow band during the first half of
1998, centered a little below the levels
that prevailed in the latter part of 1997.
The thirty-year bond yield touched its
lowest value since the bond was introduced to the regular auction calendar
in 1977; it was also lower than any
sustained yield on the twenty-year bond
(the longest maturity Treasury security
88
85th Annual Report, 1998
before the issuance of the thirty-year
bond) since 1968. Meanwhile, the average yield on five-year notes in the first
half of the year was the lowest since
early 1994.
Several factors have contributed to
the decline in intermediate- and longterm interest rates over the past year.
For one, developments in the U.S. economy and overseas reduced expected
inflation and, perhaps, uncertainty about
future inflation. Between the second
quarter of 1997 and the second quarter
of 1998, the median long-term inflation
expectation in the Michigan Survey
Research Center survey of households
dropped lA percentage point, and the
average expectation in the Philadelphia
Federal Reserve's Survey of Professional Forecasters fell almost Vi percentage point. Over the same period, the
variance of long-term inflation expectations in the Michigan survey was
halved. This greater consensus of expectations suggests that people may now
place less weight on the possibility of a
sharp acceleration in prices; a reduction
in perceived inflation risk would tend to
reduce term premiums and thereby cut
long-term interest rates. A damping of
expected growth in real demand here
and abroad, triggered importantly by the
Asian financial crisis, also has probably
pulled rates lower, as has an apparent
shift in desired portfolios away from
Asia and, to some extent, from other
emerging market economies. Lastly,
diminished borrowing by the federal
government has restrained interest rates
by reducing the competition for private
domestic saving and for borrowed funds
from abroad.
Assessing the relative importance of
some of these factors might be aided, in
principle, by comparing yields on nominal and inflation-indexed Treasury
notes. Between the second quarters of
1997 and 1998, the nominal ten-year
yield fell more than 1 percentage point,
whereas the inflation-indexed ten-year
yield increased a bit. Unfortunately,
the relatively recent introduction of
inflation-indexed securities and the thinness of trading makes interpreting their
yield levels and movements difficult. In
particular, light trading may lead investors to view these new securities as
providing less liquidity than traditional
Treasury notes, and investors may value
liquidity especially highly now in the
face of uncertainty about developments
in Asia.
The yield curve for Treasury securities has recently been flatter than at any
point since the beginning of the decade.
For example, the difference between the
ten-year-note yield and the three-monthbill yield was smaller in the first half of
1998 than in any other half-year period
since early 1990. In that earlier episode,
the yield curve had been flattened by a
sharp run-up in short-term interest rates
as the Federal Reserve tried to check an
upcreep in inflation. In the current episode, short rates have held fairly steady,
while long-term rates have declined significantly. Some of the current flatness
of the term structure probably stems
from the apparent reduction in term premiums noted above. But the flat yield
curve may also reflect the expectation
that short-term real interest rates, which
have been boosted by the decline in
inflation over the past year, will drop in
the future. Supporting that notion, the
yield curve for inflation-indexed debt
has become inverted this year, as the
return on the five-year indexed note has
risen above the return on the ten-year
indexed note, which exceeds the return
on the new thirty-year indexed bond.
Equity Prices
Equity markets have remained ebullient
this year. The S&P 500 composite index
Monetary Policy Reports, July
rose sharply in the first several months
of 1998; it then fell back a little before
moving up to a new record in July. The
NASDAQ composite, NYSE composite,
and Dow Jones Industrial Average
followed roughly similar patterns, and
these indexes now stand about 17 to
28 percent above their year-end marks.
Small capitalization stocks have not
fared so well this year, with the Russell
2000 index up about a third as much on
net.
The increase in equity prices combined with the recent slowdown in earnings growth has kept many valuation
measures well above their historical
ranges. The ratio of prices in the
S&P 500 to consensus estimates of earnings over the coming twelve months
reached a new high in April and has
retreated only slightly from that point.
At the same time, the real long-term
bond yield—measured either by the tenyear indexed yield or by the difference
between the ten-year nominal Treasury
yield and inflation expectations in
the Philadelphia Federal Reserve's
survey—is little changed since year-end.
As a result, the forward-earnings yield
on stocks exceeds the real yield on
bonds by one of the smallest amounts in
many years. Apparently, investors share
analysts' expectations of robust longterm earnings growth, or they are content with a much smaller equity premium than the historical average.
International Developments
Events in Asia, including in Japan, have
continued to dominate developments in
global asset markets so far in 1998. During the first months of the year, many
financial markets in Asia appeared to
stabilize, and progress in implementing
economic and financial reform programs
was made in most of the countries seriously affected by the crises. In early
89
April, the agreement between Korean
banks and their external bank creditors
to stretch out short-term obligations was
implemented, ending an interval of rollovers by creditors that was endorsed
by the authorities in countries that had
pledged to support the Korean program.
Indonesia reached a second revised
agreement with the International Monetary Fund (IMF) in April on a reform
program, which was subsequently
derailed by political strife and the resignation of the president in late May; the
change in political regime was followed
by calm, and a new agreement was
reached with the IMF management in
late June and approved by the IMF
Executive Board on July 15.
After having risen sharply during
the final months of 1997 through midJanuary of 1998, the exchange value of
the dollar in terms of the currencies of
Korea, Indonesia, Thailand, and other
ASEAN countries partly retraced those
gains during February, March, and
April. Since then, however, market pressures have again led to further sharp
increases in the exchange value of
the dollar in terms of the Indonesian
rupiah while the dollar has changed
little against most of the other Asian
emerging-market currencies. Since the
end of December, the dollar has
declined, on balance, 24 percent against
the Korean won and nearly 14 percent
against the Thai baht and has risen moderately in terms of the Taiwan dollar and
increased about 130 percent in terms of
the Indonesian rupiah.
During the first weeks of the year,
the dollar depreciated in terms of the
Japanese yen as improved prospects
elsewhere in Asia and market uncertainty regarding potential intervention
by the Japanese monetary authorities
lent support to the yen. Indications
that significant measures for economic
stimulus might be announced also put
90
85 th Annual Report, 1998
upward pressure on the yen. In February, the dollar resumed its appreciation
with respect to the yen. The rise in the
dollar was only temporarily interrupted
by sizable intervention purchases of
dollars by Japanese authorities in April.
Upward pressure on the dollar relative
to the yen intensified in late May and
June. Renewed signs of cyclical weakness in the Japanese economy and lack
of market confidence in the announced
programs for addressing the chronic
problems within the financial sector contributed to pessimism toward the yen.
Persistent weakness in the Japanese
economy and the yen, in turn, heightened concerns about prospects elsewhere in Asia; the lower yen adversely
affected the competitiveness of goods
produced in the Asian emerging-market
economies and raised questions about
the sustainability of current exchange
rate policies in China and Hong Kong.
On June 17, the monetary authorities
in the United States and Japan cooperated in foreign exchange intervention purchases of yen for dollars. This
intervention operation was the first by
U.S. authorities since August 1995. In
announcing the market intervention,
Treasury Secretary Rubin cited Japanese government plans to restore the
health of their financial system and to
strengthen Japanese domestic demand.
He pointed to the stake of Asia and the
international community as a whole in
Japan's success. The yen rose somewhat
following the exchange market intervention and has since partially given back
that gain. In the wake of the recent
election, which cost the Liberal Democratic Party numerous seats in the upper
house of the Diet and precipitated the
resignatioa of Prime Minister Hashimoto, the yen changed little. On balance, the dollar has appreciated about
7 percent in terms of the yen since the
end of December.
Equity prices in the Asian emergingmarket economies have been volatile so
far this year as well. These prices recovered somewhat in the first weeks of
the year in response to the market perception that the crisis was easing; after
having fluctuated narrowly, they began
moving back down in March and April,
reaching new lows in June in Korea,
Thailand, and Hong Kong. On balance,
these equity prices have moved down
about 25 percent (Singapore and Malaysia) to up about 20 percent (Indonesia)
since the end of last year. Equity prices
in Japan also rose early in the year on
improved optimism but then gave back
those gains over time with the release of
indicators suggesting additional weakness in the Japanese economy. Since the
middle of June, Japanese equity prices
have rebounded on the perception that
significant fiscal stimulus is now more
likely. On balance, Japanese equity
prices are up about 9 percent from their
level at the end of last year. Japanese
long-term interest rates continued
through May on their downward trend
that began in mid-1997, declining an
additional 50 basis points during the first
five months. Since then, long-term interest rates have retraced more than half of
that decline, in part in response to the
announcement of the plan for financial
restructuring and in part in response
to the outcome of the recent election,
which heightened expectations of additional fiscal stimulus.
The Asian financial crises have
resulted in a sharp drop in the pace of
economic activity in the region. Output
declined precipitously in the first quarter
in those countries most affected, such
as Korea, Indonesia, and Malaysia, and
slowed in other Asian economies, such
as China and Taiwan, that have suffered
a loss of competitiveness and reduced
external demand as a consequence of
the crises. Data for recent months sug-
Monetary Policy Reports, July
gest that additional slowing has occurred
and that the risk of further spread and
deepening of cyclical weakness throughout the region cannot be ruled out.
Depreciation of their respective currencies has led to acceleration of domestic
prices in several of these economies,
particularly in Indonesia and Thailand.
Real GDP in Japan also fell sharply in
the first quarter, and output indicators
suggest a further decline in the second
quarter. Consumer price inflation remains very low. Japanese authorities
have announced a series of fiscal measures that are expected to boost domestic demand during the second half of
this year. In addition, officials have
announced a package of steps directed
at restoring the soundness of the financial sector, including (1) introduction of
a bridge bank mechanism to facilitate
the resolution of failed banks while
permitting some of their borrowers to
continue to receive credit, (2) measures
to improve the disposal of bad bank
loans, (3) enhanced transparency and disclosure by banks, and (4) strengthened
bank supervision. These actions are intended to restore confidence in Japanese
financial institutions and in the prospects for the economy more broadly.
In the other major industrial countries, economic developments so far this
year have generally been favorable. The
exchange value of the dollar in terms of
the German mark has fluctuated narrowly and, on balance, is little changed
since the end of December. Market perceptions that progress toward the start of
the final stage of European Monetary
Union (EMU) is going smoothly and
signs of momentum in the U.S. and German economies resulted in little pressure in either direction on the exchange
rate. The dollar also fluctuated narrowly
against the U.K. pound with little net
change so far this year. Moves to tighten
monetary conditions in the United King
91
dom lent support to the pound, countering some tendency for weak external
demand to depress the currency. The
Canadian dollar rebounded following a
tightening of monetary conditions by the
Bank of Canada on January 30. Since
early March, however, it has tended to
move down as market participants have
come to believe that further upward
shifts of official interest rates are
unlikely and as weakness in global commodity markets, partly the result of
reduced economic activity in Asia, have
weighed on the currency. The exchange
value of the U.S. dollar in terms of the
Canadian dollar reached new highs in
July and, on balance so far this year, has
risen about 4 percent.
Long-term interest rates have declined, and equity prices have generally
risen strongly in European and Canadian markets this year. Despite signs of
strengthening activity in Germany and
other continental European countries
and continued healthy expansion in the
United Kingdom and Canada, long-term
rates have moved down since December; long rates are about 60 basis points
lower in Germany and less than half that
amount lower in Canada. Shifts of international portfolios away from Asian
assets and toward those perceived to be
safer have probably contributed to rate
declines in Continental Europe and in
the United States. Stock prices have also
continued to rise in Europe and Canada.
Since December, the gains have ranged
from about 40 percent in Germany and
France to about 10 percent in Canada.
The pace of real economic activity
improved somewhat in the first quarter
in Germany and on average in the
eleven countries slated to proceed with
currency union on January 1, 1999.4
4. Those countries are Austria, Belgium, Finland, France, Ireland, Italy, Germany, Luxembourg, the Netherlands, Portugal, and Spain.
92
85th Annual Report, 1998
Production and employment data for
more recent months suggest continued
expansion. Business confidence has
firmed as progress toward EMU has
continued. Domestic demand is becoming more buoyant in several of these
countries, offsetting weakening of external demand arising from events in Asia.
On average, inflation remains subdued
within the euro area. In the United Kingdom and Canada, real output continues
to expand at a relatively rapid rate. U.K.
inflation threatens to exceed the government's target of 2Vi percent, and the
Bank of England raised its official lending rate 25 basis points in June in order
to lessen price pressures. Consumer
price inflation in Canada remains very
low.
Events in Asia have spilled over to
affect developments in Latin American
countries. Declines in global oil prices
have contributed to downward pressure
on the exchange value of the Mexican
peso. The peso declined sharply in terms
of the dollar at the start of the year but
then stabilized in February through May
as Asian markets partially recovered. It
depreciated further in May and June,
resulting in a net decline of about 9 percent in terms of the dollar so far this
year. The Brazilian exchange rate
regime of a controlled crawl and the
Argentine regime of pegging the peso to
the dollar remain in place, and Brazilian
short-term interest rates have been low-
ered from the very high levels to which
they were raised when the Asian crisis
intensified in late 1997. Equity prices in
these three Latin American countries
have been volatile, rising early in the
year and giving back those gains since
April. On balance this year, equity prices
have declined about 10 percent in
Mexico and Argentina and have risen
about 8 percent in Brazil.
Real output growth remains strong in
Mexico and Argentina, but the rate has
slowed somewhat from last year's vigorous pace. In Brazil, economic activity
has weakened more sharply, in part in
response to the tightening of monetary
conditions that followed the outbreak of
the Asian crisis.
Lower global oil prices have combined with a poorly functioning domestic tax system to trigger a financial crisis
in Russia. Russian officials have reached
agreement with IMF management on a
revised program that includes proposed
increased funds from the IMF and other
sources. To help finance this program,
the General Arrangements to Borrow
are being activated in light of the inadequacy of IMF resources to meet actual
or expected requests for financing and a
need to forestall impairment of the international monetary system. The General
Arrangements to Borrow provide the
IMF with supplementary lines of credit
from the G-10 countries.
•
Part 2
Records, Operations,
and Organization
95
The Board of Governors and the
Government Performance and Results Act
Under the Government Performance and
Results Act of 1993, many 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. Though not required to do so,
the Board of Governors is voluntarily
complying with the requirements of the
act.
Strategic and Performance Plans
The Board sent its strategic plan for the
period 1997-2002 to the Congress in
October 1997. The 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 performance evaluation.
In September 1998, the Board sent to
the Congress a performance plan for its
1998-99 budget.1 The plan sets forth
specific targets for some of the performance measures identified in the strategic plan. It also describes the operational
processes and resources needed to meet
those targets and discusses validation
and verification of results.
1. The act requires that a performance plan
be submitted for each fiscal year beginning with
fiscal 1999. The Board budgets over a calendar
year, and its budget covers a two-year period. The
budget for 1998-99 was approved in November
1997.
The text of the strategic and performance plans is available on the Board's
public web site. A summary of the goals
and objectives set forth in those plans is
given in the next section.
Goals and Objectives
The Federal Reserve has three interrelated and mutually reinforcing goals,
with supporting objectives:
Goal
To conduct monetary policy toward the
achievement of maximum sustainable
long-term growth and stable prices
Objectives
• Stay abreast of recent developments
and prospects in the U.S. economy
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
96
85th Annual Report, 1998
• 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 through
supervision and regulation of the nation's banking and financial systems,
through its function as the lender of last
resort, and through effective implementation of statutes designed to inform and
protect the consumer
Objectives
• Maintain ability and capacity as a
bank supervisor and central bank to
ensure that emerging financial threats
can be identified early and successfully resolved
• Provide comprehensive and effective
supervision of U.S. banks, bank holding companies, U.S. operations of
foreign banking organizations, and
related entities by focusing supervisory efforts and resources on areas
of highest risk to individual organizations and the financial system as a
whole, and developing effective regulations to promote a safe and sound
banking environment
• Promote sound practices for managing risk at banking organizations
that provide for strong internal controls, active boards of directors, and
senior management oversight and
accountability
• Promote sound banking and effective
supervisory practices among developed and emerging countries through
ongoing coordination with international supervisory bodies and through
training programs for international
supervisors and bankers
• Heighten the positive effect of market
discipline on banking organizations by
encouraging improved disclosures,
accounting standards, risk measurement, and overall market transparency
• Harness benefits of technology in carrying out responsibilities to improve
supervisory efficiency and to reduce
burden on banking organizations
• Maintain an understanding of the
effect of financial innovation and technology (for example, new powers and
products, new risk management and
measurement methodologies, and
electronic banking) on the operations
and risk profile of banking organizations and the payment system. Ensure
that supervisory programs accommodate prudent advances that benefit
consumers and businesses or improve
risk management
• Remove unnecessary banking restrictions consistent with safety and
soundness. Refine or eliminate unnecessary or ineffective policies, procedures, regulations, or restrictions
to ensure that reforms are effectively implemented, consistent with
safety and soundness of banking
organizations
• Assure fair access to financial services
for all Americans through vigorous
enforcement of the Equal Credit
Opportunity, Fair Housing, Community Reinvestment, and Home Mortgage Disclosure Acts and by encouraging state member bank involvement
in community development activities
• Administer and ensure compliance
with consumer protection statutes
relating to consumer financial transactions (such as the Truth in Lending,
Truth in Savings, Consumer Leasing,
and Electronic Fund Transfer Acts) to
carry out congressional intent, striking
the proper balance between protection
of consumers and burden to the
industry.
The Board of Governors and the Government Performance and Results Act
Goal
To foster the integrity, efficiency, and
accessibility of U.S. dollar payment and
settlement systems, issue currency, and
act as the fiscal agent and depository of
the U.S. government
Objectives
• Provide Federal Reserve Bank priced
payment services that maintain and
improve the efficiency and integrity of
the U.S. dollar payment mechanism
• Meet public demand for U.S. currency
in the United States and abroad, work
with Treasury to implement effective
counterfeit-deterrence and detection
features in U.S. currency, and provide
for the smooth introduction of newdesign currency
• Provide efficient and effective fiscal
agency and depository services on
behalf of Treasury and other government agencies
• Study and monitor U.S. dollar payment, clearing, and settlement systems and the risk issues pertaining to
these systems to facilitate sound policy decisions that foster the integrity
of the nation's payment systems.
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
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 the chief
financial officers of 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 and has established four subgroups to focus on examinations, outreach, performance planning, and planning/budget linkage.
These and similar planning efforts can
significantly lower data processing and
other costs for the government and the
costs for depository institutions of compliance with federal regulations.
•
2. The FFIEC member agencies are the Board
of Governors, 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 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.
97
99
Record of Policy Actions
of the Board of Governors
Regulation B
Equal Credit Opportunity
Regulation C
Home Mortgage Disclosure
March 23, 1998—Amendments
September 21, 1998—Amendments
The Board amended certain model
forms in Regulation B to reflect revisions to the disclosures provided under
the Fair Credit Reporting Act that must
be given to consumers who are denied
credit on the basis of information from
an affiliate of the creditor or a consumer
reporting agency, effective April 30,
1998.
The Board amended Regulation C to
require lenders to report dates on the
loan application register using four digits for the year to bring Home Mortgage
Disclosure Act reporting into compliance with Year 2000 data system standards, effective September 24, 1998.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, Mr. Kelley, Ms. Phillips, and
Messrs. Meyer, Ferguson, and Gramlich.1
Regulation B requires creditors to
provide consumers with a notice of
action taken if an application for credit
is denied, an account is terminated, or
the terms of an account are unfavorably
changed. The Fair Credit Reporting Act
requires that disclosures be provided to
consumers when credit is denied on the
basis of information obtained from an
affiliate of the creditor, or from a consumer reporting agency or a third party
other than a consumer reporting agency.
The Board revised the language in several model forms to reflect 1996 amendments to the act.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, and Messrs. Kelley, Meyer,
Ferguson, and Gramlich.2
Regulation C, which implements the
Home Mortgage Disclosure Act, requires most mortgage lenders in metropolitan statistical areas to report annually to federal supervisory agencies and
to disclose to the public information
about their home mortgage and home
improvement lending. The Board
amended Regulation C to modify the
loan application register that is used to
report this information to prepare for
Year 2000 data systems conversion and
to make certain other technical changes.
Regulation D
Reserve Requirements
of Depository Institutions
March 23, 1998—Amendments
The Board amended Regulation D for
institutions that report deposits weekly
1. In voting records throughout this chapter,
Board members, except the Chairman and Vice
Chair, are listed in order of seniority.
2. Throughout this chapter, note 2 indicates that
one vacancy existed on the Board when the action
was taken.
100 85th Annual Report, 1998
to move from contemporaneous reserve
maintenance to a system under which
reserves are maintained on a lagged
basis, effective as of the maintenance
period beginning July 30, 1998.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, Mr. Kelley, Ms. Phillips, and
Messrs. Meyer, Ferguson, and Gramlich.
The Board revised Regulation D to
improve the ability of the Federal
Reserve and depository institutions to
estimate accurately the quantity of
reserves that will be needed to meet
reserve requirements. The amendments
introduce a lag of thirty days between
the beginning of a reserve computation
period and the beginning of a reserve
maintenance period and a similar lag for
computing the vault cash that can be
applied to satisfy reserve requirements.
November 19, 1998—
Amendments
The Board amended Regulation D to
decrease the amount of net transaction
accounts at depository institutions to
which a lower reserve requirement
applies and to increase the amount of
reservable liabilities that is exempt from
reserve requirements, for 1999. The
Board also announced higher deposit
cutoff levels for determining deposit
reporting requirements.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, and Messrs. Kelley, Ferguson,
and Gramlich. Absent and not voting:
Mr. Meyer.2
Under the Monetary Control Act of
1980, depository institutions, Edge Act
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 subject to the lower reserve
requirement to reflect changes in net
transaction accounts at depository institutions. Recent declines in net transaction accounts warranted a decrease to
$46.5 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 to
$4.9 million, and the Board amended
Regulation D accordingly.
For institutions reporting weekly, the
amendments are effective with the
reserve computation period beginning
December 1, 1998, and the corresponding reserve maintenance period beginning December 31, 1998. For institutions reporting quarterly, the amendments are effective with the reserve
computation period beginning December 15, 1998, and the corresponding
reserve maintenance period beginning
January 14, 1999.
To reduce the reporting burden on
small institutions, depository institutions
with total deposits below specified levels are required to report their deposits
and reservable liabilities quarterly or
less frequently. To reflect increases
in the growth rate of total deposits at
all depository institutions, the Board
increased the deposit cutoff levels used
in determining the frequency and detail
of depository reporting to $81.9 million
for nonexempt depository institutions
and to $52.6 million for exempt depository institutions, beginning in September 1999.
Board Policy Actions
Regulation E
Electronic Fund Transfers
March 4, 1998- -Interim
Amendment
The Board approved an interim amendment to Regulation E to permit depository institutions and other entities to
provide disclosures electronically if the
customer agrees, effective March 25,
1998.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, Mr. Kelley, Ms. Phillips, and
Messrs. Meyer, Ferguson, and Gramlich.
Regulation E, which implements the
Electronic Fund Transfer Act, requires
depository institutions and other entities
to provide consumers with disclosures
about the terms and conditions of electronic fund transfer services, account
activity, error resolution, and authorizations or confirmations concerning electronic fund transfers. The disclosures
generally must be provided in writing.
Under the interim amendment, depository institutions or other entities subject
to the act are permitted to use electronic
communication to satisfy written disclosure, documentation, notice, and other
information requirements if the consumer agrees to such communication.
The Board has sought comment on the
interim amendment and on proposed
rules similar to the interim amendment
to address electronic communication
under Regulations B (Equal Credit
Opportunity), DD (Truth in Savings),
M (Consumer Leasing), and Z (Truth in
Lending).
September 21, 1998—Amendments
The Board amended Regulation E to
revise the time periods for investigating
certain errors, effective September 24,
1998.
101
Votes for this action: Mr. Greenspan,
Ms. Rivlin, and Messrs. Kelley, Meyer,
Ferguson, and Gramlich.2
The Electronic Fund Transfer Act and
Regulation E require a financial institution to investigate and resolve a consumer's claim of error within specified time
limits. The amendments to Regulation E
revise the time for claims involving
point-of-sale and foreign-initiated transactions to require institutions to provide
provisional credit within ten business
days and to complete their investigation
within ninety calendar days. For new
accounts, the amendments revise Regulation E to allow an institution twenty
business days to provide provisional
credit and ninety calendar days to complete the investigation.
Regulation H
Membership of State
Banking Institutions in the
Federal Reserve System
February 13, 1998—Amendments
The Board amended Regulation H
to lengthen the examination-frequency
cycle for certain financial institutions,
effective April 2, 1998.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, Mr. Kelley, Ms. Phillips, and
Messrs. Meyer, Ferguson, and Gramlich.
The Board, jointly with the other federal banking and thrift agencies, made
certain financial institutions eligible
to be examined on an eighteen-month
cycle rather than a twelve-month cycle,
consistent with provisions of the Riegle
Community Development and Regulatory Improvement Act of 1994 and
the Economic Growth and Regulatory
Paperwork Reduction Act of 1996. Insti-
102 85 th Annual Report, 1998
tutions with assets of $250 million or
less and composite ratings of " 1 " or
" 2 " under the uniform rating system
that are well capitalized and well
managed generally would qualify for
the lengthened cycle. The amendments
make final an interim rule approved by
the Board on January 23, 1997.
Regulation H
Membership of State
Banking Institutions in the
Federal Reserve System
Regulation P
Security Procedures
June 26, 1998—Amendments and
Rescission of Regulation
September 28, 1998—Interim
Guidelines
The Board amended Regulation H to
include guidelines that establish safety
and soundness standards applicable to
efforts by insured depository institutions
to achieve Year 2000 readiness, effective October 15, 1998.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, and Messrs. Kelley, Meyer,
Ferguson, and Gramlich.2
The Board, jointly with the other federal banking and thrift agencies, adopted
interim Interagency Guidelines Establishing Year 2000 Standards for Safety
and Soundness. The guidelines apply
only to insured depository institutions
and incorporate standards for compliance that previously had been issued by
the agencies in several guidance papers.
Under powers granted by section 39 of
the Federal Deposit Insurance Act, as
amended, the Board may direct a state
member bank that does not comply with
the guidelines to submit an acceptable
corrective action plan without the necessity of an administrative proceeding.
The Board may also direct a state member bank that fails to submit an acceptable corrective action plan or does not
comply with an acceptable plan to take
immediate corrective action. The agencies sought public comment on the
interim guidelines.
The Board amended Regulation H to
reduce regulatory burden by simplifying and updating the regulation, and
rescinded Regulation P, which was
incorporated into Regulation H, effective October 1, 1998.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, Ms. Phillips, and Messrs.
Meyer, Ferguson, and Gramlich. Absent
and not voting: Mr. Kelley.
The amendments to Regulation H
remove outdated material, update and
reorganize the remaining material, incorporate provisions designed to reduce
burden on state member banks, and
eliminate several obsolete interpretations. The Board also rescinded Regulation P because its provisions were
incorporated into Regulation H. These
actions are consistent with provisions of
the Riegle Community Development and
Regulatory Improvement Act of 1994.
Regulation H
Membership of State
Banking Institutions in the
Federal Reserve System
Regulation Y
Bank Holding Companies and
Change in Bank Control
June 26, 1998—Amendments
The Board amended Regulations H and Y
Board Policy Actions
to permit institutions to include in tier 2
capital up to 45 percent of their unrealized holding gains on certain equity securities, effective October 1, 1998.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, Ms. Phillips, and Messrs.
Meyer, Ferguson, and Gramlich. Absent
and not voting: Mr. Kelley.
The Board, jointly with the other
federal banking and thrift agencies,
amended the risk-based capital standards for banks, bank holding companies, and thrift institutions regarding
the capital treatment of unrealized holding gains on certain equity securities.
The amendments permit institutions to
include in supplementary (tier 2) capital
up to 45 percent of the before-tax net
unrealized holding gains on certain
available-for-sale equity securities.
July 24, 1998—Amendments
The Board approved amendments to
Regulations H and Y to revise its capital
adequacy standards for state member
banks and bank holding companies to
address the regulatory capital treatment
of servicing assets on mortgage assets
and financial assets other than mortgages, effective October 1, 1998.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, and Messrs. Meyer, Ferguson,
and Gramlich. Absent and not voting:
Mr. Kelley.2
The amendments, adopted by the
Board jointly with the other federal
banking and thrift agencies, increase the
maximum amount of servicing assets,
when combined with purchased credit
card relationships, that may be included
in regulatory capital from 50 percent to
100 percent of tier 1 capital. The amendments apply a further limit of 25 percent
of tier 1 capital to the aggregate amount
103
of nonmortgage servicing assets and
purchased credit card relationships and
impose a 10 percent discount on the
valuation of mortgage servicing assets,
nonmortgage servicing assets, and purchased credit card relationships.
Regulation I
Issue and Cancellation of Federal
Reserve Bank Capital Stock
June 26, 1998—Amendment
The Board amended Regulation I to
reduce regulatory burden by simplifying
and updating its requirements, effective
October 1, 1998.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, Ms. Phillips, and Messrs.
Meyer, Ferguson, and Gramlich. Absent
and not voting: Mr. Kelley.
The amendments simplify, modernize, and condense the regulation; reflect
the replacement of share certificates by
a book-entry system; codify Board and
staff interpretations; provide for carryover of small adjustments in Reserve
Bank stock positions; adopt a 360-day
year of 30-day months for dividend
accruals; and clarify certain accounting
issues. These actions are consistent with
provisions of the Riegle Community
Development and Regulatory Improvement Act of 1994.
Regulation J
Collection of Checks and Other
Items by Federal Reserve Banks
Regulation CC
Availability of Funds and
Collection of Checks
December 7, 1998—Termination of
Proposed Rulemaking
The Board decided not to make regu-
104 85 th Annual Report, 1998
latory changes with respect to certain
legal disparities that exist in the presentment and settlement of checks.
Votes for this action: Messrs. Greenspan,
Kelley, Meyer, Ferguson, and Gramlich.
Absent and not voting: Ms. Rivlin.2
In March 1998, the Board requested
comment on an advance notice of proposed rulemaking on the reduction or
elimination of the remaining legal disparities between Federal Reserve Banks
and private-sector banks in the presentment and settlement of checks and
on the advantages and disadvantages of
the same-day settlement rule, which
requires paying banks to settle in sameday funds for checks presented to them
by private-sector banks by 8:00 a.m.
local time at a location specified by the
paying bank. On the basis of its analysis
of the comments received, the Board
concluded that the costs associated with
further regulatory changes would outweigh any gains in efficiency for the
payments system.
Regulation K
International Banking Operations
April 27, 1998—Interim
Amendment
The Board approved an interim amendment to Regulation K to lengthen the
examination-frequency cycle for certain
U.S. branches and agencies of foreign
banks, effective August 28, 1998.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, Mr. Kelley, Ms. Phillips, and
Messrs. Meyer, Ferguson, and Gramlich.
The interim rule, which was issued
jointly with the Office of the Comptroller of the Currency and the Federal
Deposit Insurance Corporation, imple-
ments provisions of the Economic
Growth and Regulatory Paperwork
Reduction Act of 1996 by making certain U.S. branches and agencies of foreign banks eligible for an eighteenmonth examination cycle rather than a
twelve-month cycle. U.S. branches and
agencies of foreign banks with assets
of $250 million or less qualify for the
lengthened cycle if they meet the criteria provided in the interim amendment.
The agencies also sought public comment on the interim amendment.
Regulation M
Consumer Leasing
September 21, 1998—Amendments
The Board amended Regulation M and
its commentary to clarify rules on lease
payments, advertisements, and rounding
calculations, effective September 24,
1998.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, and Messrs. Kelley, Meyer,
Ferguson, and Gramlich.2
Regulation M implements the Consumer Leasing Act, which requires
lessors to provide consumers with
uniform cost and other disclosures
about consumer lease transactions. The
amendments to Regulation M make several technical changes to the regulation
and commentary concerning lease payments, advertisements, and the treatment of taxes.
Regulation Y
Bank Holding Companies and
Change in Bank Control
March 20, 1998—Clarification of
Conditions
The Board clarified that a section 20
subsidiary that operates off the premises
Board Policy Actions
of a depository institution is not required to make certain oral disclosures
to retail customers, effective March 27,
1998.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, Mr. Kelley, Ms. Phillips, and
Messrs. Meyer, Ferguson, and Gramlich.
The Board approved a clarification
to the operating standard on customer
disclosures applicable to the securities
activities of section 20 subsidiaries. As
modified, a section 20 subsidiary that
operates off the premises of a depository
institution may satisfy the disclosure
requirements of that operating standard
by providing a one-time written disclosure when an investment account is
opened.
May 29, 1998—Amendments
The Board amended Regulation Y to
simplify the tier 1 leverage capital standard for bank holding companies and to
incorporate the market risk capital rule
into the leverage standard, effective
June 30, 1998.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, and Messrs. Kelley, Meyer,
Ferguson, and Gramlich. Absent and not
voting: Ms. Phillips.
105
agerial weaknesses, or if they are
anticipating or experiencing significant
growth.
November 19, 1998—Amendment
The Board amended Regulation Y to
exempt from its appraisal requirements
any transaction by a section 20 subsidiary involving underwriting and dealing
in mortgage-backed securities, effective
December 28, 1998.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, and Messrs. Kelley, Ferguson,
and Gramlich. Absent and not voting:
Mr. Meyer.2
The amendment permits section 20
subsidiaries to underwrite and deal in
all types of mortgage-backed securities
without confirming that the underlying
loans met applicable appraisal requirements when they were originated or
without obtaining new appraisals for
loans that lack acceptable appraisals.
Regulation Z
Truth in Lending
February 2, 1998—Amendment
The Board amended Regulation Z to
adjust the threshold amount of mortgage
Under the amended capital standard, fees that triggers additional disclosures
a minimum ratio of tier 1 capital to total and certain limitations, effective January 1, 1998.
assets (leverage ratio) of 3 percent is
established for bank holding companies
Votes for this action: Mr. Greenspan,
that either are rated composite " 1 "
Ms. Rivlin, Mr. Kelley, Ms. Phillips, and
under the rating system for bank holding
Messrs. Meyer, Ferguson, and Gramlich.
companies or have implemented the
Board's risk-based capital market risk
The Home Ownership and Equity
measure. The minimum leverage ratio Protection Act of 1994 imposes addifor all other bank holding companies tional disclosure requirements and ceris 4 percent. Bank holding companies tain substantive limitations on mortare expected to maintain higher-than- gages if total points and fees payable by
normal capital ratios if they have super- the consumer exceed the greater of $400
visory, financial, operational, or man- or 8 percent of the total loan amount.
106 85th Annual Report, 1998
The Board is required to adjust annually
the $400 threshold based on the annual
percentage change in the consumer price
index (CPI) as of June 1 of the preceding year. On the basis of the CPI on
June 1, 1997, the Board increased the
threshold amount for 1998 to $435.
Regulation DD
Truth in Savings
July 9, 1998—Amendments
The Board made final an interim rule
amending Regulation DD to permit
institutions to disclose an annual percentage yield equal to the contract interest rate for certain deposit accounts
with maturities longer than one year,
effective August 28, 1998.
Votes for this action: Messrs. Greenspan,
Kelley, Meyer, Ferguson, and Gramlich.
Absent and not voting: Ms. Rivlin.2
The Truth in Savings Act requires
depository institutions to provide disclosure of an annual percentage yield
on interest-bearing accounts calculated
under a method prescribed by the Board.
The amendments, which make final an
interim rule the Board adopted in January 1995, address an anomaly for certain
certificates of deposit that occurs when
the annual percentage yield disclosure is
lower than the stated interest rate. Under
the amendments, an institution is permitted to disclose an annual percentage
yield equal to the contract interest rate
for noncompounding time accounts with
a maturity greater than one year if the
accounts require interest distributions at
least annually.
September 21, 1998—Amendments
The Board amended Regulation DD to
modify rules affecting lobby signs and
disclosures for certain time accounts,
effective September 24, 1998.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, and Messrs. Kelley, Meyer,
Ferguson, and Gramlich.2
The amendments to Regulation DD
implement changes to the Truth in Savings Act enacted in 1996. The changes
modify the rules for indoor lobby signs,
eliminate subsequent disclosure requirements for automatically renewable time
accounts with terms of one month or
less, and repeal civil liability provisions
as of September 30, 2001.
Rules Regarding
Delegation of Authority
November 18, 1998—Amendments
The Board amended its Rules Regarding
Delegation of Authority to expand the
authority of the Director of the Division
of Consumer and Community Affairs
to perform certain administrative duties
and review certain technical matters
under the Board's consumer statutes
and regulations, effective November 25,
1998.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, and Messrs. Kelley, Meyer,
Ferguson, and Gramlich.2
The Board delegated to the director
the authority to issue interpretations
under the Fair Credit Reporting Act, to
adjust annually the dollar amount of
loans subject to the Home Ownership
and Equity Protection Act and the
threshold for exempting small depository institutions under the Home Mortgage Disclosure Act, to make certain
determinations under Regulation BB
(Community Reinvestment), and to
conduct public hearings or other pro-
Board Policy Actions
ceedings under applicable statutes on
consumer-law issues.
Policy Statements and
Other Actions
March 4, 1998—Uniform Cash
Access Policy
The Board revised its cash access policy
to clarify the base level of free currency
access to all depository institutions in an
interstate branching environment, effective May 4, 1998.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, Mr. Kelley, Ms. Phillips, and
Messrs. Meyer, Ferguson, and Gramlich.
The Board clarified that each depository institution may designate up to
ten endpoints to receive free currency
access from each Reserve Bank office
but may not designate an endpoint to
receive free cash access from more than
one Reserve Bank office. The Board also
delegated to the Director of the Division
of Reserve Bank Operations and Payment Systems the authority to interpret
the policy, to approve changes in the
base number of free endpoints and the
volume thresholds, and to waive the policy for a limited period of time if warranted by special circumstances.
April 6, 1998—Fedwire Securities
Transfer Operating Hours and
Receiver Controls
The Board decided not to adopt an earlier opening time for the Fedwire securities transfer service and authorized the
Federal Reserve Banks to design and
implement an optional automatic securities transfer reversal feature for use by
Fedline participants.
Votes for this action: Messrs. Greenspan
and Kelley, Ms. Phillips, and Messrs.
107
Meyer, Ferguson, and Gramlich. Absent
and not voting: Ms. Rivlin.
The Board's decision not to implement an earlier opening time for the
service at this time that had been proposed in January 1995 was based on the
anticipated cost and technical difficulties identified by industry participants.
In connection with this action, the Board
authorized the Reserve Banks to design
and implement an optional automatic
securities transfer reversal feature for
use by Fedline participants to give them
better control over their use of intraday
credit.
June 17, 1998—Policy Statement
on Payments System Risk
The Board approved certain revisions to
its policy on payments system risk in
certain private multilateral settlement
arrangements, effective January 4, 1999.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, Mr. Kelley, Ms. Phillips, and
Messrs. Meyer, Ferguson, and Gramlich.
The Board adopted a policy statement
on Privately Operated Multilateral
Settlement Systems to provide a flexible, risk-based approach to risk management as part of its payments system
risk reduction program. The policy integrates the "large-dollar" and "smalldollar" components of the Board's
existing policy statement, which are
being repealed concurrently with the
effective date of the new policy, into one
comprehensive policy.
October 27, 1998—Policy
Statement on Income Tax
Allocation in a Holding Company
Structure
The Board approved a policy statement
on intercompany tax allocation agree-
108 85th Annual Report, 1998
ments among holding companies and
their depository institution subsidiaries,
effective November 23, 1998.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, and Messrs. Kelley, Meyer,
Ferguson, and Gramlich.2
Consistent with provisions of the
Riegle Community Development and
Regulatory Improvement Act of 1994,
the Board, jointly with the other federal
banking and thrift agencies, provided
guidance on the allocation and payment
of taxes for banking and thrift organizations that file income tax returns as
members of a consolidated group. The
guidance generally provides that tax
settlements between parent and depository institution subsidiaries should be
on terms that are no less favorable to
the subsidiary than if it were a separate
taxpayer.
October 29, 1998—Notice of
Service Enhancement
The Board approved enhancements to
the net settlement services that the Federal Reserve Banks offer to financial
institutions, effective March 29, 1999.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, and Messrs. Kelley, Meyer,
Ferguson, and Gramlich.2
Under the enhanced service, the
Reserve Banks will offer a fully automated settlement service that provides
participants in clearing arrangements
with finality of settlement intraday on
the settlement date. The service will provide the agent in a clearing arrangement
with an on-line mechanism to submit an
electronic file of settlement information
to the Federal Reserve. The enhanced
service is intended to increase operational efficiency and to facilitate a reduc-
tion in the duration of settlement risk for
participants.
November 23, 1998—Policy
Statement on Loan Loss Reserves
The Board approved a policy statement
on the allowance for loan losses of
depository institutions, issued November 24, 1998.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, and Messrs. Kelley, Ferguson,
and Gramlich. Absent and not voting:
Mr. Meyer.2
The Board, jointly with the other federal banking and thrift agencies and the
Securities and Exchange Commission,
issued the statement to better ensure
the consistent application of loan-loss
accounting policy and to improve the
transparency of financial statements.
December 7, 1998—Fedwire Funds
Transfer Segmented Settlement
Period
The Board decided to retain the current
thirty-minute settlement period at the
end of the Fedwire funds transfer operating day and not to implement restrictions on respondent bank transfers during the last fifteen minutes of the
settlement period, from 6:15 p.m. to
6:30 p.m. eastern time.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, and Messrs. Kelley, Meyer,
Ferguson, and Gramlich.2
The Board decided not to implement
a segmented settlement period for the
Fedwire funds transfer service that had
been proposed in June 1998 because
it was unclear that such an approach
would significantly reduce uncertainty
and volatility for the markets as a whole
and because of potentially costly operational changes.
Board Policy Actions
1998 Discount Rates
During 1998, the Board of Governors
approved two reductions of XA percentage point in the basic discount rate
charged by the Federal Reserve Banks.
These actions, taken in mid-October and
mid-November, lowered the basic rate
from 5 percent to 4Vi percent. The rates
for seasonal and extended credit, which
are set on the basis of market-related
formulas, were changed more frequently, and they 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
developments. These developments are
reviewed more fully in part 1 of this
REPORT and in the minutes of the 1998
FOMC meetings, which also appear in
this REPORT.
January to September: No Changes
Economic activity expanded rapidly
during the early months of 1998 after
posting robust gains in the latter part
of 1997. The expansion was paced by
exceptionally strong growth in private
domestic spending for consumption,
housing, and business equipment. Despite indications of persisting pressures
on compensation associated with continued rapid growth in employment and
tightening labor markets, price inflation
abated. Large declines in energy prices
contributed to this favorable inflation
result, but rapid growth in productivity
helped to hold down the advance in
labor costs. Against this background,
most Federal Reserve Banks continued
to favor an unchanged basic discount
109
rate of 5 percent, its level since early
1996. However, two Banks concerned
about what they viewed as strong prospects for rising inflation requested a
l
A percentage point increase during the
first quarter, and they were joined by
two other Banks by early spring. The
Board took no action on these requests,
but the Board members agreed on the
need to monitor the economy for warning signs of mounting inflationary
pressures.
Over the spring and summer, growth
in economic activity moderated to a
pace well below that experienced during the opening months of the year.
Price inflation remained subdued, and
wage inflation changed little during
the period. By mid-summer only one
Reserve Bank was proposing an increase
in the basic rate, while another was
requesting a decrease. Subsequently, the
proposal for an increase was withdrawn
and a growing number of Banks called
for reductions of lA or Vi percentage
point. The requests for lower rates were
submitted in the context of rising concerns about the adverse effects of foreign economic and financial developments on the U.S. economy.
October and November:
Basic Rate Reduced
The FOMC decided to ease the stance of
monetary policy slightly in late September, thereby inducing a decline of lA percentage point in the federal funds rate
to an average of about 5lA percent. The
easing was deemed to be desirable to
cushion the likely adverse consequences
on future domestic economic activity of
the global financial turmoil that had
weakened foreign economies and had
contributed in large measure to the
emergence of tighter conditions in U.S.
financial markets. On October 15, the
FOMC eased the stance of policy
110 85th Annual Report, 1998
slightly further, with the federal funds
rate expected to decline to an average of
around 5 percent. In a companion action,
the Board approved pending requests
to reduce the basic rate XA percentage
point, to 43/4 percent. These actions were
taken in light of heightened concerns
among lenders and the unsettled conditions in financial markets more generally that were seen as likely to restrain
aggregate demand in the future. On
November 17, the FOMC and the Board
announced further slight easing actions
that reduced the federal funds rate to
an average of around 43A percent and
the basic discount rate to 41/2 percent.
Although conditions in financial markets had become much more settled
since mid-October, unusual strains
remained. The further easing actions
together with those taken since late September were expected to be sufficient
to foster financial conditions that would
promote sustained economic expansion
and subdued inflation. Over the balance
of the year, no Reserve Bank submitted
further requests to change the basic discount rate.
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 are charged on seasonal
and extended credit. These flexible rates
are calculated every two weeks in accordance with formulas that are approved
by the Board.
The purpose of the seasonal program
is to help smaller institutions meet needs
arising from a clear pattern of intrayearly movements in their deposits
and loans. Funds may be provided for
periods longer than those permitted
under adjustment credit. Since its introduction in early 1992, the flexible rate
charged on seasonal credit has been
closely aligned with short-term 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;
under the current structure, that rate is
the flexible rate on extended credit.
At the end of 1998, the structure of
discount rates was as follows: a basic
rate of 4.50 percent for short-term
adjustment credit, a rate of 4.85 percent
for seasonal credit, and a rate of
5.35 percent for extended credit. During
1998, the rate for seasonal credit ranged
from a low of 4.85 percent to a high of
5.65 percent, and that for extended
credit ranged from a low of 5.35 percent
to a high of 6.15 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
Board Policy Actions
requests every fourteen days to renew
the formulas for calculating the marketrelated rates on seasonal and extended
credit. Votes relating to the reestablishment of the formulas for these flexible
rates are not shown in this summary. All
votes on discount rates taken by the
Board of Governors during 1998 were
unanimous.
Votes on the Basic Discount Rate
October 15, 1998. Effective this date,
the Board approved actions taken by the
directors of the Federal Reserve Banks
of Boston, New York, Philadelphia,
Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, and San Francisco to
reduce the basic discount rate by lA percentage point, to 43/4 percent.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, Messrs. Kelley, Meyer, and
Ferguson. Votes against this action: None.
Absent and not voting: Mr. Gramlich.
The Board subsequently approved
similar actions taken by the directors
111
of the Federal Reserve Banks of Cleveland, Richmond, and Dallas, effective
October 16, 1998.
November 17, 1998. Effective this date,
the Board approved actions taken by the
directors of the Federal Reserve Banks
of New York, Philadelphia, Dallas, and
San Francisco to reduce the basic discount rate by lA percentage point, to
4]/2 percent.
Votes for this action: Mr. Greenspan,
Ms. Rivlin, Messrs. Kelley, Meyer, Ferguson, and Gramlich. Votes against this
action: None.
The Board subsequently approved
similar actions taken by the directors of
the Federal Reserve Banks of Boston,
Richmond, Atlanta, St. Louis, and Kansas City, effective November 18, 1998,
and by the Federal Reserve Banks of
Cleveland, Chicago, and Minneapolis,
effective November 19, 1998.
.
113
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
such 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 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 along with
a summary of the reasons for their
dissent.
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 activities, the
Federal Reserve Bank of New York
operates under two sets of instructions
from the Federal Open Market Committee: an Authorization for Domestic Open
Market Operations 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
1998. Changes in the instruments during
the year are reported in the minutes for
the individual meetings.
Authorization for D o m e s t i c
O p e n M a r k e t Operations
In Effect January 1, 1998
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
114 85 th Annual Report, 1998
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 $8.0 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) When appropriate, to buy or sell in
the open market, from or to acceptance dealers and foreign accounts maintained at the
Federal Reserve Bank of New York, on a
cash, regular, or deferred delivery basis, for
the account of the Federal Reserve Bank of
New York at market discount rates, prime
bankers acceptances with maturities of up to
nine months at the time of acceptance that
(1) arise out of the current shipment of goods
between countries or within the United
States, or (2) arise out of the storage within
the United States of goods under contract of
sale or expected to move into the channels of
trade within a reasonable time and that are
secured throughout their life by a warehouse
receipt or similar document conveying title
to the underlying goods; provided that the
aggregate amount of bankers acceptances
held at any one time shall not exceed
$100 million;
(c) 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, and
prime bankers acceptances of the types
authorized for purchase under l(b) above,
from dealers for the account of the Federal
Reserve Bank of New York under agreements for repurchase of such securities, obligations, or acceptances in 15 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; and provided further that in the
event bankers acceptances covered by any
such agreement are not repurchased by the
seller, they shall continue to be held by the
Federal Reserve Bank or shall be sold in
the open market.
2. In order to ensure the effective conduct of
open market operations, the Federal Open
Market Committee authorizes and directs the
Federal Reserve Banks to lend U.S. Government securities held in the System Open
Market Account to Government securities
dealers and to banks participating in Government securities clearing arrangements conducted through a Federal Reserve Bank,
under such instructions as the Committee
may specify from time to time.
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 15 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(c), 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.
Minutes of FOMC Meetings
Domestic Policy Directive
In Effect January 1, 19981
The information reviewed at this meeting
suggests that economic activity continued to
grow rapidly in recent months. Nonfarm payroll employment increased sharply in October and November; the civilian unemployment rate fell to 4.6 percent in November,
its low for the current economic expansion.
Industrial production continued to advance
at a brisk pace in October and November.
Retail sales were unchanged on balance
over the two months after rising sharply in
the third quarter. Housing starts increased
slightly further in October and November.
Available information suggests on balance
that business fixed investment will slow from
the exceptionally strong increases of the second and third quarters. The nominal deficit
on U.S. trade in goods and services widened
significantly in the third quarter from its rate
in the second quarter. Price inflation has
remained subdued, despite some increase in
the pace of advance in wages.
Short-term interest rates have registered
small mixed changes since the day before
the Committee meeting on November 12,
1997, while bond yields have fallen somewhat. Share prices in U.S. equity markets
recorded mixed changes over the period;
equity markets in other countries, notably
in Asia, have remained volatile. In foreign
exchange markets, the value of the dollar has
risen over the intermeeting period in terms
of both the trade-weighted index of the other
G-10 countries and the currencies of a number of Asian countries.
M2 and M3 grew rapidly in November.
For the year through November, M2
expanded at a rate slightly above the upper
bound of its range for the year and M3 at a
rate substantially above the upper bound of
its range. Total domestic nonfinancial debt
has expanded in recent months at a pace
somewhat below the middle of its range.
The Federal Open Market Committee
seeks monetary and financial conditions that
will foster price stability and promote sustainable growth in output. In furtherance of
these objectives, the Committee at its meeting in July reaffirmed the ranges it had established in February for growth of M2 and M3
1. Adopted by the Committee at its meeting on
December 16, 1997.
115
of 1 to 5 percent and 2 to 6 percent respectively, measured from the fourth quarter of
1996 to the fourth quarter of 1997. The range
for growth of total domestic nonfinancial
debt was maintained at 3 to 7 percent for the
year. For 1998, the Committee agreed on a
tentative basis to set the same ranges as in
1997 for growth of the monetary aggregates
and debt, measured from the fourth quarter
of 1997 to the fourth quarter of 1998. The
behavior of the monetary aggregates will
continue to be evaluated in the light of
progress toward price level stability, movements in their velocities, and developments
in the economy and financial markets.
In the implementation of policy for the
immediate future, the Committee seeks conditions in reserve markets consistent with
maintaining the federal funds rate at an
average of around 5Vi percent. In the context
of the Committee's long-run objectives for
price stability and sustainable economic
growth, and giving careful consideration to
economic, financial, and monetary developments, a slightly higher federal funds rate or
a slightly lower federal funds rate might
be acceptable in the intermeeting period.
The contemplated reserve conditions are
expected to be consistent with some moderation in the growth in M2 and M3 over coming months.
Authorization for Foreign
Currency Operations
In Effect January 1, 1998
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 Settle-
116 85th Annual Report, 1998
ments, and with other international financial
institutions:
Austrian schillings
Belgian francs
Canadian dollars
Danish kroner
Pounds sterling
French francs
German marks
Italian lire
Japanese yen
Mexican pesos
Netherlands guilders
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
Amount
(millions of
dollars equivalent)
Austrian National Bank
National Bank of Belgium
Bank of Canada
National Bank of Denmark
Bank of England
Bank of France
German Federal Bank
Bank of Italy
Bank of Japan
Bank of Mexico
Netherlands Bank
Bank of Norway
Bank of Sweden
Swiss National Bank
Bank for International Settlements
Dollars against Swiss francs
Dollars against authorized European
currencies other than Swiss francs
250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,000
3,000
500
250
300
4,000
600
1,250
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 1(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.
Minutes of FOMC Meetings
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
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;
117
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, 1998
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 and with the Bank for
International Settlements.
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.
118 85th Annual Report, 1998
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, 1998
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. 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 posi-
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 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.
Meeting Held on
February 3-4, 1998
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, February 3, 1998, at 2:30
p.m. and continued on Wednesday, February 4, 1998, at 9:00 a.m.
Minutes of FOMC Meetings, February
Present:
Mr. Greenspan, Chairman
Mr. McDonough, Vice Chairman
Mr. Ferguson
Mr. Gramlich
Mr. Hoenig
Mr. Jordan
Mr. Kelley
Mr. Meyer
Ms. Minehan
Ms. Phillips
Ms. Rivlin
Messrs. Boehne, McTeer, Moskow, 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. Coyne, Assistant Secretary
Mr. Gillum, Assistant Secretary
Mr. Mattingly, General Counsel
Mr. Baxter, Deputy General Counsel
Mr. Prell, Economist
Mr. Truman, Economist
Ms. Browne, Messrs. Cecchetti,
Dewald, Hakkio, Lindsey,
Promisel, Simpson, Sniderman,
and Stockton, Associate
Economists
Mr. Fisher, Manager, System Open
Market Account
Mr. Ettin, Deputy Director, Division of
Research and Statistics, Board of
Governors
119
Mr. Reinhart, Assistant Director,
Division of Monetary Affairs,
Board of Governors
Messrs. Brayton2 and Rosine,2 Senior
Economists, Division of Research
and Statistics, Board of Governors
Ms. Garrett and Mr. Nelson,2
Economists, Division of Monetary
Affairs, Board of Governors
Ms. Low, Open Market Secretariat
Assistant, Division of Monetary
Affairs, Board of Governors
Mr. Rives, First Vice President, Federal
Reserve Bank of St. Louis
Messrs. Beebe, Eisenbeis, Hunter,
Ms. Krieger, Messrs. Lang,
Rolnick, and Rosenblum, Senior
Vice Presidents, Federal Reserve
Banks of San Francisco, Atlanta,
Chicago, New York, Philadelphia,
Minneapolis, and Dallas
respectively
Mr. Hetzel, Vice President, Federal
Reserve Bank of Richmond
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
January 1, 1998, and ending December 31, 1998, had been received and that
these individuals had executed their
oaths of office.
The elected members and alternate
members were as follows:
Mr. Slifman, Associate Director,
Division of Research and
Statistics, Board of Governors
Messrs. Alexander, Hooper, and
Ms. Johnson, Associate Directors,
Division of International
Finance, Board of Governors
2. Attended portions of meeting relating to the
Committee's review of the economic outlook and
establishment of its monetary and debt ranges for
1998.
120 85th Annual Report, 1998
William J. McDonough, President of the
Federal Reserve Bank of New York,
with Ernest T. Patrikis, 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 Edward
G. Boehne, President of the Federal
Reserve Bank of Philadelphia, as
alternate;
Jerry L. Jordan, President of the Federal
Reserve Bank of Cleveland, with
Michael H. Moskow, President of the
Federal Reserve Bank of Chicago, as
alternate;
Robert D. McTeer, Jr., President of the Federal Reserve Bank of Dallas, as voting
alternate pending the election of a President of the Federal Reserve Bank of
St. Louis;
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 meeting of the Committee after
December 31, 1998, 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
Donald L. Kohn
Secretary and
Economist
Deputy Secretary
Assistant
Secretary
Assistant
Secretary
General Counsel
Deputy General
Counsel
Economist
Economist
Normand R.V Bernard
Joseph R. Coyne
Gary P. Gillum
J. Virgil Mattingly, Jr.
Thomas C. Baxter, Jr.
Michael J. Prell
Edwin M. Truman
Lynn E. Browne, Stephen G. Cecchetti,
William G. Dewald, Craig S. Hakkio,
David E. Lindsey, Larry J. Promisel,
Thomas D. Simpson, Mark S.
Sniderman, and David J. Stockton,
Associate Economists
By unanimous vote, the Federal
Reserve Bank of New York was selected
to execute transactions for the System
Open Market Account until the adjournment of the first meeting of the Committee after December 31, 1998.
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.
On the recommendation of the Manager, the Committee at this meeting
unanimously approved two changes in
the Authorization for Domestic Open
Market Operations.
First, the Committee amended paragraph l(a) of the Authorization to raise
from $8 billion to $12 billion the limit
on intermeeting changes in System
account holdings of U.S. government
and federal agency securities. The
increase was the first permanent change
in the limit since February 1990, when it
was raised from $6 billion to $8 billion.
The Manager indicated that the Committee had approved temporary increases
several times during the past year and
that the existence of a permanent
$12 billion limit would have obviated
the need for most of the increases. A
permanent increase to $12 billion would
reduce the number of occasions requiring special Committee action, while still
Minutes of FOMC Meetings, February 121
calling the need for particularly large
changes to the Committee's attention.
The Committee concurred in the Manager's view that a $4 billion increase
was appropriate.
Second, the Committee terminated
the Manager's authority to conduct
transactions in bankers acceptances.
This involved the deletion of paragraph
l(b), which authorized purchases or
sales of prime bankers acceptances in
the open market, and also the deletion of
the reference in paragraph l(c), which
authorized repurchase agreements in
such market instruments. The Manager
indicate that operations in bankers
acceptances were not a practical means
of affecting reserves under current circumstances, given the ample availability
of U.S. Treasury obligations in the market. Indeed, the Committee previously
had decided in 1977 to suspend transactions on an outright basis in bankers
acceptances and had completed the System's disengagement from this market
in 1984 by instructing the Manager to
discontinue the use of repurchase agreements involving bankers acceptances.
While those decisions had left open the
possibility of resuming transactions in
bankers acceptances and no changes
had been made in the Authorization,
the Committee agreed that the existing
authority no longer served a practical
purpose. Accordingly, the amended
Authorization for Domestic Open
Market Operations was unanimously
approved in the form shown below.
Authorization for Domestic
Open Market Operations
Amended February 3, 1998
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 pol
icy 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
US. 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 securities 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 15 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.
2. In order to ensure the effective conduct
of open market operations, the Federal Open
Market Committee authorizes and directs the
Federal Reserve Banks to lend U.S. Government securities held in the System Open
Market Account to Government securities
dealers and to banks participating in Government securities clearing arrangements
conducted through a Federal Reserve Bank,
122 85th Annual Report, 1998
under such instructions as the Committee
may specify from time to time.
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 15 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.
With Mr. Jordan dissenting, the
Authorization for Foreign Currency Operations shown below was reaffirmed.
Authorization for Foreign Currency
Operations
Reaffirmed February 3, 1998
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, includ
ing 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:
Austrian schillings
Belgian francs
Canadian dollars
Danish kroner
Pounds sterling
French francs
German marks
Italian lire
Japanese yen
Mexican pesos
Netherlands guilders
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:
Minutes of FOMC Meetings, February 123
Amount of
Fore.gnbank
dollars equivalent)
Austrian National Bank
National Bank of Belgium
Bank of Canada
National Bank of Denmark
Bank of England
Bank of France
German Federal Bank
Bank of Italy
Bank of Japan
Bank of Mexico
Netherlands Bank
Bank of Norway
Bank of Sweden
Swiss National Bank
250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,000
3,000
500
250
300
4,000
Bank for International Settlements:
Dollars against Swiss francs
Dollars against authorized European
currencies other than Swiss francs
1,250
600
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
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. Staff officers of the Committee are
authorized to transmit pertinent information
on System foreign currency operations
124 85th Annual Report, 1998
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.
With Mr. Jordan dissenting, the Foreign Currency Directive shown below
was reaffirmed.
Foreign Currency Directive
Reaffirmed February 3, 1998
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 and with the Bank for
International Settlements.
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.
Mr. Jordan dissented in the votes on
the Foreign Currency Authorization and
the Foreign Currency Directive because
these policy instruments provide the
basis for foreign exchange market transactions. He believes that the primary
mission of the Federal Reserve is to
achieve and maintain a stable purchasing power of the U.S. dollar. That
objective is best achieved when open
market transactions are restricted to
purchases and sales of U.S. government
securities. When compatible with the
System's primary objective, foreign
exchange transactions are redundant
to open market operations. Often, however, foreign exchange transactions conflict with the System's primary objective, requiring opposite adjustments in
System holdings of U.S. Treasury obligations. Moreover, holdings of foreign
securities expose the Reserve Banks
to foreign exchange translation losses
resulting from the depreciation of foreign currencies relative to a strong and
stable U.S. dollar.
By unanimous vote, the Procedural
Instructions with Respect to Foreign
Currency Operations shown below were
reaffirmed.
Procedural Instructions with
Respect to Foreign Currency
Operations
Reaffirmed February 3, 1998
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
Minutes of FOMC Meetings, February
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 16, 1998, the continuing
rules, regulations, authorizations, and
other instructions of the Committee
were distributed with the advice that,
125
in accordance with procedures approved
by the Committee, they were being
called to the Committee's attention
before the February 3-4 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, and no requests for consideration were received.
By unanimous vote, the minutes of
the meeting of the Federal Open Market
Committee held on December 16, 1997,
were approved.
The Manager of the System Open
Market Account reported on developments in foreign exchange and international financial markets in the period
since the previous meeting on December 16, 1997. There were no System
open market transactions in foreign currencies during this period, and thus no
vote was required of the Committee.
The Manager of the System Open
Market Account also reported on developments in domestic financial markets
and on System open market transactions in government securities and
federal agency obligations during the
period from December 17, 1997,
through February 3, 1998. By unanimous vote, the Committee ratified these
transactions.
The Committee then turned to a discussion of the economic and financial
outlook, the ranges for the growth of
money and debt in 1998, 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.
126 85th Annual Report, 1998
The information reviewed at this
meeting suggested that the economy
continued to expand at a robust pace
during the closing months of 1997. Both
employment and industrial output recorded substantial increases in the fourth
quarter. While spending for final goods
and services by U.S. residents decelerated noticeably, inventory investment
strengthened and the deficit in international trade in goods and services
appeared to have narrowed. Tighter
labor markets brought some acceleration in wages, but falling import and
energy prices helped to hold down price
inflation over the closing months of the
year.
Labor demand expanded rapidly in
the fourth quarter; a sharp increase in
nonfarm payroll employment in December followed large advances in October
and November, and the average workweek edged up on balance over the
three-month period. Job gains were
widely spread across industries. In the
fourth quarter, new hires in manufacturing accounted for more than half of
that sector's total for the year, and
construction employment also registered
an unusually large rise compared with
earlier in 1997. Job growth surged
in retail trade and persisted at a rapid
pace in service-producing industries.
The civilian unemployment rate, at
4.7 percent in December, was near
its low for the current economic
expansion.
Industrial production continued to
advance at a brisk pace in the fourth
quarter. Growth in the manufacturing of
durable goods remained strong despite
sharply slower, though still substantial,
expansion in the output of computing
and office equipment. The production of
nondurable goods picked up after having been sluggish earlier in the year.
Capacity utilization in manufacturing
was at a relatively high rate in the fourth
quarter, but available information suggested few bottlenecks.
Consumer spending, in real terms,
rose at a slower though still appreciable
rate in the fourth quarter. Purchases of
durable goods increased moderately
after having surged in the third quarter,
and spending on nondurables edged
down. By contrast, expenditures for
consumer services grew at a somewhat
faster rate. Recent surveys indicated that
consumer confidence remained at a very
high level.
Housing demand continued to exhibit
considerable strength at year-end in the
context of sharp declines in fixed mortgage rates in recent months, further
sizable gains in employment and household income, and very positive consumer assessments of homebuying conditions. Applications for mortgages to
purchase homes increased to a new
monthly high in December; the pace
of sales of existing homes rose further
in the fourth quarter; and sales of new
homes in November (latest available
monthly data) were at their highest
monthly pace in more than ten years.
Housing starts edged lower in December but remained close to the highs of
the current expansion.
After unusually strong increases earlier in the year, real business fixed
investment declined slightly in the
fourth quarter. However, the outlook for
further growth remained positive, with
corporate cash flow still healthy and the
user cost of capital still low. Data on
shipments of nondefense capital goods
in December indicated a rebound in
business spending on capital goods,
notably for office, computing, and communications equipment, after sizable
declines in the October-November
period. Business spending on nonresidential structures declined slightly in the
fourth quarter despite rising real estate
prices and falling vacancy rates.
Minutes of FOMC Meetings, February 111
The pace of business inventory
investment evidently picked up somewhat in the fourth quarter. In manufacturing, inventories climbed further in
November (latest monthly data available), and the stock-shipments ratio was
at the top of its narrow range for the past
twelve months. The accumulation of
wholesale stocks continued its strong
upward trend, and by November the
inventory-sales ratio for the wholesale
sector had reversed its 1996 decline. In
the retail sector, inventories declined
slightly in November after having
changed little in October; the inventorysales ratio for this sector was near the
bottom of its range for the last twelve
months.
The nominal deficit on U.S. trade in
goods and services narrowed substantially on average in October and November from its level in the third quarter.
The value of exports rose appreciably in
the October-November period, with the
largest increases occurring in automotive and agricultural products. The average value of imports for October and
November changed little from the thirdquarter rate. Imports of consumer goods
and machinery rose, but they were about
offset by declines in automotive products, computers, and, to a lesser extent,
a wide variety of other products. The
available information indicated that
economic expansion remained healthy
in most of the foreign G-7 countries,
although slowing somewhat from the
third quarter. In Asia, weakness in economic activity in Japan continued into
the fourth quarter, and persisting financial turmoil was having strong adverse
effects on the economies of a number of
developing countries.
Consumer price inflation remained
low in December, damped by a sizable
further drop in energy prices and a small
decline in food prices. Excluding food
and energy items, an acceleration in the
costs of services, notably medical care
and shelter, provided a slight boost to
core consumer price inflation in December. For the year as a whole, prices of
core consumer items rose considerably
less than in 1996, in part reflecting the
effect of declining import prices. At the
producer level, prices of all finished
goods and of the core finished goods
component declined further in December. For the year 1997, the core producer
price index was little changed after a
relatively small rise the previous year;
the total index, weighed down by falling
prices of finished food and energy items,
partially reversed its 1996 increase.
Prices also remained subdued at earlier
stages of processing in 1997, with prices
of crude materials falling substantially.
Labor costs, as measured by the hourly
compensation of private industry workers, increased at appreciably faster rates
in the fourth quarter and for the year.
At its meeting on December 16, 1997,
the Committee adopted a directive that
called for maintaining conditions in
reserve markets that were consistent
with an unchanged federal funds rate
averaging around 5Vi percent. In light
of the increased uncertainties in the outlook and the possibility that the next
change in policy might be in either
direction, the Committee adopted a
directive that did not include a presumption about the likely direction of any
adjustment to policy during the intermeeting period. Reserve market conditions associated with this directive were
expected to be consistent with some
moderation in the growth of M2 and M3
over coming months.
Open market operations were directed
throughout the intermeeting period
toward maintaining reserve conditions
consistent with the intended federal
funds rate average of around 5Vi percent, and the effective rate averaged
close to that level despite some largely
128 85th Annual Report, 1998
anticipated upward pressures in reserve
markets around year-end. Most other
domestic market interest rates moved
down on balance during the intermeeting period, apparently as a result of
increased concerns over the turbulence
in Asia and its potential implications for
the U.S. economy. Share prices in U.S.
equity markets moved up slightly on
net, perhaps partly in response to the
bond market rally, while equity markets
in some other countries, notably in Asia,
remained unsettled.
In foreign exchange markets, the dollar appreciated on balance over the intermeeting period. The dollar rose considerably further against the currencies of
many of the emerging market economies in Asia amid continuing market
concerns about the adequacy of reforms
that would be undertaken in the affected
countries and the magnitude and availability of international financial assistance that would be needed to support
those efforts. The dollar also gained
slightly on average in relation to the
currencies of the other G-10 currencies.
A sizable advance by the dollar relative to the German mark was largely
reversed late in the intermeeting period;
incoming information suggesting greater
strength in the German economy lifted
the value of the mark and tended to
offset growing concern about the likely
effect of the Asian crisis on Germany.
The dollar declined somewhat on balance against the yen as heightened prospects for domestic fiscal stimulus in
Japan fostered hopes of a less weak
performance of the Japanese economy.
M2 and M3 continued to grow at
relatively rapid rates in December and
apparently also in January. Recent gains
in nominal income evidently underpinned much of the greater-thanexpected strength in M2 in January;
also contributing were a pickup in mortgage refinancing activity and, perhaps,
depositor transfers of funds from market
instruments whose yields had declined
relative to those on M2 assets. Large
increases in repurchase agreements contributed to rapid growth of M3 in January; the rise in M3 helped to finance
further solid expansion of bank credit.
From the fourth quarter of 1996 to the
fourth quarter of 1997, M2 increased at
a rate somewhat above the upper bound
of its range for the year and M3 at a rate
substantially above the upper bound of
its range. Total domestic nonfinancial
debt expanded in 1997 at a pace somewhat below the middle of its range,
reflecting the slow rise in the federal
debt.
The staff forecast prepared for this
meeting indicated that the expansion of
economic activity would slow appreciably during the next few quarters and
remain moderate in 1999. The staff
analysis suggested that slower growth
abroad and the considerable rise that
already had occurred in the foreign
exchange value of the dollar would exert
substantial restraint on the demand for
U.S. exports and subject domestic producers to even stiffer competition from
imports. An anticipated reduction in the
desired rate of inventory accumulation
would add to the restraint on the expansion. As output growth slowed, pressures on resources would be expected to
diminish somewhat. Nonetheless, it was
expected that, consistently measured,
inflation would increase to some degree
over the ensuing period through 1999,
owing in part to an abatement of restraining forces from foreign exchange
and oil markets.
In the Committee's discussion of current and prospective economic conditions, members commented that the performance of the economy continued to
be quite favorable. They noted that the
economy had entered the new year with
considerable momentum and very few
Minutes of FOMC Meetings, February 129
indications that growth was moderating
from what appeared to be an unsustainable rate. Nonetheless, their assessments
of the various factors bearing on the
outlook led them to conclude that appreciably slower economic growth was in
the offing for the year ahead, possibly to
a pace in the vicinity of current estimates of the economy's long-run growth
potential. Many emphasized that the
prospects for declining net exports as a
consequence of the dollar's appreciation
and the crises in a number of Asian
economies were a key factor in the outlook for some slowing in the expansion.
In addition, a moderating rate of inventory accumulation appeared likely after
the rapid buildup during 1997. At the
same time, high levels of confidence
and generally accommodative financial
conditions supported expectations of
persisting, though likely diminishing,
strength in consumer spending and business fixed investment. The members
acknowledged that their forecasts were
subject to a great deal of uncertainty
because there was little precedent to
guide them in their evaluation of the
extent and likely effect of Asian market
turmoil. In the circumstances, the risks
of a considerable deviation on the upside
or the downside of their current forecasts were unusually high. Partly as a
consequence, the outlook for inflation
was quite tentative as well. Moreover,
questions persisted about the level and
growth of sustainable output. Members
observed that price inflation had
remained subdued, and by some measures had declined, in recent months
despite very tight labor markets and
indications of somewhat faster increases
in labor compensation.
In keeping with the practice at meetings just before the Federal Reserve's
semiannual monetary policy report to
the Congress and the Chairman's associated testimony, the members of the
Committee and the Federal Reserve
Bank presidents not currently serving as
members had provided individual projections of the growth in real and nominal GDP, the rate of unemployment, and
the rate of inflation for the year ahead.
Based on developments over the second
half of 1997, the central tendency of the
projections for 1998 now pointed to
slightly more strength in real GDP and
appreciably less inflation than the forecasts prepared at the time of the July
1997 meeting. The forecasts of the rate
of expansion in real GDP in 1998 had a
central tendency of 2 to 23/4 percent and
a full range of VA to 3 percent. Such
growth was expected to be associated
with a civilian unemployment rate in a
range of AVi to 5 percent in the fourth
quarter of this year, implying little or
no change from the current level. With
regard to nominal GDP growth in 1998,
the forecasts were mainly in a range of
33/4 to AV2 percent, with an overall range
of 3!/2 to 5 percent. Projections of the
rate of inflation, as measured by the
consumer price index, had a central tendency of VA to 2lA percent, on the high
side of the outcome for 1997 when the
rise in the index was held down by
damped increases in food prices and
declines in energy prices. These forecasts took account of likely further technical improvements in the CPI by the
Bureau of Labor Statistics that would
trim the reported rate. The projections
were based on individual views concerning what would be an appropriate
policy over the projection horizon to
foster the Committee's longer-term
goals.
The members stressed that the potential extent of the negative effects of
developments in Asia on the nation's
trade balance represented a key uncertainty in the economic outlook. On the
whole, those effects had been quite
limited thus far. Anecdotal reports indi-
130 85th Annual Report, 1998
cated that a number of domestic producers, notably of agricultural, lumber, and
wood products, had experienced some
cancellations or postponements of
orders from Asian customers and there
was some evidence of increased imports
from those nations. Exports to affected
Asian nations were likely to be held
back by declining incomes and rising
prices of U.S. products in local currencies, and reportedly also by difficulties
that importing firms in Asia were
encountering in securing financing. The
eventual effects of the Asian financial
turmoil on the U.S. trade balance and
the overall economy were unknown—in
part because in some key countries
needed reforms had yet to be implemented and markets to stabilize—but
they clearly seemed likely to become
more pronounced in coming months.
Net exports also would be held down by
the appreciation of the dollar against the
currencies of the industrial countries that
had occurred earlier in 1997 before the
Asian crisis intensified.
Another factor viewed as likely to
exert a moderating effect on the growth
of economic activity was the expectation of some slowing in inventory
investment. In the past year, businesses
had added to inventories at a rate that
exceeded the rise in final sales, and
somewhat reduced accumulation to a
pace more in line with that of final sales
was seen as a reasonable expectation.
Some members expressed reservations,
however, about the extent of any weakening in inventory accumulation in light
of the relatively favorable economic
conditions that they believed were likely
to persist over the year ahead.
Members viewed further growth in
consumer spending as likely to remain
the major factor in sustaining the expansion in overall economic activity. Consumer sentiment was at or close to historically high levels according to recent
surveys, evidently reflecting the strong
uptrend in employment and income and
to some extent the very large cumulative
increase in stock market wealth over the
course of recent years. Some also noted
that consumer debt burdens, while large,
were manageable and that such burdens
would be lessened for many consumers
by their refinancing of home mortgages
at the lower mortgage rates now prevailing. Evidence of strength in the consumer sector was supported by upbeat
anecdotal reports of retail sales during
the holiday season and more recently.
While the growth in personal expenditures was likely to moderate somewhat
from its recent pace, members did not
rule out a more ebullient consumer sector in the context of substantial further
growth in disposable incomes, favorable
financing conditions for purchases of
homes, automobiles, and other consumer durables, and the high level of
stock market prices.
Business fixed investment also was
expected to provide substantial support
to continued economic expansion,
though some moderation in purchases of
business equipment seemed likely after
the exceptionally rapid rates of growth
in such investments in recent years.
Business sentiment remained generally
optimistic, and both debt and equity
financing continued to be readily available on attractive terms to most business
borrowers. However, early signs of faltering profit trends in some industries,
in part related to developments in Asia,
appeared to have introduced a cautionary note among some business planners.
Members also referred to emerging
signs of speculative overbuilding in
some areas, especially of commercial
structures. Even so, in the absence of
unanticipated weakness in consumer
expenditures, a variety of favorable factors seemed likely to sustain relatively
robust spending on business structures
Minutes of FOMC Meetings, February 131
and equipment over the year ahead. The
latter included increased opportunities
to cut costs and enhance efficiency by
investing in relatively inexpensive high
tech equipment in a period characterized
by strong competition in many markets
and rising labor compensation associated with tight labor markets.
Residential construction activity had
remained relatively robust in recent
months and was expected to be well
maintained over coming quarters. Positive indications for the housing outlook
included relatively low mortgage interest rates, very favorable measures of
cash flow affordability, and quite positive homebuying attitudes as expressed
in recent surveys. While these factors
were expected to help sustain the housing sector over coming months, members noted that housing construction had
been high for some time and some cited
anecdotal evidence of softening activity
in some parts of the country. On balance, only modest, if any, slippage from
current levels of home construction
activity seemed likely over the year
ahead.
With regard to the outlook for inflation, members referred to widespread
indications of increasingly tight labor
markets and to statistical and anecdotal
reports of faster increases in labor
compensation. Labor cost increases in
recent quarters had been especially rapid
in a large segment of the service sector,
where foreign competition was not a
factor. Some members commented,
however, that there were reasons to discount the sharp fourth-quarter increase
in the employment cost index because to
a large extent it was the result of nonrecurring developments in a limited
number of industries. Despite the
upward trend in labor compensation,
gains in productivity clearly had kept
increases in unit labor costs at a very
modest level; and with unit nonlabor
costs continuing to decline, overall unit
cost increases had remained not far
above zero. In these circumstances—
and in the context of highly competitive
conditions in many markets, declines in
input prices and in the prices of many
commodities, including oil—rising labor
costs seemed to pose little risk of an
upward impetus to inflation in coming
months.
The longer-run outlook for inflation
was more clouded and under some scenarios less promising. Inflation expectations had been moving down according
to recent surveys, and in the context
of relatively modest increases in consumer prices expected over coming
months such expectations could continue to move lower, thereby constraining increases in compensation and
prices. Nonetheless, some of the factors
that had helped to moderate price
increases—including declining oil
prices, the appreciation of the dollar,
and restrained increases in health insurance costs—were not likely to continue
to exert benign effects on inflation as
time went on. More fundamentally, the
productivity improvement that had held
down producer costs could not necessarily be counted on to continue to offset
such costs, especially if the economic
expansion remained sufficiently rapid to
put additional pressures on available
labor resources.
In keeping with the requirements of
the Full Employment and Balanced
Growth Act of 1978 (the HumphreyHawkins Act), the Committee reviewed
the ranges for growth of the monetary
and debt aggregates in 1998 that it
had established on a tentative basis at
its meeting in July 1997. Those ranges
included expansion of 1 to 5 percent for
M2 and 2 to 6 percent for M3, measured
from the fourth quarter of 1997 to the
fourth quarter of 1998. The associated
range for growth of total domestic non-
132 85th Annual Report, 1998
financial debt was provisionally set at
3 to 7 percent for 1998. The tentative
ranges for 1998 were unchanged from
the ranges that had been adopted initially for 1995 (in July of that year for
M3).
In reviewing the tentative ranges, the
members took note of a staff projection
indicating that, given the members'
expectations for the performance of the
economy and prices and assuming no
major changes in interest rates, M2
likely would grow in 1998 in the upper
half of its tentative range, and M3 somewhat above the top of its range. The
staff analysis anticipated that the velocity of M2 would continue its recent pattern of relatively stable behavior that
was more in line with historical experience than had been the case in the early
1990s. The velocity of M3 was projected to continue to decline at a somewhat faster rate than historical experience would indicate, reflecting the
greater use by business firms of
institution-only money market funds as
a cash management tool and the needs
of depository institutions for appreciable
non-M2 funding to finance brisk loan
growth. The staff projected that the debt
of the domestic nonfinancial sectors
would grow around or perhaps slightly
above the middle of its tentative range,
reflecting the credit needs of businesses
facing a weaker earnings outlook and
larger merger-related retirements of
equity.
In their discussion of the ranges for
M2 and M3, the members noted that the
apparently greater predictability of
velocity in recent years could not be
counted on to persist, given changes in
financial markets that had made investment alternatives more readily available. As a consequence, substantial
uncertainty still surrounded projections
of money growth consistent with the
Committee's basic objectives for mone-
tary policy. In this environment, the
members did not see any firm basis for
deviating from their recent practice of
setting ranges that, assuming velocity
behavior in line with historical patterns,
would serve as benchmarks for monetary expansion consistent with longerrun price stability and a sustainable rate
of real economic growth. The tentative
ranges for 1998 had been derived in this
way, and Committee members saw no
reason to change those ranges at this
time. Indeed, adjusting the ranges to
center them more closely on growth
rates deemed likely to be more consistent with the Committee's expectations
for economic activity and prices could
foster the misinterpretation that the
Committee had become much more confident of the stability and predictability
of velocity and was placing greater
emphasis on M2 and M3 as gauges of
the thrust of monetary policy. Several
members commented, however, that the
adoption of ranges centered on the Committee's expectations for growth of the
monetary aggregates should be reconsidered in the future if the members
were to become more confident about
the relationship between the growth of
the money and measures of aggregate
economic performance. The Committee
also agreed that the range for nonfinancial debt for 1998 should be left
unchanged. The tentative range readily
encompassed the pace seen as likely to
be associated with the members' forecasts for economic activity and prices.
Accordingly, the following statement
of longer-run policy for 1998 was
approved for inclusion in the domestic
policy directive:
The Federal Open Market Committee
seeks monetary andfinancialconditions that
will foster price stability and promote sustainable growth in output. In furtherance of
these objectives, the Committee at this meeting established ranges for growth of M2
Minutes of FOMC Meetings, February
and M3 of 1 to 5 percent and 2 to 6 percent
respectively, measured from the fourth quarter of 1997 to the fourth quarter of 1998. The
range for growth of total domestic nonfinancial debt was set at 3 to 7 percent for the
year. The behavior of the monetary aggregates will continue to be evaluated in the
light of progress toward price level stability,
movements in their velocities, and developments in the economy and financial markets.
Votes for this action: Messrs. Greenspan, McDonough, Ferguson, Gramlich,
Hoenig, Jordan, Kelley, McTeer, Meyer,
and Mses. Minehan, Phillips, and Rivlin.
Votes against this action: None.
In the Committee's discussion of policy for the intermeeting period ahead,
all the members endorsed a proposal
to maintain an unchanged policy stance.
The economy currently was performing
very well and the outlook over the near
term was for subdued inflation and
continued solid economic growth. Over
a longer horizon, the range of possible
outcomes was unusually wide, and the
direction that policy would need to
move to promote sustained expansion
and damped inflation was unclear. At
this point, the extent to which the still
largely anticipated external drag from
events in Asia would offset the strong
upward momentum in domestic demand
was a source of major uncertainty. In
addition, it was impossible to predict
whether or when the tightness in labor
markets would exert a more pronounced
effect on labor costs and ultimately on
price inflation. Even the thrust of the
current stance of monetary policy as it
was transmitted through financial markets was open to some question. On the
one hand, a real federal funds rate that
was on the high side of historical experience and a substantially stronger dollar
suggested some restraint. From a different perspective, however, financial conditions seemed to be quite stimulative as
evidenced by lower nominal and per-
133
haps real intermediate and long-term
interest rates, rising equity prices, ready
credit availability, and rapid growth of
the broad measures of money and credit.
While the members differed to some
extent in their forecasts of major trends
in the economy and in the risks of alternative outcomes, they agreed that, under
foreseeable circumstances, needed adjustments to policy probably could be
made on a timely basis once the balance
of underlying forces became more
evident. Accordingly, a steady policy
would not incur an unacceptable risk of
a seriously deteriorating economic performance. In the interim, the greater risk
would be to make a preemptive policy
move on the basis of inadequate evidence regarding underlying economic
trends.
In the Committee's discussion of possible intermeeting adjustments to policy,
all the members agreed that prevailing
uncertainties indicated the desirability
of retaining a symmetric instruction in
the directive. While a number of members expressed the view that the next
policy move was likely to be a tightening action and one member saw a
greater probability of an easing action,
the uncertainties were sufficiently great
to warrant remaining sensitive to the
need for a policy change in either direction. Accordingly, a symmetric directive
would signal the Committee's readiness
to respond promptly to developments
that might threaten the economy's satisfactory performance.
At the conclusion of the Committee's
discussion, all the members indicated
their support of a directive that called
for maintaining conditions in reserve
markets that were consistent with an
unchanged federal funds rate of about
5Vi percent, and all also favored a directive that did not include a presumption
about the direction of a change, if any,
in the stance of policy during the inter-
134 85th Annual Report, 1998
meeting period. Accordingly, in the context of the Committee's long-run objectives for price stability and sustainable
economic growth, and giving careful
consideration to economic, financial,
and monetary developments, the members decided that a slightly higher or a
slightly lower federal funds rate might
be acceptable during the intermeeting
period. The reserve conditions contemplated at this meeting were expected to
be consistent with some moderation in
the growth of M2 and M3 over coming
months.
The Federal Reserve Bank of New
York was authorized and directed, until
instructed otherwise by the Committee,
to execute transactions in the System
Account in accordance with the following domestic policy directive:
The information reviewed at this meeting
suggests that economic activity continued
to grow rapidly during the closing months
of 1997. Nonfarm payroll employment
increased sharply further in December after
posting very large gains in other recent
months; the civilian unemployment rate, at
4.7 percent, remained near its low for the
current economic expansion. Industrial production continued to advance at a brisk pace
in the fourth quarter. Consumer spending
rose appreciably in the quarter, and housing
starts remained close to the highs of the
current expansion. Business fixed investment weakened following exceptionally
strong increases in the second and third
quarters; nonfarm inventory accumulation
appears to have picked up somewhat. The
nominal deficit on U.S. trade in goods and
services narrowed significantly on average in
October and November from its level in the
third quarter. Price inflation has remained
subdued despite appreciably faster increases
in worker compensation in recent months.
Most interest rates have declined on balance since the day before the Committee
meeting on December 16, 1997. Share prices
in U.S. equity markets have moved up
somewhat over the period; equity markets in
some other countries, notably in Asia, have
remained volatile. In foreign exchange markets, the value of the dollar has risen over
the intermeeting period relative to the currencies of several Asian developing countries, but it has registered only a small
increase on average in relation to the currencies of major industrial nations.
M2 and M3 continued to grow at relatively rapid rates in December and apparently also in January. From the fourth quarter
of 1996 to the fourth quarter of 1997, M2
expanded at a rate somewhat above the
upper bound of its range for the year and M3
at a rate substantially above the upper bound
of its range. Total domestic nonfinancial debt
expanded in 1997 at a pace somewhat below
the middle of its range.
The Federal Open Market Committee
seeks monetary and financial conditions that
will foster price stability and promote sustainable growth in output. In furtherance of
these objectives, the Committee at this meeting established ranges for growth of M2
and M3 of 1 to 5 percent and 2 to 6 percent
respectively, measured from the fourth quarter of 1997 to the fourth quarter of 1998. The
range for growth of total domestic nonfinancial debt was set at 3 to 7 percent for the
year. The behavior of the monetary aggregates will continue to be evaluated in the
light of progress toward price level stability,
movements in their velocities, and developments in the economy and financial markets.
In the implementation of policy for the
immediate future, the Committee seeks conditions in reserve markets consistent with
maintaining the federal funds rate at an average of around 5!/2 percent. In the context
of the Committee's long-run objectives for
price stability and sustainable economic
growth, and giving careful consideration to
economic, financial, and monetary developments, a slightly higher federal funds rate
or a slightly lower federal funds rate might
be acceptable in the intermeeting period.
The contemplated reserve conditions are
expected to be consistent with some moderation in the growth in M2 and M3 over coming months.
Votes for this action: Messrs. Greenspan, McDonough, Ferguson, Gramlich,
Hoenig, Jordan, Kelley, Meyer, McTeer,
Mses. Minehan, Phillips, and Rivlin.
Votes against this action: None
It was agreed that the next meeting of
the Committee would be held on Tuesday, March 31, 1998.
Minutes of FOMC Meetings, March
The meeting adjourned at 10:50 a.m.
Donald L. Kohn
Secretary
135
Mr. Fisher, Manager, System Open
Market Account
Mr. Ettin, Deputy Director, Division of
Research and Statistics, Board of
Governors
Meeting Held on
March 31, 1998
Mr. Slifman, Associate Director,
Division of Research and
Statistics, 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.,
on Tuesday, March 31, 1998, at
9:00 a.m.
Messrs. Alexander, Hooper, and
Ms. Johnson, Associate Directors,
Division of International Finance,
Board of Governors
Present:
Mr. Greenspan, Chairman
Mr. McDonough, Vice Chairman
Mr. Ferguson
Mr. Gramlich
Mr. Hoenig
Mr. Jordan
Mr. Kelley
Mr. Meyer
Ms. Minehan
Ms. Phillips
Mr. Poole
Ms. Rivlin
Messrs. Boehne, McTeer, Moskow, 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. Coyne, Assistant Secretary
Mr. Gillum, Assistant Secretary
Mr. Mattingly, General Counsel
Mr. Baxter, Deputy General Counsel
Mr. Prell, Economist
Mr. Truman, Economist
Ms. Browne, Messrs. Cecchetti,
Dewald, Hakkio, Lindsey,
Promisel, Simpson, Sniderman,
and Stockton, Associate
Economists
Mr. Reinhart, Assistant Director,
Division of Monetary Affairs,
Board of Governors
Ms. Low, Open Market Secretariat
Assistant, Division of Monetary
Affairs, Board of Governors
Mr. Rasdall, First Vice President,
Federal Reserve Bank of
Kansas City
Messrs. Goodfriend, Hunter, Kos,
Lang, Rolnick, and Rosenblum,
Senior Vice Presidents, Federal
Reserve Banks of Richmond,
Chicago, New York, Philadelphia,
Minneapolis, and Dallas
respectively
Ms. Rosenbaum, Vice President,
Federal Reserve Bank of Atlanta
Mr. Rudebusch, Research Officer,
Federal Reserve Bank of
San Francisco
By unanimous vote, the minutes of
the meeting of the Federal Open Market
Committee held on February 3-4, 1998,
were approved.
The Report of Examination of the
System Open Market Account, conducted by the Board's Division of
Reserve Bank Operations and Payment
Systems as of the close of business on
November 6, 1997, was accepted.
136 85th Annual Report, 1998
The Manager of the System Open
Market Account reported on developments in foreign exchange and international financial markets in the period
since the previous meeting on February 3-4, 1998. There were no System
open market transactions in foreign currencies during this period, and thus no
vote was required of the Committee.
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 from February 4, 1998,
through March 30, 1998. By unanimous
vote, the Committee ratified these
transactions.
The information reviewed at this
meeting suggested that the economy
continued to expand rapidly during
the early months of 1998. Apparently,
strong growth in private domestic
spending for consumption, housing, and
business equipment more than offset
weakness in net exports and a slight
moderation in inventory investment.
Total employment continued to rise rapidly, but industrial production increased
at a considerably slower pace. Despite
indications of persisting pressures on
employment costs associated with tight
labor markets, price inflation abated further, primarily as a consequence of large
declines in energy prices.
Nonfarm payroll employment rose
sharply further in January and February.
Growth in construction jobs was particularly strong, apparently reflecting in part
the unseasonably warm weather across
much of the country and the need to
repair damage caused by ice storms and
heavy rains. In addition, service industries continued to post very large employment gains. By contrast, manufacturing payrolls contracted slightly in
February after a sizable increase in January. The civilian unemployment rate
edged down to 4.6 percent in February,
equaling its low for the current economic expansion.
Industrial production edged up on balance in January and February after
having increased rapidly in the second
half of 1997. Part of the deceleration
stemmed from the depressing effect of
unusually warm winter weather on the
provision of heating services by utilities.
The growth of manufacturing production also slowed considerably as a result
of downward adjustments to assemblies
of motor vehicles and, more generally,
weakness in the output of business
equipment. With investment in new
manufacturing facilities still brisk and
manufacturing output posting only a
small advance in the January-February
period, the factory operating rate eased a
little.
Consumers stepped up their spending
in the early months of the year; sentiment remained buoyant in the context of
continued strong growth in disposable
income and further gains in household
wealth. Particularly large increases were
recorded in expenditures on durable
goods, apparel, and general merchandise. Housing demand also strengthened, with sales of existing homes
reaching a record high in February and
sales of new homes in January (latest
data) almost equaling the previous
record. Both housing starts and building
permits remained on an upward trend.
Business fixed investment seemed to
have rebounded from a small decline in
the fourth quarter. Shipments of nondefense capital goods, notably of computing equipment whose prices continued
to fall sharply, strengthened substantially in January and February. By contrast, expenditures on transportation
equipment were sluggish. Despite further declines in vacancy rates and rising
real estate prices, business spending on
nonresidential construction also seemed
Minutes of FOMC Meetings, March 137
to have been lackluster, with such activity not having changed much since last
summer.
The pace of business inventory accumulation slowed sharply in January
from the fourth-quarter rate. Some of
the slowdown reflected a reduction in
motor vehicle stocks; the remainder was
largely associated with a drop in inventories of nondurable goods at the wholesale level. Inventory-sales ratios for
most manufacturing and trade categories were within the ranges experienced
over the past year.
The nominal deficit on U.S. trade in
goods and services widened substantially in January from its average
monthly level for the fourth quarter. The
value of exports declined considerably,
partly as a result of reduced exports to
Asia, but the value of imports changed
little. The decrease in exports was
mainly in civilian aircraft and other
capital goods. The available information
indicated that the pace of economic
expansion picked up in Europe after
having slowed somewhat in the fourth
quarter and was still strong on balance
in Canada. Economic activity remained
weak in Japan and decelerated sharply
in Asian countries that had been the
focus of financial turmoil.
Consumer prices were little changed
on balance in January and February,
as substantial declines in energy prices
largely offset increases elsewhere.
Excluding food and energy items, consumer price inflation picked up somewhat in the first two months of the year
from the pace of the second half of
1997; on a year-over-year basis, however, the increase in consumer prices
during the twelve months ended in February was slightly smaller than that in
the year-earlier period. At the producer
level, falling prices for finished energy
goods in January and February pulled
down the index of prices for all finished
items; excluding food and energy, prices
were unchanged on balance over the
two months. Over the twelve months
ended in February, producer price inflation was negligible. Tight labor markets
appeared to be putting some upward
pressure on labor compensation, but the
pickup was limited. The change in average hourly earnings over the twelve
months ended in February was only
slightly larger than the increase over the
year-earlier period.
With economic growth still solid and
inflation subdued, the Committee at
its meeting on February 3-4, 1998, had
adopted a directive that called for
maintaining conditions in reserve markets that would be consistent with an
unchanged federal funds rate of about
5V2 percent. The substantial uncertainties about the future strength of economic activity and inflation suggested
that the next change in policy could be
in either direction, and the Committee
also had agreed that the directive should
not contain a presumption about the
direction of any change in the stance of
policy during the intermeeting period.
The reserve market conditions associated with this directive had been
expected to be consistent with some
moderation in the growth of M2 and M3
over coming months.
Open market operations throughout
the intermeeting period were directed
toward maintaining reserve conditions
consistent with the intended average for
the federal funds rate of around 5 Vi percent, and the rate fluctuated in a narrow
range around that level. By contrast,
interest rates in other domestic financial
markets generally rose somewhat on
balance over the period in response to
incoming information that suggested
aggregate private demand remained
robust. Despite the rise in rates and
some erosion in the outlook for nearterm corporate profits, share prices in
138 85th Annual Report, 1998
U.S. equity markets moved up substantially further.
In foreign exchange markets, the dollar appreciated somewhat on balance
over the intermeeting period in relation
to the currencies of the other major
industrial countries. Against a background of weakening growth in Japan
and continued uncertainty about the
prospects for fiscal stimulus in that
country, the dollar rose considerably
against the yen. The dollar changed
little against the mark and other continental European currencies but declined
against the Canadian dollar and the British pound. The dollar also depreciated
significantly relative to the currencies of
several emerging market economies in
Asia, reflecting market assessments that
progress had been made in reforming
economic policies and financial and
commercial practices in most of those
countries.
The available information for February and part of March indicated that M2
and M3 expanded more rapidly than the
Committee had anticipated at the time
of its February meeting. On a quarterly
average basis, growth of both monetary
aggregates picked up somewhat in the
first quarter from already robust rates
in the fourth quarter. The increased
demand for M2 was perhaps associated
in part with the reduced attractiveness
of longer-term fixed rate market assets,
whose yields had declined significantly
relative to the returns on liquid investment components of M2. In addition,
households might have been trying
to rebalance asset portfolios that had
become more heavily weighted in
equities as a result of the run-up in
stock prices. The pickup in M3
growth reflected a surge in bank issuance of large time deposits to finance
strong demands for loans by businesses
and households. The expansion of
total domestic nonfinancial debt also
strengthened over recent months in
response to heavy private demands for
credit.
The staff forecast prepared for this
meeting indicated that the expansion of
economic activity would slow appreciably during the next few quarters and
remain moderate in 1999. The staff
analysis suggested that the surge in
household net worth over the past several years would help to support sizable,
though gradually diminishing, gains in
consumer spending; favorable cash flow
affordability would underpin housing
demand at a relatively high level; and
substantial increases in capital spending
would persist until slower growth in
business sales and weaker profits began
to have a restraining effect in 1999.
Reduced growth of foreign economic
activity and the lagged effects of the
considerable rise that had occurred in
the foreign exchange value of the dollar
were expected to exert substantial
restraint on the demand for U.S. exports
over the projection period and to increase the pressures on domestic producers that face import competition.
An anticipated slowdown in the pace
of inventory accumulation also would
restrain domestic production as stocks
were brought into balance with the
expected lower trajectory for sales.
Although pressures on production
resources would abate to a degree as
output growth slowed, inflation was
expected to increase somewhat in
response to persisting tightness in labor
markets and a diminishing drag from
non-oil import prices.
In the Committee's discussion of
current and prospective developments,
members commented on the persistence
of unusually favorable economic conditions, characterized by strong growth
and low inflation, but a number questioned how long these conditions
might last without a policy adjustment.
Minutes of FOMC Meetings, March 139
Domestic demand was exceeding expectations and was likely to continue to
increase rapidly for some time, supported by accommodative conditions
in key segments of financial markets.
Developments in foreign trade were
moderating demands on domestic
resources; but with domestic spending
strong, members were becoming more
concerned that those developments
might not exert enough restraint on
aggregate demand to slow the expansion
to a sustainable pace in line with the
growth of the economy's potential.
Despite tightening labor markets, inflation prospects remained quite favorable
for a while as a number of factors—
some temporary—helped to damp nearterm pressures on prices. Nonetheless,
in the absence of some slowing in the
expansion, labor compensation probably
would continue to accelerate and increasingly outpace productivity, adding
to pressures on prices.
In their review of the outlook for
spending in key sectors of the domestic
economy, members saw little reason to
anticipate substantial slowing in the
growth of consumer or business expenditures in coming quarters, and they also
expected housing activity to be maintained at a relatively high level. The
recent further increases in equity prices
from already high levels played an
important role in the assessments of
several members. The stock market's
rise was viewed as somewhat puzzling,
given indications of some slowing in the
growth of profits and the potential for
earnings disappointments as the expansion in spending moderated and profit
margins narrowed in the context of more
rapid labor cost increases. So long as a
high degree of optimism in the stock
market persisted, however, the elevated
level of financial wealth and the low
cost of capital should continue to boost
spending. Consumer expenditures, espe
cially for durable goods, had risen
sharply thus far this year, and the factors
that had fueled that expansion were still
unusually positive. They included large
increases in employment and personal
incomes, the continuing uptrend in
financial wealth relative to disposable
income, and, in these circumstances, the
persistence of a very high level of consumer confidence. Attractive financing
conditions and favorable business confidence also were expected to support
substantial further growth in business
investment, especially in high tech
equipment that was characterized by
rapid product improvement and falling
prices. Investment in nonresidential
structures, notably in office and other
commercial markets, seemed likely
to strengthen somewhat in response to
reduced vacancy rates and sizable
increases in rents in many areas; indeed,
several members again reported indications of speculative nonresidential construction in some parts of the country.
Residential construction was expected
to be maintained at a high level, though
single-family starts might soften over
the next few months after a surge that
appeared to have been related to relatively favorable weather conditions during the winter. With mortgage rates at
their recent reduced levels and incomes
continuing to rise, the cash flow affordability of home ownership was exceptionally favorable.
Developments in two areas of expenditures were thought likely to exert some
restraining effect on the overall expansion in economic activity over coming
quarters. One was business inventory
accumulation, which had exceeded the
robust growth in final sales in 1997 and
probably would moderate this year as
business firms sought to restrain the
buildup in their inventories to keep them
in better alignment with the expected
moderation of gains in sales.
140 85 th Annual Report, 1998
The second, foreign trade developments, also was likely to have a damping influence on the domestic economy.
While the lagged effects of the dollar's
appreciation and economic conditions
in key U.S. trading partners around the
world were important factors in this
assessment, members focused in this
discussion on the effects of weakness
in several Asian economies. Conditions
in Japan and in key emerging market
economies in Asia were still quite fragile, adjustments on the real side of the
economy were just beginning to be felt
in some cases, and outcomes for economic growth and exchange rates were
still very much in doubt. Nonetheless,
some progress had been made in putting
recovery programs together, and financial markets had seemed to stabilize in
several countries. Anecdotal reports of
adverse repercussions on individual
U.S. firms from the Asian financial
turmoil had increased somewhat since
the Committee's previous meeting,
but the direct overall impact on the
U.S. economy was still limited. Indeed,
developments in Asia also appeared
to have had positive, albeit indirect,
effects on domestic demand and prices
in the near term by exerting some downward pressure on U.S. interest rates and
world oil prices. Prices in the United
States of a number of Asian goods
and of domestic products competing
with those goods had been lowered.
Over time, conditions in key Asian
economies were thought likely to have
a more pronounced retarding effect on
the U.S. economy. While the eventual
dimensions of that effect remained
uncertain, a number of members commented that, on the basis of developments to date, they might turn out
to be less negative than had been
expected earlier, or at least that some
"worst case" outcomes seemed less
likely.
With regard to the outlook for inflation, members observed that price inflation remained quite low—in fact, it was
still declining by some measures—and
there was little evidence of any potential
acceleration in current price data or in
anecdotal reports from around the country. Nonetheless, as they had at previous
meetings, members expressed particular
concern about the outlook for prices
in the absence of appreciable slowing in
the growth of aggregate demand, which
appeared to be adding to pressures on
labor resources. Anecdotal reports from
across the nation continued to suggest
exceptionally tight labor markets and
growing indications of somewhat faster
increases in labor compensation. To
date, unit labor costs had been contained
by large capital investments and other
initiatives that had raised the productivity of labor. But additional improvements in productivity growth could not
be counted on to offset further increases
in the rate of growth of labor compensation, which were more likely to occur
especially if labor markets were to
tighten further. Moreover, the effects of
a number of special factors that had
tended to limit cost pressures and price
inflation in recent years were not likely
to persist; these included the declines in
world oil prices, the subdued increases
in the costs of health benefits, and the
lagged effects of the appreciation of the
dollar. To be sure, the factors that had
produced the favorable inflation results
of recent years were not all well understood, and consequently expectations of
greater price pressures had to be tentative. On balance, though any upsurge in
inflation seemed unlikely in the nearer
term, the risk that inflation might move
higher over the longer run seemed to
have increased.
Despite perceptions of a greater risk
of rising inflation over time, all but one
of the members indicated in the Com-
Minutes of FOMC Meetings, March 141
mittee's policy discussion that they preferred, or could accept, a proposal to
maintain an unchanged policy stance
that also included a shift from the current symmetrical directive to an asymmetrical directive tilted toward restraint.
The members agreed that should the
strength of the economic expansion and
the firming of labor markets persist, policy tightening likely would be needed at
some point to head off imbalances that
over time would undermine the expansion in economic activity. Most saw
little urgency to tighten policy at this
meeting, however. The economy might
well continue to accommodate relatively
robust economic growth and a high level
of resource use for an extended period
without a rise in inflation. Some members noted that price increases would be
held down for a while by the effects of
the higher dollar, which had not worked
their way fully through domestic prices.
Moreover, inflation continued to fall by
some measures and inflation expectations still seemed to be adjusting downward toward actual inflation; further
declines in these expectations would
restrain increases in compensation and
prices. Members also noted that the ultimate extent of retarding effects from the
financial turmoil in Asia was still uncertain, and several cited the possibility
of a downward adjustment in the stock
market, perhaps in response to disappointing growth in business profits, that
could have an adverse impact on business and consumer confidence. In these
circumstances, a preemptive policy
move to head off rising inflation could
prove premature or perhaps even unwarranted; indeed, in the view of some, a
tightening move was not inevitable.
Moreover, because a policy action was
not currently anticipated, some commented that a tightening could produce
an outsized and undesirable response in
financial markets. On balance, in light
of the uncertainties in the outlook and
given that a variety of special factors
would continue to contain inflation for a
time, the Committee could await further
developments bearing on the strength of
inflationary pressures without incurring
a significant risk that disruptive policy actions would be needed later in
response to an upturn in inflation and
inflation expectations.
One member indicated a strong preference for an immediate policy tightening move, largely on the grounds
that under current conditions relatively
rapid growth in money and credit was
not consistent with continued progress
toward reducing inflation. A number of
other members also commented that the
strength of the monetary aggregates,
especially if it should persist, was suggesting ample liquidity and accommodative financial conditions. In addition,
some cited ebullient equity markets and
narrow risk spreads in credit markets as
additional evidence that financial conditions were not restraining final demands
very much. These were factors that they
would weigh in their evaluation of the
need for, and timing of, a policy tightening move.
The members agreed that they should
be particularly sensitive to developments that might signal rising inflation
pressures, and in that regard a shift to an
asymmetric directive seemed desirable.
Such a directive would be consistent
with the Committee's judgment that the
information that had become available
since a symmetric directive was last
adopted in February had altered the
inflation risks enough to make some
tightening a likely prospect in the not
too distant future. In that regard several
suggested that the need for some policy
tightening could well materialize in the
near future.
At the conclusion of the Committee's
discussion, all but one member sup-
142 85th Annual Report, 1998
ported a directive that called for maintaining conditions in reserve markets
that were consistent with an unchanged
federal funds rate of about 5Vi percent
and that contained a bias toward the
possible firming of reserve conditions
and a higher federal funds rate. Accordingly, in the context of the Committee's
long-run objectives for price stability
and sustainable economic growth, and
giving careful consideration to economic, financial, and monetary developments, the Committee decided that
a somewhat higher federal funds rate
would be acceptable or a slightly lower
federal funds rate might be acceptable
during the intermeeting period. The
reserve conditions contemplated at this
meeting were expected to be consistent
with considerable moderation in the
growth in M2 and M3 over the months
ahead.
The Federal Reserve Bank of New
York was authorized and directed, until
instructed otherwise by the Committee,
to execute transactions in the System
Account in accordance with the following domestic policy directive:
The information reviewed at this meeting
suggests that economic activity continued
to grow rapidly during the early months
of 1998. Nonfarm payroll employment
increased sharply further in January and February, and the civilian unemployment rate, at
4.6 percent in February, equaled its low for
the current economic expansion. However,
growth in manufacturing payroll employment was down over the first two months
of the year, and factory output decelerated
appreciably. Consumer spending has risen
considerably further since year-end, and
housing activity also has strengthened in
recent months. Available indicators point to
a sharp rebound in business fixed investment
following a small decline in the fourth quarter. Fragmentary data on nonfarm inventories suggest a slower rate of accumulation
early in the year. The nominal deficit on U.S.
trade in goods and services widened substantially in January from its average monthly
rate in the fourth quarter. Despite indications
of persisting pressures on employment costs
associated with tight labor markets, price
inflation has abated further, primarily as a
consequence of large declines in energy
prices.
Interest rates generally have risen somewhat on balance over the intermeeting
period. Share prices in U.S. equity markets
have moved up substantially further over
the period. In foreign exchange markets, the
value of the dollar has increased somewhat
over the period in relation to the currencies
of other major industrial nations, but it has
depreciated relative to the currencies of most
emerging market economies in Asia.
Growth of M2 and M3 picked up somewhat in the first quarter from already robust
rates in the fourth quarter. Expansion of total
domestic nonfinancial debt also has strengthened over recent months.
The Federal Open Market Committee
seeks monetary and financial conditions that
will foster price stability and promote sustainable growth in output. In furtherance
of these objectives, the Committee at its
meeting in February established ranges for
growth of M2 and M3 of 1 to 5 percent and
2 to 6 percent respectively, measured from
the fourth quarter of 1997 to the fourth quarter of 1998. The range for growth of total
domestic nonfinancial debt was set at 3 to
7 percent for the year. The behavior of the
monetary aggregates will continue to be
evaluated in the light of progress toward
price level stability, movements in their
velocities, and developments in the economy
and financial markets.
In the implementation of policy for the
immediate future, the Committee seeks conditions in reserve markets consistent with
maintaining the federal funds rate at an average of around 5Vi percent. In the context
of the Committee's long-run objectives for
price stability and sustainable economic
growth, and giving careful consideration to
economic, financial, and monetary developments, a somewhat higher federal funds rate
would or a slightly lower federal funds rate
might be acceptable in the intermeeting
period. The contemplated reserve conditions
are expected to be consistent with considerable moderation in the growth in M2 and M3
over coming months.
Votes for this action: Messrs. Greenspan, McDonough, Ferguson, Gramlich,
Minutes of FOMC Meetings, May
Hoenig, Kelley, Meyer, Mses. Minehan,
Phillips, Mr. Poole, and Ms. Rivlin. Vote
against this action: Mr. Jordan.
Mr. Jordan dissented because growth
rates of various measures of money and
credit in the second half of 1997 and the
first quarter of this year were not consistent in his view with continued progress
in reducing inflation. Recent price statistics understated the trend rates of inflation. The one-time effects of falling oil
prices, lower food prices, and recent
appreciation of the dollar on foreign
exchange markets provided only a temporary reduction of inflation. While
some reacceleration of reported rates of
inflation was probably unavoidable, sustained rapid money growth would risk
even higher inflation in future years.
The durability of the economic expansion would be jeopardized by price and
wage decisions reflecting expectations
that the purchasing power of the dollar
would decline at faster rates in the
future. Once such expectations became
imbedded in the economy, even stronger
policy actions would be required in
order to reestablish a downward trend of
inflation.
It was agreed that the next meeting of
the Committee would be held on Tuesday, May 19, 1998.
The meeting adjourned at 1:05 p.m.
Donald L. Kohn
Secretary
Meeting Held on
May 19, 1998
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 19, 1998, at
9:00 a.m.
143
Present:
Mr. Greenspan, Chairman
Mr. McDonough, Vice Chairman
Mr. Ferguson
Mr. Gramlich
Mr. Hoenig
Mr. Jordan
Mr. Kelley
Mr. Meyer
Ms. Minehan
Ms. Phillips
Mr. Poole
Ms. Rivlin
Messrs. Boehne, McTeer, Moskow,
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
Mr. Mattingly, General Counsel
Mr. Prell, Economist
Mr. Truman, Economist
Ms. Browne, Messrs. Cecchetti,
Dewald, Hakkio, Lindsey,
Simpson, and Stockton,
Associate Economists
Mr. Fisher, Manager, System Open
Market Account
Mr. Winn, Assistant to the Board,
Office of Board Members,
Board of Governors
Ms. Fox, Deputy Congressional
Liaison, Office of Board
Members, Board of Governors
Mr. Ettin, Deputy Director,
Division of Research and
Statistics, Board of Governors
Messrs. Madigan and Slifman,
Associate Directors, Divisions
of Monetary Affairs and
Research and Statistics
respectively, Board of
Governors
144 85th Annual Report, 1998
Messrs. Alexander, Hooper, and
Ms. Johnson, Associate
Directors, Division of
International Finance,
Board of Governors
Mr. Reinhart, Assistant Director,
Division of Monetary Affairs,
Board of Governors
Ms. Garrett, Economist, Division
of Monetary Affairs, Board of
Governors
Ms. Low, Open Market Secretariat
Assistant, Division of Monetary
Affairs, Board of Governors
Mr. Kumasaka, Research Assistant,
Division of Monetary Affairs,
Board of Governors
Messrs. Eisenbeis, Goodfriend,
Hunter, Lang, Rolnick, and
Rosenblum, Senior Vice
Presidents, Federal Reserve
Banks of Atlanta, Richmond,
Chicago, Philadelphia,
Minneapolis, and Dallas
respectively
Messrs. Altig, Bentley, and Judd,
Vice Presidents, Federal
Reserve Banks of Cleveland,
New York, and San Francisco
respectively
By unanimous vote, the minutes of
the meeting of the Federal Open Market
Committee held on March 31, 1998,
were approved.
The Manager of the System Open
Market Account reported on developments in foreign exchange markets during the period March 31, 1998, through
May 18, 1998. There were no System
open market transactions in foreign currencies during this period, and thus no
vote was required of the Committee.
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
March 31, 1998, through May 18, 1998.
By unanimous vote, the Committee ratified these transactions.
The Manager informed the Committee of his intention to discuss with market participants proposed changes in the
procedures for lending securities from
the System Open Market Account. The
changes would be intended to adapt the
lending program to the evolving structure of the U.S. Treasury securities market. They are designed to make System
securities lending more effective at helping to relieve occasional significant
shortages of particular securities, which
could cause disruptions to the market.
In a brief discussion, Committee members sought clarification of some of the
proposed details of the new program
and how it would fit with the Federal Reserve's broader responsibilities.
Action to amend paragraph 2 of the
Authorization for Domestic Open Market Operations would be required at a
later date when the details of the new
program had been decided upon after
discussions with market participants.
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 the economy
continued to expand rapidly in 1998.
Strength in consumption, business outlays for durable equipment, and homebuilding boosted growth in domestic
final demand to a very rapid pace in the
first quarter, and there had been indi-
Minutes of FOMC Meetings, May
cations of slower expansion since then.
However, weakening net exports were
exerting a considerable drag on economic growth. Moreover, the extraordinary pace of inventory investment thus
far this year might foreshadow less
robust expansion ahead. Payroll employment remained on a brisk uptrend,
but industrial production decelerated
sharply after having surged in the second half of last year. Despite indications
of persisting pressures on employment
costs associated with tight labor markets, consumer price inflation remained
subdued, importantly reflecting large
declines in energy prices.
Nonfarm payroll employment registered another large increase in April
after a small decline in March; these
data, along with the still-low level of
initial claims for unemployment insurance in recent weeks, suggested that
labor demand had remained robust thus
far in 1998. Hiring in the trade, finance
and real estate, and services industries
was brisk in April; employment in construction retraced part of an apparently
weather-related drop in March. The
number of manufacturing jobs declined
in April for a second consecutive month.
The civilian unemployment rate fell
sharply, to 4.3 percent in April, after
having averaged around 43A percent
since last November.
Industrial production rose somewhat
over March and April after having
weakened earlier in the year. Part of the
slowdown this year, following rapid
growth in the second half of last year,
was attributable to weakness in utility
output associated with unusually warm
winter weather across much of the country. More importantly, though, manufacturing output had changed little on balance in recent months. In April, a pickup
in the production of business equipment,
particularly of information processing
equipment, was largely offset by further
145
declines in the output of construction
supplies, basic metals, and nondurable
materials. The production of consumer
goods was unchanged. The factory operating rate eased further in April, reflecting the continuing brisk expansion
in manufacturing facilities and slow
growth in output.
Consumer spending had remained
strong this year in the context of robust
gains in income and household net
worth and of very favorable consumer
sentiment. Total retail sales rose appreciably in April, boosted by increases in
purchases of automobiles and nondurable goods. Housing demand and residential construction activity also continued
to increase at a rapid pace this year.
Home sales were at very high levels,
reflecting the continuing improvement
in housing affordability as a result of
declining mortgage rates. Although
housing starts slipped in April, they
remained at an elevated level.
Business fixed investment rebounded
sharply in the first quarter from a small
decline in the fourth quarter of 1997. A
surge in expenditures on producers'
durable equipment, notably on computers, communications equipment, and
heavy trucks, more than offset continued
weakness in outlays for nonresidential
structures. While available indicators
pointed to further substantial gains in
equipment purchases over coming
months, data on construction contracts
offered little evidence of a pickup in
nonresidential construction activity in
the near term, even though vacancy rates
were declining and office rents were
rising.
Business inventories increased at a
very rapid pace in the first quarter, but
with sales strong, inventory-sales ratios
remained within their ranges over the
past year. In manufacturing, stock accumulation slowed in March after having
increased fairly rapidly in January and
146 85th Annual Report, 1998
February. At the wholesale level, inventories rose about in line with sales during the quarter, and in the retail sector
inventories built up at a greatly accelerated pace in the first quarter.
The nominal deficit on U.S. trade in
goods and services widened substantially in January and February from
its average monthly rate in the fourth
quarter. The value of exports declined
considerably in the January-February
period, with most of the drop attributable to reduced sales to Asian countries.
The decrease in exports was concentrated in agricultural products, industrial
supplies, and machinery. The value of
imports rose slightly, largely reflecting
higher amounts of imported automotive
products and higher service payments.
The available information suggested that
economic growth in continental Europe
strengthened in the first quarter, with
strong domestic demand apparently offsetting the effects of Asian turmoil on
foreign trade. Robust domestic demand
also continued to buoy the Canadian
economy. By contrast, economic activity in Japan contracted in the first quarter and decelerated sharply further in
Asian countries that had experienced
financial turmoil.
Consumer prices were unchanged in
March and rose moderately in April.
Energy prices were down slightly further in April after having declined markedly in previous months, and food prices
increased a little; excluding food and
energy, consumer price inflation picked
up in April as prices of services accelerated and prices of tobacco surged higher.
Over the course of recent months, core
consumer inflation had accelerated to
rates that were somewhat above those
registered earlier. Even so, on a yearover-year basis, the increases in total
and core consumer prices were substantially smaller over the twelve months
ended in April than they had been in the
year-earlier period; falling import prices
apparently helped damp the goods component of the index. At the producer
level, price inflation of finished goods
other than food and energy picked up
a bit in April, but it was considerably
lower over the twelve months ended in
April than over the year-earlier interval.
Inflation at earlier stages of production
also remained subdued. The rate of
increase in hourly compensation of private industry workers slowed in the
first quarter, reflecting smaller advances
in both the wage and benefit components of the index; however, compensation costs accelerated appreciably on
a year-over-year basis, primarily as a
result of faster growth in wages and
salaries.
At its meeting on March 31, 1998,
the Committee adopted a directive that
called for maintaining conditions in
reserve markets that were consistent
with an unchanged federal funds rate
averaging around 5 Vi percent. However,
in light of increased concerns that
growth in aggregate demand might outpace the expansion of the economy's
potential for some time, possibly generating inflationary imbalances in labor
markets, the Committee decided that the
directive should include a bias toward
the possible firming of reserve conditions and a higher federal funds rate.
The reserve conditions associated with
this directive were expected to be consistent with considerable moderation in
the growth in M2 and M3 over the
months ahead.
Open market operations throughout
the intermeeting period were directed
toward maintaining reserve conditions
consistent with the intended average of
around 5Vi percent for the federal funds
rate. Though tax flows were heavy at
times and reserves were drained from
depository institutions as tax payments
spilled into Treasury deposits at the Fed-
Minutes of FOMC Meetings, May 147
eral Reserve Banks, the federal funds
rate averaged a little below its intended
level over the period. Most other market interest rates declined slightly on
balance over the intermeeting period;
incoming data suggested that labor
markets remained tight and that the
economy retained considerable upward
momentum, but market participants evidently gave greater weight to information indicating that wage and price inflation was well contained in the first
quarter. Share prices in U.S. equity markets rose further despite some reports
of soft corporate earnings, and equity
prices in most other industrial countries
also reached new highs.
In foreign exchange markets, the
trade-weighted value of the dollar in
terms of major currencies changed little
on balance over the period. The dollar
declined considerably against the German mark and other continental European countries amid signs of strong
growth in the German economy and further progress in resolving the outstanding issues associated with next year's
launch of the euro; French and German
interest rates also rose slightly over the
period. The dollar appreciated somewhat against the yen; the announcement
of a large fiscal stimulus package and
Japan's intervention in support of the
yen did not offset indications of further
weakening in the Japanese economy and
related declines in Japanese interest
rates. Other Asian financial markets
came under renewed pressure after a
brief period of relative calm. The currencies of several key Asian emerging
market economies depreciated considerably against the dollar; and in sharp
contrast to the performance of equity
markets in most industrial countries,
prices in Asian equity markets declined
substantially on balance over the period
to near their lows of late 1997 or early
1998.
M2 and M3 expanded briskly further
in April, but data for late April and early
May showed M2 declining and M3 leveling out; much of the fluctuation in M2
during the April-May period appeared
to be related to movements of funds
associated with unusually heavy nonwithheld tax payments and a surge in
mortgage refinancings to take advantage
of lower long-term rates. On balance,
the underlying growth of these aggregates seemed to be slowing from the
pace of the first quarter. The moderation
in M3 partly reflected a reduced need
for non-M2 sources of funds at a time
when bank credit expansion seemed to
be slowing. Growth of total domestic
nonfinancial debt apparently had slipped
somewhat after picking up earlier in the
year.
The staff forecast prepared for this
meeting indicated that the expansion of
economic activity would slow considerably during the next few quarters
and remain moderate in 1999. Reduced
growth of foreign economic activity and
the lagged effects of the sizable rise that
had occurred in the foreign exchange
value of the dollar were expected to
place substantial restraint on the demand
for U.S. exports and to add to the pressures on domestic producers to hold
down prices to meet import competition.
An anticipated sharp slowdown in the
pace of inventory accumulation also
would damp domestic production as the
growth of stocks was brought into balance with the expected more moderate
trajectory of final sales. The staff analysis suggested that further strong gains
in income, along with the surge in
household net worth over the past several years, would support brisk, though
gradually diminishing, gains in consumer spending. Housing demand,
fostered by the favorable cash flow
affordability of home ownership, was
expected to remain at a generally high
148 85th Annual Report, 1998
level, though the anticipated slowing
in income growth over the projection
period would damp residential construction activity somewhat. Substantial
increases in capital spending would
continue, but slower growth in business
sales and profits would produce a
gradual deceleration. While pressures
on production resources were likely
to abate to a degree as output growth
slowed, inflation was expected to
increase somewhat from its recent pace
in response to rising compensation costs
associated with persisting tightness in
labor markets, a limited rebound in
energy prices, and a diminishing drag on
non-oil import prices.
In the Committee's discussion of current and prospective economic developments, members noted the exceptional
strength in domestic final demand and
viewed robust further expansion in such
demand as highly likely. Final purchases
were being supported by accommodative financial conditions, especially
a rising equity market, by ebullient
consumer sentiment, and by business
spending on productivity-enhancing
equipment. While there were limited
indications of weakness in some sectors
of the economy—such as manufacturing, energy, and agriculture in some
areas—the members did not see conclusive evidence of appreciable moderation
in the pace of the overall economic
expansion. Nonetheless, they generally
believed that substantial moderation
in the expansion was a likely prospect
in coming quarters, largely as a consequence of a marked slowing in inventory investment from the clearly unsustainable pace of the first quarter and, to
a lesser extent, from some further weakness in net exports. The outlook for the
latter was especially uncertain, and the
weakness could be greater than previously anticipated owing to renewed turmoil in emerging Asian economies and
pronounced weakness in Japan. Whether
the moderation in U.S. economic growth
would be sufficient to forestall cost
increases arising from tight labor markets that in turn would add to pressures
on prices was open to question. To date,
developments in business costs had been
relatively benign, owing to an important
extent to somewhat faster productivity
growth. This circumstance and a number of one-time influences holding down
costs and prices had contained inflation
at rates that were lower than those seen
in several decades, and probably would
continue to do so for a while. But the
members generally were concerned that
inflation might begin to rise over the
intermediate term, especially if labor
markets tightened further.
In their assessment of the factors
underlying the persisting strength of
aggregate final demand, members took
particular note of the effect of accommodative financial conditions. The rapid
growth in consumer spending was being
bolstered by large gains in stock market
wealth; and the strength in housing and
other interest-sensitive consumer expenditures also reflected declines in nominal, and perhaps in real, intermediateand long-term interest rates and the
ample availability of loans. Likewise,
the ready availability of equity and debt
financing on favorable terms was a key
factor in the continuing robust growth
of business investment. Indeed, some
members expressed concern that the
widespread perceptions of reduced risk
or complacency that had bolstered
equity prices beyond levels that seemed
justified by fundamentals were beginning to be felt in a variety of other markets as well, including commercial and
residential properties, business ventures,
and land. In the view of a number of
members, rapid growth of the monetary
aggregates, though it had slowed very
recently, was a further indication that
Minutes of FOMC Meetings, May
financial conditions were not restraining
economic activity.
Despite the failure of domestic demand to moderate in line with their
earlier expectations, the members were
persuaded that appreciable slowing in
the growth of economic activity was
a likely prospect over the course of
coming quarters even though its exact
timing and extent were unknown. Key
elements in this assessment were the
outlook for inventories and net exports.
The surge in inventory accumulation in
the first quarter did not appear to have
resulted in overall stock imbalances
as evidenced by stock-sales ratios or
anecdotal reports. Even so, growth in
inventory investment at a pace sharply
exceeding the sustainable growth of
final sales was unlikely to continue for
an extended period. Given the ample
availability of industrial capacity and
the related absence of pressures on lead
or delivery times, business firms did
not need to build precautionary stocks.
Thus, inventory investment was likely
to respond to the expected deceleration
in final sales over coming quarters.
Some members expressed reservations
about the probable extent of the deceleration in the period ahead, especially
in the context of their expectations of a
still relatively robust uptrend in final
sales.
Developments in Asia clearly were
having adverse effects on a number of
U.S. industries, but the overall effects on
the U.S. economy appeared to have been
limited thus far. Indeed, the direct effects
of the Asian financial and economic
problems on U.S. trade over time needed
to be weighed against their indirect but
positive effects in the near term in helping to hold down U.S. interest rates and
in reducing the prices of oil and other
imported commodities. However, members were concerned that, as evidenced
by the most recent developments, con
149
ditions in Asian financial markets and
economies were deteriorating further,
with potentially adverse consequences
for net U.S. exports. Of particular concern in this regard was the possibility of
worsening economic conditions in Japan
and the negative implications not only
for U.S. trade with Japan but for worldwide trade and financial markets. Some
members also commented that unsettled
financial and economic conditions in
East Asia could tend to exacerbate the
economic problems of several important
emerging economies in other parts of
the world, including major Latin American trading partners of the United States.
On balance, forecasts of a limited further drag on U.S. net exports from developments in Asia were subject to substantial uncertainty, with the risks tilted
toward a greater effect on the U.S. economy than had been anticipated earlier.
Moreover, the lingering effects of the
dollar's appreciation last year against a
broad array of currencies would continue to depress the nation's foreign
trade position for some time.
The decline in the unemployment
rate to its lowest level in nearly three
decades underscored anecdotal reports
of further tightening in labor markets
in recent months and added to concerns
about the outlook for inflation. Though
the first-quarter data had not suggested
as steep an increase as a number of
observers had anticipated, labor compensation clearly was trending higher.
But as suggested by the rise until
recently in profit margins, businesses
had been able to realize productivity
gains that tended to offset the faster
increases in compensation costs. Indeed,
while the most recent data were difficult
to read, once likely revisions were taken
into account productivity improvements
could well be on a steeper uptrend than
had been estimated earlier. Even so, the
members remained concerned that if
150 85th Annual Report, 1998
pressures on labor resources continued
to intensify, the associated increases in
labor compensation would at some point
significantly exceed the gains in productivity. The resulting pressures on prices
might be muted, but probably only for a
time, by the inability of many business
firms in highly competitive markets to
raise their prices or to raise them sufficiently to offset rising costs. Some members emphasized that a number of developments that had held down prices,
including the dollar's sizable appreciation last year, the drop in world oil
prices, and the downtrend in employee
benefit cost increases, were unlikely to
be repeated over the coming year and
could even be reversed to a degree.
Members acknowledged, however, that
the nexus between labor market tightness, accelerating labor costs, and the
effects on price inflation was very difficult to ascertain and analyses based on
earlier patterns that pointed to rising
inflation had proved consistently wrong
in recent years.
In the Committee's discussion of
monetary policy for the intermeeting
period ahead, a majority of the members
indicated that they preferred or could
accept an unchanged policy. These
members also expressed a preference
for retaining the asymmetric instruction
in the directive that the Committee had
adopted at the previous meeting. In this
view, the uncertainties in the outlook
for economic expansion and inflation
remained sufficiently great to warrant a
continued wait-and-see policy stance.
Considerations underlying this view
included the possibility that financial
and economic conditions in Asia might
worsen further and exert a stronger
retarding effect on the performance of
the U.S. economy than presently seemed
to be in train. A good deal of uncertainty
also surrounded the potential extent to
which developments in the domestic
economy, notably the pace of inventory
accumulation over coming months,
might foster slower economic expansion and the related degree to which
pressures in labor markets would be
affected. Moreover, considerable questions remained about the relationship
of labor market pressures to inflation.
In these circumstances, it was possible
that inflation would continue to be contained, though the risks clearly seemed
to be tilted in the direction that action
would become necessary at some point
to keep inflation low.
While a delay in implementing a
tighter policy that ultimately proved
to be needed to curb rising inflation
involved some risks, many of the members concurred in the view that the
potential costs of postponing action for
a limited time were small. By some
measures, inflation had continued to
drop in the first quarter, and the appreciation of the dollar, reduced commodity
prices, and low—if not declining—
inflation expectations would help to hold
down nominal wage increases and price
pressures for some time, even if, as a
number of members suspected, the
economy was now producing beyond
its long-run potential. Forecasts of rising inflation had proved unreliable and
needed to be viewed in light of the
considerable uncertainties surrounding
them. The members recognized, however, that the longer any needed action
was delayed, the more important it
would be to take prompt and perhaps
vigorous action once the danger of rising
inflation became clearer.
Another reason for not taking action
at this meeting was the possibility that
even a modest tightening action could
have outsized effects on the already very
sensitive financial markets in Asia. The
resulting unsettlement could have substantial adverse repercussions on U.S.
financial markets and, over time, on the
Minutes of FOMC Meetings, May
U.S. economy. Many of the members
emphasized, however, that market considerations could not be allowed to jeopardize the effective conduct of a U.S.
monetary policy aimed at an optimal
performance of the U.S. economy.
Indeed, such a performance would best
serve the interests of troubled financial
markets and economies abroad.
A number of members indicated that
the decision was a close call for them. In
this regard, some emphasized that financial conditions were very accommodative in terms of the ample availability
of financing to most borrowers on very
attractive terms and increases in equity
prices. Several expressed concern that
the persistence of quite rapid monetary
growth this year was symptomatic of a
monetary policy that was not positioned
to restrain ebullient domestic demand
sufficiently, even if short-term real interest rates were quite high. Although some
of these members could accept postponing action for the present to await further information on the balance of risks,
two members, while acknowledging
the uncertainties that surrounded the
economic outlook, indicated a strong
preference for tightening the stance of
policy at this meeting. They believed
that current policy was accommodating excessive strength in aggregate
demand that very likely would be felt
in higher inflation before long. Prompt
tightening was needed to avert the
necessity of stronger and potentially disruptive policy actions later to contain
inflation.
All the members who intended to vote
for an unchanged policy at this meeting
supported the retention of a directive
that was biased toward restraint. In their
view, current developments did not call
for any policy action, at least at this
meeting, but because they felt the risks
were tilted in the direction of rising
inflation, a policy tightening move, pos
151
sibly in the near future, was a likely
though not an inevitable prospect.
At the conclusion of the Committee's
discussion, all but two of the members supported a directive that called
for maintaining conditions in reserve
markets that were consistent with an
unchanged federal funds rate of about
51/2 percent and that contained a bias
toward the possible firming of reserve
conditions and a higher federal funds
rate. Accordingly, in the context of the
Committee's long-run objectives for
price stability and sustainable economic
growth, and giving careful consideration
to economic, financial, and monetary
developments, the Committee decided
that a somewhat higher federal funds
rate would be acceptable or a slightly
lower federal funds rate might be
acceptable during the intermeeting
period. The reserve conditions contemplated at this meeting were expected to
be consistent with considerable moderation in the growth of M2 and M3 over
the months ahead.
The Federal Reserve Bank of New
York was authorized and directed, until
instructed otherwise by the Committee,
to execute transactions in the System
Account in accordance with the following domestic policy directive:
The information reviewed at this meeting
suggests that economic activity has continued to grow rapidly in 1998. Nonfarm payroll employment registered another substantial increase in April after a slight decline in
March, and the civilian unemployment rate
fell to 4.3 percent in April. However, factory
output has changed little on balance in recent
months. Retail sales grew appreciably in
April, and consumer spending as a whole has
been very strong this year. Residential sales
and construction also have strengthened this
year. Business fixed investment rebounded
sharply in the first quarter after having
declined slightly in the fourth quarter, and
available indicators point to continuing
strength over coming months. Business
152 85th Annual Report, 1998
inventories appear to have increased very of the Committee's long-run objectives for
rapidly in the first quarter. The nominal defi- price stability and sustainable economic
cit on U.S. trade in goods and services wid- growth, and giving careful consideration to
ened substantially in January and February economic, financial, and monetary developfrom its average monthly rate in the fourth ments, a somewhat higher federal funds rate
quarter. Despite indications of persisting would or a slightly lower federal funds rate
pressures on employment costs associated might be acceptable in the intermeeting
with tight labor markets, price inflation has period. The contemplated reserve conditions
remained subdued this year, primarily as a are expected to be consistent with considerconsequence of large declines in energy able moderation in the growth in M2 and M3
prices.
over coming months.
Most market interest rates have declined
slightly on balance over the intermeeting
Votes for this action: Messrs. Greenperiod. Share prices in U.S. equity markets
span, McDonough, Ferguson, Gramlich,
have moved up a little further. In foreign
Hoenig, Kelley, Meyer, Mses. Minehan,
exchange markets, the trade-weighted value
Phillips, and Rivlin. Votes against this
of the dollar in terms of major currencies has
action: Messrs. Jordan and Poole.
changed little on net over the period. However, the dollar has risen on balance against
Mr. Poole dissented because he bethe currencies of key emerging market
economies, particularly those in Asia. Equity lieved that the sustained increase in
markets in Asia have fallen substantially money growth in recent quarters and
over the period to near their lows of late associated accommodative conditions
1997, while those in Europe have risen to
in the credit markets pointed to rising
new highs.
M2 and M3 expanded briskly further in inflation. Although faster productivity
April, but data for late April and early May growth suggested that trend output
show M2 declining and M3 leveling out. growth might be modestly higher than
The swing in these measures seemed to be previously thought, the growth rate of
related largely to movements of funds asso- aggregate demand over the past two
ciated with tax payments. Expansion of total years clearly had exceeded the econodomestic nonfinancial debt appears to have
moderated somewhat after a pickup earlier in my's long-run growth potential. Without a reduction of aggregate demand
the year.
The Federal Open Market Committee growth, inflation would rise. In his view,
seeks monetary and financial conditions that the Federal Reserve should therefore
will foster price stability and promote sus- take prompt action to reduce money
tainable growth in output. In furtherance
of these objectives, the Committee at its growth to limit the rise in inflation and
meeting in February established ranges for to avoid an increase in longer-term inflagrowth of M2 and M3 of 1 to 5 percent and tion expectations, which would tend to
2 to 6 percent respectively, measured from destabilize aggregate employment and
the fourth quarter of 1997 to the fourth quar- financial markets.
ter of 1998. The range for growth of total
Mr. Jordan also noted that the monedomestic non-financial debt was set at 3 to
7 percent for the year. The behavior of the tary and credit aggregates had accelermonetary aggregates will continue to be ated further from already rapid growth
evaluated in the light of progress toward rates in 1997. In his view, these high
price level stability, movements in their growth rates were fueling unsustainvelocities, and developments in the economy ably rapid increases of real estate and
and financial markets.
other asset prices, and reports of "too
In the implementation of policy for the much cash chasing too few deals" were
immediate future, the Committee seeks conditions in reserve markets consistent with becoming more frequent. Anticipated
maintaining the federal funds rate at an aver- gains on both real and financial investage of around 5'/2 percent. In the context ments had risen relative to the cost of
Minutes of FOMC Meetings, June-July
borrowed funds. In these circumstances,
it was increasingly likely that the Committee would face a choice between
smaller increases in interest rates sooner
versus larger increases later. He added
that maximum sustainable economic
growth occurs when businesses and
households act on the assumption that
the dollar will maintain its value over
time, and nothing he had heard from
consumer groups, bankers, or other business people in his District led him to
believe that decisions were being made
in the expectation that the purchasing
power of the dollar would be stable.
Furthermore, expectations that market
values of income-producing investments would continuously rise relative
to underlying earning streams were
not consistent with a stable purchasing
power of money. He also believed that
the view that real interest rates currently were high was not confirmed
by observed behavior. Bankers told him
that both consumers and businesses
believed that credit was cheap and plentiful. These potentially inflationary conditions and imbalances in the economy
were not conducive to sustained maximum growth.
It was agreed that the next meeting
of the Committee would be held on
Tuesday-Wednesday, June 30-July 1,
1998.
The meeting adjourned at 1:35 p.m.
Donald L. Kohn
Secretary
153
and continued on Wednesday, July 1,
1998, at 9:00 a.m.
Present:
Mr. Greenspan, Chairman
Mr. McDonough, Vice Chairman
Mr. Ferguson
Mr. Gramlich
Mr. Hoenig
Mr. Jordan
Mr. Kelley
Mr. Meyer
Ms. Minehan
Mr. Poole
Ms. Rivlin
Messrs. Boehne, McTeer, Moskow, 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. Gillum, Assistant Secretary
Mr. Mattingly, General Counsel
Mr. Baxter, Deputy General Counsel
Mr. Prell, Economist
Mr. Truman, Economist
Ms. Browne, Messrs. Dewald, Hakkio,
Lindsey, Simpson, and Stockton,
Associate Economists
Mr. Fisher, Manager, System Open
Market Account
Mr. Winn, Assistant to the Board,
Office of Board Members,
Board of Governors
Meeting Held on
June 30-July 1, 1998
Mr. Ettin, Deputy Director, Division
of Research and Statistics,
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.,
on Tuesday, June 30, 1998, at 1:30 p.m.
Messrs. Madigan and Slifman,
Associate Directors, Divisions of
Monetary Affairs and Research
and Statistics respectively,
Board of Governors
154 85th Annual Report, 1998
Messrs. Alexander, Hooper, and
Ms. Johnson, Associate Directors,
Division of International Finance,
Board of Governors
Mr. Reinhart, Assistant Director,
Division of Monetary Affairs,
Board of Governors
Messrs. Small,3 Reifschneider,3 and
Whitesell, Section Chiefs,
Divisions of Monetary Affairs,
Research and Statistics, and
Monetary Affairs respectively,
Board of Governors
Ms. Kusko,4 Senior Economist,
Division of Research and
Statistics, Board of Governors
Mr. Elmendorf4 and Ms. Garrett,
Economists, 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
Messrs. Beebe, Eisenbeis, Goodfriend,
Hunter, Lang, Rosenblum, and
Steindel, Senior Vice Presidents,
Federal Reserve Banks of
San Francisco, Atlanta, Richmond,
Chicago, Philadelphia, Dallas, and
New York respectively
Ms. Perelmuter, Vice President,
Federal Reserve Bank of
New York
Mr. Bryan, Assistant Vice President,
Federal Reserve Bank of
Cleveland
3. Attended portion of the meeting relating to
the discussion of the Committee's consideration of
its monetary and debt ranges for 1998 and 1999.
4. Attended portions of the meeting relating to
the Committee's review of the economic outlook
and consideration of its monetary and debt ranges
for 1998 and 1999.
Mr. Weber, Senior Research Officer,
Federal Reserve Bank of
Minneapolis
By unanimous vote, the minutes of
the meeting of the Federal Open Market
Committee held on May 19, 1998, were
approved.
The Manager of the System Open
Market Account reported on developments in foreign exchange markets and
on System transactions in those markets
during the period May 19, 1998, through
June 30, 1998. By unanimous vote, the
Committee ratified these transactions.
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 19, 1998, through June 30, 1998.
By unanimous vote, the Committee ratified these transactions.
The Committee then turned to a discussion of the economic and financial
outlook, the ranges for the growth of
money and debt in 1998 and 1999, 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 the expansion in
economic activity had slowed considerably after a very rapid advance in the
first quarter. Much of the slowdown
reflected a substantial moderation in
business inventory accumulation. Consumer spending, business investment,
and residential homebuilding, though
remaining robust, apparently also were
decelerating somewhat after very strong
Minutes of FOMC Meetings, June-July
gains in the first quarter; and the erosion
in net exports continued to damp demand for domestically produced goods.
Payroll employment persisted on a
brisk uptrend, but industrial production
seemed likely to record only modest further expansion in the second quarter.
Labor markets remained tight, and there
were indications of some further acceleration in employment costs. Recent
data on consumer prices were a little
less favorable than they had been earlier
in the year.
Nonfarm payroll employment registered substantial increases in April
and May despite further job losses in
manufacturing. Construction payrolls
declined in May, but they were up
sharply on balance over the April-May
period following substantial gains earlier in the year. Employment increases
in service-producing industries, notably
business services and retail and wholesale trade, continued to be robust. The
civilian unemployment rate stayed at
4.3 percent in May, and initial claims
for unemployment insurance remained
low through mid-June, after taking into
account the onset of layoffs associated
with the strike at General Motors.
Industrial production picked up in
April and May after having changed
little in the first quarter, but the strike
at General Motors likely depressed
industrial production substantially in
June. In manufacturing, the output of
motor vehicles rose briskly on balance
over April and May, and the production
of computers and office equipment
remained robust. Growth in the manufacture of materials slowed sharply, perhaps reflecting the effects of reduced
exports to Asia. Output of utilities,
which continued to fluctuate widely,
changed little on balance over the AprilMay period. The rate of utilization of
manufacturing capacity edged down in
May to its lowest level in more than two
155
years as capacity grew at a faster rate
than output.
Total nominal retail sales posted large
gains in April and May. Sales were
strong at automotive dealers in response
to a sharp increase in incentives offered
by the Big Three automakers. Sales
also rose briskly at building material
and supply outlets and at general merchandise, apparel, and furniture and
appliance stores. Although the growth in
real outlays for services in April (latest
data available) was held down by a
small decline in purchases of energy
services, the expansion of outlays for
non-energy services remained brisk.
Sales of homes were very strong in
April and May, but housing starts and
building permits declined slightly on
a seasonally adjusted basis from their
elevated first-quarter rates.
Available information suggested that
the growth of business fixed investment
slowed somewhat in the second quarter
from a very strong pace earlier in the
year. A deceleration in expenditures
for producers' durable equipment, after
the surge in purchases of computer and
communications equipment in the first
quarter, apparently more than offset a
pickup in spending on nonresidential
structures. The recent upturn in building
activity was consistent with the continuing indications of declining vacancy
rates and rising real estate prices, but
available data on construction contracts
did not point to further strength in nonresidential construction.
Business
inventory
investment
slowed sharply in April from the extraordinarily rapid rate of accumulation in
the first quarter. In manufacturing,
stockbuilding picked up somewhat in
April from the first-quarter pace, but
with sales also rising, the stock-sales
ratio remained at a very low level.
Wholesale inventories declined sharply
in April, primarily reflecting runoffs in
156 85th Annual Report, 1998
stocks of motor vehicles; the inventorysales ratio for the sector remained near
the upper end of its range over the
preceding twelve months. Retail inventory accumulation slowed somewhat in
April, and the aggregate inventory-sales
ratio stayed close to the lower end of its
range over the past year.
The nominal deficit on U.S. trade in
goods and services widened further in
April, as the value of exports declined
more than that of imports. Exports of
aircraft and parts dropped sharply from
the first-quarter level, and exports of
industrial supplies decreased by lesser
amounts. Most of the decline in imports
was in capital goods and automotive
products. Recent information suggested
a mixed economic performance among
the major foreign industrial countries.
Economic activity in Japan contracted
sharply in the first quarter after having
declined slightly in the fourth quarter,
and many other economies in Asia
remained quite weak. The Asian crises
held down exports of the major European countries, partly offsetting the
influence of strong domestic demand.
Consumer prices advanced at a
slightly faster rate in May as an upturn
in energy prices and a large increase in
food prices more than offset a slower
rate of increase in the prices of nonfood,
non-energy items. Core consumer prices
accelerated during the three months
ended in May, largely reflecting higher
tobacco prices and shelter costs. Nonetheless, core consumer prices rose less
over the twelve months ended in May
than they had over the previous twelve
months. At the producer level, prices of
finished goods other than food and
energy continued to rise at a subdued
rate in May. For the twelve months
ended in May, core producer prices rose
by a small amount after having changed
little in the year-earlier period. At the
intermediate level, core producer prices
edged down in May and were little
changed on net over the twelve months
ended in May. Average hourly earnings
of production or nonsupervisory workers increased at a slightly faster rate
on balance over April and May. Measured on a year-over-year basis, average
hourly earnings accelerated further in
the year ended in May. The largest gains
were in business services and finance,
insurance, and real estate, but marked
acceleration also was evident in wholesale and retail trade. By contrast, gains
in manufacturing had changed little over
the past three years.
At its meeting on May 19, 1998, the
Committee adopted a directive that
called for maintaining conditions in
reserve markets that would be consistent
with the federal funds rate continuing
to average around 5!/2 percent. In light
of concerns that growth in aggregate
demand might remain so strong relative
to the expansion of the economy's
potential that inflationary pressures
would tend to be generated, the Committee chose to retain an asymmetric
directive tilted toward a possible firming
of reserve conditions and a higher federal funds rate. The reserve conditions
associated with this directive were
expected to be consistent with considerable moderation in the growth of M2
and M3 over the months ahead.
Open market operations were directed
throughout the intermeeting period
toward maintaining the existing degree
of pressure on reserve positions, and the
federal funds rate averaged close to
the intended level of 5Vi percent. Market participants interpreted the further
turmoil in financial markets in Asia
and emerging market economies elsewhere as damping the outlook for U.S.
economic growth and improving the
chances that inflation would remain
low. While most short-term interest
rates changed little on balance over the
Minutes of FOMC Meetings; June-July
period, yields on longer-term Treasury
securities, and to a lesser extent on private debt instruments, declined somewhat, at least partly reflecting a further flight to safety and quality from
renewed turbulence in a number of foreign markets. Share prices in U.S. equity
markets remained volatile, and changes
in major indexes were mixed on balance
over the intermeeting period.
In foreign exchange markets, the
trade-weighted value of the dollar in
terms of other major currencies continued to increase through the middle of
June, but it then retraced much of that
rise, ending the intermeeting period
somewhat higher on balance. The
recent fluctuations in the dollar's tradeweighted value were largely accounted
for by movements in the Japanese yen,
which reached an eight-year low against
the dollar in the middle of June in
response to growing market pessimism
about the prospects for a prompt resolution of Japan's financial sector problems
and for economic recovery in that country. The yen rebounded in mid-June in
response to coordinated intervention by
the Japanese and U.S. governments but
soon renewed its downward drift, partly
as a result of rising concerns that the
Japanese government would not take
prompt action to address weaknesses
in the country's banking sector and in
aggregate demand; the yen finished the
period substantially lower on balance.
The dollar changed little on net against
the German mark and other continental
European currencies; declines in longterm interest rates in those countries
generally matched the drop in yields on
comparable U.S. instruments. Against
the backdrop of weakness in the yen, the
currencies of key emerging market
economies, particularly some of those in
Asia, fell further against the dollar.
Growth of M2 and M3 slowed in
the second quarter but remained fairly
157
robust. Households accumulated unusually large deposit balances to make hefty
nonwithheld tax payments in April, and
these balances ran off in May as tax
checks cleared; averaging through these
gyrations, the expansion of the broad
aggregates slowed on balance over
April and May, and preliminary data
suggested further slowing in June.
The growth of M3 remained a little
faster than that of M2, reflecting the
further progress made by institutiononly money market funds in attracting
corporate cash-management business.
For the year through June, both aggregates rose at rates well above the Committee's ranges for the year. Expansion
of total domestic nonflnancial debt
appeared to have moderated somewhat
after picking up earlier in the year; the
moderation evidently reflected some
slowing in the growth of business and
household borrowing as well as paydowns of federal debt made possible by
robust tax revenues.
The staff forecast prepared for this
meeting indicated that economic activity would expand more slowly over the
projection period than it had in recent
years. Moderation in business inventory
investment would damp domestic production as inventory accumulation was
brought into better balance with the
expected more moderate trajectory of
final sales. In addition, reduced growth
of foreign economic activity and the
lagged effects of the sizable earlier rise
in the foreign exchange value of the
dollar were anticipated to place substantial restraint on the demand for U.S.
exports and to lead to further substitution of imports for domestic products.
The staff analysis suggested that the prospective gains in income coupled with
the run-up that had occurred in household wealth would support further brisk,
though gradually diminishing, increases
in consumer spending. Housing demand
158 85th Annual Report, 1998
was expected to remain at a generally
high level in the context of the persisting favorable cash flow affordability
of home ownership, though the slower
income growth anticipated over the projection period would damp homebuilding somewhat. Growth in business fixed
investment would gradually moderate
from the vigorous pace of the first
half of the year in response to smaller
increases in business sales and profits.
Pressures on labor resources were likely
to diminish somewhat as the expansion
of economic activity slowed, but underlying inflation was expected to pick
up gradually as gains in compensation
increasingly outpaced improvements in
productivity.
In the Committee's discussion of current and prospective economic developments, the members generally agreed
that the expansion in economic activity
was likely to be relatively moderate over
coming quarters, and that such growth
would be consistent with some limited
increase in inflation from the current
unusually low level. The accumulation
of business inventories, which until
recently had added substantially to economic growth, was expected to continue
at a much lower and more sustainable
pace. Moreover, the effects on the U.S.
trade balance of the appreciated value of
the dollar and of economic weakness in
several of the nation's trading partners
probably would hold down increases
in domestic output in coming quarters.
Many of the members commented, however, that the already substantial risks
surrounding the economic outlook had
increased on both sides of their forecasts. On the downside, the greater risks
focused on potential developments in
Asia. Financial and economic conditions in Asia had deteriorated in recent
months, and the members could not rule
out the possible emergence of even
greater financial turmoil and economic
weakness in that part of the world that
could spill over to other countries,
including the United States. On the
upside, in the absence of strongly retarding effects from developments in Asia,
persistent strength in domestic final
demand might well add to inflationary
pressures. Indeed, there were signs of
modestly rising inflation in some recent
measures of prices, though the rate of
inflation was still relatively subdued.
In keeping with the practice at meetings when the Committee sets its longrun ranges for the money and debt
aggregates, the members of the Committee and the Federal Reserve Bank presidents not currently serving as members
provided individual projections of the
growth in real and nominal GDP, the
rate of unemployment, and the rate of
inflation for the years 1998 and 1999.
The forecasts of the rate of expansion
in real GDP for 1998 as a whole had
a central tendency of 3 to 3lA percent,
which implied some moderation over
the second half from staff estimates at
the time of this meeting of the average
rate of growth in the first and second
quarters; for 1999 the forecasts pointed
to moderate growth and were centered
on a range of 2 to 2Vi percent. These
projected rates of economic growth were
accompanied by a very slight rise in the
civilian rate of unemployment over the
next eighteen months to still quite low
rates centering on 4Vi to 43A percent in
the fourth quarter of 1999. With regard
to the growth of nominal GDP, most of
the forecasts were in ranges of 4!/2 to
5 percent for 1998 and 4lA to 5 percent
for 1999. Projections of the rate of inflation, as measured by the consumer price
index, indicated a slightly faster rise
over the second half of this year and in
1999, largely because of expectations
that the plunge in energy prices earlier
in the year would not be repeated. Specifically, the projections converged on
Minutes of FOMC Meetings, June-July
CPI inflation rates of \3A to 2 percent
for 1998 as a whole and 2 to 2Vi per
cent in 1999.
In their review of developments in
different parts of the country, Reserve
Bank presidents reported high levels of
business activity across the nation, but
several also indicated that there were
signs of some slowing in the expansion
of regional economic activity. With
regard to the nation as a whole, members noted that rising levels of employment and incomes were continuing to
foster solid growth in consumer spending, a development that was abetted by
the sharp increases that had occurred in
household wealth as a consequence of
the extended uptrend in stock market
prices and to a lesser extent the appreciation of home prices. However, some
anecdotal and other evidence suggested
that retail sales had moderated in recent
weeks in at least some areas; the moderation appeared to be only partly associated with the work stoppage at General Motors. The apparent deceleration
in retail sales could prove to be temporary, though some slowing in the growth
of overall consumer spending over the
forecast horizon, perhaps to a pace more
in line with the growth of disposable
income, was viewed as a reasonable
expectation, especially with equity price
gains of recent years unlikely to be
repeated.
Business fixed investment remained
on a strong uptrend, buoyed by several
favorable factors. The latter included the
ready availability of debt and equity
financing on relatively attractive terms,
and opportunities to invest in high-tech
equipment at lower prices to enhance
productivity and hold down labor costs
in a period of very tight labor markets.
While these factors were expected to
support appreciable further expansion in
business investment, growth in demand
for capital goods was likely to diminish
159
as a result of the projected slowing in
the expansion of final sales and business
profits and the absence of pressure on
manufacturing capacity. With regard to
the outlook for nonresidential construction, members reported that declining
vacancy rates and rising prices and rents
of office buildings and to some extent
other commercial structures were fostering very high levels of construction
activity in several areas. Moreover, there
were indications that some construction
projects were being delayed because of
scarcities of labor or construction materials. A number of members commented
that some of the construction was being
undertaken on a speculative basis and
that the strong pace of building activity
pointed to overbuilding in some areas.
On the residential side, construction
activity also displayed considerable
strength across much of the country.
There were widespread anecdotal and
other reports of high levels of home
sales and few reports of faltering housing demand. Favorable factors undergirding current housing activity, including the robust growth in employment
and incomes, high wealth-to-income
ratios, and very attractive terms on home
mortgages, seemed likely to continue to
hold housing construction close to current elevated levels.
Based on very partial data, business
inventory investment appeared to have
moderated considerably in the second
quarter from an unsustainable pace in
the first quarter, and some further reductions in inventory accumulation could
be expected over the balance of the year.
Several members commented, however,
that despite the outsized rate of stockbuilding early in the year, there were
no broad indications of an inventory
overhang, whether from the standpoint
of inventory-sales ratios or anecdotal
expressions of concern. Against this
background, many of the members saw
160 85 th Annual Report, 1998
little reason to anticipate a further sizable drop in nonfarm inventory investment, though the performance of this
sector of the economy was always subject to a high degree of uncertainty.
With regard to the external sector of
the economy, the recent deterioration of
conditions in Japan and several emerging economies in Asia and the related
effects on other countries around the
world were adding significantly to the
uncertainties facing the U.S. economy.
Members commented that it was too
soon to judge the eventual extent and
duration of the turmoil in Asia and its
spillover to other nations, but several
suggested that the consequences were
likely to be more severe and longer lasting than they had anticipated earlier.
Moreover, there seemed to be a very
small but growing possibility of marked
and spreading weakness that might have
a more major effect on U.S. financial
markets and the U.S. economy. One key
to an improvement in the outlook for
Asia was the adoption of appropriate
policies by Japan, but very difficult
political as well as economic problems
clearly were involved for that nation and
their resolution might well require an
extended period of internal deliberations. From the standpoint of the United
States, the Asian crisis and its repercussions around the world obviously were
deepening the nation's trade deficit, but
other effects such as those on U.S. interest rates and prices in world commodity
markets, notably oil, were boosting
domestic demand and tended to have
a moderating near-term influence on
inflation.
With regard to the outlook for prices
and wages, members observed that some
key measures of price inflation had displayed a modest uptilt recently. Though
overall price inflation had remained subdued when viewed over a longer horizon, signs of a continuing acceleration,
should they become evident, would be a
matter of growing concern. Reflecting
very tight labor markets, the rate of
increase in labor compensation had been
on an uptrend, but the rise in unit labor
costs and overall unit product costs had
been held down to a very modest pace
by gains in productivity. At some point,
however the advance in labor compensation would exceed likely improvements
in productivity by an increasing margin
unless the expansion in overall demand,
and hence in labor demand, moderated
significantly. Members cited greater,
albeit still occasional, indications of
heightened worker demands in labor
negotiations that likely were encouraged
in part by ample job opportunities. Any
tendency for faster increases in labor
costs to feed through to price inflation
was likely to be reinforced for a time by
the unwinding of a number of special
factors that had tended to hold inflation
down, including the decline in energy
prices in recent quarters and the dollar's
appreciation during 1997. Moreover, a
rise in inflation would tend to erode
currently favorable inflation expectations and lead workers to demand higher
nominal compensation. Nonetheless,
questions could be raised about how rapidly and to what extent the effects of
tight labor markets would show through
to higher labor compensation and overall producer costs and in turn how
quickly the latter would induce significantly faster increases in prices. Very
competitive domestic and international
markets for a wide range of products
along with reduced prices of oil, other
commodities, and imports more generally could well keep inflation in check
for some time. It was noted in this
regard that members had tended in
recent years to anticipate greater inflation than had materialized.
In keeping with the requirements of
the Full Employment and Balanced
Minutes of FOMC Meetings, June-July
Growth Act of 1978 (the HumphreyHawkins Act), the Committee at this
meeting reviewed the ranges for growth
of the monetary and debt aggregates that
it had established in February for 1998
and also decided on tentative ranges for
those aggregates in 1999. The current
ranges for the period from the fourth
quarter of 1997 to the fourth quarter of
1998 were unchanged from the ranges
for other recent years and included
expansion of 1 to 5 percent for M2 and
2 to 6 percent for M3. An unchanged
range of 3 to 7 percent also was set in
February for growth of total domestic
nonfinancial debt in 1998.
All the members favored or could
support the retention of the current
ranges for this year and their extension
on a provisional basis to 1999. They
took note of a staff projection that
indicated that, given the Committee's
expectations for the performance of the
economy and prices and assuming no
major changes in interest rates, growth
of M2 and M3 probably would exceed
the current ranges in 1998 and decline to
a little below the upper end of those
ranges in 1999. Both M2 and M3 had
grown unusually quickly relative to
spending in the first half of the year. The
staff analysis suggested that some of the
forces that might have been responsible
for this decline in velocity would abate,
and the projections anticipated that the
velocity of M2 would be roughly in line
with historical experience before the
early 1990s, as it had been, on balance,
for several years.
In their discussion of the choice of
ranges for growth of M2 and M3 in
1998 and 1999, the members agreed that
those ranges should not reflect forecasts
of money growth under anticipated
economic and financial conditions, but
instead should be viewed as anchors
or benchmarks for money growth that
would be associated with price stability
161
and sustained economic growth, assuming behavior of velocity in line with
historical experience. Reaffirming the
current ranges for 1998 and extending them to 1999 would thus underscore
the Committee's commitment to a policy of achieving price stability over
time. In the view of a few members, the
Committee should consider adopting
ranges centered on its expectations
for growth of the monetary aggregates
in the future, but only if the members
became more confident about the relationship between the growth of money
and measures of aggregate economic
performance and undertook to give
more weight to the growth of the broad
monetary aggregates in setting monetary policy. Some members noted that
retention of the current monetary ranges
oriented toward price stability did
not preclude greater use of the aggregates in assessing overall financial conditions and the formulation of monetary policy. The Committee agreed
that the current range for nonfinancial
debt for 1998 should be left unchanged
and that the same range should be
extended to 1999. The current range
readily encompassed the growth rate
seen likely to be associated with the
members' forecasts for economic activity and prices.
At the conclusion of this discussion,
the Committee voted to reaffirm the
ranges for growth of M2, M3, and total
domestic nonfinancial debt that it had
established in February for 1998 and
to extend those ranges on a tentative
basis to 1999. In keeping with its
usual procedure under the HumphreyHawkins Act, the. Committee would
review its preliminary ranges for 1999
early next year. Accordingly, the Committee voted to incorporate the following statement regarding the 1998
and 1999 ranges in its domestic policy
directive:
162 85 th Annual Report, 1998
The Federal Open Market Committee seeks monetary and financial conditions
that will foster price stability and promote
sustainable growth in output. In furtherance of these objectives, the Committee
reaffirmed at this meeting the ranges it had
established in February for growth of M2
and M3 of 1 to 5 percent and 2 to 6 percent
respectively, measured from the fourth quarter of 1997 to the fourth quarter of 1998. The
range for growth of total domestic nonfinancial debt was maintained at 3 to 7 percent for the year. For 1999, the Committee
agreed on tentative ranges for monetary
growth, measured from the fourth quarter of
1998 to the fourth quarter of 1999, of 1 to
5 percent for M2 and 2 to 6 percent for M3.
The Committee provisionally set the associated range for growth of total domestic nonfinancial debt at 3 to 7 percent for 1999. The
behavior of the monetary aggregates will
continue to be evaluated in the light of
progress toward price level stability, movements in their velocities, and developments
in the economy and financial markets.
Votes for this action: Messrs. Greenspan, McDonough, Ferguson, Gramlich,
Hoenig, Jordan, Kelley, Meyer, Ms. Minehan, Mr. Poole, and Ms. Rivlin. Votes
against this action: None.
In the Committee's discussion of policy for the intermeeting period ahead, all
but one of the members indicated that
they could support an unchanged policy
stance and retention of the current tilt
toward possible tightening in the directive. Although recent developments had
increased both the upside and the downside uncertainties in the economic outlook, most of the members felt that the
risks continued to point on balance
toward rising inflation. While the available evidence suggested that the economic expansion had in fact slowed considerably in the second quarter, largely
because of reduced inventory accumulation against the backdrop of weakness
in the foreign trade sector, the retarding
effects of those factors were seen as
likely to wane over coming quarters and
there were only limited indications of
any softening in domestic final demand.
Moreover, the persistence of accommodative financial conditions, as evidenced
by the ample availability of financing on
favorable terms to business and household borrowers and by robust monetary
growth, might well continue to support
relatively strong domestic spending. As
a consequence, many of the members
expressed concern that the expansion in
demand might continue at a fast enough
pace to raise pressures on wages and
prices over time. Nonetheless, the substantial uncertainties relating to prospective developments argued, as they had at
recent meetings, in favor of a cautious
"wait and see" policy stance.
Another important reason for deferring any policy action was that a tightening move would involve the risk of
outsized reactions and consequent destabilizing effects on financial markets in
the growing number of countries abroad
that were experiencing severe financial
difficulties. It was not possible to anticipate precisely what those effects might
be, but the risks seemed to be particularly high at this time. To be sure, U.S.
monetary policy had to be set ultimately
on the basis of the needs of the U.S.
economy, but recognition had to be
given to the feedback of developments
abroad on the domestic economy. Those
repercussions could be quite severe in
the event of further sizable economic
and financial disturbances in some of
the nation's important trading partners.
Many members concluded that because
there did not seem to be any urgency to
tighten current policy for domestic reasons, given the likelihood that inflation
would remain subdued for a while,
important weight should be given to
potential reactions abroad. A number of
these members emphasized, however,
that they continued to see a high probability that some tightening of monetary
policy would be needed later to curb
Minutes of FOMC Meetings, June-July
rising inflationary pressures. Accordingly, they believed that the Committee
should take advantage of any early
opportunity to tighten policy in order
to improve the prospects of containing
inflation and prolonging the economic
expansion. One member was persuaded,
however, that such a policy move should
be implemented at this meeting in order
to avert the need for a stronger and
probably more disruptive policy adjustment that would be needed later to head
off rising inflation.
Given that the balance of risks was
seen as pointing to rising inflation over
time, the members agreed that it was
desirable to retain the tilt toward
restraint in the directive. Such a tilt
would continue to underscore the Committee's commitment to its long-run
objective of price stability and its view
of the likely direction of the next policy
move.
At the conclusion of the Committee's
discussion, all but one of the members
accepted a directive that called for maintaining conditions in reserve markets
that were consistent with an unchanged
federal funds rate of about 5Vi percent
and that contained a bias toward the
possible firming of reserve conditions
and a higher federal funds rate. Accordingly, in the context of the Committee's
long-run objectives for price stability
and sustainable economic growth, and
giving careful consideration to economic, financial, and monetary developments, the Committee decided that
a somewhat higher federal funds rate
would be acceptable or a slightly lower
federal funds rate might be acceptable
during the intermeeting period. The
reserve conditions contemplated at this
meeting were expected to be consistent
with moderate growth in M2 and M3
over the months ahead.
The Federal Reserve Bank of New
York was authorized and directed, until
163
instructed otherwise by the Committee,
to execute transactions in the System
Account in accordance with the following domestic policy directive:
The information reviewed at this meeting suggests that the expansion in economic activity has slowed considerably after
a very rapid advance in the first quarter.
Nonfarm payroll employment registered
another substantial increase in May, and the
civilian unemployment rate was unchanged
at 4.3 percent. Industrial output picked up
in recent months after weakening early this
year; however, a strike at General Motors
likely depressed output substantially in June.
Although retail sales posted large gains in
April and May, overall consumer spending
appears to have grown less rapidly in the
second quarter than in the first. Residential
sales have remained exceptionally strong,
but housing starts and building permits
slipped back in the spring, on a seasonally
adjusted basis, from a sharply increased firstquarter level. Available indicators suggest
that growth of business fixed investment also
is slowing after a surge earlier in the year.
Business inventory accumulation appears to
have moderated in April from an extraordinarily rapid rate in the first quarter. The
nominal deficit on U.S. trade in goods and
services continued to widen in April. Developments in the food and energy sectors contributed to a slightly faster advance in consumer prices in May.
Most short-term interest rates have
changed little since the meeting on May 19,
but longer-term rates have declined somewhat. Share prices in U.S. equity markets
remained volatile and changes in major
indexes were mixed on balance over the
intermeeting period. In foreign exchange
markets, the trade-weighted value of the dollar rose sharply through mid-June in terms
of other major currencies, declined more
recently, but is up somewhat on net since the
May meeting; the fluctuations in the average
value of the dollar in terms of these major
currencies were largely related to movements against the Japanese yen. The dollar
has risen further against the currencies of
key emerging market economies, particularly some of those in Asia.
Growth of M2 and M3 slowed in the
second quarter, but remained fairly robust.
For the year through June, both aggregates
164 85th Annual Report, 1998
rose at rates well above the Committee's
ranges for the year. Expansion of total
domestic nonflnancial debt appears to have
moderated somewhat after a pickup earlier in
the year.
The Federal Open Market Committee
seeks monetary and financial conditions that
will foster price stability and promote sustainable growth in output. In furtherance of
these objectives, the Committee reaffirmed
at this meeting the ranges it had established
in February for growth of M2 and M3 of 1 to
5 percent and 2 to 6 percent respectively,
measured from the fourth quarter of 1997
to the fourth quarter of 1998. The range for
growth of total domestic nonflnancial debt
was maintained at 3 to 7 percent for the year.
For 1999, the Committee agreed on tentative
ranges for monetary growth, measured from
the fourth quarter of 1998 to the fourth quarter of 1999, of 1 to 5 percent for M2 and 2 to
6 percent for M3. The Committee provisionally set the associated range for growth of
total domestic nonflnancial debt at 3 to 7 percent for 1999. The behavior of the monetary
aggregates will continue to be evaluated
in the light of progress toward price level
stability, movements in their velocities, and
developments in the economy and financial
markets.
In the implementation of policy for the
immediate future, the Committee seeks conditions in reserve markets consistent with
maintaining the federal funds rate at an average of around 5V2 percent. In the context
of the Committee's long-run objectives for
price stability and sustainable economic
growth, and giving careful consideration to
economic, financial, and monetary developments, a somewhat higher federal funds rate
would or a slightly lower federal funds rate
might be acceptable in the intermeeting
period. The contemplated reserve conditions
are expected to be consistent with moderate
growth in M2 and M3 over coming months.
Votes for this action: Messrs. Greenspan, McDonough, Ferguson, Gramlich,
Hoenig, Kelley, Meyer, Ms. Minehan,
Mr. Poole, and Ms. Rivlin. Votes against
this action: Mr. Jordan.
Mr. Jordan dissented because he
believed that the unsustainably rapid
growth of domestic demand—fueled by
the acceleration of money and credit
Digitized growth in the past year—was reflected
for FRASER
in the recent sharp increase in imports
and rising trade deficits. As U.S. output
growth slows significantly from the
rapid pace of 1997 and early 1998, it
will be essential that domestic demand
also slow. The very welcome progress
toward eliminating inflation in recent
years has contributed to the outstanding
performance of the economy. Allowing
domestic demand to continue to exceed
domestic production would run the risk
that corrosive effects of rising inflation
would undermine future growth prospects. Furthermore, the resultant trade
and current account deficits would have
to be matched by ever larger inflows
of foreign capital. Modest monetary
restraint at this time might prevent either
the buildup of inflationary imbalances
that would eventually necessitate future
policy restraint or unsustainable capital
flows. In either case an economic contraction might become unavoidable.
The meeting adjourned at 12:40 p.m.
Donald L. Kohn
Secretary
Meeting Held on
August 18, 1998
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 18, 1998, at
9:00 a.m.
Present:
Mr. Greenspan, Chairman
Mr. McDonough, Vice Chairman
Mr. Ferguson
Mr. Gramlich
Mr. Hoenig
Mr. Jordan
Mr. Kelley
Mr. Meyer
Ms. Minehan
Mr. Poole
Ms. Rivlin
Minutes of FOMC Meetings, August
Messrs. Boehne, McTeer, Moskow, and
Stern, Alternate Members of the
Federal Open Market Committee
Messrs. Guynn and Parry, Presidents
of the Federal Reserve Banks of
Atlanta and San Francisco
respectively
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
Mr. Prell, Economist
Mr. Truman, Economist
Messrs. Cecchetti, Dewald, Hakkio,
Lindsey, Simpson, Sniderman, and
Stockton, Associate Economists
Mr. Fisher, Manager, System Open
Market Account
Mr. Ettin, Deputy Director, Division
of Research and Statistics,
Board of Governors
Messrs. Madigan and Slifman,
Associate Directors, Divisions
of Monetary Affairs and Research
and Statistics respectively,
Board of Governors
Mr. Hooper and Ms. Johnson,
Associate Directors, Division
of International Finance,
Board of Governors
Mr. Reinhart, Deputy Associate
Director, Division of Monetary
Affairs, Board of Governors
Mr. Struckmeyer, Assistant Director,
Division of Research and
Statistics, Board of Governors
Ms. Low, Open Market Secretariat
Assistant, Division of Monetary
Affairs, Board of Governors
Ms. Strand and Mr. Varvel, First Vice
Presidents, Federal Reserve Banks
of Minneapolis and Richmond
respectively
165
Messrs. Beebe, Goodfriend, and
Rosenblum, Senior Vice
Presidents, Federal Reserve Banks
of San Francisco, Richmond, and
Dallas respectively
Messrs. Bolwell, King, Kopcke, Meyer,
and Sullivan, Vice Presidents,
Federal Reserve Banks of
New York, Atlanta, Boston,
Philadelphia, and Chicago
respectively
Mr. Weber, 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 30-July 1,
1998, were approved.
The Manager of the System Open
Market Account reported on developments in foreign exchange markets
during the period since the previous
meeting. There were no open market
operations in foreign currencies for
the System's account during this period,
and thus no vote was required of the
Committee.
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
July 1, 1998, through August 17, 1998.
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.
166 85 th Annual Report, 1998
The information reviewed at this
meeting suggested that domestic final
demand continued to expand at a robust
pace. However, increases in consumer
spending and business investment
seemed to be moderating somewhat
after very large gains earlier in the year,
and inventory investment had slowed
markedly. Net exports remained weak as
a result of the persisting turmoil in Asian
economies. The strike at General Motors
had damped overall economic activity
temporarily, but total payroll employment continued to trend upward, and
labor markets remained extremely tight.
Despite the pressures on labor resources,
trends in wages and prices had remained
stable in recent months.
Nonfarm payroll employment expanded further in July even though
manufacturing payrolls plunged in association with the General Motors strike;
job growth remained strong in most
nonmanufacturing sectors. Construction
employment continued to increase at
about the brisk pace recorded over the
first half of the year, and hiring in retail
trade surged. The expansion of jobs in
the services industry slowed considerably in July, but this partly reflected a
decline in temporary help jobs related
to the GM strike. The civilian unemployment rate was unchanged in July at
4.5 percent.
Industrial production declined considerably in June and July. Abstracting
from the effects of the GM strike, manufacturing output fell slightly over the
June-July period after having recorded
moderate gains on average in earlier
months of the year; production of business equipment expanded briskly in
June and July, while the output of consumer goods and materials weakened.
The rate of utilization of manufacturing
capacity was down appreciably in June
and July, mostly reflecting the effects of
the GM strike.
Total nominal retail sales fell in July
after having risen at a rapid pace in the
first half of the year. A sharp contraction
in spending for motor vehicles, reflecting the termination at midyear of sales
incentives offered by the Big Three
automakers and shrinking inventories at
GM dealers, more than accounted for
the drop in July. Non-auto-related outlays continued on a robust upward trend,
with gains evident in all major categories. Sales increases were particularly
large at furniture and appliance stores
and apparel outlets. In the housing sector, both demand and construction activity remained strong. Starts of singlefamily units edged down in May but
rebounded in June. Sales of new homes
were at an all-time high in June, and
sales of existing homes were only a
little below the record level reached in
March of this year. With sales robust,
the inventory of unsold new homes
remained low.
Growth of business fixed investment
slowed in the second quarter as the
pace of business spending for durable
equipment moderated considerably
from the exceptionally strong rate of
earlier in the year. Nonetheless, outlays for computer and communications
equipment continued to expand rapidly
in the second quarter, and purchases
of other capital goods rose briskly.
Available information suggested that
growth in business spending on capital goods likely would slow further
in the months ahead. In contrast to
the strength in equipment spending,
expenditures on nonresidential building
declined further in the second quarter,
and available indicators pointed to a
mixed outlook for this sector in coming
months.
Business
inventory
investment
slowed sharply in the second quarter,
owing in substantial measure to a runoff
of motor vehicle inventories at the
Minutes of FOMC Meetings, August
wholesale and retail levels. In manufacturing, stockbuilding slowed somewhat
in the second quarter, and the stockshipments ratio at the end of the quarter
remained close to the low level that had
prevailed over the past year. Wholesale
inventories changed little on balance in
the second quarter as a sizable decline
in motor vehicle stocks offset a buildup
of non-auto durable goods; in June, the
aggregate inventory-sales ratio for this
sector was at the upper end of its narrow
range for the past year. At the retail
level, a drop in inventories of motor
vehicles in the second quarter more
than offset a small increase in stocks
at non-auto retailers, and the aggregate
inventory-sales ratio in June was a little
below the lower end of its range for the
past year.
The nominal deficit on U.S. trade in
goods and services widened substantially further in the second quarter; the
value of exports of goods and services
declined for a second straight quarter,
while the value of imports continued to
rise, though at a somewhat reduced
pace. Much of the decline in exports in
the second quarter was in capital goods,
but there also were noticeable decreases
in most other major trade categories.
The increase in imports was concentrated in imported consumer goods, aircraft, and steel. Economic activity in
most of the major foreign industrial
countries continued to expand, though
at a slower rate, in the second quarter.
In Japan, however, economic activity
appeared to have contracted sharply further in the second quarter. In most other
Asian economies, currencies and equity
prices were under downward pressure,
and in Russia, asset values plummeted
in often disorderly markets. Risk
spreads on dollar-denominated debt
widened substantially, not only in Russia but for Latin American issuers as
well.
167
Price and wage inflation had remained
relatively stable in recent months. Both
the overall CPI and the CPI excluding
food and energy items rose slightly on
balance in June and July; a small rise in
food prices offset a noticeable decline
in energy prices over the two-month
period. For the twelve months ended
in July, the core CPI registered a slightly
smaller increase than it had in the yearearlier period, partly reflecting lower
prices for new motor vehicles. Producer
prices of finished goods changed little
on balance in June and July; a sizable
drop in the prices of energy products
over the June-July period more than
offset a modest rise in core producer
prices. For the year ended in July, core
producer prices rose somewhat more
than in the year-earlier period, reflecting
larger increases in the prices of finished
consumer goods. Hourly compensation
of private industry workers rose in the
second quarter at about the average rate
for the previous two quarters. For the
year ended in June, however, hourly
compensation picked up significantly
from the year-earlier period; the
acceleration in compensation was evident in wages and salaries and in
benefits.
At its meeting on June 30-July 1,
1998, the Committee adopted a directive that called for maintaining conditions in reserve markets that would
be consistent with the federal funds
rate continuing to average around
5!/2 percent. With the balance of risks
still pointing to the possibility of rising
inflation over time, the Committee
chose to retain an asymmetric directive tilted toward a possible firming
of reserve conditions and a higher federal funds rate. The reserve conditions
associated with this directive were expected to be consistent with moderate
growth in M2 and M3 over the months
ahead.
168 85th Annual Report, 1998
Open market operations were directed
throughout the period since the meeting
on June 30-July 1 toward maintaining the existing degree of pressure
on reserve positions, and the federal
funds rate averaged a little above the
intended level of 5XA percent. Most
other interest rates fell slightly on balance over the intermeeting period in
response to market assessments that
worsening conditions in Asia, Latin
America, and Russia portended slower
growth in U.S. output and inflation
over an extended period ahead. Declines in Treasury yields also reflected
a continuing flight toward safety and
quality from the persisting turbulence
in foreign markets. In an atmosphere
of increasing concerns about the prospects for corporate earnings, share
prices in U.S. equity markets remained
volatile and major indexes declined
appreciably on balance over the intermeeting period.
In foreign exchange markets, the
trade-weighted value of the dollar rose
somewhat further over the intermeeting
period in relation to other major currencies. The dollar changed little against
the continental European currencies, but
it moved up strongly against the Japanese yen and, to a lesser extent, the
Canadian dollar. The dollar's rise in
terms of the yen reflected spreading pessimism regarding the Japanese government's ability to redress the problems
of its troubled banking system and provide fiscal stimulus adequate to turn its
economy around. The dollar's advance
against the Canadian dollar occurred
in the context of continuing weakness
in global commodity prices that was
weighing down that currency. The dollar
also appreciated slightly in terms of an
index of the currencies of the developing countries of Latin America and Asia
that are important trading partners of the
United States.
After having expanded briskly in the
second quarter, M2 grew at a somewhat
more moderate rate in July, and M3
changed little. The deceleration in M2
reflected reduced inflows to retail money
market funds. The halt in the growth of
M3 was associated with a sharp runoff
of large time deposits and outflows from
institution-only money market funds
triggered by a temporary spike in interest rates on market instruments around
quarter-end. For the year through July,
both aggregates rose at rates well above
the Committee's ranges for the year.
Expansion of total domestic nonfinancial debt appeared to have moderated
somewhat in recent months after a
pickup earlier in the year.
The staff forecast prepared for this
meeting indicated that economic activity would expand through 1999 at a pace
somewhat below the estimated growth
of the economy's potential. Reduced
growth of foreign economic activity and
the lagged effects of the sizable earlier
rise in the foreign exchange value of the
dollar were anticipated to place substantial restraint on the demand for U.S.
exports and to lead to further substitution of imports for domestic products.
Moreover, additional moderation in
business inventory investment would
damp domestic production as inventory
accumulation was brought into better
balance with the forecast of a more
moderate trajectory of final sales. The
staff analysis suggested that the prospective gains in income coupled with the
earlier run-up in household wealth
would support further brisk, though
gradually diminishing, gains in consumer spending. Housing demand was
expected to remain relatively strong in
the context of the persisting favorable
cash flow affordability of home ownership, though the slower income growth
anticipated over the projection period
would damp homebuilding somewhat.
Minutes of FOMC Meetings, August
Growth in business fixed investment
would gradually moderate from the vigorous pace of the first half of the year
in response to smaller increases in
business sales and profits. Pressures on
labor resources were likely to diminish somewhat as the expansion of economic activity slowed, but inflation was
expected to pick up gradually as a result
of an anticipated reversal of some of the
decline in energy prices this year.
In the Committee's discussion of current and prospective economic conditions, members focused on the disparate
forces that continued to shape trends
in economic activity, notably the persistence of considerable strength in private
domestic spending and the damping
influences stemming from foreign economic developments. The latter seemed
likely to be larger than previously anticipated as financial turmoil in some
foreign economies had deepened and
spread and currently showed few signs
of stabilizing. Moreover, equity prices
and risk spreads in U.S. financial markets were beginning to be adversely
affected, potentially slowing domestic
demand. The members generally anticipated somewhat more moderate growth
than they had in their previous forecasts,
with prospective expansion at a pace
near or somewhat below the growth
of the economy's potential. Nonetheless, they remained concerned about the
potential for higher inflation, given the
widespread tightness in labor markets
and an upward tilt in the rise of labor
compensation. For the present, however,
inflation remained subdued, and it was
likely to remain relatively low for some
time in light of the weakness in commodity and other import prices and the
tendency for low current inflation to
hold down expected price increases.
Among the factors bearing on the outlook for domestic economic activity, the
members viewed the external sector as a
169
major source of uncertainty. The continued rapid decline in net exports during
the first half of the year largely seemed
to reflect the further financial unsettlement and a deeper contraction in Asian
economies than had been anticipated
earlier, and several members commented that they saw little evidence that
financial and economic conditions in
Asia were stabilizing. Indeed, such conditions appeared to be worsening further
in some Asian nations, and other countries had been affected by the associated
weakening in the demand for commodities and the more risk-averse attitudes
of investors. Anecdotal reports at this
meeting suggested that the impact on
the domestic economy was being felt by
manufacturing firms in several industries, although some firms also reported
that declining exports to Asia were
being offset at least in part by rising
exports to other areas of the world.
Looking ahead, the members agreed that
the duration and extent of disruptions
in Asian and other economies could not
be anticipated with any degree of confidence; while net exports were not
expected to decline as rapidly as they
had in the first half of the year, even
more serious disruptions in Asia could
not be ruled out and would have important implications for the U.S. economy.
In their review of developments in
key expenditure sectors of the domestic
economy, members observed that over
the first half of the year the strength in
domestic final demand, notably in the
consumer and business investment sectors, had more than offset the negative
effects of developments in the foreign
sector and other factors. In the consumer
sector, the outlook for further sizable
increases in spending was buttressed by
unusually favorable underlying factors,
including solid ongoing gains in employment and incomes and substantial
further increases in household net worth
170 85th Annual Report, 1998
this year. A pause in the robust gains
in retail sales in early summer was
accounted for in part by limited inventories of new motor vehicles associated
with the now-settled GM strike. While a
variety of factors pointed to sustained
growth in consumer spending, a less
ebullient stock market, should it persist,
would foster more moderate expansion
in consumer spending, perhaps at a pace
more in line with the rise in consumer
incomes, or at an even slower pace if
consumer confidence were adversely
affected by developments in financial
markets.
Business fixed investment also
seemed to be on a solid upward trajectory, though some slowing in the growth
of business investment spending was
anticipated in response to a projected
deceleration in overall business output
and weaker business profits. Members
continued to cite anecdotal evidence of
very strong construction activity in
many parts of the country, including
indications that building projects were
being delayed because of shortages of
labor and some construction materials.
In other parts of the country, building
activity remained at a high level but
seemed to have moderated somewhat.
Business spending for various types of
high-tech equipment had surged to an
undoubtedly unsustainable pace in the
first half of the year. Against this background, several members referred to
emerging signs of slightly more cautious attitudes among their business
contacts, in many cases the result of
concerns about developments in Asia.
On balance, diminishing momentum in
business investment appeared to be a
likely prospect, but the ample availability of financing on favorable terms
would continue to support this sector.
In the housing sector, construction
activity remained at a high level in most
parts of the nation and, as was the case
for construction activity more generally,
homebuilding continued to be restrained
in a number of areas by limits on the
availability of labor and other inputs.
The housing market clearly was benefiting from strong gains in household incomes, high levels of household
wealth, and very attractive financing
costs. There were few indications of any
moderation in this sector of the economy. Even so, some slowing was anticipated, at least after current construction
backlogs were satisfied, in response to
the projected slowing in employment
growth and the high level of the housing
stock.
Currently available data indicated that
the pace of inventory accumulation had
moderated substantially in the second
quarter. Nonetheless, the rate of nonauto inventory investment in the spring
still appeared to have exceeded a pace
that was consistent with sustainable
growth in sales. Anecdotal reports at
this meeting pointed to a somewhat
mixed picture with regard to desired
inventory levels, including examples of
both overstocking and shortages. Looking ahead and apart from short-run fluctuations, inventories were not expected
to add to demand over coming quarters, at least after the restocking of
motor vehicles by General Motors was
completed.
In the Committee's discussion of the
outlook for wages and prices, members
commented that the rate of inflation in
consumer prices was difficult to characterize with precision because alternative price indexes provided different
measurement results; in particular, chain
price indexes for consumption expenditures showed substantially less inflation
than the CPI. Even so, it was clear on
the basis of any measure that consumer
prices and inflation more generally had
remained remarkably subdued in the
context of very tight labor markets and
Minutes of FOMC Meetings, August 111
upward pressure on labor compensation.
And whatever the explanation, it seemed
that the economy had been less prone to
rising inflation than it had been historically under similarly tight labor market
conditions. The members acknowledged
that a number of special factors were
contributing to the relatively benign
inflation climate. Those factors included
the appreciation of the dollar; declines
in many commodity prices, notably that
of oil; ample industrial capacity; and
evidently diminished inflation expectations. Moreover, substantial gains in
productivity were muting the effects of
rising labor compensation on unit costs,
and vigorous competition in numerous
markets was continuing to make it very
difficult or impossible for business firms
to raise their prices to cover rising costs
or enhance profit margins. Against this
backdrop, members remained persuaded
that a significant rise in price inflation
was not likely to occur in the nearer
term.
Looking further ahead, however, the
members generally agreed that rising
price inflation remained an important
threat. Significant additional tightening
in labor markets would, of course, exacerbate that risk, but even at current levels these markets were tight and at some
point labor costs could increase more
rapidly, pressing on prices. Moreover,
the effects of some of the factors holding down inflation seemed likely to
wane, and possibly to reverse, over time.
The latter included the effects of the
dollar's appreciation on the prices of
imports and competing domestic products, a possible upturn in energy prices
and perhaps other commodity prices as
foreign economies stabilized, and faster
increases in the costs of worker benefits,
notably those related to health care. The
apparently greater willingness of labor
unions to press for higher wages and
other benefits in very tight labor markets
might also intensify upward pressures
on labor costs. On balance, while the
risks of an overheating economy and
rising price inflation might have faded
to some degree, many of the members
continued to emphasize that the Committee could not ignore those risks in its
policy formulation.
In the Committee's discussion of policy for the intermeeting period ahead, all
but one of the members agreed on the
desirability of maintaining a steady policy stance. The overall performance of
the economy remained highly satisfactory. While inflation risks were still a
concern, given the high level of output
and strong domestic demand, the uncertainties bearing on the economic outlook remained substantial, and indeed
the risks on the downside seemed
to have increased appreciably further.
On balance, domestic economic and
financial conditions had not changed
sufficiently during the intermeeting
period to warrant an adjustment to policy. With regard to the current uncertainties in the economic outlook, members
emphasized that the extent and ultimate
effects of the apparently spreading fragility in foreign financial markets and
economies on U.S. financial and economic conditions were unknown. In
these circumstances, nearly all the members believed that a cautious wait-andsee approach to policy seemed appropriate to allow the Committee time to
assess the course of events and the interplay of the divergent forces bearing on
the performance of the economy. In this
regard it was noted that while domestic
financial conditions remained generally
accommodative, recent developments
in foreign exchange and domestic financial markets had tended on balance to
decrease some of the stimulative effects
of financial conditions on aggregate
demand in the United States by shifting
demand overseas, increasing somewhat
172 85th Annual Report, 1998
the cost of raising capital, and reducing
the financial wealth of households.
However, a few members expressed
concern about the potentially inflationary implications of relatively rapid
growth in key monetary aggregates
over the past year, though such growth
appeared to have moderated recently.
And in the view of one of these members, the trend in monetary growth along
with indications of rising speculative
imbalances and excesses in various markets for financial and nonfinancial assets
called for a prompt firming of monetary
policy.
While overall economic conditions
had not changed enough in recent weeks
to warrant an adjustment in policy, a
majority of the members agreed that the
risks to the economic outlook were now
more balanced and called for a shift
from asymmetry to symmetry in the
Committee's directive. Such a directive
would better represent their view that
the Committee's next policy move could
be in either direction depending on
developments abroad and their interaction with a domestic economy that
had remained quite strong. Greater difficulties abroad and associated downward
pressures on demand and prices had substantially diminished the chances of a
strengthening of inflation pressures over
coming months and quarters that would
require a near-term tightening of policy.
Other members continued to believe that
the risks were still tilted to some degree
toward rising inflation, though to a
lesser extent than earlier. Labor market
developments continued to suggest that
the economy could well be producing
beyond its sustainable potential and concrete signs that inflation pressures would
abate had yet to emerge. Accordingly,
they still preferred an asymmetrical
directive but could accept symmetry in
light of the prevailing uncertainties in
the economic outlook and the expecta-
tion, shared by the other members, that
policy would not need to be changed
during the intermeeting period ahead.
At the conclusion of the Committee's
discussion, all but one of the members
were in favor of retaining a directive
that called for maintaining conditions
in reserve markets that were consistent
with an unchanged federal funds rate of
about 5lA percent. Most also indicated
that they could support a shift to a directive that did not include a presumption
about the likely direction of any adjustments to policy during the intermeeting
period. Accordingly, in the context of
the Committee's long-run objectives for
price stability and sustainable economic
growth, and giving careful consideration
to economic, financial, and monetary
developments, the Committee decided
that slightly greater or slightly lesser
reserve restraint would be acceptable
during the intermeeting period. The
reserve conditions contemplated at this
meeting were expected to be consistent
with moderate growth in M2 and M3
over coming months.
The Federal Reserve Bank of New
York was authorized and directed, until
instructed otherwise by the Committee,
to execute transactions in the System
Account in accordance with the following domestic policy directive:
The information reviewed at this meeting
suggests that domestic final demand has
continued to expand at a robust pace, but
overall economic activity has been adversely
affected by the strike at General Motors and
developments in Asia. Nonfarm payroll
employment continued to expand through
July and the civilian unemployment rate was
unchanged at 4.5 percent. Industrial production declined considerably in June and
July; most of the drop over the two months
reflected the GM strike. A decline in total
retail sales in July was more than accounted
for by a sharp contraction in spending for
motor vehicles. Residential sales and construction have remained exceptionally strong
Minutes of FOMC Meetings, August
in recent months. Available indicators point
to continued growth in business capital
spending, although apparently at a more
moderate pace than earlier in the year. Business inventory accumulation slowed sharply
in the spring. The nominal deficit on U.S.
trade in goods and services widened substantially further in the second quarter. Trends in
wages and prices have remained stable in
recent months.
Most interest rates have fallen slightly on
balance since the meeting on June 30-July 1.
Share prices in U.S. equity markets have
remained volatile and major indexes have
declined appreciably on balance over the
intermeeting period. In foreign exchange
markets, the trade-weighted value of the dollar rose somewhat further over the intermeeting period in relation to other major currencies; in addition, it was up slightly in terms
of an index of the currencies of the developing countries of Latin America and Asia
that are important trading partners of the
United States.
After robust growth in the second quarter,
M2 decelerated somewhat and M3 was about
unchanged in July. For the year through July,
both aggregates rose at rates well above the
Committee's ranges for the year. Expansion
of total domestic nonflnancial debt appears
to have moderated somewhat in recent
months after a pickup earlier in the year.
The Federal Open Market Committee
seeks monetary and financial conditions that
will foster price stability and promote sustainable growth in output. In furtherance of
these objectives, the Committee reaffirmed
at its meeting on June 30-July 1 the ranges
it had established in February for growth
of M2 and M3 of 1 to 5 percent and 2 to
6 percent respectively, measured from the
fourth quarter of 1997 to the fourth quarter
of 1998. The range for growth of total
domestic nonflnancial debt was maintained
at 3 to 7 percent for the year. For 1999, the
Committee agreed on a tentative basis to set
the same ranges for growth of the monetary
aggregates and debt, measured from the
fourth quarter of 1998 to the fourth quarter
of 1999. The behavior of the monetary
aggregates will continue to be evaluated in
the light of progress toward price level stability, movements in their velocities, and
developments in the economy and financial
markets.
In the implementation of policy for the
immediate future, the Committee seeks con-
173
ditions in reserve markets consistent with
maintaining the federal funds rate at an average of around 5Vi percent. In the context
of the Committee's long-run objectives for
price stability and sustainable economic
growth, and giving careful consideration to
economic, financial, and monetary developments, a slightly higher federal funds
rate or a slightly lower federal funds rate
would be acceptable in the intermeeting
period. The contemplated reserve conditions
are expected to be consistent with moderate
growth in M2 and M3 over coming months.
Votes for this action: Messrs. Greenspan, McDonough, Ferguson, Gramlich,
Hoenig, Kelley, Meyer, Ms. Minehan,
Mr. Poole, and Ms. Rivlin. Vote against
this action: Mr. Jordan.
Mr. Jordan dissented because he
believed that the underlying strength of
aggregate demand in the U.S. economy
would remain fundamentally intact,
despite economic problems abroad. The
problems in Asia provide a channel
for economic imbalances to develop.
Exports from some U.S. manufacturing
industries will decline due to softer foreign markets and import competition. At
the same time, domestic demand for
imports, housing, and consumer durables will increase due to favorable interest rate trends. Though U.S. production
of goods and services might slow during
the period ahead, it is not yet clear that
total demand" will diminish at a comparable pace. At the same time, ample
credit provision encourages speculative
lending and excessive consumption.
Consequently, continued rapid growth
in the money supply creates the risk that
inflation will accelerate and economic
imbalances will become protracted.
Telephone Conference
On September 21 the Committee held a
telephone conference to discuss recent
developments in domestic and interna-
174 85th Annual Report, 1998
tional financial markets and their implications for the U.S. economy. The consultation was held as background for
Chairman Greenspan's testimony on
September 23 before the Senate Budget
Committee.
It was agreed that the next meeting of
the Committee would be held on Tuesday, September 29, 1998.
The meeting adjourned at 12:45 p.m.
Donald L. Kohn
Secretary
Meeting Held on
September 29, 1998
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, September 29, 1998, at
9:00 a.m.
Present:
Mr. Greenspan, Chairman
Mr. McDonough, Vice Chairman
Mr. Ferguson
Mr. Gramlich
Mr. Hoenig
Mr. Jordan
Mr. Kelley
Mr. Meyer
Ms. Minehan
Mr. Poole
Ms. Rivlin
Messrs. Boehne, McTeer, Moskow,
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. Gillum, Assistant Secretary
Mr. Mattingly, General Counsel
Mr. Baxter, Deputy General Counsel
Mr. Truman, Economist
Messrs. Cecchetti, Dewald,
Hakkio, Lindsey, Simpson,
Sniderman, and Stockton,
Associate Economists
Mr. Fisher, Manager, System Open
Market Account
Mr. Winn, Assistant to the Board,
Office of Board Members,
Board of Governors5
Mr. Ettin, Deputy Director,
Division of Research and
Statistics, Board of Governors
Messrs. Madigan and Slifman,
Associate Directors, Divisions
of Monetary Affairs and
Research and Statistics
respectively, Board of
Governors
Messrs. Alexander, Hooper, and
Ms. Johnson, Associate
Directors, Division of
International Finance,
Board of Governors
Mr. Reinhart, Deputy Associate
Director, Division of Monetary
Affairs, Board of Governors
Mr. Struckmeyer, Assistant Director,
Division of Research and
Statistics, Board of Governors
Ms. Low, Open Market Secretariat
Assistant, Division of Monetary
Affairs, Board of Governors
Messrs. Spillenkothen and Parkinson,6
Director, Division of Supervision
and Regulation, and Associate
Director, Division of Research and
Statistics respectively, Board of
Governors
5. Attended portion of the meeting relating to
the Committee's disclosure policies.
6. Attended portion of meeting relating to
developments stemming from the financial difficulties of a large hedge fund.
Minutes of FOMC Meetings, September
Mr. Connolly, First Vice President,
Federal Reserve Bank of Boston
Messrs. Eisenbeis, Goodfriend, Hunter,
Kos, Lang, and Rolnick, Senior
Vice Presidents, Federal Reserve
Banks of Atlanta, Richmond,
Chicago, New York, Philadelphia,
and Minneapolis respectively
Messrs. Judd and Rosengren, Vice
Presidents, Federal Reserve Banks
of San Francisco and Boston
respectively
Ms. Yucel, Research Officer, Federal
Reserve Bank of Dallas
By unanimous vote, the minutes of
the meeting of the Federal Open Market
Committee held on August 18, 1998,
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, and thus no vote was
required of the Committee.
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
August 18, 1998, through September 28,
1998. 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.
175
The information reviewed at this
meeting suggested that economic activity was expanding at a moderate rate.
Growth of private domestic final demand had slowed from its pace in the
first half of the year, though it was still
relatively robust, and reduced spending
on U.S. exports and rising import competition were exerting appreciable restraint on overall activity, as was a slowing in inventory investment. Reflecting
the moderation in growth from the first
half of the year, total payroll employment was trending up at a somewhat
slower pace. Despite the pressures on
labor resources associated with stilltight labor markets, trends in wages and
prices remained stable.
Growth in nonfarm payroll employment slowed somewhat over the
July-August period. The deceleration
reflected further job losses in the manufacturing sector, notably in the apparel
and electronic components industries
on which the crisis in Asia was having
a sizable adverse effect. Outside of
manufacturing, employment increases
remained strong in the serviceproducing industries, and even though
anecdotal reports continued to indicate
shortages of skilled workers, further sizable job gains were recorded in construction. The civilian unemployment
rate stayed at 4.5 percent in August.
Industrial output rebounded in August
as production at General Motors
resumed following the settlement of the
labor strike. Outside the motor vehicle
sector, however, output had changed
little on balance over recent months
in association with the erosion in net
exports stemming from the turmoil in
Asia and its repercussions on a number
of other U.S. trading partners; production of consumer goods edged down
on balance in July and August, and the
growth of output of business equipment
slowed. The rise in industrial production
176 85th Annual Report, 1998
in August boosted the rate of utilization
of manufacturing capacity, but the factory operating rate remained somewhat
below the level of late last year.
Total retail sales were held down in
July and August by a sharp contraction
in spending for motor vehicles, but nonauto sales continued to rise at a brisk
pace. The gains were widespread, with
increases in spending on furniture and
appliances, apparel, and miscellaneous
nondurables especially strong. Purchases of services also were up appreciably further in July and August after
a rapid second-quarter rise. Sales and
construction of residential buildings
remained quite strong on balance, reflecting very favorable homebuying conditions. Housing starts slipped in August
but were still above the high level of the
first half of the year. Sales of existing
homes dropped back in August from
the record high registered in July, while
sales of new homes were slightly higher
in July (latest data) than in the first half
of the year.
Available indicators pointed to more
moderate growth in business fixed
investment after the surge in capital
spending during the first half of the year.
Shipments of nondefense capital goods
declined in July and August, retracing
much of June's large increase, while
sales of medium and heavy trucks continued to increase at a rapid pace. Nonresidential construction weakened in
July, extending a pattern of sluggish
building activity; construction of industrial structures remained in a downtrend,
and office building activity changed
little on balance over June and July.
Business inventory accumulation
eased further in July after having slowed
sharply in the second quarter, and
inventory-sales ratios remained moderate. Stockbuilding in manufacturing was
at a somewhat lower rate in July than
in the second quarter, and the stock
shipments ratio for the sector stayed a
little above the low level that had prevailed over the past year. At the wholesale level, a further decline in inventories reflected additional reductions in
motor vehicles; the inventory-shipments
ratio remained in the upper part of its
narrow range for the past year. In the
retail sector, a sharp drop in stocks at
automotive dealerships more than offset
a rise in stocks of other goods. The
aggregate inventory-sales ratio for the
retail sector was at a relatively low level.
The nominal deficit on U.S. trade in
goods and services narrowed slightly in
July from its second-quarter average,
with the value of imports falling more
than the value of exports. Much of the
decline in imports and exports involved
trade in automotive products with Canada and Mexico. Economic activity in
the major foreign industrial countries
other than Japan decelerated on average
in the second quarter, with a deterioration in net exports partially offsetting
continued strength in domestic final
demand. In Japan, activity contracted
for a third consecutive quarter; net
exports made a large positive contribution as imports dropped sharply, but
domestic demand, most notably business fixed investment, fell steeply.
Both the overall and the core CPI
again rose moderately in August; a further increase in food prices was offset
by a sizable decrease in energy prices.
For the twelve months ended in August,
core consumer prices rose slightly more
than they had in the year-earlier period.
At the producer level, prices of finished
goods dropped appreciably in August,
largely reflecting declines in the prices
of finished foods and, notably, energy
goods. Producer prices of finished goods
other than food and energy moved
slightly higher in the twelve months
ended in August after having edged
down in the year-earlier period. Pro-
Minutes of FOMC Meetings, September 177
ducer prices at earlier stages of production were under strong downward pressure; prices of intermediate materials
fell during the year ended in August by
slightly more than they had risen in the
year-earlier period, and prices of crude
materials plunged further in the twelve
months ended in August. Average
hourly earnings of production or nonsupervisory workers continued to increase
at a relatively moderate pace in the
July-August period, and for the twelve
months ended in August they rose
slightly more than in the year-earlier
period.
At its meeting on August 18, 1998,
the Committee adopted a directive that
called for maintaining conditions in
reserve markets that would be consistent
with the federal funds rate continuing
to average around 5Vi percent. However, in light of mounting financial
strains abroad, their potential implications for the U.S. economy, and less
accommodative conditions in domestic
financial markets, the Committee concluded that the risks to the outlook were
no longer tilted toward rising inflation
but had become more balanced. Accordingly, the Committee adopted a directive
that did not include a presumption about
the likely direction of any adjustment to
policy during the intermeeting period.
The reserve conditions associated with
this directive were expected to be consistent with moderate growth of M2 and
M3 over coming months.
Open market operations were directed
throughout the intermeeting period toward maintaining the existing degree of
pressure on reserve positions, and the
federal funds rate remained close to its
intended level of 5Vi percent. In an
atmosphere of greatly increased volatility in financial asset values worldwide
and a reduced appetite for risk among
many investors, interest rates on U.S.
Treasury securities, and to a much
smaller extent on investment-grade corporate debt, fell appreciably during the
intermeeting period; in contrast, yields
on the bonds of lower-rated firms
increased sharply, and a number of large
banks tightened terms and standards for
making business loans to sizable firms.
Credit conditions also tightened in
Europe, Asia, and Latin America. Share
prices in U.S. and foreign equity markets remained volatile during the intermeeting period, and major U.S. equity
price indexes declined considerably further on balance.
In foreign exchange markets, the
trade-weighted value of the dollar depreciated substantially over the intermeeting period in relation to other major
currencies. A spreading perception that
the United States was more vulnerable
than either Europe or Japan to an economic downturn in Latin America,
increasing expectations of monetary easing in the United States, and shifts into
yen associated with the end of the fiscal
half-year in Japan and the unwinding of
some investment positions financed in
yen were factors that weighed on the
dollar. By contrast, the dollar appreciated slightly in terms of an index of
currencies that includes the developing
countries of Latin America and Asia
that are important trading partners of the
United States.
Growth of M2 and M3 picked up
considerably in August and apparently
strengthened further in September. The
acceleration was the result of unusually
large inflows to money market funds
that in part reflected households' preference for relatively safe, liquid placements for funds shifted out of equities
and lower-rated corporate debt. For the
year through September, both aggregates recorded growth rates well above
the Committee's ranges for the year.
Expansion of total domestic nonfinancial debt had moderated somewhat in
178 85th Annual Report, 1998
recent months after having picked up
earlier in the year.
The staff forecast prepared for this
meeting incorporated a considerably
weaker assessment of underlying aggregate demand, owing to downward revisions to growth abroad and to the less
accommodative conditions that were
evolving in U.S. financial markets. The
staff projected that the expansion of economic activity would slow for a time to
a pace appreciably below the estimated
growth of the economy's potential and
then would pick up to a rate more in line
with that potential. Damped expansion
of foreign economic activity and the
lagged effects of the earlier rise in the
foreign exchange value of the dollar
were expected to place considerable restraint on the demand for U.S. exports
for a period ahead and to lead to further
substitution of imports for domestic
products. Domestic production also
would be held back for a while by the
efforts of firms to bring inventories into
better balance with the anticipated moderation in the trajectory of final sales. In
addition, private final demand would be
restrained by tighter lending terms and
conditions as well as the drop that had
occurred in equity prices. Pressures
on labor resources were likely to ease
somewhat as the expansion of economic
activity slowed, but inflation was projected to pick up gradually in association with a partial reversal of the decline
in energy prices this year.
In the Committee's discussion of current and prospective economic conditions, members focused on developments that pointed to the potential for
a significant weakening in the growth
of spending. They recognized that there
were at present few statistical indications that the economy was on a significantly slower growth track. Indeed, the
available data suggested that consumer
expenditures and business investment
retained considerable strength. At the
same time, however, investors' perceptions of risks and their aversion to taking on more risk had increased markedly in financial markets around the
world. That change in sentiment was
exacerbating financial and economic
problems in a number of important
trading partners of the United States. In
addition, it was generating lower equity
prices and tightening credit availability in U.S. financial markets. As a consequence, the downside risks to the
domestic expansion appeared to have
risen substantially in recent weeks.
Though labor markets were expected
to remain relatively tight for some
time, the members saw little prospect
that inflation would gather significant
momentum in coming quarters. Declining commodity and other import prices
would be restraining prices and inflation
expectations for a while. Overall consumer prices might rise a little more
rapidly next year as the effects of a
number of favorable factors, such as
falling energy prices, diminished or
reversed, but underlying inflation was
expected to stay quite subdued as inflation expectations remained damped and
pressures in labor markets became less
pronounced.
The intensification and further spread
of turmoil in international financial markets, notably since the outbreak of a
financial crisis in Russia in mid-August,
had spilled over into U.S. financial markets. Strong demands for safety and
liquidity had driven down yields on
U.S. Treasury securities, but spreads of
private rates over Treasury rates had
gapped higher. Increases in risk spreads
were especially large for lower-grade
borrowers and on bonds below investment grade, whose rates had increased
considerably since mid-August. In addition, many banks had tightened their
credit standards and terms. Prices in U.S.
Minutes of FOMC Meetings, September 179
equity markets, which had weakened
appreciably before the crisis in Russia,
had declined substantially further. These
market developments strongly suggested, and anecdotal reports tended to
confirm, the emergence of widespread
perceptions of greater risks in a broad
range of financial investment activities
and of considerably greater reluctance
to put capital at risk. The members did
not believe that the tightness in credit
markets and strong demand for safety
and liquidity were likely to lead to a
"credit crunch," though some members
expressed the view that such an outcome could not be ruled out. At a time
when business balance sheets already
indicated a significant softening of cash
flows owing to weaker profits, many
business firms were experiencing increased difficulty and costs in their
efforts to raise funds in debt or equity
markets or to borrow from lending institutions; if these conditions were to persist, the sustainability of the current
strength in business capital expenditures
would come into question. The decline
in stock market prices also appeared
likely to damp the growth of consumer
spending over time, with added implications for business capital expenditures.
Despite the emergence of decidedly
less hospitable financial conditions,
there were few indications in the data
available to the Committee of any
weakening as yet in consumer and business spending. Consumer expenditures,
though temporarily held back by shortages of new motor vehicles stemming
from the work stoppage at General
Motors, had remained on a solid
uptrend, with overall growth in recent
months apparently slipping only a little
from a remarkably rapid pace in the first
half of the year. Strong growth in jobs
and incomes along with substantial further increases in stock market prices
through mid-July had fostered a high
level of consumer confidence and spending. Members commented that the more
recent weakness in the stock market and
the related decline in household net
worth had removed an important support for the growth of consumer spending, but they noted that recent surveys
indicated only a slight deterioration in
consumer sentiment and that the stimulus from earlier stock market gains probably would dissipate only gradually.
Looking further ahead, consumer spending could be expected to expand at a
pace that was more in line with the
growth of household incomes than it
had been in recent years.
Growth in business investment spending, while apparently moderating from
an extraordinary pace during the first
half of the year, likewise seemed to
have been little affected to date by the
tightening in credit conditions and
the increased aversion to risktaking.
Data on shipments of capital equipment
continued to display a clear uptrend, and
members reported very strong construction activity in many parts of the country. Declining relative prices and rapid
technological advances were likely to
generate appreciable further growth in
spending for computer and office equipment over the projection horizon. Moreover, new orders for capital equipment
did not suggest any general weakening,
though such orders had declined dramatically in the steel industry under the
weight of intense foreign competition.
Even so, the members anticipated that
the pronounced increase in investor and
lender perceptions of risk would result
in considerable moderation in the
growth of overall business investment,
especially in light of concurrent expectations of reduced gains in sales and profits and evidence of some diminution in
both internal and external sources of
financing. Reports from nearly every
Federal Reserve District suggested that
180 85th Annual Report, 1998
executives had become considerably
more concerned about business prospects. In a number of cases they already
had seen a substantial downturn in their
exports or a surge in competing imports
at prices they found difficult to match.
In other cases they were anticipating
such developments or were reacting to
the general sense of unease and uncertainty evident in financial markets.
Forthcoming data on capital spending,
including new orders and contracts,
were likely to point to a weaker uptrend
in business fixed investment. How much
weaker was a major uncertainty in the
economic outlook and a key to determining the extent to which financial
market turmoil was likely to affect the
real economy.
Very favorable underlying factors,
including a strong job market and
declining mortgage rates, had helped
to sustain homebuilding activity at an
elevated level. The large further advance
in stock market prices earlier in the year
also appeared to have been a positive
factor in the strong performance of the
housing market. While anecdotal reports
suggested that softening was confined to
only a few areas, the delayed effects of
the drop in stock market prices and forecasts of slower employment and income
growth suggested some moderation in
housing activity at some point. Even
so, the continued affordability of new
homes for many households was likely
to sustain housing demand at a relatively high albeit diminished level, and
homebuilding activity would be bolstered for a time as backlogs created by
shortages of skilled construction workers in many areas were worked off.
Net exports, while subject to a great
deal of uncertainty, were seen as likely
to continue to restrain demand and production to a substantial extent over coming quarters. Members cited examples
from across the country of business
firms, notably in the manufacturing sector but also in energy, agriculture, forest
products, and some other industries, that
already were being adversely affected
by weaker export markets and increased
competition from lower-priced imports.
Moreover, the intensification of turmoil in international financial markets
since the Russian devaluation and debt
moratorium had led to tighter financial
conditions in key U.S. trading partners—
especially in the Americas—a development that was likely to weaken
growth in those markets and demand for
U.S. products. Of potentially greater
importance for the domestic economic
outlook, however, was the spread of
international financial unsettlement to
U.S. financial markets and the attendant
deterioration in business and investor
confidence. It was clear that the contagious effects of international economic
and financial turmoil had markedly
increased the downside threat to the
domestic expansion.
In their comments about the outlook
for inflation, members referred to the
persistence of very tight labor markets
across the nation and to indications of
escalating increases in labor compensation in a number of areas. At the same
time, price inflation generally had
remained subdued, with little evidence
of acceleration. As had been true for an
extended period, competitive pressures
were widely reported to be preventing
employers from passing through rising
labor costs to consumer prices. Looking
ahead, members cited a variety of factors bearing on the prospects for inflation that on the whole suggested that
the risks of an inflationary uptrend had
receded. Favorable factors in the outlook for prices included the lingering
effects of the dollar's earlier appreciation, ample industrial capacity, generally declining commodity and other
import prices, and an apparently more
Minutes of FOMC Meetings, September
rapid trend of productivity gains. Over
time, some slowing in economic growth
and less intense pressures on labor
resources would hold down increases
in labor costs. Developments that might
tend to offset these positive factors, at
least in part, included a possible turnaround in energy prices after sizable
declines over the past year and an upturn
in the costs of worker benefits, notably
for medical expenses. A few members
also observed that the rapid growth
of key monetary aggregates, including
M2, over a period of several quarters
was a worrisome element in the outlook
for inflation, though the most recent
surge in M2 probably was induced in
large measure by a flight to quality and
liquidity.
In their discussion of policy for the
intermeeting period ahead, all the members endorsed a proposal calling for a
slight easing in reserve markets to produce a decline of lA percentage point in
the federal funds rate to an average of
about 5!A percent. In their view, such
an action was desirable to cushion the
likely adverse consequences on future
domestic economic activity of the global
financial turmoil that had weakened
foreign economies and of the tighter conditions in financial markets in the United
States that had resulted in part from that
turmoil. At a time of abnormally high
volatility and very substantial uncertainty, it was impossible to predict how
financial conditions in the United States
would evolve. In the view of many
members, equity prices and risk spreads
in U.S. financial markets previously had
embodied an overly optimistic assessment of business prospects, and they
saw some correction in these markets as
a positive development. Moreover, they
expected markets to become much more
settled once the initial adjustments to
new risk assessments had been made.
On balance, however, credit conditions
181
were likely to remain tighter and equity
prices lower than earlier, and in the
context of continued damped inflation, monetary policy had the room to
adjust to these new circumstances. In
any event, an easing policy action at this
point could provide added insurance
against the risk of a further worsening in
financial conditions and a related curtailment in the availability of credit to many
borrowers.
The members agreed that the decrease
in the federal funds rate should be limited to 25 basis points. Several emphasized in this regard that although the risk
of rising inflation might have receded, it
was still present, especially in light of
the persistence to date of very tight labor
markets and relatively robust economic
growth. In these circumstances, while
an easing move was warranted to provide some insurance against undesirably
tight domestic financial conditions,
many members saw the need for a
cautious policy action. A more sizable
policy move at this point might convey an exaggerated impression of the
Committee's current thinking regarding the extent of downside risks in the
economy.
The members were divided over
whether to retain the current symmetrical directive or to adopt an asymmetrical directive that would be tilted toward
ease. A small majority favored moving to asymmetry on the grounds that
it seemed more consistent with the
increased downside risks to the economy that they believed would exist even
after the contemplated policy action and
that it would underscore the Committee's readiness to respond promptly to
conditions that might threaten the sustainability of the expansion. Other members expressed a preference for a symmetric directive but indicated that they
could accept a directive that was tilted
toward ease. In their opinion, the uncer-
182
85th Annual Report, 1998
tainties relating to the direction of the
next policy move were sufficiently great
on both sides to justify a neutral directive. Some commented that unanticipated developments were likely in any
event to provide the principal basis for
future policy actions. They suggested
that the Committee would undoubtedly
confer by telephone should such developments materialize during the intermeeting period, and the symmetry or
asymmetry of the directive would have
little bearing on whatever policy decision might be reached.
At the conclusion of the Committee's
discussion, all the members supported a
directive that called for conditions in
reserve markets that would be consistent
with a slight decrease in the federal
funds rate to an average of about
5lA percent. All the members also indicated that they could accept a change in
the directive to include a bias toward
easing. Accordingly, in the context of
the Committee's long-run objectives for
price stability and sustainable economic
growth, and giving careful consideration
to economic, financial, and monetary
developments, the Committee decided
that a slightly higher federal funds
rate might be acceptable or a somewhat lower federal funds rate would
be acceptable during the intermeeting
period. The reserve conditions contemplated at this meeting were expected to
be consistent with some moderation in
the growth of M2 and M3 over the
months ahead.
The Federal Reserve Bank of New
York was authorized and directed, until
instructed otherwise by the Committee,
to execute transactions in the System
Account in accordance with the following domestic policy directive:
The information reviewed at this meeting
suggests that the economy has been growing
at a moderate rate, paced by brisk, albeit
slowing, increases in spending by businesses
and households, while expansion in overall economic activity has continued to be
restrained by developments abroad. Nonfarm payroll employment grew somewhat
more slowly over July and August, mostly
reflecting job losses in the manufacturing
sector; the civilian unemployment rate was
unchanged at 4.5 percent in August. Industrial production has changed little on balance
over recent months. Total retail sales over
July and August were held down by a sharp
contraction in spending for motor vehicles.
Residential sales and construction have
remained quite strong in recent months.
Available indicators point to continued
growth in business capital spending, but at a
more moderate pace than in the first half of
the year. Business inventory accumulation
slowed further in July. The nominal deficit
on U.S. trade in goods and services narrowed
slightly in July from its second-quarter average. Trends in wages and prices have
remained stable in recent months.
Most interest rates have fallen appreciably
since the meeting on August 18, though
yields on the bonds of lower-rated firms have
increased and a number of large banks have
tightened terms and standards for making
business loans. Broadly similar developments have occurred in major foreign markets. Share prices in U.S. and global equity
markets have remained volatile and major
indexes have declined considerably further
on balance over the intermeeting period.
In foreign exchange markets, the tradeweighted value of the dollar declined substantially over the intermeeting period in
relation to other major currencies; it was up
slightly in terms of an index of the currencies of the developing countries of Latin
America and Asia that are important trading
partners of the United States.
Growth of M2 and M3 strengthened considerably in August and appeared to have
picked up further in September, partly
reflecting shifts of funds by households out
of investments in equities and lower-rated
corporate debt. For the year through September, both aggregates rose at rates well above
the Committee's ranges for the year. Expansion of total domestic nonfinancial debt has
moderated somewhat in recent months after
a pickup earlier in the year.
The Federal Open Market Committee
seeks monetary and financial conditions that
will foster price stability and promote sus-
Minutes of FOMC Meetings, September
tainable growth in output. In furtherance of
these objectives, the Committee reaffirmed
at its meeting on June 30-July 1 the ranges
it had established in February for growth
of M2 and M3 of 1 to 5 percent and 2 to
6 percent respectively, measured from the
fourth quarter of 1997 to the fourth quarter
of 1998. The range for growth of total
domestic nonfinancial debt was maintained
at 3 to 7 percent for the year. For 1999, the
Committee agreed on a tentative basis to set
the same ranges for growth of the monetary
aggregates and debt, measured from the
fourth quarter of 1998 to the fourth quarter
of 1999. The behavior of the monetary
aggregates will continue to be evaluated
in the light of progress toward price level
stability, movements in their velocities, and
developments in the economy and financial
markets.
In the implementation of policy for the
immediate future, the Committee seeks conditions in reserve markets consistent with
decreasing the federal funds rate to an average of around 5V* percent. In the context
of the Committee's long-run objectives for
price stability and sustainable economic
growth, and giving careful consideration to
economic, financial, and monetary developments, a slightly higher federal funds rate
might or a somewhat lower federal funds
rate would be acceptable in the intermeeting
period. The contemplated reserve conditions
are expected to be consistent with some
moderation in the growth in M2 and M3
over coming months.
Votes for this action: Messrs. Greenspan, McDonough, Ferguson, Gramlich,
Hoenig, Jordan, Kelley, Meyer, Ms. Minehan, Mr. Poole, and Ms. Rivlin. Votes
against this action: None.
Release of Information
about FOMC Meetings
At this meeting, the Committee reviewed its current practices relating to
its policy announcements, meeting minutes, and directive wording. This discussion was part of an ongoing appraisal
of the Committee's disclosure policies.
The Committee took no action at this
183
meeting but agreed that further review
of some of these issues would be
appropriate.
Financial Problems
of a Large Hedge Fund
The Committee discussed the limited
role of the Federal Reserve Bank of
New York in facilitating a private-sector
resolution of the severe financial problems encountered in the portfolio managed by Long-Term Capital Management L.R The size and nature of the
positions of this fund were such that
their sudden liquidation in already
unsettled financial markets could well
have induced further financial dislocations around the world that could
have impaired the economies of many
nations, including that of the United
States. Against this background, the
Federal Reserve Bank of New York had
brought together key interested parties
with the aim of increasing the probability of an orderly private-sector solution
to the hedge fund's difficulties.
It was agreed that the next meeting of
the Committee would be held on Tuesday, November 17, 1998.
The meeting on September 29
adjourned at 2:40 p.m.
After the meeting, the following press
release was issued:
The Federal Open Market Committee
decided today to ease the stance of monetary
policy slightly, expecting the federal funds
rate to decline VA percentage point to around
5VA percent.
The action was taken to cushion the effects
on prospective economic growth in the
United States of increasing weakness in foreign economies and of less accommodative
financial conditions domestically. The recent
changes in the global economy and adjustments in U.S. financial markets mean that a
slightly lower federal funds rate should now
184 85th Annual Report, 1998
be consistent with keeping inflation low and
sustaining economic growth going forward.
The discount rate remains unchanged at
5 percent.
Conference Call
In a telephone conference held on October 15, 1998, the Committee members
discussed recent economic and financial
developments and their implications for
monetary policy. Risk aversion in financial markets had increased further since
the Committee's meeting in September,
raising volatility and risk spreads even
more, eroding market liquidity, and constraining borrowing and lending in a
number of sectors of the financial markets. Although indications of any softening in the pace of the economic expansion across the country remained sparse,
the widespread signs of deteriorating
business confidence and evidence of
less accommodative domestic financial
conditions suggested that the downside
risks to the expansion had continued to
mount.
Against this background, a consensus
emerged in favor of a XA percentage
point reduction in the federal funds rate
that would accompany a reduction in the
discount rate that the Board of Governors was expected to approve at a meeting following this telephone conference.
Some members were concerned that
a policy move so soon after the late
September action might be misread as
indicative of a degree of concern about
prospective developments in financial
markets or the economic outlook that
did not represent the Committee's thinking. However, the members generally
concluded that the risk of adverse market reactions was worth taking and that
the easing actions under consideration
were more likely to help settle volatile
financial markets and cushion the effects
of more restrictive financial conditions
on the ongoing expansion. At the conclusion of this discussion, the Chairman
indicated that he would instruct the
Federal Reserve Bank of New York to
lower the intended federal funds rate
by 25 basis points, consistent with the
Committee's directive issued at the
meeting on September 29, 1998.
Donald L. Kohn
Secretary
On October 15, 1998, the following
press release was issued:
The Federal Reserve today announced the
following set of policy actions:
• The Board of Governors approved a reduction in the discount 3rate by 25 basis points
from 5 percent to A A percent.
• The federal funds rate is expected to fall
25 basis points from around 5lA percent to
around 5 percent.
Growing caution by lenders and unsettled
conditions in financial markets more generally are likely to be restraining aggregate
demand in the future. Against this backdrop,
further easing of the stance of monetary policy was judged to be warranted to sustain
economic growth in the context of contained
inflation.
In taking the discount rate action, the
Board approved requests submitted by the
Boards of Directors of the Federal Reserve
Banks of New York, Philadelphia, Atlanta,
Chicago, St. Louis, Minneapolis, Kansas
City, and San Francisco. The discount rate is
the interest rate that is charged depository
institutions when they borrow from their district Federal Reserve Banks.
Meeting Held on
November 17, 1998
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 17, 1998, at
9:00 a.m.
Minutes of FOMC Meetings, November
Present:
Mr. Greenspan, Chairman
Mr. McDonough, Vice Chairman
Mr. Ferguson
Mr. Gramlich
Mr. Hoenig
Mr. Jordan
Mr. Kelley
Mr. Meyer
Ms. Minehan
Mr. Poole
Ms. Rivlin
Messrs. Boehne, McTeer, Moskow, 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. Bernard, Deputy Secretary
Ms. Fox, Assistant Secretary
Mr. Mattingly, General Counsel
Mr. Prell, Economist
Messrs. Cecchetti, Dewald, Lindsey,
Simpson, Sniderman, and
Stockton, Associate Economists
Mr. Fisher, Manager, System Open
Market Account
Mr. Winn, Assistant to the Board,
Office of Board Members,
Board of Governors
Ms. Johnson, Director, Division of
International Finance,
Board of Governors
Mr. Ettin, Deputy Director, Division
of Research and Statistics,
Board of Governors
Messrs. Alexander and Hooper,
Deputy Directors, Division of
International Finance, Board of
Governors
Messrs. Madigan and Slifman,
Associate Directors, Divisions of
Monetary Affairs and Research
and Statistics respectively,
Board of Governors
185
Mr. Reinhart, Deputy Associate
Director, Division of Monetary
Affairs, Board of Governors
Mr. Whitesell, Assistant Director,
Division of Monetary Affairs,
Board of Governors
Ms. Garrett, Economist, Division of
Monetary Affairs, 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. Moore, First Vice President,
Federal Reserve Bank of
San Francisco
Messrs. Beebe, Eisenbeis, Ms. Krieger,
Messrs. Lang, and Rosenblum,
Senior Vice Presidents, Federal
Reserve Banks of San Francisco,
Atlanta, New York, Philadelphia,
and Dallas respectively
Messrs. Evans, Fuhrer, Hetzel, Miller,
and Sellon, Vice Presidents,
Federal Reserve Banks of
Chicago, Boston, Richmond,
Minneapolis, and Kansas City
respectively
By unanimous vote, the minutes of
the meeting of the Federal Open Market
Committee held on September 29, 1998,
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, and thus no
vote was required of the Committee.
The Manager also reported on developments in domestic financial markets
and on System open market transactions
186 85th Annual Report, 1998
in government securities and federal
agency obligations during the period
September 29, 1998, through November 16, 1998. By unanimous vote, the
Committee ratified these transactions.
The Manager informed the Committee that he planned to initiate outright
purchases in the secondary market of
inflation-indexed Treasury securities. In
the past, the System had been acquiring
holdings of such securities in Treasury
auctions in exchange for maturing
nominal obligations. In the Manager's
opinion, secondary market transactions
would provide a helpful addition to
the current range of assets that the
System normally purchased, especially
in a period of little or no increase
in Treasury debt. Some members expressed concern that sizable purchases
of indexed securities by the central bank
might impair the liquidity of the market
and limit the usefulness of these obligations as indicators of inflationary expectations. It was noted, however, that relatively limited System purchases of such
securities were contemplated so that the
market was not likely to be significantly
affected. Moreover, the System's participation could contribute to a more active
and liquid secondary market.
In further discussion of the wording
of the operating paragraph of its directive, the Committee at this meeting
focused on proposals by members to
simplify and clarify the sentence relating to the symmetry or asymmetry
of the directive as it applied to possible
future policy changes. Time constraints
did not permit the Committee to complete its deliberations, and it agreed
to continue its discussion at a later
meeting.
The Committee then turned to 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. Committee decisions to amend the
Authorization for Domestic Open Market Operations and to renew certain
swap line agreements also are summarized below.
The information reviewed at this
meeting suggested some moderation in
the expansion of economic activity from
a brisk pace during the summer months.
Although growth of economic activity
in the third quarter apparently about
matched the pace in the first half of the
year, a large buildup of nonfarm inventories had accounted for a significant
portion of the persisting strength of the
expansion during the quarter. Growth in
consumer spending had been well maintained during the summer months, and
housing activity had remained at a high
level. In other major sectors of the economy, business fixed investment had softened after having surged in the first half,
and net exports had declined further,
although at a reduced pace. Growth in
employment had slowed appreciably on
balance during the summer and early
fall months, but tight conditions had
persisted in most labor markets. Recent
wage and price developments had been
mixed.
Growth in nonfarm payroll employment slowed appreciably in September and October. The slowing partly
reflected sizable job losses in manufacturing, which has been substantially
affected since earlier in the year by
rising foreign competition stemming
from the crisis in Asia. Outside of manufacturing, increases in employment in
the service-producing industries moderated somewhat over the two months,
although gains in finance, insurance, and
Minutes of FOMC Meetings, November
real estate were relatively robust. The
civilian unemployment rate remained
near AVi percent during the two months.
Industrial output had declined slightly
in recent months after having rebounded
in August when production resumed at
General Motors following settlement of
the labor strike. Outside the motor vehicle sector, manufacturing output edged
lower in recent months after having
decelerated markedly earlier in the year.
Weakness in the manufacturing and
mining sectors was associated in large
measure with the fallout from the turmoil in Asia, its repercussions on a number of U.S. trading partners, and the
related softness in world oil markets.
The downward trend in the utilization of
capacity in manufacturing left the factory operating rate appreciably below its
level of late last year.
Personal consumption expenditures
rose considerably further during the
third quarter, though at a much slower
pace than that recorded earlier in the
year. Retail sales were down slightly on
balance during the quarter, reflecting a
sharp drop in sales of motor vehicles
associated with the work stoppage at
General Motors. However, the settlement of that strike and the resumption
of production led to an upturn in motor
vehicle sales in August and a sizable
advance in September. A large further
gain in such sales contributed to a sharp
rise in overall retail sales in October.
Consumer confidence retreated further
in October, but according to a major
survey it turned up in early November,
albeit to a level still somewhat below its
peak earlier in the year.
Available indicators pointed to a
pickup in business capital spending after
a third-quarter lull, owing to some
extent to a recovery from the General
Motors strike. Business investment
expenditures during the summer were
held down in part by the strike-related
187
decline in fleet sales of new motor vehicles. In addition, spending for other
types of business equipment grew somewhat more slowly in the third quarter
after having expanded at an extraordinary pace earlier in the year. Orders
received by U.S. equipment makers continued to trend up through September. In
contrast, nonresidential building activity
apparently fell somewhat further in the
third quarter. While the construction
of lodging facilities surged and the construction of office space persisted at a
high level, there was a decline in other
commercial building, which includes
retail stores and warehouses, industrial
structures, and institutional buildings.
The availability of financing for various
types of construction appeared to lessen
substantially in late summer, and financing costs rose for many borrowers.
In the residential sector, housing sales
and starts remained quite strong, though
below early summer highs. Housing
activity showed signs of dropping off
from peak levels during the latter part of
the summer, but the decline in mortgage
rates this fall produced an upturn in
several indicators of demand for singlefamily housing, including a rebound in a
survey index of homebuying conditions.
Multifamily housing starts increased
considerably in the third quarter, but
since late summer the availability of
financing for multifamily building
projects has tended to diminish and
interest costs to rise.
Business inventory accumulation was
sizable in the third quarter, and stockssales ratios rose to uncomfortable levels
in some industries that were being
adversely affected by the nation's growing trade deficit. In manufacturing, however, stockbuilding slowed during the
summer months and the stock-shipment
ratio was unchanged at a level just
above its average for the past year. At
the wholesale level, a rapid increase dur-
188 85th Annual Report, 1998
ing the third quarter lifted the inventorysales ratio for this sector to its highest
level since 1986; nearly half the rise was
the result of a buildup of farm products
that was related in part to an early
harvest, but wholesalers of machinery,
chemicals, and metals and minerals also
apparently experienced undesired buildups of stocks. Retail inventories excluding motor vehicles accumulated at a
slow pace during the summer, and the
inventory-sales ratio for this category
remained well within the narrow range
of the past year.
The nominal deficit on U.S. trade in
goods and services widened to some
extent in July-August from its secondquarter average. The value of imports in
the July-August period, though rising
appreciably in August, was somewhat
below the second-quarter average, with
most of the decline involving automotive products and oil. The value of
exports fell somewhat over the two
months, largely reflecting declines in
exports of automotive products and
industrial supplies and reduced service
transactions. Decreases in exports partly
reflected weakness in foreign economies. In the third quarter, growth in
economic activity slowed on average in
the major industrial countries, other than
Japan, from the average pace in the first
half of the year and contracted for a
fourth consecutive quarter in Japan.
There were widespread indications in
the industrial nations, particularly from
surveys of business and consumer confidence, that some slowing was persisting
into the fourth quarter. Elsewhere, the
available evidence pointed to some
improvement in economic trends in a
number of Asian nations, but the economies of several sizable South American
countries appeared to have weakened.
Recent economic indicators for Mexico
were mixed.
The performance of various measures
of wages and prices was uneven in
recent months. The most recently available employment cost index indicated
that hourly compensation of private
industry workers posted a sizable
increase in the third quarter. However,
gains in average hourly earnings moderated considerably in September and
October. The increase in the employment cost index over the past year was
appreciably larger than in the previous
year, while the advance in average
hourly earnings moderated somewhat.
Consumer energy prices rose appreciably in October, but they were still
down sharply from a year earlier and on
balance limited the increase of overall
consumer prices over the past year. Core
consumer prices moved up at a faster
pace than overall consumer prices in
recent months and over the past year,
reflecting sizable increases in the prices
of tobacco, used cars and trucks, and
services. At the producer level, prices of
finished goods edged up in recent
months but were down on balance over
the past year; excluding food and energy
items, producer prices rose somewhat
over the past year.
At its meeting on September 29,
1998, the Committee adopted a directive
that called for implementing conditions
in reserve markets that were consistent
with a one-quarter percentage point
decrease in the federal funds rate to an
average of around 514 percent. The
Committee also decided to adopt an
asymmetric directive that was tilted
toward ease to highlight its view that the
risks to the economic expansion were
mainly on the downside and to underscore its readiness to respond promptly
to developments that threatened the sustainability of the expansion. The reserve
conditions associated with this directive
were expected to be consistent with
Minutes of FOMC Meetings, November
some moderation in the growth of M2
and M3 over subsequent months.
Following the meeting, open market
operations were directed initially toward
implementing a slight easing in the
degree of pressure on reserve positions.
The federal funds rate, responding to
quarter-end pressures and uncertainties
created by shifting funding patterns in
volatile financial markets, tended at first
to average somewhat above the intended
rate of 5lA percent despite a relatively
liberal provision of reserves by the System. Strains in financial markets continued to mount, with intermediaries
and final investors much more cautious
about risks and leverage and much more
eager to hold very liquid assets. These
developments in turn disrupted flows of
funds in a number of financial markets.
On October 15, the Committee discussed these developments and their
implications for the domestic economy,
and the members supported the Chairman's suggestion that, in keeping with
the directive issued at the September 29
meeting, he instruct the Federal Reserve
Bank of New York to reduce the intended federal funds rate by a further
25 basis points to around 5 percent. On
the same day, the Board of Governors
approved a reduction in the discount
rate from 5 percent to 43A percent. These
actions were taken in the light of growing indications of caution by lenders and
unsettled conditions in financial markets
more generally that were deemed likely
to restrain aggregate demand in the
future. Subsequently, trading in the federal funds market remained relatively
volatile but the federal funds rate averaged close to its lower intended level. In
financial markets more generally, strains
gradually moderated after mid-October
and sizable issuance of securities resumed in a number of key markets, but
uncertainty remained high and relatively
189
illiquid conditions persisted. In the stock
market, share prices dropped in the
weeks following the September meeting, but the market rallied strongly after
mid-October and key market indexes
posted sizable gains on balance over the
intermeeting period.
In foreign exchange markets, the
trade-weighted value of the dollar fell
moderately over the period in relation
to other major currencies. The largest
decline occurred in relation to the Japanese yen and appeared to reflect efforts
to reduce speculative exposure to that
currency; changes in the value of the
dollar against other major currencies
were mixed, likely fostered by disparate
interest rate and economic developments. The dollar also fell somewhat in
terms of a broad index of currencies of
other countries that are important trading partners of the United States, including the developing nations of Latin
America and Asia.
M2 and M3 posted very large
increases in September and October.
The gains appeared to be induced to an
important extent by increased demand
for safe and liquid assets in a period of
substantial turmoil in financial markets
that led to shifts of funds by households
out of investments in equities and lowerrated corporate debt. The advance in
M2 during October probably also was
boosted by the decline in its opportunity
cost resulting from the effects of the
System's easing actions on market interest rates and the unusual softness in
Treasury bill rates during much of the
month. The even faster increase in M3
in October also reflected both inflows to
institution-only money market mutual
funds that were stimulated by declines
in short-term market rates and bank
efforts to fund heavy demand for loans
arising in part from the deflection of
demand for funding from securities mar-
190 85th Annual Report, 1998
kets. For the year through October, both
aggregates rose at rates well above the
Committee's ranges for the year. Expansion of total domestic nonfinancial debt
moderated slightly in recent months
after having picked up earlier in the
year.
The staff forecast prepared for this
meeting continued to point to considerable slowing in the expansion of economic activity to a pace appreciably
below the estimated growth of the
economy's potential, but the expansion
was expected to pick up later to a rate
more in line with that potential. Subdued expansion of foreign economic
activity and the lagged effects of the
earlier rise in the foreign exchange value
of the dollar were expected to place
considerable, albeit diminishing, restraint on the demand for U.S. exports
for some period ahead and to lead
to further substitution of imports for
domestic products. Domestic production
would also be held back for a time by
the efforts of firms to bring inventories
into better balance with the anticipated
moderation in the trajectory of final
sales. In addition, private final demand
would be restrained a bit by the tighter
terms and conditions that were now
imposed by many types of lenders and
by the anticipated waning of positive
wealth effects stemming from earlier
increases in equity prices. Pressures on
labor resources were likely to ease
somewhat as the expansion of economic
activity moderated, but inflation was
projected to rise considerably over the
year ahead in association with a partial
reversal of the decline in energy prices
this year.
In the Committee's discussion of current and prospective economic developments, members observed that indications of some moderation in the pace of
the economic expansion were still quite
limited, but they generally agreed that
the economy appeared to be headed
toward slower growth. Relatively tight
profit margins and less ebullient growth
in wealth were among the factors
expected to be damping investment and
consumption. In addition, even apart
from the possibility of further financial
contagion in Latin America, the weakness in foreign economies continued to
be seen as a persistent source of restraint
on demand in a number of domestic
sectors, notably manufacturing, agriculture, and some extractive businesses.
Although the financial markets had
improved substantially in recent weeks,
overall credit conditions were still relatively unsettled and a possible reintensification of difficulties in credit markets
constituted an important downside risk
to the expansion. The members recognized that not all the risks were in one
direction, however. The economy had
demonstrated remarkable resilience and
strength over recent years, and in the
view of some members the rapid growth
of liquidity and bank credit suggested
that financial conditions were not excessively tight. With regard to the outlook
for inflation, members noted that while
statistical and anecdotal information
pointed to persistently tight labor markets in much of the nation, price inflation remained subdued. Indeed, even
though the recent evidence relating to
prices was somewhat mixed, several
broad measures of prices suggested that
inflation might be on a declining trend.
In the course of the Committee's discussion, the members gave considerable
attention to recent financial developments and their implications for the
economic outlook. Financial markets
clearly had calmed markedly since the
System's easing actions in mid-October,
though they were still atypically volatile. Risk spreads had narrowed substantially and other measures of financial
market performance also suggested that
Minutes of FOMC Meetings, November
risk aversion and the related desire for
liquidity had diminished appreciably.
Markets for new issues had reopened
for many borrowers, and stock market
prices had posted large gains. Nonetheless, strains and weaknesses in financial
markets had not disappeared—many
risk spreads were still at unusually high
levels—and the markets remained quite
sensitive to unanticipated developments.
Members also noted that the improvement in debt markets appeared to have
come to a halt most recently and that
renewed strains had emerged in some
short-term debt markets, though the latter probably were related in large measure to concerns about year-end pressures in the money markets. Indeed,
efforts by lenders and borrowers to position for year-end financial statements
were likely to contribute considerably
to keeping market conditions unsettled
over coming weeks. Lending activity at
banks had increased sharply in recent
months as many borrowers found other
sources of funds less receptive or
unavailable and turned to backup lines
for credit, but banks also had tightened
their credit terms and standards for most
new loans and lines of credit. As a
result, financing generally had become
less available and more expensive for
higher-risk business borrowers. In light
of these developments, members believed that the continuing fragility of
financial markets and the increased scrutiny of the credit quality of borrowers,
though the latter was in some respects a
welcome development, posed a considerable downside risk to the expansion.
The very recent behavior of equity
prices was difficult to explain satisfactorily, and potential movements in those
prices posed risks on both sides of the
most likely forecast: A future substantial increase would bolster wealth and
spending, but a sharp decline also could
not be ruled out—especially if, as
191
seemed quite possible, added increases
in prices were not supported by robust
increases in profits.
Foreign economic and financial developments were another important
source of downside risk and uncertainty.
The economic and financial turmoil
in Asia had spread to numerous other
nations around the world and to an
extent to the United States. While economic weakness in many U.S. trading
partners likely would continue to have
adverse effects on net U.S. exports, the
potential extent of such weakness was
subject to considerable uncertainty as
were the associated repercussions on
financial markets. As they had at previous meetings, members referred to
numerous anecdotal reports of heightened competition from foreign producers that was curbing the sales of many
domestic manufacturers, notably in the
steel industry, and in some other industries and agriculture. Moreover, the low
level of world oil prices, which appeared
to be importantly associated with diminished demand from Asian countries, was
retarding production and reducing revenues in the U.S. energy and related
industries. On the positive side, members commented that economic and financial conditions appeared to have stabilized or improved a bit in a number of
Asian nations, though the recession in
Japan showed little evidence of coming
to an end, and the outlook for Brazil
seemed a little more promising. However, economic and financial conditions
in Brazil and a number of other countries remained very fragile. The recent
depreciation of the dollar, while perhaps
putting some upward pressure on prices,
would damp the deterioration in net U.S.
exports.
In their review of recent and prospective developments across the nation and
in key sectors of the economy, members referred to scattered indications of
192 85th Annual Report, 1998
some slowing in private domestic final
demands. In the important consumer
sector, however, evidence of weakening
growth in expenditures was quite limited. The most recent anecdotal reports
pointed to solid growth in most though
not all regions of the country, and retail
sales posted a strong advance in October. Moreover, consumer sentiment
remained at a high level, albeit below its
peak earlier in the year according to a
recent survey. Members commented,
however, that the more moderate growth
in employment and incomes experienced recently likely would persist and
should result in reduced gains in consumer expenditures next year, but they
also noted that the extent of the deceleration was subject to considerable
uncertainty. Some members referred to
reports from contacts in the retailing
industry who expressed some concern
about the potential for weaker retail
sales after the holiday season. A significant factor bearing on consumer spending would be the performance of the
stock market. The impetus from the
wealth effects of rapidly rising share
prices would wane if such prices were to
stabilize near current levels.
With regard to business fixed investment, anecdotal evidence was accumulating that many business firms, notably
in manufacturing, were scaling back
their planned capital outlays for the year
ahead. Factors contributing to the prospective deceleration in business capital
expenditures included a weaker trend in
profits over the past several quarters, a
related deterioration in business cash
flows, and a large buildup in capacity
over the course of recent years. Members also referred to indications of
curtailed availability and more costly
financing for some businesses, notably
for relatively speculative construction
projects. A number of members observed that the latter was a healthy
development in that it would tend to
hold down overbuilding in some areas.
Overall, capital expenditures would
undoubtedly recover from their slight
decline during the summer months, but
the outlook was for growth next year at
a pace well below that experienced for
an extended period before mid-1998.
Housing construction was expected to
remain at a high level, buttressed by
attractive terms on new home mortgages, but housing activity appeared to
have peaked or declined slightly in some
regions.
The rapid buildup in inventories during the third quarter was not likely to
continue, but the timing and extent of
the expected moderation were largely
unpredictable. It was noted in this
regard that while inventories appeared
to have risen to uncomfortable levels in
some industries, there was no evidence
of a general inventory overhang. Looking ahead, the projected slowing in the
growth of final sales, including the
effects of weak export markets, likely
would reinforce business efforts to bring
the growth of their inventories into
better alignment with that of their sales,
and such a development should contribute to the projected slowing in overall
economic activity in coming quarters. It
was unclear at this point to what extent
year 2000 concerns might stimulate
extra inventory investment prior to the
end of 1999.
In their review of developments bearing on the outlook for inflation, members commented that labor markets
remained exceptionally tight, though
there was little evidence that they had
tightened further in recent weeks. Employers were continuing to resist pressures to grant unusually large wage
increases, and the persistence of vigorous competition, including that from
Asian imports, was preventing most
business firms from passing cost
Minutes of FOMC Meetings, November
increases through to prices. Indeed, the
declining trend in profits in recent quarters suggested that many firms were
absorbing some of their rising labor
costs to the extent that the latter were
not offset by improvements in productivity. Looking ahead, slower growth in
economic activity would tend to hold
down pressures on wages and prices
during 1999 and imports from Asian
and other depressed economies would
continue to generate intense competition
in many markets; but labor markets
remained tight, energy and commodity
prices could well turn up after substantial declines, and the recent depreciation
of the dollar would lessen pressures
from foreign competition. A number of
members expected that, on balance,
inflation might be less favorable next
year, though any deterioration in underlying trends should be relatively limited; others anticipated little change in
and possibly some further ebbing of
price inflation, extending the subdued
behavior of a number of comprehensive
measures of prices.
In the Committee's discussion of policy for the intermeeting period ahead,
nearly all the members indicated that
they could accept a proposal to reduce
the federal funds rate by a further
25 basis points to an average of 43/4 percent. This policy decision was viewed as
a close call by several members. While
the growth of the economy was expected
to slow appreciably over the year ahead,
the expansion currently displayed only
modest signs of moderating from what
seemed to be an unsustainable pace.
Moreover, many members saw some
risk that an easing move at this point
might trigger a strong further advance in
stock market prices that would not be
justified on the basis of likely future
earnings and could therefore lead to a
relatively sharp and disruptive market
adjustment later. The members were
193
more concerned, however, about the
risks stemming from the still sensitive
state of financial markets, and in that
regard many believed that a prompt policy easing would help to ensure against
a resurgence of severe financial strains.
A further easing move would complete
the policy adjustment to the changed
economic and financial climate that had
emerged since midsummer and would
provide some insurance against any
unexpectedly severe weakening of the
expansion. Most members saw little
risk that a modest easing would ignite
inflationary pressures in the economy,
given the subdued behavior of inflation
and their outlook for economic activity.
Moreover, the easing could readily be
reversed if unexpected circumstances
should call for such an action. In this
view, the risks of inaction were greater
in terms of the potential financial consequences and also could materialize
much sooner than the risks of stimulating greater inflation through the slight
easing that was contemplated.
Some members indicated that in light
of continued robust economic growth,
tight labor markets, and improving
financial conditions they had a preference for awaiting further developments
that might provide a stronger basis
for an easing action. Some of these
members expressed concern that easier
reserve conditions would accommodate
a step-up in monetary growth that was
already quite rapid, with potentially
inflationary consequences later. Nonetheless, all but one of these members could endorse the decision to ease,
given the evident downside risks in the
international situation, financial market
uncertainty, the likelihood that inflation
would still be quite low, and the possibility of reversing the action reasonably
promptly should circumstances warrant.
Given its decision to ease policy, the
Committee favored a change to symme-
194 85th Annual Report, 1998
try from the asymmetry toward ease
in its recent directives. A symmetrical
directive was now felt to be appropriate
in light of the Committee's expectation
that further easing was not likely to be
needed over the months ahead unless
ongoing developments pointed to a more
substantial decline in the growth of economic activity or further ebbing of inflation than was currently anticipated. The
members recognized that the possible
emergence of severe year-end pressures
in the money market might require some
temporary easing in reserve conditions,
but such a development did not seem to
have a high probability and could in any
event be readily and properly accommodated regardless of the bias in the
directive.
At the conclusion of the Committee's
discussion, all except one member supported a directive that called for conditions in reserve markets that would
be consistent with a slight decrease in
the federal funds rate to an average of
about 43/4 percent. These members also
accepted a proposal to remove the bias
toward easing that had been adopted at
the previous meeting. Accordingly, in
the context of the Committee's long-run
objectives for price stability and sustainable economic growth, and giving careful consideration to economic, financial,
and monetary developments, the Committee decided that a slightly higher federal funds rate or a slightly lower federal
funds rate would be acceptable during the the intermeeting period. A staff
analysis prepared for this meeting suggested that the reserve conditions contemplated by the Committee were likely
to be consistent with some moderation
in the growth of M2 and M3 over the
months ahead.
The Federal Reserve Bank of New
York was authorized and directed, until
instructed otherwise by the Committee,
to execute transactions in the System
Account in accordance with the following domestic policy directive:
The information reviewed at this meeting
suggests some moderation in the expansion
of economic activity from a brisk pace during the summer months. Growth in nonfarm
payroll employment slowed appreciably in
September and October; the civilian unemployment rate remained near AVi percent.
Industrial production has declined slightly in
recent months. Business inventory accumulation was sizable in the third quarter, and
stock-sales ratios rose to uncomfortable levels in some sectors strongly affected by the
nation's trade deficit. The nominal deficit on
U.S. trade in goods and services widened
somewhat in July-August from its secondquarter average. Total retail sales rose
sharply in October after increasing only
moderately in August and September. Residential sales and building starts have
remained quite strong, but below recent
peaks. Available indicators point to a pickup
in business capital spending after a lull in the
third quarter, owing in part to a recovery
from the summer strike in the motor vehicle
industry. Trends in various measures of
wages and prices have been mixed in recent
months.
Most market interest rates have risen on
balance since the meeting on September 29,
though yields on the bonds of lower-rated
firms have declined. The Board of Governors approved a reduction in the discount
rate from 5 to 43/4 percent on October 15.
Share prices in U.S. and global equity markets have remained volatile but have posted
sizable gains on balance over the intermeeting period. In foreign exchange markets, the
trade-weighted value of the dollar declined
moderately over the period in relation to
other major currencies; it also fell somewhat
in terms of an index of the currencies of
other countries that are important trading
partners of the United States.
M2 and M3 have posted very large gains
in recent months, reflecting the effects of
recent System easing actions on market
interest rates and shifts of funds by households out of investments in equities and
lower-rated corporate debt. For the year
through October, both aggregates rose at
rates well above the Committee's ranges for
the year. Expansion of total domestic non-
Minutes of FOMC Meetings, November
financial debt has moderated slightly in
recent months after a pickup earlier in the
year.
The Federal Open Market Committee
seeks monetary and financial conditions that
will foster price stability and promote sustainable growth in output. In furtherance of
these objectives, the Committee reaffirmed
at its meeting on June 30-July 1 the ranges
it had established in February for growth
of M2 and M3 of 1 to 5 percent and 2 to
6 percent respectively, measured from the
fourth quarter of 1997 to the fourth quarter
of 1998. The range for growth of total
domestic nonfinancial debt was maintained
at 3 to 7 percent for the year. For 1999, the
Committee agreed on a tentative basis to set
the same ranges for growth of the monetary
aggregates and debt, measured from the
fourth quarter of 1998 to the fourth quarter
of 1999. The behavior of the monetary
aggregates will continue to be evaluated in
the light of progress toward price level
stability, movements in their velocities, and
developments in the economy and financial
markets.
In the implementation of policy for the
immediate future, the Committee seeks conditions in reserve markets consistent with
decreasing the federal funds rate to an average of around 43/4 percent. In the context
of the Committee's long-run objectives for
price stability and sustainable economic
growth, and giving careful consideration to
economic, financial, and monetary developments, a slightly higher federal funds rate
or a slightly lower federal funds rate would
be acceptable in the intermeeting period.
The contemplated reserve conditions are
expected to be consistent with some moderation in the growth in M2 and M3 over coming months.
Votes for this action: Messrs. Greenspan, McDonough, Ferguson, Gramlich,
Hoenig, Kelley, Meyer, Ms. Minehan,
Mr. Poole, and Ms. Rivlin. Vote against
this action: Mr. Jordan.
Mr. Jordan dissented because he believed that the two recent reductions in
the federal funds rate were sufficient
responses to the stresses in financial
markets that had emerged suddenly in
late August. An additional rate reduc
195
tion risked fueling an unsustainably
strong growth rate of domestic demand.
He expressed concern that the excessively rapid rates of growth of the monetary and credit aggregates were inconsistent with continued low inflation.
Moreover, any further monetary expansion in response to economic weakness
abroad could ultimately have a disrupting influence on domestic prosperity if
policy were forced to reverse course at
a later date to defend the purchasing
power of the dollar.
Renewal of Reciprocal Currency
Arrangements with the Banks of
Canada and Mexico
The Committee voted unanimously to
reauthorize Federal Reserve participation in the North American Framework
Agreement, established in 1994, and the
associated bilateral reciprocal currency
("swap") arrangements with the Bank
of Canada and the Bank of Mexico.
These arrangements, which predated the
North American Framework Agreement,
were linked into a trilateral facility in
connection with the establishment of
the North American Financial Group in
1994 to facilitate consultation and cooperation among the three countries in the
area of macroeconomic policy as an
outgrowth of the increasing integration
of those economies expected to result
from the North American Free Trade
Agreement.
Owing to the formation of the European Central Bank and in light of
15 years of disuse, the bilateral swap
arrangements of the Federal Reserve
with the Austrian National Bank, the
National Bank of Belgium, the Bank
of France, the German Federal Bank,
the Bank of Italy, and the Netherlands
Bank were jointly deemed no longer
to be necessary in view of the well
established present-day arrangements
196 85th Annual Report, 1998
for international monetary cooperation.
Accordingly, it was agreed by all the
bilateral parties to allow them to lapse.
Similarly, it was jointly agreed to allow
the bilateral swap arrangements between
the Federal Reserve and the National
Bank of Denmark, the Bank of England,
the Bank of Japan, the Bank of Norway,
the Bank of Sweden, the Swiss National
Bank, and the Bank for International
Settlements to lapse in light of their
disuse and present day arrangements for
international monetary cooperation.
Authorization for Domestic Open
Market Operations
On the recommendation of the Manager,
the Committee voted unanimously to
amend the authorization for domestic
open market operations to extend the
maximum maturity of System repurchase agreements from 15 calendar days
to 60 calendar days. The purpose of
the expanded authority was to enhance
the flexibility of the Manager in meeting reserve-supplying objectives during
periods of pronounced seasonal needs,
notably those associated with the
year-end. Subject to the Committee's
approval, the Manager would initiate the
System's use of extended-term repurchase agreements ahead of the coming
year-end, and he anticipated that such
use could prove to be especially advantageous in late 1999 to the extent that
year 2000 concerns generated accentuated seasonal demand for currency. In
addition, the availability of the extended
funding could help to allay concerns in
the federal funds market about the cost
of financing during periods of peak seasonal pressures, with favorable effects
on the market's functioning.
Accordingly, effective November 17,
1998, paragraphs l(b) and 3 of the
authorization for domestic open market
operations were amended to read as
follows:
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:
(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 60 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.
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 60 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.
Minutes of FOMC Meetings, December
It was agreed that the next meeting of
the Committee would be held on Tuesday, December 22, 1998.
The meeting adjourned at 1:25 p.m.
Normand Bernard
Deputy Secretary
After the meeting, the following press
release was issued:
The Federal Reserve today announced the
following set of policy actions:
• The Board of Governors approved a reduction in the discount rate by 25 basis points
from 43/4 percent to AV2 percent.
• The federal funds rate is expected to fall
25 basis points from around 5 percent to
around 43/4 percent.
Although conditions in financial markets
have settled down materially since midOctober, unusual strains remain. With the
75 basis point decline in the federal funds
rate since September, financial conditions
can reasonably be expected to be consistent
with fostering sustained economic expansion while keeping inflationary pressures
subdued.
In taking the discount rate action, the
Board approved requests submitted by the
Boards of Directors of the Federal Reserve
Banks of New York, Philadelphia, and
Dallas. The discount rate is the interest rate
that is charged depository institutions when
they borrow from their district Federal
Reserve Banks.
Meeting Held on
December 22, 1998
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 22, 1998, at
9:00 a.m.
Present:
Mr. Greenspan, Chairman
Mr. McDonough, Vice Chairman
197
Mr. Ferguson
Mr. Gramlich
Mr. Hoenig
Mr. Jordan
Mr. Kelley
Mr. Meyer
Ms. Minehan
Mr. Poole
Ms. Rivlin
Messrs. Boehne, McTeer, Moskow, 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. Gillum, Assistant Secretary
Mr. Mattingly, General Counsel
Mr. Baxter, Deputy General Counsel
Mr. Prell, Economist
Ms. Browne, Messrs. Cecchetti,
Hakkio, Lindsey, Simpson,
Sniderman, and Stockton,
Associate Economists
Mr. Fisher, Manager, System Open
Market Account
Mr. Winn, Assistant to the Board,
Office of Board Members, Board
of Governors
Ms. Johnson, Director, Division of
International Finance, Board of
Governors
Messrs. Alexander and Hooper,
Deputy Directors, Division of
International Finance, Board of
Governors
Messrs. Madigan and Slifman,
Associate Directors, Divisions of
Monetary Affairs and Research
and Statistics respectively, Board
of Governors
Mr. Reinhart, Deputy Associate
Director, Division of Monetary
Affairs, Board of Governors
198 85 th Annual Report, 1998
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, Goodfriend,
Hunter, Lang, and Rolnick, Senior
Vice Presidents, Federal Reserve
Banks of San Francisco, Atlanta,
Richmond, Chicago, Philadelphia,
and Minneapolis respectively
Mr. Gavin and Ms. Perelmuter, Vice
Presidents, Federal Reserve Banks
of St. Louis and New York
respectively
Mr. Duca, Assistant Vice President,
Federal Reserve Bank of Dallas
By unanimous vote, the minutes of
the meeting of the Federal Open Market
Committee held on November 17, 1998,
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, and thus no vote was
required of the Committee.
By unanimous vote the Committee
amended the Authorization for Foreign
Currency Operations to add the euro to
the list of foreign currencies in which
the Federal Reserve Bank of New York
is authorized to conduct open market
operations. The Desk's holdings of German marks will automatically be converted to euros when that currency is
introduced on January 1, 1999.
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
November 17, 1998, through Decem-
ber 21, 1998. By unanimous vote, the
Committee ratified these transactions.
The Committee then turned to 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 the economy had
continued to expand at a brisk pace in
recent months. Domestic final demand
had remained robust, and production
and employment had recorded further
solid gains. Trends in various measures
of wages and prices had been mixed in
recent months.
Nonfarm payroll employment rose
strongly in November after having recorded reduced increases in September
and October. Job gains were widespread
in November; hiring in the services
industries remained brisk, construction
payrolls surged further, and retail
employment rebounded after a lackluster rise in October. In sharp contrast
to the general job picture, employment
in manufacturing continued to drop.
The civilian unemployment rate fell to
4.4 percent in November.
Total industrial production declined
somewhat in November in association
with a weather-related drop in utilities
output and persisting weakness in mining activity. Manufacturing output was
unchanged in November after a considerable increase in October. Production in high-tech industries recorded
large gains over the October-November
period, the output of construction supplies climbed rapidly, and consumer
goods manufacture expanded briskly.
Minutes of FOMC Meetings, December
However, production of motor vehicles
and parts was unchanged on balance
over the two months and materials output continued to decline, with the iron
and steel industry registering particularly large decreases. The utilization of
manufacturing capacity dropped over
the October-November period to its
lowest level in more than five years.
Strength in consumer spending persisted in October and November, with
retail sales rising sharply in both
months. Increases in sales of motor
vehicles and other durable goods were
particularly large, but expenditures for
nondurable goods also recorded sizable advances. Supported by continuing gains in disposable income and the
rebound in the stock market, consumer
confidence remained at a relatively
favorable level, though noticeably below the peak reached earlier in the year.
The residential housing sector continued to surge, as single-family housing
starts registered another strong advance
in November and sales of new homes
remained at a very high level. Unseasonably favorable weather over much of the
country evidently contributed to that
performance. Nonetheless, the low level
of mortgage rates and a record high in
an index of consumer assessments of
homebuying conditions in November
suggested that strength in single-family
housing might continue for a time.
Multifamily housing starts in October
and November were slightly above the
average for earlier in the year, and permits for new projects had been rising
recently.
Business fixed investment appeared
to have rebounded from a small decrease
in the third quarter that had been associated in part with a strike-related drop
in business purchases of motor vehicles
and persisting weakness in nonresidential construction. Shipments of office
and computing equipment rose sharply
199
in October after having declined for two
months, and a sizable backlog of orders
for communications equipment suggested that the downturn in shipments in
October after a September surge would
be shortlived. In addition, outlays for
heavy trucks reached record levels and
expenditures for aircraft were well
maintained. In the nonresidential sector,
building activity remained soft in October. Office construction picked up further in response to falling vacancy rates
and rising rental costs, but other building activity continued sluggish, and
available data on new contracts pointed
to persisting weakness.
Business inventory accumulation
slowed appreciably in October after a
sizable rise in the third quarter. In manufacturing, however, the pace of stockbuilding picked up in October from a
slow rate in the third quarter, and the
stock-shipments ratio remained in the
upper portion of its narrow range over
the past year. In the wholesale sector,
inventories declined somewhat in October following a large increase in the
third quarter; much of the reduction was
in farm products. The inventory-sales
ratio for the wholesale sector was still at
the top of its range over the past year.
Retail inventory accumulation in October was near the modest pace of the
third quarter, and the inventory-sales
ratio was slightly below its range over
the preceding twelve months.
The nominal deficit on U.S. trade in
goods and services in October was little
changed from its September level but
was slightly smaller than its average for
the third quarter. The value of exports
was up considerably in October from its
third-quarter average; the largest gains
were in machinery, agricultural products, and industrial supplies. The value
of imports also rose in October. The
rise in imports was spread across all
major trade categories, with the largest
200 85th Annual Report, 1998
increases being in capital goods and oil.
The limited information available for
the fourth quarter suggested that the
Japanese economy remained mired in
recession and that the pace of economic
growth in most of the other major industrial countries was slowing. Activity in
most of the Asian developing economies remained depressed, though there
were signs that activity in some was
nearing a trough and that growth in
China and Taiwan had picked up somewhat. In contrast, economic conditions
in most Latin American economies had
worsened considerably in recent months.
Consumer price inflation remained
subdued in November, with both the
overall index and the index excluding
food and energy items rising at the same
relatively low rates as in October. For
the twelve months ended in November,
the increase in core consumer prices
was a little larger than in the previous
twelve-month period, reflecting slightly
bigger advances in the prices of both
commodities and services. A similar
pattern was evident in producer prices
of finished goods other than food and
energy; core producer prices continued
to rise at a low rate in November, and
the increase in these prices in the twelve
months ended in November was somewhat larger than in the previous twelvemonth period. In contrast, prices for
crude and intermediate materials continued their downward trend in both
the October-November period and the
twelve months ended in November.
Growth in average hourly earnings of
production or nonsupervisory workers
had slowed over recent months to a
modest rate in October and November. While the deceleration in hourly
earnings was relatively widespread
across industries, and most pronounced
in manufacturing, wages continued to
accelerate in the services industries and
in finance, insurance, and real estate.
At its meeting on November 17,
1998, the Committee adopted a directive
that called for implementing conditions
in reserve markets that were consistent
with a one-quarter percentage point
decrease in the federal funds rate to an
average of around 43A percent. The
Committee also decided that moving to
a symmetric directive would be appropriate, given that further easing likely
would not be needed over the months
ahead unless unexpected developments
were to point toward a more substantial
weakening in the growth of economic
activity or to less inflation than was
currently anticipated. The reserve conditions associated with this directive were
expected to be consistent with some
moderation in the growth of M2 and M3
over the months ahead.
Open market operations immediately
after the meeting were directed toward
implementing the desired slight easing
in the degree of pressure on reserve
positions, and through the remainder of
the intermeeting period the Manager
sought to maintain that easier stance.
The federal funds rate remained very
close to its intended lower level on average, and most other short-term market
rates registered small mixed changes.
Longer-term Treasury rates declined
somewhat in response to a weaker outlook for foreign economic activity and
the potential damping effect of lower
commodity prices on inflation. Share
prices in U.S. equity markets remained
volatile but posted substantial increases
on balance over the intermeeting period.
In foreign exchange markets, the
trade-weighted value of the dollar fell
slightly over the intermeeting period in
relation to other major currencies and
also in terms of an index of the currencies of other countries that are important
trading partners of the United States.
Concerns about the vulnerability of
U.S. markets to financial difficulties in
Minutes of FOMC Meetings, December 201
Brazil and uncertainty generated by the
impeachment proceedings were said to
weigh on the dollar at times. The dollar's larger decline against the Japanese
yen than against the German mark and
other European currencies may have
stemmed from a disparity in interest rate
movements in those countries; longterm interest rates rose in Japan, partly
in anticipation of heightened financing
requirements associated with further
fiscal stimulus, while European interest
rates fell in response to cuts in official
interest rates and weaker-than-expected
economic data. Financial conditions
affecting emerging market economies
continued to improve for a time after the
Committee eased monetary policy at its
November 17 meeting, but that trend
was subsequently reversed after Brazil's
legislature decided to reject a key fiscal
reform measure.
M2 and M3 had continued to expand
rapidly in recent months, although
incoming data indicated that growth was
slowing somewhat in December. The
continued strength of M2 in November
reflected the reduction in its opportunity cost as a result of recent easings
of monetary policy, greater growth of
liquid deposits in association with heavy
mortgage refinancing activity, and brisk
demand for U.S. currency both at home
and abroad. M3 growth was bolstered
by further large flows into institutiononly money market funds and additional
RP financing in association with hefty
acquisitions of securities by banks. For
the year through November, both aggregates rose at rates well above the Committee's annual ranges. Total domestic
nonfinancial debt had expanded in
recent months at a pace somewhat above
the middle of its range. Continued paydowns of debt by the federal government were more than offset by appreciable growth of private demands for
credit to finance strong spending on
durable goods, housing, and business
investment, as well as merger and acquisition activity.
The staff forecast prepared for this
meeting pointed to considerable slowing
in the expansion of economic activity
in the year ahead to a pace somewhat
below the estimated growth of the
economy's potential. However, the
expansion was expected to pick up later
to a rate more in line with that potential.
Subdued expansion of foreign economic
activity and the lagged effects of the
earlier rise in the foreign exchange value
of the dollar were expected to place
continuing, albeit diminishing, restraint
on the demand for U.S. exports for some
period ahead and to lead to further substitution of imports for domestic products. In addition, growth in private final
demand would be restrained to some
extent by the tighter terms and conditions that were now being imposed by
many types of lenders, by the anticipated waning of positive wealth effec^
stemming from earlier large increases
in equity prices, and by the buildup of
stocks of consumer durables, housing
units, and business capital goods. Pressures on labor resources were likely to
ease slightly as the expansion of economic activity moderated, but inflation
was projected to rise noticeably over the
year ahead, largely in association with a
partial reversal of the decline in energy
prices this year.
In the Committee's discussion of current and prospective economic conditions, members commented that moderate growth at a pace close to the
economy's potential remained a reasonable expectation for the year ahead. The
members recognized, however, that such
a projection was subject to an unusually
wide range of uncertainty in both directions. On the upside, they emphasized
the marked resilience and persisting
strength of private domestic demand,
202 85th Annual Report, 1998
which had kept the economy expanding
at a faster pace than most had anticipated. In addition, members commented
that domestic financial conditions,
including the rebound in stock market
prices, currently were supportive of further expansion in aggregate demand,
and in that regard several noted the continued rapid growth of the broad monetary aggregates. Still, domestic financial
markets remained unusually sensitive
and subject to relatively pronounced
adjustments to unanticipated developments that could have substantial effects
on confidence and economic activity.
The external sector continued to represent a major source of downside risk;
the economies of several industrial
countries seemed to be weakening and
the outlook for several key emerging
market economies remained in doubt,
with a further loss of confidence and
contagion from the latter a continuing
threat. With regard to the outlook for
inflation, members reported that labor
markets were extraordinarily tight
across the nation, but they saw only
limited evidence of accelerating wage
increases and little or no evidence of
rising inflation in broad measures of
prices. Several commented, however,
that the risks of inflation appeared to be
tilted to the upside, given the continuing
strength of the domestic expansion and
accommodative financial conditions.
In their review of developments in
various parts of the country and major
industries, members referred to widespread evidence of high levels and
strong growth of overall domestic production and demand, but also to the
continued retarding effects of the foreign trade sector on agriculture and
manufacturing and extractive industries.
Growth in consumer spending was
expected to moderate over coming quarters from a very robust pace. Factors
contributing to this assessment included
expectations of somewhat slower
growth in employment and incomes and
the prospect that increases in financial
wealth would moderate or even end at
some point. Members also referred to
the possibility that the very low saving
rate would tend to limit increases in
consumer spending, but they noted that
high levels of consumer confidence and
wealth along with low interest rates
should help to sustain at least moderate
growth in coming quarters.
Forecasts of business investment
spending pointed to appreciable deceleration in the year ahead after very rapid
increases in recent years. Among the
factors cited in support of a slowing
uptrend were the anticipated slower
growth in overall demand and the large
cumulative buildup of business capital
that had resulted in comparatively subdued pressures on capacity. Forecasts of
reduced growth in business expenditures tended to be supported by anecdotal reports that many business firms
were planning to trim their capital outlays during the year ahead. Perhaps the
slower growth in corporate earnings,
which had been evident since earlier in
the year, and reduced cash flows were
beginning to exert some restraint on
business capital spending. Some members observed, however, that there was
little evidence thus far of any deceleration in business equipment expenditures
and that the persistence of tight labor
markets should continue to encourage
relatively rapid growth in labor-saving
business capital.
Housing activity had displayed a great
deal of strength in recent months according to both anecdotal and statistical
reports at this meeting. Comparatively
warm weather had extended the building season in several areas, while rising
incomes and low interest rates had continued to stimulate housing demand.
Some retrenchment in housing activity
Minutes of FOMC Meetings, December 203
from currently high levels seemed likely
over coming quarters, given the recent
large additions to the stock of housing
units and some anticipated deceleration
in the growth of jobs and incomes.
Members viewed the foreign sector as
likely to exert a smaller negative effect
on domestic growth in the year ahead.
This view was based on the expectation
of some stabilization or improvement in
foreign financial markets and economies. In addition, the foreign exchange
value of the dollar had been declining
in recent months, and the effects of its
earlier appreciation on the trade balance would be waning. However, they
recognized that net exports could turn
out to be substantially more negative
than the modal forecast, given the persistence of very fragile financial and
economic conditions in several large
emerging economies, continued weakness in the Japanese economy, and questions about the prospective strength of
economic activity in other industrial
nations. As recent experience had demonstrated, a crisis in one or a group of
important financial markets and economies could spread rapidly around the
world.
The outlook for inflation remained
favorable, though some members referred to a number of upside risks
going forward. For now, however, there
were few signs of rising price inflation
despite widespread indications of very
tight labor markets, including reports of
further tightening in some areas. Indeed,
the most recent wage and price data
were encouraging. Increases in core
measures of prices were limited, and
sizable declines in oil and commodity
prices should help to moderate inflation
going forward, in part by holding down
inflation expectations. Looking beyond
the nearer term, current forecasts suggested that moderating growth in overall
economic activity would tend to limit
pressures on resources and foster relatively subdued price inflation in the context of robust productivity growth and
ample industrial capacity. Members who
viewed the risks as tilted mainly to the
upside commented that the effects of
the anticipated reversal of a number of
factors—including the declines in oil
and commodity prices and restrained
increases in health care costs—that had
tended to hold down overall inflation
might turn out to be more pronounced
than was currently forecast. Moreover,
underlying cost and price pressures
might emerge more rapidly under
such circumstances, especially if overall demand continued to outpace the
growth of potential. Some members also
referred to the potential inflationary
effects over time of the continuation
of quite rapid monetary growth. On balance, however, the members generally
believed that prospective trends in overall economic activity and the persistence
of strong competitive pressures in most
markets, including the effects of foreign
competition, were likely in the context
of now firmly embedded expectations of
low inflation to moderate any tendency
for price inflation to accelerate over the
year ahead.
In the Committee's discussion of policy for the intermeeting period, all the
members agreed on the desirability of
maintaining an unchanged policy stance.
The System's policy easing actions
since late September had helped to stabilize a dangerously eroding financial situation, and current financial conditions as
well as underlying economic trends suggested that needed policy adjustments
had been completed. For now at least,
monetary policy appeared to be consistent with the Committee's objectives
of fostering sustained low inflation and
high employment. Accordingly, the
Committee had entered a period where
vigilance was called for but where the
204 85th Annual Report, 1998
direction and timing of the next policy
move were uncertain.
As already noted, Committee members saw risks on both sides of their
forecasts. Persistently strong demand
and increasingly supportive conditions
in debt and equity markets suggested the
possibility of rising inflation pressures.
But greater disturbances abroad, especially if they were to be transmitted to
domestic financial markets, could exert
considerable restraint on the domestic
economy. Fortunately, with low inflation, if not price stability, increasingly
embedded in expectations, the Committee would have time to react to potential inflationary pressures. In the event
of downward shocks to the expansion,
prompt action to ease policy would be
needed, but such shocks could not be
anticipated at this point. Against this
background, all the members indicated
that they were in favor of retaining the
symmetry in the existing directive.
Before its vote on policy at this meeting, the Committee discussed the wording of the operating paragraph of the
directive, building on progress made
toward a consensus at previous meetings. Attention focused in part on proposed new wording to describe the possibility of intermeeting actions. There
were minor differences about specific
wording, but no strongly held opinions,
and all the members agreed that the new
wording preferred by a majority of the
members represented an improvement
over the traditional language in that it
would communicate more clearly and
succinctly the substance of the Committee's policy decisions. The Committee
also discussed deleting the last sentence
in the operating paragraph relating to
the outlook for the growth of money;
another paragraph in the directive would
continue to report the long-run ranges
for such growth that the Federal Reserve
Act requires the Committee to establish.
With regard to the proposed deletion,
some felt it was desirable for the central
bank to retain a reference to money in
the operating paragraph; more members
supported the deletion on the ground
that, as had been explained to the Congress, money growth had not had any
special significance for some time in the
formulation of monetary policy owing
to often unexplained and unexpected
changes in velocity. The rewording of
the sentence on symmetry and the deletion of the sentence on money were not
intended to imply any change in policy
or the Committee's approach to policy
or its decisionmaking.
At the conclusion of the Committee's
discussion, all the members supported a
reworded directive that called for maintaining conditions in reserve markets
that were consistent with an unchanged
federal funds rate of about 43/4 percent and did not contain any bias with
respect to the direction of possible
adjustments to policy during the intermeeting period.
The Committee then 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 information reviewed at this meeting
suggests that the economy has continued to
expand at a brisk pace in recent months.
Growth in nonfarm payroll employment was
strong in November, after more moderate
gains in September and October, and the
civilian unemployment rate fell to 4.4 percent. Total industrial production declined
somewhat in November, but manufacturing
output was stable and up considerably from
the third-quarter pace. Business inventory
accumulation slowed appreciably in October
after a sizable rise in the third quarter. The
nominal deficit on U.S. trade in goods and
services narrowed slightly in October from
its third-quarter average. Total retail sales
rose sharply in October and November, and
Minutes of FOMC Meetings, December
housing starts were strong as well. Available
indicators point to a considerable pickup in
business capital spending after a lull in the
third quarter. Trends in various measures of
wages and prices have been mixed in recent
months.
Most short-term interest rates have
changed little on balance since the meeting
on November 17, but longer-term rates have
declined somewhat. Share prices in equity
markets have remained volatile and have
posted sizable gains on balance over the
intermeeting period. In foreign exchange
markets, the trade-weighted value of the
dollar has declined slightly over the period
in relation to other major currencies and in
terms of an index of the currencies of other
countries that are important trading partners
of the United States.
M2 and M3 have posted very large
increases in recent months. For the year
through November, both aggregates rose at
rates well above the Committee's annual
ranges. Total domestic nonfinancial debt has
expanded in recent months at a pace somewhat above the middle of its range.
The Federal Open Market Committee
seeks monetary and financial conditions that
will foster price stability and promote sustainable growth in output. In furtherance of
these objectives, the Committee reaffirmed
at its meeting on June 30-July 1 the ranges
it had established in February for growth
of M2 and M3 of 1 to 5 percent and 2 to
6 percent respectively, measured from the
fourth quarter of 1997 to the fourth quarter
of 1998. The range for growth of total
domestic nonfinancial debt was maintained
at 3 to 7 percent for the year. For 1999, the
Committee agreed on a tentative basis to set
the same ranges for growth of the monetary
aggregates and debt, measured from the
fourth quarter of 1998 to the fourth quarter
of 1999. The behavior of the monetary
aggregates will continue to be evaluated in
the light of progress toward price level
stability, movements in their velocities, and
developments in the economy and financial
markets.
To promote the Committee's long-run
objectives of price stability and sustainable
economic growth, the Committee in the
immediate future seeks conditions in reserve
markets consistent with maintaining the federal funds rate at an average of around
43/4 percent. In view of the evidence cur
205
rently available, the Committee believes that
prospective developments are equally likely
to warrant an increase or a decrease in the
federal funds rate operating objective during
the intermeeting period.
Votes for this action: Messrs. Greenspan, McDonough, Ferguson, Gramlich,
Hoenig, Jordan, Kelley, Meyer, Ms. Minehan, Mr. Poole, and Ms. Rivlin. Votes
against this action: None.
Disclosure Policy
The members also discussed various
issues relating to the timing and manner
of releasing information about the Committee's policy decisions. A range of
views was expressed, as at earlier meetings, on the desirability of releasing a
statement routinely not only after those
meetings at which there was a change in
the stance of policy but also after meetings where the Committee altered its
view of the direction of possible policy
actions during the intermeeting period.
Members who favored more announcements believed that such disclosure,
by providing more information on the
Committee's views of the risks in
the economic outlook, generally would
allow financial market prices to reflect
more accurately the likely future stance
of monetary policy. However, other
members were concerned that such
announcements often would provoke
market reactions. As a consequence, the
Committee would become less willing
to change the symmetry in the directive,
and a policy of immediate release might
therefore have adverse repercussions on
the Committee's decisionmaking. Nonetheless, the members decided to implement the previously stated policy of
releasing, on an infrequent basis, an
announcement immediately after certain
FOMC meetings when the stance of
monetary policy remained unchanged.
Specifically, the Committee would do so
206 85 th Annual Report, 1998
on those occasions when it wanted to
communicate to the public a major shift
in its views about the balance of risks or
the likely direction of future policy.
Such announcements would not be made
after every change in the symmetry of
the directive but only when it seemed
important for the public to be aware
of an important shift in the members'
views. On the basis of experience with
such announcements, the Committee
would evaluate later whether further
changes in its approach to disclosures
would be desirable.
It was agreed that the next meeting
of the Committee would be held on
Tuesday-Wednesday, February 2-3,
1999.
The meeting adjourned at 12:55 p.m.
Donald L. Kohn
Secretary
207
Consumer and Community Affairs
In 1998 the Board's activities in consumer and community affairs centered
on reviewing applications for the acquisition of banking organizations, on
improving disclosures to consumers
about mortgage transactions, and on fair
lending issues, including the material
enhancement of the Board's enforcement capabilities.
As consolidation of the banking
industry continued during 1998, the
Board received applications for several
exceptionally large mergers and acquisitions, and held public meetings on
five of them. After extensive analysis,
the Board approved all the applications,
finding in each instance that approval
was consistent with the convenience and
needs of the communities to be served.
In July the Board and the Department
of Housing and Urban Development
(HUD) issued a report to the Congress
suggesting legislative reforms to the
Truth in Lending Act (which is administered by the Board) and the Real Estate
Settlement Procedures Act (which is
administered by HUD). The two agencies had earlier considered whether the
disclosures required under these laws
could be simplified and streamlined,
either by regulatory or statutory amendment. After determining that regulatory
change alone would not achieve the
improvements called for by the Congress in 1996 legislation, the Board and
HUD made recommendations on four
key questions as a starting point for
congressional consideration of statutory
reform.
In the fair lending area, the Board's
enforcement capabilities were materially enhanced with the adoption of new
interagency examination procedures,
developed over the past two years by
an interagency team. The Board referred
one discrimination case involving a state
member bank to the Department of
Justice.
Acting on behalf of the Federal
Financial Institutions Examination
Council (FFIEC) and HUD, the Board
prepared Home Mortgage Disclosure
Act (HMDA) statements for individual
lenders and aggregate reports for metropolitan areas. The statements reflected
data reported in 1998 for the preceding
year. These data indicated that denial
rates continued to show disparities
among racial and ethnic groups; the
number of loans to black and Hispanic
applicants increased in 1997 as in previous years, but the increases were modest compared with the average annual
increase during the five years from 1993
through 1997.»
These matters are discussed below,
along with other Board activities in the
areas of consumer and community
affairs.
Applications
While most applications to the Board
for approval of an acquisition are processed by a Reserve Bank under authority delegated by the Board, the Board
itself considers applications for acquisitions that are exceptionally large or
that raise substantive issues. As required
by the Bank Holding Company Act
(BHCA), the Board's consideration of
1. The period 1993-97 is used for analysis of
trends in HMDA data because HMDA coverage
was expanded in 1993 to include a significantly
larger group of independent mortgage companies.
208 85th Annual Report, 1998
such applications in 1998 takes account
of specific factors, including the competitive effects of the acquisitions, the
parties' financial and managerial resources, and the convenience and needs
of the communities to be served, including the Community Reinvestment Act
(CRA) performance records of the insured depository institutions involved.
In addition to soliciting written comment from the public on these applications, in 1998 the Board held public
meetings on five applications to give
interested persons an opportunity to
present oral testimony. After extensive
analysis, the Board approved all the
applications, finding in each case that
approval was consistent with the factors
prescribed by the BHCA, including the
convenience and needs of the communities to be served.
• In April the Board approved the
application by First Union Corporation, Charlotte, North Carolina, to
acquire CoreStates Financial Corporation, Philadelphia, Pennsylvania.
• In August the Board approved the
application by NationsBank Corporation, Charlotte, North Carolina, to
acquire BankAmerica Corporation,
San Francisco, California, a merger
resulting in the nation's largest
depository institution.
• In September the Board approved the
application by Travelers Group, Inc.,
New York, New York, to acquire
Citicorp, New York, New York. The
resulting company, Citigroup, became
the largest commercial banking organization in the world, offering not only
banking but also securities and insurance services.
• Also in September the Board approved the application by Bane One
Corporation, Columbus, Ohio, to acquire First Chicago NBD Corporation,
Chicago, Illinois. This acquisition
created the largest banking organization in the Midwest and the fifth largest in the nation.
• In October the Board approved the
application by Norwest Corporation,
Minneapolis, Minnesota, to acquire
Wells Fargo and Company, San Francisco, California.
• Also in October the Board approved
the application by SunTrust Banks,
Inc., Atlanta, Georgia, to acquire
Crestar Financial Corporation, Richmond, Virginia.
These applications generated significant public interest. While they
were supported by many commenters,
adverse comment generally focused on
anticipated job losses, branch closures,
decreased lending, or other economic
effects in the areas served by the organization being acquired. Commenters
also criticized the CRA records of
depository institutions involved in the
acquisitions. Responding to such comment, some organizations pledged specific sums for future lending, investment, and services.
In each of these applications, the
Board found the CRA records of the
organizations involved to be consistent
with approval. In the cases involving
anticipated branch closures, the Board
required that the merged organizations
report, for a two-year period, all branch
closures and consolidations resulting
from the mergers.
In addition to these "megamergers,"
the Federal Reserve System acted on
nineteen bank and bank holding company applications during 1998 that
involved protests by members of the
public concerning insured depository
institutions' performance under the CRA
and three applications that involved
depository institutions' adverse CRA
performance records. One other application involved both a CRA protest and an
Consumer and Community Affairs 209
adverse CRA performance record. The
Federal Reserve reviewed another
twenty-five applications involving fair
lending and other issues related to
compliance with consumer protection
laws.2
TILA and RESPA Reform
In July the Board and HUD submitted a
report to the Congress concerning legislative changes to the Truth in Lending
Act (TILA) and the Real Estate Settlement Procedures Act (RESPA) as these
statutes apply to home-secured loans.
The report responded to a congressional
mandate for the Board and HUD to
simplify and improve the disclosures
required by the two laws and to create a
single format for complying with them.
The agencies' report followed an
eighteen-month study indicating that
consumers primarily wanted disclosures
about mortgage costs to be given earlier, so that they could comparison shop
before applying for a loan from a particular lender. Consumers also wanted
the cost disclosures to be as accurate
as possible, so that they would not face
unexpected charges at loan closing,
when they no longer have the flexibility
to seek other financing. Consumer advocates believed that the benchmark figure
for comparison shopping—the annual
percentage rate (APR)—should be retained and made more inclusive, and
that any rate and other cost information
provided at the time of application
should be firm, subject to only limited
conditions. They also believed that
abusive lending practices should be
addressed as part of any reform effort.
2. In addition, three applications were withdrawn in 1998—one involving an adverse CRA
performance record and two involving issues with
respect to compliance with consumer protection
laws.
Many creditors asserted that the regulatory framework could be simplified by
eliminating many of the disclosures,
including the APR and finance charge
items. They suggested that disclosures
should focus instead on the interest rate,
points, monthly payments, and settlement costs. To address concerns about
the accuracy of settlement cost disclosures, some creditors favored a system
of guaranteed costs in exchange for
protection from RESPA's anti-kickback
provisions. Other creditors and settlement service providers expressed concern that under such a plan they would
be unable to compete with larger creditors and service providers.
The report to the Congress discussed
ways to provide consumers with more
meaningful and more timely cost information about home-secured transactions
and at the same time ease compliance burdens on creditors. It contained
recommendations addressing four key
questions:
• Should the finance charge and APR
disclosures be eliminated, or modified
and retained? The Board and HUD
recommended that the finance charge
and APR concepts be retained and
that the definition of the finance
charge be expanded to include all
costs the consumer is required to pay
to obtain the loan, with limited exceptions. The agencies also recommended
changes in the disclosures—such as
including the contract interest rate, so
that consumers can better understand
the distinction between that rate and
the APR.
• Should creditors be required to give
firmer quotes for closing costs disclosed under RESPA? The Board and
HUD recommended that creditors be
required to give consumers morereliable closing cost information, to
promote shopping and competition.
210 85th Annual Report, 1998
Currently, creditors provide a good
faith estimate of closing costs, but
there are no standards for accuracy.
The agencies recommended that creditors be given a choice of either guaranteeing the settlement costs (with the
possibility of relief from RESPA's
anti-kickback provisions) or providing a good faith estimate that is accurate within a specified tolerance.
Should the timing rules for providing cost disclosures to consumers
be changed (and should creditors be
required to provide disclosures before
imposing substantial fees)? The Board
and HUD recommended that consumers be given cost disclosures for any
home-secured loan as early as possible in the shopping process. The
Board recommended that the initial
disclosures be provided not later than
three days after application. In addition, the Board and HUD recommended that, three days before closing, creditors be required to redisclose
significant changes in the APR or
other material disclosures and to provide an accurate copy of the required
HUD settlement statement. For homesecured transactions not involving a
home purchase, the Board recommended that, three days before closing, consumers also receive a notice
of a pre-closing right to a refund of
fees paid that in most instances would
substitute for the existing right to
rescind the transaction and receive a
refund.
Should additional substantive consumer protections be added to the
statutes to address abusive lending
practices? The Board and HUD recommended the adoption of substantive protections that target abusive
lending practices without unduly
interfering with the flow of credit,
creating unnecessary creditor burden,
or narrowing consumers' options in
legitimate transactions. The agencies
specifically recommended extending
restrictions on balloon payments for
loans subject to the Home Ownership
and Equity Protection Act (HOEPA);
prohibiting the advance collection of
lump-sum credit-insurance premiums
for HOEPA loans; and requiring certain minimum standards for the notice
of home foreclosures that creditors
must provide.3
The Board and HUD presented their
recommendations in hearings before
subcommittees of the House Committee on Banking and Financial Services
and the Senate Committee on Banking,
Housing, and Urban Affairs. The agencies suggested that the Congress use the
recommendations as a starting point for
considering legislative changes.
Regulatory Matters
The Board has responsibility for implementing federal laws concerning
consumer financial services and fair
lending. In 1998, significant regulatory
developments in these areas included
the following:
• Mandatory compliance with comprehensive new rules under Regulation
M (Consumer Leasing) became effective January 1, 1998.
• In March the Board published an
advance notice of proposed rulemaking, announcing a comprehensive
review of Regulation B (Equal Credit
Opportunity). The notice solicited
comment on several specific issues,
including lenders' pre-application
marketing practices and whether the
3. Enacted in 1994, HOEPA amended the TILA
to require additional disclosures and provide for
substantive restrictions on nonpurchase-money
home loans that involve rates or fees above a
certain amount.
Consumer and Community Affairs 211
current prohibition on creditors' collecting race and similar information
about applicants for nonmortgage
credit products should be removed.
In March the Board published an
advance notice of proposed rulemaking, launching a comprehensive
review of Regulation C (Home Mortgage Disclosure). The review will
identify ways in which the Board
could revise the regulation to clarify
and simplify the regulatory language,
respond to technological and other
developments, reduce undue regulatory burden on the industry, eliminate
obsolete provisions, and improve the
quality and usefulness of the data collected under the regulation. The Board
solicited comment on several specific
issues, such as whether to require
creditors to collect and report data
on pre-approvals and whether to modify the current reporting categories
applicable to refinancings and home
improvement loans.
In March the Board issued a proposal
to permit the electronic delivery
of disclosures for Regulations B,
M, Z (Truth in Lending), and DD
(Truth in Savings). The proposal
would allow financial institutions,
creditors, and others—with the consumer's consent—to provide electronically the information required by
these regulations. This information
could include such items as initial
disclosures of terms and conditions of
accounts, loans, and leases; periodic
statements of account activity; and
notices about error resolution. The
proposal corresponds in approach to
an interim rule, also published in
March, amending Regulation E (Electronic Fund Transfers). The Board
received more than 200 public comments on the proposal and the interim
rule. Commenters generally supported
modifying the regulations to permit
the electronic delivery of disclosures
but expressed concerns about how
the rules would apply in particular
circumstances.
• In September the Board published
revisions to Regulation E reducing
the time periods for investigations of
claimed errors involving consumers'
use of debit cards at point-of-sale
and in foreign-initiated transactions.
The revised rule requires a financial
institution to provisionally credit an
account within ten business days—
rather than twenty, as the regulation
permitted formerly—if the institution
has not resolved the error claim within
that time. To address commenters'
concerns about the amount of time
necessary to complete an investigation, the revised rule leaves in place a
provision that gives institutions up to
ninety calendar days to complete the
investigation. At the same time, the
Board adopted a rule that increases
the time period for investigating
errors claimed within thirty days
after a consumer has opened an
account; this rule was issued to
address fraudulent claims of error
on new accounts. Under the rule, an
institution has up to twenty business
days—rather than the ten formerly
permitted—to resolve an alleged error
before it must provisionally credit
funds. It also has up to ninety calendar
days to complete the investigation,
rather than forty-five days.
In addition, the Board took the following regulatory actions:
• Adopted amendments to the model
forms in Regulation B related to consumer rights under the Fair Credit
Reporting Act
• Published technical amendments to
Regulation M that clarify the rules for
disclosing scheduled lease payments
212 85 th Annual Report, 1998
and the disclosure requirements for
advertisements
• Updated the official staff commentary
to Regulation Z to give guidance on
disclosures for open-end credit plans
that offer deferred payment features or
that permit creditors to increase rates
when consumers make late payments
or exceed established credit limits,
and to address the treatment of annuity costs in reverse mortgage transactions and transaction fees imposed
on checking accounts with overdraft
protection
• Adopted amendments to Regulation
DD to implement minor changes to
the Truth in Savings Act contained in
the Economic Growth and Regulatory
Paperwork Reduction Act of 1996
• Made final an interim rule (adopted in
1995) on the disclosure of the annual
percentage yield for certain certificates of deposit that have maturities
greater than one year and that do not
compound interest.
Also, in March the Board reported to
the Congress on the ways in which it
assists small entities regarding compliance with Board regulations. The report
was required under the Small Business
Regulatory Enforcement Fairness Act of
1996. The Board reported that, in accordance with the Federal Deposit Insurance Act, it ordinarily will reduce civil
penalties against small entities from the
amount that would be assessed against
larger entities, or may waive them altogether. But the Board will not reduce
or waive these penalties when aggravating factors exist. Guidance to small
entities is available from the Federal
Reserve through conferences or training
for bankers; review of submitted forms
and other documents; educational advisory visits to banks; brochures, compliance guides, and newsletters; and telephone responses to calls and letters.
HMDA Data and
Lending Patterns
The Home Mortgage Disclosure Act
requires mortgage lenders covered by
the act to 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 and met
the asset threshold at the end of the
preceding year. For 1997, the asset
threshold for depository institutions was
$28 million. Mortgage companies are
covered if they were located in or made
loans in metropolitan areas and had
assets of more than $10 million (when
combined with the assets of any parent
company) at the end of the preceding
year; and they are covered, regardless of
asset size, if they originated 100 or more
home purchase loans in the preceding
year.
In 1998, 6,886 depository institutions
and affiliated mortgage companies and
1,039 independent mortgage companies reported HMDA data for calendar
year 1997 to their supervisory agencies.
These lenders submitted information
about the geographic location of the
properties related to their loans and
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 processed the data and produced disclosure statements on behalf
of HUD and the FFIEC's member
agencies.4
4. The member agencies of the FFIEC are the
Board, 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).
Consumer and Community Affairs 213
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
July, each institution made its disclosure
statement public; in August, 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 were used not only
by the FFIEC member agencies, the
reporting institutions, and the public, but
also by HUD in its oversight of Fannie
Mae and Freddie Mac and by HUD and
the Department of Justice as one component of fair lending reviews. The data
also assisted 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 in 1998 for the
prior year included 16.4 million reported
loans and applications, an increase of
about 11 percent over 1996, due primarily to increased refinancing activity.
The number of home purchase loans
extended in 1997 compared with 1996
increased 12 percent for Asians, 4 percent for blacks and Hispanics, and
2 percent for whites, while decreasing
1 percent for Native Americans. Over
the five years from 1993 through 1997,
the number of home purchase loans
extended increased 62 percent for
blacks, 58 percent for Hispanics, 29 percent for Asians, 25 percent for Native
Americans, and 16 percent for whites.
5. Oivbehalf of the nation's eight 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 downpayments.
The number of home purchase loans
extended to applicants in all income
categories increased in 1997 compared
with the preceding year. The number
of such loans extended to lower-income
applicants increased 6 percent, and the
number extended to upper-income applicants increased 5 percent. Over the five
years from 1993 to 1997, the number of
home purchase loans extended to lowerincome and upper-income applicants
increased 38 percent and 27 percent
respectively.
In 1997, 34 percent of Hispanic applicants and 26 percent of black applicants for home purchase loans sought
government-backed mortgages; the
comparable figures for white applicants,
Asian applicants, and Native American
applicants were 15 percent, 12 percent,
and 11 percent, respectively. Twentyseven percent of lower-income applicants for home purchase loans applied
for government-backed loans in 1997,
compared with 11 percent of upperincome applicants.
Denial rates for conventional (nongovernment-backed) home purchase
loans in 1997 were 53 percent for black
applicants, 52 percent for Native American applicants, 38 percent for Hispanic
applicants, 26 percent for white applicants, and 13 percent for Asian applicants. Except for Asian applicants, each
of these rates exceeded the comparable
rate for 1996.
Overall, the denial rate for conventional loans was 29 percent in 1997.
This rate has increased in each of the
past several years, reflecting, in part, the
increasing share of applications for conventional loans filed by lower-income
applicants.
In recent years, a growing share of
the applications reported under HMDA
has been filed with lenders that specialize in manufactured housing and
subprime lending. In 1997, these lenders
214 85th Annual Report, 1998
denied 56 percent of all applications for
conventional home purchase loans they
received, compared with 12 percent for
other lenders.
Fair Lending
The Board's fair lending activity during
1998 focused on enhanced enforcement
capabilities, referrals to the Department
of Justice, and consumer education.
Examination Procedures
During 1998 the Board adopted new
procedures for fair lending examinations. The new procedures' principal
analytical technique calls for examining
the files of denied applications, identifying the minority applicant with the least
deficient credit record for a given denial
reason, and comparing that applicant's
record against nonminority applicants
whose credit records were more deficient, relative to the same denial reason,
and yet were approved for credit. Variations of this technique will be employed
in examining for potential discrimination in pricing, commercial lending, and
credit-scored products and for redlining analysis. The new procedures were
field-tested during 1998 in several Federal Reserve Districts and will be in
effect for all compliance examinations
begun after January 1, 1999. To prepare
examiners for the new procedures, the
Board over the past year developed and
implemented two training programs for
fair lending.
The Board also made important
enhancements to the statistical regression program used to aid examiners
in assessing fair lending compliance
among large-volume mortgage lenders.
For example, a methodology for analyzing discrimination in loan pricing was
added to the program's existing methDigitizedodology for the analysis of apparent disfor FRASER
criminatory disparities in application
denials. In addition, efforts continued
in 1998 to achieve closer matching of
minority and nonminority applicants
for comparative analysis through adjustments to the type and number of factors
(or variables) used in the regression.
Finally, significant work was done on
developing a regression methodology
for use in examining groups of loan
transactions that included too few
denied applications to permit use of the
existing regression format. This latter
effort addressed a recurring limitation
on the use of regression analysis.
Referrals to the
Department of Justice
Under the 1991 amendments to the
Equal Credit Opportunity Act, the Board
refers to the Department of Justice violations that it believes may constitute a
"pattern or practice" of discrimination.
Potential referral cases identified during
Federal Reserve compliance examinations are sent to the Board for review
and a determination as to whether there
is "reason to believe" that a pattern
or practice warranting referral has
occurred. Of the sixteen cases reviewed
by the Board in 1998, three involved
complicated fact patterns regarding the
acceptance or denial of loan applications and eight raised issues of potentially discriminatory pricing identified
through review of bank policies and
analysis of loan files. One case was
referred to the Department of Justice in
1998; it involved the failure of a credit
card issuer to consider child support
payments as income. Four cases were
still under investigation at year-end.
Consumer Education
In 1998 an interagency Fair Lending
Task Force prepared a booklet on mort-
Consumer and Community Affairs
gage loan pricing, Looking for the Best
Mortgage—Shop, Compare, Negotiate.
The booklet tells prospective loan applicants how mortgage loans are priced,
how to obtain and compare price information from different lenders, and how
to negotiate the best price. It focuses
on such pricing practices as "overages,"
which have been the subject of recent
regulatory agency fair lending investigations. It also advises consumers about
the applicability of the fair lending laws
to the loan-pricing practices of mortgage lenders.
Community Development
Through its community affairs program,
the Federal Reserve conducts ongoing
outreach, informational, and educational
activities to help financial institutions
and the public understand and address
financial services issues affecting lowand moderate-income persons and communities. In 1998 the Board and the
Reserve Banks began a Systemwide
strategic planning process to re-examine
their mission in regard to community affairs and to develop strategies for
responding better to emerging financial
services issues.
Throughout 1998, educational and
technical assistance activities focused
increasingly on small business and
economic development in low- and
moderate-income and rural communities. For example,
• The Federal Reserve Bank of Cleveland began the implementation phase
of its "Access to Capital Initiative," a
joint effort with the Small Business
Administration and the Greater Cleveland Growth Association's Council
of Smaller Enterprises. The initiative
was designed to help expand small
business access to technical assistance
on financing and business development. Recommendations and action
215
plans were developed at a meeting of
more than 175 bankers, small business finance intermediaries, venture
capitalists, accountants, attorneys,
public officials, and business owners.
• The Chicago Reserve Bank began
planning its "Small Business Credit
Access Initiative." This initiative
seeks to identify and address barriers
to equity and debt capital for small
enterprises in the Chicago metropolitan area, especially businesses located
in predominantly minority and lowand moderate-income communities.
• The Richmond Reserve Bank, in
conjunction with the National Association of Women Business Owners,
conducted a series of six conferences
on "Access to Capital: Start to Finish," which focused on the financing
needs of and resources for womenowned businesses.
• The Boston Reserve Bank sponsored
a conference, "Making It in the Mainstream," that reviewed partnerships
between minority business enterprises
and major corporations as a strategy
for inner-city business development
and job creation.
Several educational programs focused
on financial and technical assistance to
help very small and start-up businesses.
For example,
• The Minneapolis Reserve Bank sponsored a conference on small business
development.
• The Atlanta Reserve Bank conducted
a workshop on issues affecting microenterprise lending, and the Boston
Reserve Bank developed a training
curriculum on lending and the provision of technical assistance for
organizations that offer services to
microentrepreneurs.
Rural community development was
the focus of several educational programs and publications. For example,
216 85 th Annual Report, 1998
• The Kansas City Reserve Bank's
community affairs and economic
research departments worked together
to sponsor a conference, "Equity for
Rural America: From Main Street
to Wall Street," to explore how rural
communities can gain access to equity
capital markets to strengthen local
economies.
• The St. Louis Reserve Bank produced
the Community Development Resource
Guide: A Rainbow of Opportunity
in the Delta, a resource focusing on
organizations and financial resources
available in the lower Mississippi
Delta region. The Bank also conducted community
development
workshops that highlighted many of
the successful initiatives that are helping to revitalize that region.
Several Reserve Banks' educational
programs explored techniques for helping low-income persons move into
mainstream employment and the financial services markets. For example, the
Richmond Reserve Bank, together with
Virginia Commonwealth University,
sponsored a symposium on the "Delivery of Financial Services in a PostWelfare Reform Society." Participants
discussed means of serving individuals
who do not have transaction accounts
with depository institutions; the effects
that trends toward electronic benefits
transfer and other electronic banking
trends will have on low- and moderateincome households; and techniques for
helping low-income persons build financial assets.
Three Reserve Banks continued their
long-term efforts to facilitate community and economic development on
Indian reservations:
• The San Francisco Reserve Bank
joined with the Affiliated Tribes of
Northwest Indians to conduct four
workshops on "Sovereign Lending"
for bankers and tribal leaders, to help
facilitate lending by financial institutions in Indian Country.
• The Minneapolis Reserve Bank cosponsored, with the Federal Deposit
Insurance Corporation (FDIC), two
roundtables for Montana bankers on
lending in Indian Country, with an
emphasis on small business financing
and economic development; and continued to work on community development issues at the Pine Ridge
Reservation. The Reserve Bank also
continued to develop a personal
finance course to be offered at the
Fond du Lac Tribal Community
College.
• The Kansas City Reserve Bank
drafted a case study focusing on community development issues encountered by Native Americans for use
in educational programs in Indian
Country.
Other educational programs focused
on community development and reinvestment tools and techniques. For
example,
• The Philadelphia Reserve Bank convened a workshop for Philadelphiaarea nonprofit community development organizations and local bankers
to share information on potential
projects and financing opportunities.
• The Dallas Reserve Bank sponsored a
workshop on "Asset-Based Community Development: Mobilizing an
Entire Community," which focused
on ways to strengthen community-led
development of affordable housing
and small business initiatives in the
Dallas-Ft. Worth area.
• The San Francisco Reserve Bank, in
cooperation with the University of
California at Berkeley and the Institute of Urban and Regional Development, conducted the National
Community Development Lending
Consumer and Community Affairs 217
School—a weeklong training program
for lenders engaged in financing
affordable housing, small businesses,
commercial development, and community facilities in the community
development context.
Overall during 1998, Reserve Banks
sponsored or cosponsored 280 conferences, seminars, and informational
meetings on community and economic
development, reinvestment, and fair
lending topics. More than 12,900 bankers, examiners, and participants from
small businesses and community and
consumer groups attended. Board and
Reserve Bank community affairs staff
also made presentations at conferences,
seminars, and meetings sponsored by
banking, governmental, business, and
community organizations.
The Board and Reserve Banks provided in-depth technical assistance to
bankers and community organizations
on a variety of housing, community,
and economic development issues. For
example, the Atlanta Reserve Bank
assisted bankers in their efforts to create
bank and bank holding company community development corporations, and
provided guidance on the financial
structure of housing projects qualifying
for federal low-income housing tax
credits.
Also during 1998, Board and Reserve
Bank community affairs staff conducted
more than 1,600 outreach meetings with
financial institutions, community development organizations, small businesses,
public-sector agencies, academic institutions and foundations, and consumer
and community groups to discuss community credit needs and issues related
to the provision of financial services.
In conjunction with these outreach
efforts, several Reserve Banks developed or updated community profiles that
identify key community and economic
development needs and describe resource organizations in selected communities. These profiles are made available
to banks and to community and business
organizations, and often help stimulate
collaborative approaches to community
reinvestment.
The Reserve Banks issued a variety
of publications and other resources to
provide bankers and community development organizations with information
about community development issues
and opportunities. For example,
• The Richmond Reserve Bank published two MarketWise Reports. One
focused on development opportunities associated with the redevelopment of environmentally damaged
areas (called "brownfields"); the
other summarized survey data on the
credit needs of small businesses and
provided information on financial
resources and technical assistance
available to small firms.
• The Chicago Reserve Bank produced
a videotape, To Their Credit: WomenOwned Businesses, designed to
heighten awareness among lenders
about barriers affecting the loan application process for women-owned
businesses and to encourage and
facilitate small business lending
affiliations.
• The New York Reserve Bank published a Directory of Small Business
Assistance Resources for Northern
New Jersey.
The Reserve Banks published a total
of twelve community affairs newsletters
dealing with various aspects of community and economic development, reinvestment, and fair lending topics. The
average combined circulation of these
newsletters in 1998 was more than
67,000 bankers, small-business owners,
housing, community and economic
development officials, and community-
218 85 th Annual Report, 1998
based development and consumer
groups.
Community affairs staff members in
1998 continued to support the Federal
Reserve's supervisory responsibilities.
For example,
• They joined in reviewing proposals
for community development initiatives from banks and bank holding
companies, and assisted examiners
by providing community contact and
other information useful in CRA
examinations.
• At several Reserve Banks, they assisted in conducting analyses of
HMDA and CRA small business lending data.
• They held meetings with national
organizations representing property
insurers and appraisers to discuss
issues and recommendations emerging from Mortgage Credit Partnership
Projects, two-year efforts coordinated
by six Reserve Banks to help identify
and address barriers to equal access to
credit in the homebuying process in
selected cities.
• At the New York, Philadelphia, Chicago, Minneapolis, and San Francisco
Reserve Banks, they arranged public
meetings associated with Board consideration of applications for mergers involving major bank holding
companies.
Board and Reserve Bank staff continued to provide support to members of
the Board and Reserve Bank presidents
on community development and financial services issues affecting low- and
moderate-income households and communities. Their efforts included support
for the Conference of Presidents' Subcommittee on Community Affairs; assistance with speeches and presentations
by Board members before conferences
and meetings of community, consumer,
and civil rights groups; help in connec-
tion with tours by Board members of
low- and moderate-income neighborhoods and community development
projects; and support for a Board member who serves as Chairman of the
Board of Directors of the Neighborhood
Reinvestment Corporation.
Economic Effects of the
Electronic Fund Transfer Act
As required by statute, the Board monitors the effects of the Electronic Fund
Transfer Act (EFTA) on the compliance
costs and consumer benefits related to
electronic fund transfer (EFT) services.
In 1998 the economic effects of the
EFTA likely continued to increase because of the continued growth of EFT
services.
The Board approved two amendments
to Regulation E involving the resolution
of billing errors claimed by consumers.
(See "Regulatory Matters.") Neither
amendment is expected to have a negative economic effect. There were no
changes to the EFTA in 1998.
Results of consumer surveys (most
recently in 1996) indicate that during
this decade the proportion of U.S. households using EFT services has grown at
an annual rate of about 2 percent. About
85 percent of households have one or
more EFT features on their accounts at
financial institutions. Automated teller
machines (ATMs) remain the most
widely used EFT service. Over the past
year, the number of ATM transactions
increased about 2 percent, from 910 million a month in 1997 to 930 million
a month in 1998. Over the same period
the number of installed ATMs rose
13 percent, to 187,000. Direct deposit is
another widely used EFT service: More
than half of all households in the United
States have funds deposited directly into
their accounts. Use of the service is particularly widespread in the public sector,
Consumer and Community Affairs 219
accounting for more than half of social
security payments and two-thirds of
federal salary and retirement payments.
Taking into account both public and
private payments, the proportion of
households receiving direct deposits has
grown about 5 percent a year in this
decade. About one-third of U.S. households have debit cards, which consumers use at merchant terminals to debit
their transaction accounts. Such pointof-sale (POS) systems still account for a
fairly small share of electronic transactions, but their use continued to grow
rapidly in 1998. Over the past year, the
number of POS transactions rose 25 percent, from about 120 million a month in
1997 to 150 million a month, and the
number of POS terminals rose 31 percent, to 1.7 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 EFTA are also difficult to measure
because they cannot be isolated from
consumer protections that would have
been provided in the absence of regulation. The available evidence suggests no
serious consumer problems with EFT at
present. (See "Agency Reports on Compliance with Consumer Regulations.")
Compliance
During 1998, the Board's compliance
activities included examinations, examiner training, and participation in the
compliance activities of the Federal
Financial Institutions Examination
Council, including activities promoting
increased uniformity in Community
Reinvestment Act examinations.
Compliance Examinations
Since 1977 the Federal Reserve has
maintained a compliance examination
program to ensure that state member
banks and foreign banking organizations subject to Federal Reserve examination comply with federal laws protecting consumers in the provision of
financial services. During the 1998
reporting period (July 1, 1997, through
June 30, 1998), the Federal Reserve conducted 546 examinations for compliance with consumer protection laws:
416 of state member banks and 130 of
foreign banking organizations.6
Examiner Training
Examiner training in consumer protection laws, fair lending laws, and the
CRA is an important aspect of the Federal Reserve's compliance program.
New Reserve Bank examiners attend a
two-week basic compliance course; and
examiners with six to twelve months
of field experience attend a two-week
advanced course, a two-week course in
examination techniques for fair lending,
and a one-week course in CRA examination techniques. During the 1998
reporting period, the Federal Reserve
conducted two basic compliance courses
with a total of thirty-four participants,
two advanced compliance courses with
a total of forty-one participants, two
courses in fair lending examination
techniques with a total of twenty-eight
participants, and three courses in CRA
examination techniques with a total of
sixty-one participants.
6. The foreign banking organizations examined
by the Federal Reserve are organizations operating
under section 25 or 25(a) of the Federal Reserve
Act (Edge Act or agreement corporations) and
state-chartered commercial lending companies
owned or controlled by foreign banks. These institutions are not subject to the CRA and, typically,
in comparison with state member banks, engage in
relatively few activities that are covered by consumer protection laws.
220 85th Annual Report, 1998
Participation in FFIEC Activities
The FFIEC is charged with developing
uniform examination principles, standards, and report forms. In 1998, the
member agencies of the FFIEC jointly
revised examination procedures to reflect changes in consumer protection
laws and regulations, including the Real
Estate Settlement Procedures Act and
the Electronic Fund Transfer Act. In
addition, the FFIEC revised its policy
guide, Administrative Enforcement of
the Truth in Lending Act—Restitution,
for the first time since 1980.
During 1998 the Board also participated in the FFIEC s efforts to promote
consistency among the agencies in
reporting CRA ratings information to
the public—in particular, in developing
a page on the Internet for CRA ratings
(http: //www.ffiec.gov/cracf /crarating/
main.cfm).
The FFIEC worked during 1998 to
foster consistency in the application of
large-bank CRA examination procedures, which became fully effective on
July 1, 1997. As part of this effort, the
Board, the FDIC, the OCC, and the OTS
reviewed performance evaluations for
institutions examined under the lending,
investment, and service tests; they also
conducted eight joint examinations.
The agencies found that examiners
are generally conducting examinations
in accordance with interagency CRA
examination procedures for large retail
institutions and the interagency questions and answers; some minor differences were noted among the performance evaluations reviewed and among
the examiners participating in the joint
examinations. In October, the agencies
held an interagency examiner forum to
discuss the results of the performance
evaluation review and the joint examinations, as well as to develop recommendations for refining examiner guidance
for large institutions. Interpretive guidance on issues identified through these
efforts will be issued in 1999.
Community Reinvestment Act
The Federal Reserve assesses the Community Reinvestment Act performance
of state member banks during regular
compliance examinations and takes their
CRA ratings (as well as other factors)
into account when acting on applications from state member banks and from
bank holding companies for mergers,
acquisitions, and certain other actions.
The Federal Reserve has a threefaceted program for fostering better
bank performance under the CRA:
• Examining institutions to assess compliance with the CRA
• Disseminating information on community development techniques to
bankers and the public through community affairs offices at the Reserve
Banks
• Performing CRA analyses in connection with applications from banks and
bank holding companies.
During the 1998 reporting period
(July 1, 1997, through June 30, 1998),
the Federal Reserve conducted 410 CRA
examinations. Of the banks examined,
96 were rated "outstanding" in meeting
community credit needs, 308 were rated
"satisfactory," 5 were rated "needs to
improve," and 1 was rated as being in
"substantial noncompliance."
Agency Reports on Compliance
with Consumer Regulations
The Board is required to report annually
on compliance with Regulation B,
which implements the Equal Credit
Opportunity Act (ECOA); Regulation E,
which implements the Electronic Fund
Transfer Act (EFTA); Regulation M,
Consumer and Community Affairs 221
which implements the Consumer Leasing Act (CLA); Regulation Z, which
implements the Truth in Lending Act
(TILA); Regulation CC, which implements the Expedited Funds Availability
Act (EFAA); Regulation DD, which
implements the Truth in Savings Act
(TISA); and Regulation A A, which targets unfair and deceptive practices. The
Board assembles data on compliance
from the Reserve Banks and also collects compliance data from the FFIEC
agencies and other federal supervisory
agencies.7
Summarized below are the reported
compliance data for the period July 1,
1997, through June 30, 1998 (referred to
below as the 1998 reporting period, or
sometimes simply as 1998). The overall
level of compliance in 1998 was similar to the overall level in 1997, but, as
in past years, the level of compliance
varied considerably from regulation to
regulation.
Regulation B
(Equal Credit Opportunity)
The FFIEC agencies reported that
79 percent of the institutions examined
during the 1998 reporting period were
in compliance with Regulation B, compared with 80 percent for the 1997
reporting period. Of the institutions not
in compliance, 69 percent had one to
five 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,
7. The agencies use different methods to compile compliance data. Accordingly, the data—
which are presented here in terms of percentages
of financial institutions supervised or examined—
support only general conclusions.
•
•
•
•
•
a Regulation B notice, and the name
and address of the federal agency that
enforces compliance
Collect information for monitoring
purposes about the race or national
origin, sex, marital status, and age of
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 Regulation B
Give a statement of reasons for credit
denial or other adverse action that is
specific and indicates the principal
reasons for the credit denial or other
adverse action
Take a written credit application for
the purchase or refinancing of a principal residence
Refrain from requesting the race,
color, religion, national origin, or
sex of an applicant in transactions
not covered by the monitoring
requirements.
The Office of Thrift Supervision
(OTS) issued two formal enforcement
actions that contained provisions relating to Regulation B.
The Federal Trade Commission
(FTC) filed a complaint in a federal
district court charging a mortgage lender
in the Washington, D.C., area with violations of the ECOA, including, among
others, failing to take written applications for mortgage loans, failing to collect monitoring information on mortgage loan applicants, and providing
inadequate notices of adverse action to
loan applicants. The FTC is seeking
civil money penalties and injunctive
relief.
The FTC also participated in creditrelated seminars organized by the Congressional Black Caucus and released
a new publication, Bound for Good
Credit, designed to educate consumers
222 85 th Annual Report, 1998
on credit-related issues. In addition, the
FTC is continuing its work with other
government agencies and with creditor
and consumer organizations to increase
awareness of and compliance with the
ECOA.
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, 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 certain
violations of the ECOA, most of them
due to creditors' failure to collect information for monitoring purposes and to
comply with rules regarding adverse
action notices; however, no formal
actions were initiated. The SEC reported
that no violations of the ECOA were
detected in examinations of registered
broker-dealers conducted by selfregulatory organizations, the SEC's
principal method of reviewing for
compliance.
Regulation E
(Electronic Fund Transfers)
The FFIEC agencies reported that
approximately 96 percent of the institutions examined during the 1998 reporting period were in compliance with
Regulation E, compared with 94 percent for the 1997 reporting period.
Financial institutions most frequently
failed to comply with the following
requirements:
• Investigate an alleged error promptly
after receiving a notice of error, determine whether an error was actually
made, and transmit the results of the
investigation and determination to the
consumer within ten business days
• Provide customers with a periodic
statement of all required information
at least quarterly, or monthly if EFT
activity occurred.
The OTS issued two formal enforcement actions that contained provisions
relating to Regulation E during the 1998
reporting period. The FTC issued final
decisions and orders with three Internet
service providers settling charges that
these companies violated the EFTA;
specifically, the companies' "free trial"
offers for on-line service resulted in
unexpected charges for many consumers because the providers failed to make
clear that consumers had an affirmative
obligation to cancel before the trial
period ended. The SEC reported that no
violations of Regulation E were detected
in examinations of registered brokerdealers conducted by self-regulatory
organizations.
Regulation M
(Consumer Leasing)
The FFIEC agencies reported substantial compliance with Regulation M for
the 1998 reporting period. As in 1997,
more than 99 percent of the institutions
examined were in compliance. The few
violations involved failures to adhere to
specific disclosure requirements.
In 1998 the FTC issued final decisions and orders in thirteen administrative cases concerning alleged deceptive
lease or credit advertising, specifically,
failure to clearly and conspicuously
disclose and make available advertised
lease and credit terms, in violation of
the CLA or the TILA. Final decisions and orders issued by the FTC
in 1998 settled charges against two
Consumer and Community Affairs 223
major automobile manufacturers, and
five dealerships and their chief executive officers in the St. Louis area, for
violations of the CLA and the TILA
involving misrepresentation and hiding
or failing to disclose adequately the
terms of advertised automobile lease
deals.
The FCA reported that it identified no
violations of the CLA during its examinations in 1998.
Regulation Z
(Truth in Lending)
The FFIEC agencies reported that
74 percent of the institutions examined
during the 1998 reporting period were
in compliance with Regulation Z, compared with 75 percent in 1997. The
Board and the OTS reported increases
in compliance, the OCC and the FDIC
reported decreases, and the NCUA
reported an unchanged level of compliance. The FFIEC agencies indicated that
of the institutions not in compliance,
62 percent had one to five violations, the
same as in 1997.
The violations of Regulation Z most
often observed were failures to comply
with the following requirements:
• Accurately disclose the finance
charge, payment schedule, annual percentage rate, security interest in collateral, and amount financed
• Accurately itemize the amount
financed upon request
• Provide disclosures within three
business days of application for
RESPA-related residential mortgage
applications
• Redisclose the annual percentage rate
when a change occurred before consummation or settlement
• Withhold loan funds until the end of
the rescission period.
The OTS issued two formal enforcement actions that contained provisions
relating to Regulation Z. A total of 205
institutions supervised by the Board, the
FDIC, or the OTS were required, under
the Interagency Enforcement Policy on
Regulation Z, to refund $2.3 million to
consumers in 1998 because of improper
disclosures.
The FTC filed a complaint in federal
district court charging a mortgage lender
in the Washington, D.C., area, and
its owner, with violating the TILA in
connection with alleged deceptive and
unfair practices in home mortgage lending. The FTC also issued final decisions
and orders in thirteen administrative
cases concerning alleged deceptive lease
or credit advertising that involved the
failure to clearly and conspicuously
disclose and make available advertised
lease and credit terms, in violation of
the CLA or the TILA.
During 1998 the FTC also issued
three publications informing consumers
about home equity loans and reverse
mortgages. In addition, the FTC issued a
news release to customers of two airlines to assist them in exercising their
rights under the Fair Credit Billing Act
provisions of the TILA.
The Department of Transportation
(DOT) continued during 1998 to prosecute an ongoing formal enforcement
proceeding instituted in 1993 against
a travel agency and a charter operator.
The complaint in this proceeding 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. A
motion filed by the DOT before an
administrative law judge for summary
judgment was denied. The DOT is
currently in negotiations to settle this
litigation.
224 85 th Annual Report, 1998
Regulation CC
(Expedited Funds Availability)
The FFIEC agencies reported that
89 percent of institutions examined during the 1998 reporting period were
in compliance with Regulation CC,
compared with 87 percent in the 1997
reporting period. Of the institutions not
in compliance, 65 percent had one to
five violations. Institutions most frequently failed to comply with the following requirements:
• Follow special procedures for largedollar deposits
• For deposits not subject to next-day
availability, provide immediate availability of amounts up to $100
• Make funds from certain checks, both
local and nonlocal, available for withdrawal within the times prescribed by
the regulation
• Provide exception notices about funds
availability, including all required
information.
The OTS in 1998 issued two formal
enforcement actions that contained provisions relating to Regulation CC.
Regulation DD
(Truth in Savings)
The FFIEC agencies reported that
88 percent of institutions examined
during the 1998 reporting period were
in full compliance with Regulation DD. Institutions most frequently
failed to comply with the following
requirements:
• Provide appropriate maturity notices
for certificates of deposit maturing in
more than one year
• State required additional information in advertisements containing the
annual percentage yield.
Regulation AA
(Unfair or Deceptive Acts
or Practices)
The three bank regulators with responsibility for enforcing Regulation AA's
Credit Practices Rule—the Federal
Reserve, the OCC, and the FDIC—
reported that 99 percent of the institutions examined during the 1998 reporting period were in compliance. The
most frequent violation was failure to
provide a clear, conspicuous disclosure
regarding a cosigner's liability for a
debt. No formal enforcement actions for
violations of the regulation were issued
during the period.
Consumer Complaints
The Federal Reserve investigates complaints against state member banks and
forwards to the appropriate enforcement
agencies complaints that involve other
creditors and businesses (see table). The
Federal Reserve also monitors and
analyzes complaints about unregulated
practices.
Complaints against
State Member Banks
In 1998 the Federal Reserve received
3,889 complaints: 3,108 by mail, 760
by telephone, 14 electronically, and 7 in
person. Fewer than half of the complaints (1,643) were against state member banks; of these, almost two-thirds
involved unregulated practices. Of the
complaints against state member banks,
about 71 percent concerned lending:
3 percent alleged discrimination on
a prohibited basis, and 68 percent
addressed a variety of other practices,
such as the denial of credit on a basis
not prohibited by law (for example,
credit history or length of residence)
Consumer and Community Affairs 225
or the release or use of credit information. Another 20 percent involved disputes about interest on deposits and general deposit account practices; the
remaining 9 percent concerned disputes
about electronic fund transfers, trust services, or other miscellaneous practices
(see table).
In 1998 the Federal Reserve also
received 2,114 inquiries about consumer
credit and banking policies and practices. In responding to these inquiries,
the Board and the Reserve Banks gave
specific explanations of laws, regulations, and banking practices and provided relevant printed materials on consumer issues.
complaints received about unregulated
practices, the five most numerous categories related to credit cards: penalty
charges on accounts (154); miscellaneous problems involving credit cards
(148); customer service problems (138);
interest rates and terms (125); and debt
collection tactics (79). The specific
complaints within these categories concerned such matters as creditors' failure
to close accounts as requested; penalty charges, including over-limit fees;
increased interest rates on accounts; and
changed credit terms on pre-approved
accounts. Each of these five complaint
categories accounted for a small portion
(4 percent or less) of all consumer complaints received by the Federal Reserve.
Unregulated Practices
Under section 18(f) of the Federal Trade
Commission Act, the Board in 1998
continued to monitor complaints about
banking practices that are not subject
to existing regulations and to focus on
those complaints alleging practices that
may be unfair or deceptive. Of the 2,381
Complaint Referrals
to and by HUD
In 1998, in accordance with a memorandum of understanding between the agencies, the Board referred to HUD five
complaints about state member banks
that alleged violations of the Fair Hous-
Consumer Complaints against State Member Banks and Other Institutions Received by the
Federal Reserve System in 1998
Subject
State member
banks
Other
institutions'
Total
Regulation B (Equal Credit Opportunity)
Regulation E (Electronic Fund Transfers)
Regulation M (Consumer Leasing)
Regulation 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
Fair Housing Act
Flood insurance
Regulations G, T, U, and X
Real Estate Settlement Procedures Act
Unregulated practices
9
0
I
0
2
1,109
1
5
0
28
1,272
663
4
74
95
403
33
1
6
0
30
2,381
Total
1,643
2,246
3,889
1. Complaints against these institutions were referred
to the appropriate enforcement agencies.
59
20
7
1
270
0
23
40
39
53
19
1
393
4
51
55
102
301
24
73
26
2
226 85 th Annual Report, 1998
ing Act. Investigations of these complaints (and of three others pending at
year-end 1997) revealed no evidence of
unlawful discrimination.
Also in accordance with the memorandum of understanding, during 1998
HUD referred two complaints involving state member banks to the Federal Reserve. By year-end the Federal
Reserve had completed its investigation
of one of the two complaints; the investigation revealed no evidence of unlawful discrimination.
Complaint Program Activities
During 1998 the Board's consumer
complaints staff completed work on the
Complaint Analysis Evaluation System
and Reports (CAESAR) system, a personal computer-based system that will
consolidate and replace mainframebased analysis tools. The Board uses
CAESAR, scheduled to be implemented
in January 1999, to monitor the status
and resolution of consumer complaints
and inquiries received by the Federal
Reserve. Along with other management
tools, CAESAR produces reports that
allow staff to analyze, by type of allegation, the discrimination complaints
received by the Federal Reserve; to
automatically generate response letters
to individual complaints; and to analyze
data to determine patterns and trends.
During 1998 individual staff members from the Reserve Banks continued
to work at the Board for several weeks
at a time to gain familiarity with complaint operations in Washington. Fourteen participants from eleven Reserve
Banks participated in the program.
Consumer Policies
Through its consumer policies program,
the Board explores ways to protect consumers in the area of retail financial
Consumer Complaints Received by the Federal Reserve System, by Type and Function, 1998
Complaints against state member banks
Total
Not investigated
Investigated
Bank legally correct
Complaint
Number
Loans
Discrimination alleged
Real estate loans
Credit cards
Other loans
Discrimination not alleged
Real estate loans
Credit cards
Other loans
Deposits
Electronic fund transfers
Trust services
Other
.
Total
Percent
9
26
24
1
1
1
92
880
135
326
20
14
117
1,643
Unable
to obtain
sufficient
information
0
Explanation
of law
provided
to consumer
No reimbursement
or other
accommodation
Goodwill
reimbursement or
other
accommodation
0
1
0
5
0
6
6
12
0
2
0
6
54
8
20
1
1
7
2
7
0
5
2
1
13
14
135
30
36
1
6
21
35
217
55
128
3
44
9
319
14
55
1
2
18
100
31
248
514
420
8
Consumer and Community Affairs 227
services other than by regulation, and
conducts research that bears directly on
policymaking. During 1998 much of
this work related to leasing. The Board
researched and analyzed consumers'
understanding of lease terms and conditions, and helped disseminate consumer
information on the consumer leasing
disclosure requirements that took effect
in January 1998. More than 650,000
copies of the Board's publication Keys
to Vehicle Leasing—A Consumer Guide
have been distributed through trade
associations and conferences, auto
shows, and the media; and the Board's
web site on consumer leasing has had
almost 175,000 visits.
During 1998 the Board also participated on an interagency team working
to educate consumers about basic financial services. The team has developed a
package of materials, entitled Helping
People in Your Community Understand
Basic Financial Services, that commu-
nity educators can use in promoting
direct deposit among recipients of federal benefits. In connection with this
effort, the Board used data from its Survey of Consumer Finances to develop a
profile of households that do not have
transaction accounts with depository
institutions.
For its work during 1998 on reform
of the Truth in Lending Act and the
Real Estate Settlement Procedures Act,
the Board studied the credit shopping
behavior of consumers. Using data from
the Board's 1995 Survey of Consumer
Finances and from the Survey Research
Center's monthly surveys of consumers,
staff members analyzed consumers'
mortgage-shopping behavior and their
understanding of mortgage terms and
conditions; results were shared with
other agencies and the public through
meetings, conferences, and journal articles. Staff members also gathered qualitative information from consumer focus
Consumer Complaints Received—Continued
Complaints against state member banks
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
2
0
1
1
1
0
0
1
0
0
0
2
10
9
14
11
14
23
37
38
0
11
0
2
1
0
0
16
123
20
55
6
1
11
3
11
1
9
1
0
2
0
3
1
2
0
0
0
3
2
3
11
0
0
2
10
52
23
0
1
6
303
747
361
462
53
6
275
395
1,627
496
788
73
20
392
14
234
30
7
21
124
2,246
3,889
1 j
228 85th Annual Report, 1998
groups in Baltimore and northern Virginia; alternative disclosure formats for
the annual percentage rate and contract
interest rates, the good faith estimate
given under the Real Estate Settlement
Procedures Act, and the disclosures of
guaranteed settlement costs were tested.
Consumer Advisory Council
The Consumer Advisory Council convened in March, June, and October to
advise the Board on matters concerning laws that the Board administers and
other issues related to consumer financial services. The council's thirty members come from consumer and community organizations, the financial services
industry, academic institutions, and state
government agencies. Council meetings
are open to the public.
The implementation of the Community Reinvestment Act was addressed at
each of the three meetings. In March the
council focused on perceived problems
with uniformity among the supervisory
agencies in evaluating the CRA performance of their respective institutions
under the revised CRA regulations. In
recognition of these issues, the agencies
were taking steps to help assess the uniformity of their approaches. At all three
meetings the council discussed the challenges faced by institutions and examiners in delineating an institution's CRA
assessment area. This issue is significant
for numerous banks, such as national
institutions that have only one branch or
main office, consumer lenders that have
loan production offices but no depositgathering branches, and Internet banks
that have no branch or main office.
Council members voiced concerns
that de-emphasizing geography might
adversely affect low- and moderateincome persons and those in rural areas
who do not have access to electronic
distribution systems. Other CRA issues
discussed by the council included how
the lending test accounts for loans originated and purchased, bank performance
under the investment and service tests,
and use of the strategic plan option by
financial institutions.
In March the council discussed
legislative recommendations being developed to simplify, consolidate, and
streamline regulations implementing the
Truth in Lending Act and the Real
Estate Settlement Procedures Act. (See
"TILA and RESPA Reform.") The discussion focused on the timing and feasibility of providing firm mortgage loan
cost estimates that would enable consumers to make meaningful cost comparisons when they shopped for loans.
The accuracy of early disclosures was
a particular concern. Some members
believe that the existing good faith estimate, provided within three days of a
mortgage loan application, gives reasonable certainty about closing costs.
Others expressed interest in reform proposals in which the lender might guarantee both the interest rate and closing
costs. In June the council reviewed
remedies that protect consumers when
the timing or content of the disclosures
is improper or defective. Concerns that
twenty-four states do not require the
sending of a notice of foreclosure to a
debtor who is in default, and that only
nineteen states give the homeowner a
statutory right to cure a default, led the
council to consider whether there should
be a federally required notice and a
right-to-cure.
Also in June the council discussed the
collection of data on the race and sex
of applicants for consumer loans other
than mortgages. Regulation B currently
prohibits such collection. The council
focused on whether lenders should be
required, or allowed, to collect such
data. Some members favored, and
others opposed, mandatory data col-
Consumer and Community Affairs 229
lection. Some preferred letting lenders
collect the data voluntarily. It was suggested that either mandatory or voluntary collection could provide useful data
in marketing and fair lending, could help
lenders create targeted marketing programs, and could facilitate referrals for
special credit programs. Council members' concerns about the data collection
included cost burdens, problems in identifying an applicant's characteristics
when the applicant does not volunteer
the information, and difficulties in characterizing the characteristics when a
firm applying for a small-business loan
has multiple owners. The council also
discussed the benefits and disadvantages
of requiring that pre-approvals or prequalifications for home mortgage loans
be reported in the HMDA data. Currently, a preliminary evaluation of a
potential applicant's creditworthiness is
not reported.
The council also addressed issues
concerning the substitution of electronic
delivery of consumer disclosures for
traditional paper copies. The Board's
interim rule governing electronic fund
transfer, issued in March 1998, permits
depository institutions to deliver certain
disclosures electronically if the consumer agrees. (See "Regulatory Matters.") Council members provided a
variety of comments on electronic delivery of federal disclosures. For example,
some believed that consumers should
have a right to paper copies of certain
disclosures upon request. Some were
concerned about creditors providing certain notices electronically, such as the
TILA right of rescission. Others were
concerned about ensuring that consumers make informed decisions about
receiving disclosures electronically.
At its October meeting the council
considered how the use of credit scoring systems was affecting consumer and
small business lending. Members noted
that credit scoring provides many benefits, including significant efficiencies
that reduce lender costs while helping to
minimize subjectivity in loan decisions;
but credit scoring has also raised a number of issues. Council members noted
that credit scoring can have fair lending
implications. For example, some members suggested that unequal access to
credit by minorities could bias or distort
the data used in a scoring model.
In October, the council also discussed
barriers to lending and reinvestment
efforts by financial institutions on Indian
reservations. Council members noted
that Indian Country is perceived to be
among the most underserved credit and
banking service markets in the nation.
One critical restraint to economic and
community development on Indian reservations is that each tribe is a sovereign
nation with its own commercial laws
that affect creditors' rights.
Testimony and Legislative
Recommendations
In June the Board testified before the
House Committee on Commerce on
developments in electronic commerce
generally, and electronic payments specifically. The testimony noted that new
payment products, such as stored-value
cards and electronic cash for use on
the Internet, are designed to substitute
for existing payment methods such as
cash, checks, and credit and debit cards;
thus, to gain acceptance, they will likely
need to offer consumers and businesses
significantly improved features in terms
of cost and convenience. Although
anticipating that the effect of the emerging electronic payment methods on
the Board's core responsibilities will
be minimal in the near term, the Board
cautioned that technological change
and the growth of electronic commerce
230 85th Annual Report, 1998
could raise complex policy issues that
may require careful monitoring.
In July the Board testified before the
House and Senate Banking Committees
on ways to improve the disclosures
required for home mortgage loans under
the TILA and to unify them with the
disclosures required under RESPA. The
Board's testimony discussed the joint
report issued by the Board and the
Department of Housing and Urban
Development, which provided a framework for simplifying and streamlining
the information given to consumers
in the mortgage lending process. (See
"TILA and RESPA Reform.")
Recommendations of
Other Agencies
Each year the Board asks for recommendations from the other federal supervisory agencies for amending the consumer financial services laws or the
implementing regulations.
The OCC believes that despite legislative and regulatory efforts to reduce
compliance burden, the rules and disclosure requirements under the consumer financial services laws remain
complex for consumers and costly for
creditors. Accordingly, the OCC suggests that the Congress consider alternatives to provide more meaningful disclosures to consumers that are less
burdensome to depository institutions.
In addition, the OCC recommends that
the Congress consider modifications to
the referral requirements in the ECOA.
The OCC suggests, for example, limiting mandatory referrals to specific prohibited bases, authorizing the Department of Justice to relieve an agency
from mandatory referral requirements,
or authorizing agency waiver of referral
if detected violations stem from selfassessments.
The FTC supports the Board's current
review of Regulation B and would
support any similar effort to update and
clarify Regulation Z. The FDIC supports amending Regulations B, M, Z,
and DD to allow for the electronic delivery of certain disclosures. The FDIC
also expresses concern about the predatory marketing practices of some
subprime credit-card lenders, and in
this regard supports the development
of regulatory or legislative changes to
Regulation Z or Regulation AA that
would enable the agencies to supervise
current trade practices more effectively.
Year 2000 Initiatives
During 1998 the Board made a major
effort to ensure that the hardware and
software systems it uses in connection with consumer and community
affairs matters are Year 2000 compliant. Among other things, it revised
certain systems and converted them
from a mainframe environment to a
personal-computer environment. Certification of compliance is scheduled for
March 1999.
231
Litigation
During 1998, the Board of Governors
was a party in eighteen lawsuits or
appeals filed that year and was a party
in fifteen other cases pending from previous years, for a total of thirty-three
cases. In 1997, the Board had been a
party in a total of thirty-eight cases.
Four of the eighteen lawsuits or appeals
filed in 1998 raised questions under the
Bank Holding Company Act. As of
December 31, 1998, fourteen cases were
pending.
Judicial Review of Board Orders
under the Bank Holding
Company Act
Independent Bankers Association of
America v. Board of Governors, No. 981482 (D.C. Circuit, filed October 21,
1998), is a petition for review of a Board
order dated September 23, 1998, conditionally approving the applications of
Travelers Group, Inc., New York, New
York, to become a bank holding company by acquiring Citicorp, New York,
New York, and its bank and nonbank
subsidiaries (84 Federal Reserve Bulletin 985). Another case challenging the
same order, Cunningham v. Board of
Governors, No. 98-1459 (D.C. Circuit,
filed September 30, 1998), was dismissed by the court on December 4,
1998.
In Attorneys Against American Apartheid v. Board of Governors, No. 981483 (D.C. Circuit, filed October 21,
1998), petitioners seek review of a
Board order dated August 17, 1998, approving the application by NationsBank
Corporation, Charlotte, North Carolina,
to merge with BankAmerica Corpora
tion, San Francisco, California (84 Federal Reserve Bulletin 858).
In Inner City Press/Community on the
Move v. Board of Governors, No. 971514 (U.S. Supreme Court, petition for
certiorari filed March 12, 1998), petitioners sought review of the dismissal
by the U.S. Court of Appeals for the
District of Columbia Circuit (130 F.3d
1088) of their petition for review of a
Board order dated May 14, 1997,
approving the application of Bane One
Corporation, Inc., Columbus, Ohio, to
merge with First USA, Inc., Dallas,
Texas (83 Federal Reserve Bulletin
602). On June 22, 1998, the Supreme
Court denied review (118 S. Ct. 2341).
Greeffv. Board of Governors, No. 971976 (4th Circuit, filed June 17, 1997),
was a petition for review of a Board
order dated May 19, 1997, approving
the application of Allied Irish Banks,
pic, Dublin, Ireland, and First Maryland Bancorp, Baltimore, Maryland, to
acquire Dauphin Deposit Corporation,
Harrisburg, Pennsylvania, and thereby
acquire Dauphin's banking and nonbanking subsidiaries (83 Federal
Reserve Bulletin 607). On August 14,
1998, the court denied the petition.
In The New Mexico Alliance v. Board
of Governors, No. 96-9552 (10th Circuit, filed December 24, 1996), petitioners sought review of a Board order
dated December 16, 1996, approving the
acquisition by NationsBank Corporation
and NB Holdings Corporation, both of
Charlotte, North Carolina, of Boatmen's
Bancshares, Inc., St. Louis, Missouri
(83 Federal Reserve Bulletin 148). On
January 21, 1998, the court transferred
the case to the U.S. Court of Appeals
for the District of Columbia Circuit
232 85th Annual Report, 1998
(No. 98-1049), and on May 27, 1998,
that court granted the Board's motion to
dismiss the petition.
Litigation under the Financial
Institutions Supervisory Act
In Pharaon v. Board of Governors,
No. 98-103 (U.S. Supreme Court, petition for certiorari filed July 15, 1998),
petitioner sought review of a decision
by the U.S. Court of Appeals for the
District of Columbia Circuit (135 R3d
148) denying a petition for review of a
Board order dated January 31, 1997,
imposing civil money penalties and an
order of prohibition against Ghaith R.
Pharaon for violations of the Bank Holding Company Act (83 Federal Reserve
Bulletin 347). On October 19, 1998, the
Supreme Court denied review (119
S.Ct. 371).
In Board of Governors v. Carrasco,
No. 98-3474 (S.D. New York, filed
May 15, 1998), the Board seeks to
freeze the assets of an individual pending the administrative adjudication of an
action by the Board requiring restitution
by the individual. On May 26, 1998,
the district court granted the Board's
request for a preliminary injunction.
In Board of Governors v. Pharaon,
Nos. 98-6101 and 98-6121 (2d Circuit,
filed May 4 and May 22, 1998), both
parties appeal an order of the U.S. District Court for the Southern District of
New York (No. 91-6250, March 18,
1998) granting in part and denying in
part the Board's motion for partial summary judgment in an action to freeze
assets of an individual pending adjudication of a civil money penalty assessment
by the Board.
In Banking Consultants of America v.
Board of Governors, No. 98-5354 (6th
Circuit, filed March 10, 1998), plaintiffs
appeal an order of the U.S. District
Court for the Western District of Ten-
nessee (No. 97-2791, January 23, 1998)
dismissing their action to enjoin an
investigation by the Board, the Office of
the Comptroller of the Currency, and the
Department of Labor.
Leuthe v. Office of Financial Institution Adjudication, No. 97-1826 (3d Circuit, filed October 7, 1997), was an
appeal of a district court dismissal (977
F. Supp. 537 (E.D. Pa. 1997)) of an
action against the Board and other federal banking agencies challenging the
constitutionality of the Office of Financial Institution Adjudication. On June 8,
1998, the court of appeals affirmed the
district court's dismissal.
Towe v. Board of Governors, No. 9771143 (9th Circuit, filed September 15,
1997), is a petition for review of a Board
order dated August 18, 1997 (83 Federal Reserve Bulletin 849), prohibiting
Edward Towe and Thomas E. Towe
from further participation in the banking
industry.
In Vickery v. Board of Governors,
No. 97-1344 (D.C. Circuit, filed May 9,
1997), petitioner sought review of a
Board order dated April 14, 1997, prohibiting Charles R. Vickery, Jr., from
further participation in the banking
industry (83 Federal Reserve Bulletin
535). On March 3, 1998, the court of
appeals denied the petition, and on
May 4, 1998, it denied petitioner's petition for rehearing and suggestion for
rehearing in bane (159 F.3d 638).
Other Actions
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 practices.
Inner City Press/Community on the
Move v. Board of Governors, No. 984608 (2d Circuit, filed December 3,
1998), is an appeal of an order of the
Litigation 233
U.S. District Court for the Southern District of New York (No. 98-4608, September 30, 1998) granting the Board's
motion for summary judgment on plaintiff's Freedom of Information Act complaint.
Goldman v. Department of the Treasury, No. 98-9451 (11th Circuit, filed
November 10, 1998), is an appeal from
an order of the U.S. District Court
for the Northern District of Georgia
(No. 1-97-CV-3798, November 2,
1998) dismissing an action challenging
Federal Reserve notes as lawful money.
In Wasserman v. Board of Governors,
No. 98-CIV-6017 (S.D. New York,
filed August 24, 1998), plaintiff alleged
that the Board wrongfully failed to
investigate the activities of a bank. The
plaintiff voluntarily withdrew his complaint on October 14, 1998, following
the filing of the Board's motion to
dismiss.
Clarkson v. Greenspan, No. 98-5349
(D.C. Circuit, filed July 29, 1998), is an
appeal of a district court order granting
the Board's motion for summary judgment on plaintiff's Freedom of Information Act complaint.
In Research Triangle Institute v.
Board of Governors, No. 97-1759 (U.S.
Supreme Court, petition for certiorari
filed April 28, 1998), petitioners sought
review of a decision by the U.S. Court of
Appeals for the Fourth Circuit (132 F.3d
985) affirming the dismissal of a contract action against the Board. On October 5, 1998, the Supreme Court denied
review (119 S. Ct. 44).
Fenili v. Davidson, No. C-9801568CW (N.D. California, filed
April 17, 1998), is a case claiming tort
and constitutional violations arising out
of the return of a check.
Wilkins v. Warren, No. 98-1320 (4th
Circuit, filed March 5, 1998), was an
appeal of an order of the U.S. District
Court for the Eastern District of Vir-
ginia dismissing plaintiff's complaint
arising out of a dispute with a bank. On
June 10, 1998, the court of appeals
affirmed the district court dismissal.
Jones v. Board of Governors, No. 9830138 (5th Circuit, filed February 9,
1998), was an appeal of a decision by
the U.S. District Court for the Western
District of Louisiana dismissing plaintiff's complaint alleging violations of
the Fair Housing Act. On November 19,
1998, the court of appeals dismissed the
action.
Logan v. Greenspan, No. 98-0049 (D.
District of Columbia, filed January 9,
1998), is an employment discrimination
action.
Kerr v. Department of the Treasury, No. CV-S-97-01877-DWH (D.
Nevada, filed December 22, 1997), is a
challenge to income taxation and Federal Reserve notes.
Allen v. Indiana Western Mortgage
Corp., No. 97-7744 RJK (CD. California, filed November 12, 1997), was a
customer dispute with a bank. On
March 25, 1998, the court dismissed the
action.
Patrick v. United States, No. 9775564 (E.D. Michigan, filed November 7, 1997), and Patrick v. United
States, No. 97-75017 (E.D. Michigan,
filed September 30, 1997), were actions
for damages arising out of tax disputes.
On August 20, 1998, both cases were
dismissed.
Artis v. Greenspan, No. 97-5235
(D.C. Circuit, filed September 19,
1997), was an appeal of a district court
order dismissing a class complaint alleging race discrimination in employment.
The court of appeals affirmed the dismissal on October 20, 1998 (158 F.3d
1301). A related employment discrimination case, Artis v. Greenspan, No. 975234 (D.C. Circuit, filed September 19,
1997), was an appeal of the dismissal of
an individual discrimination claim. On
234 85th Annual Report, 1998
January 29, 1998, the court of appeals
granted the Board's motion for summary affirmance of the district court's
dismissal.
In In re Subpoena Duces Tecum
Served on the Board of Governors,
No. 97-5229 (D.C. Circuit, filed September 12, 1997), the plaintiff appealed
a district court order denying his motion
to compel production of pre-decisional
supervisory documents and testimony
sought in connection with an action by
Bank of New England Corporation's
trustee in bankruptcy against the Federal Deposit Insurance Corporation. On
June 26, 1998, the court of appeals
reversed the district court's order, 145
F.3d 1422, and on October 6, 1998, the
court amended its opinion following the
Board's petition for rehearing (156 F.3d
1279).
Bettersworth v. Board of Governors,
No. 97-CA-624 (W.D. Texas, filed
August 21, 1997), is a complaint under
the Privacy Act.
Maunsell v. Greenspan, No. 97-6131
(2d Circuit, filed May 22, 1997), was an
appeal of district court dismissal of an
action for compensatory and punitive
damages for alleged violations of civil
rights by a federal savings bank. On
May 12, 1998, the court dismissed the
appeal.
American Bankers Insurance Group,
Inc. v. Board of Governors, No. 96-CV2383-EGS (D. District of Columbia,
filed October 16, 1996), was an action
seeking declaratory and injunctive relief
invalidating a new regulation issued by
the Board under the Truth in Lending
Act relating to treatment of fees for debt
cancellation agreements (12 C.F.R. section 226.4(d)(3)). On April 21, 1998, the
district court granted the Board's motion for summary judgment (3 F. Supp.
237).
235
Legislation Enacted
Among the legislation enacted during
1998, the Consumer Reporting Employment Clarification Act, the Credit Union
Membership Access Act, the Examination Parity and Year 2000 Readiness for
Financial Institutions Act, the Federal
Employees Health Care Protection Act,
the Homeowners Protection Act, the
Money Laundering and Financial
Crimes Strategy Act, and the U.S. Holocaust Assets Commission Act directly
affect the Federal Reserve System or the
institutions it regulates.
Consumer Reporting
Employment Clarification Act
The Consumer Reporting Employment
Clarification Act amends the Fair Credit
Reporting Act by removing the sevenyear limitation on the reporting of criminal convictions by consumer reporting agencies. This change should help
insured depository institutions comply
with the prohibition on employing individuals convicted of criminal offenses
involving dishonesty or a breach of
trust.
In addition, the act expands an
exemption, created in the Intelligence
Authorization Act for Fiscal Year 1998,
from certain Fair Credit Reporting Act
disclosure provisions when a U.S. government agency or department has
obtained, or seeks to obtain, a consumer
report for use in a national security
investigation, such as a review of a
consumer's security clearance. For the
agency or department to qualify for the
exemption, the head of the agency or
department must make a written finding
that the consumer report is relevant to
its national security investigation; that
the investigation is within its jurisdiction; and that there is reason to believe
that compliance with the disclosure
requirements will (1) endanger the life
or physical safety of any person,
(2) result in flight from prosecution,
(3) result in the destruction of, or tampering with, evidence relevant to the
investigation, (4) result in the intimidation of a potential witness relevant to
the investigation; (5) result in the compromise of classified information, or
(6) otherwise seriously jeopardize or unduly delay the investigation or another
official proceeding.
Credit Union Membership
Access Act
The Credit Union Membership Access
Act, among other things, reverses the
Supreme Court's recent decision in
National Credit Union Administration v.
First National Bank & Trust Co.,1 which
held that the same common bond of
occupation must unite all members of an
occupationally defined federal credit
union.2 The act permits the formation of
credit unions on the basis of more than
one common bond, and thus increases
the potential customer base of credit
unions. The act also requires the Secretary of the Treasury to conduct a study
of the difference between credit unions
and other federally insured financial
institutions. It requires the National
Credit Union Administration Board
(NCUA Board) to periodically assess
the potential liquidity needs of credit
unions and the options available to
1. 118 S.Ct. 927(1998).
2. Id. at 939.
236 85th Annual Report, 1998
credit unions to meet those needs, and
to make available to Federal Reserve
Banks information relevant to making
advances to such credit unions, including the NCUA Board's reports of examination. Finally, the act requires the federal banking agencies to submit a report,
one year from the date of enactment of
the act, detailing their progress in carrying out section 303(a) of the Riegle
Community Development and Regulatory Improvement Act of 1994.
Examination Parity and
Year 2000 Readiness
for Financial Institutions Act
The Examination Parity and Year 2000
Readiness for Financial Institutions Act
requires that each federal banking
agency offer to the depository institutions it regulates seminars on the implications of the Year 2000 computer problem. It also requires that each federal
banking agency make available to the
depository institutions it regulates model
approaches to common Year 2000 computer concerns, such as project management, vendor contracts, testing regimes,
and business continuity planning.
The act also authorizes the Office of
Thrift Supervision to examine service
companies that provide services to, or
are owned by, savings associations to
the same extent savings associations are
currently examined. The act allows such
examinations to be conducted by any
federal banking agency that supervises
any other owner of part of the service
company or subsidiary. It also authorizes the National Credit Union Administration to examine credit union organizations to the same extent insured
credit unions are currently examined and
allows such examinations to be conducted by any federal banking agency
that supervises any other person who
maintains an ownership interest in a
credit union organization.
Federal Employees Health Care
Protection Act
Among other things, the Federal Employees Health Care Protection Act permits certain Board employees, who were
previously ineligible, to participate in
the Federal Employees Health Benefits
Program (FEHBP). This change will
enable certain employees who retired
from the Board before becoming eligible to participate in FEHBP the opportunity to participate in FEHBP during
their retirement.
Homeowners Protection Act
The Homeowners Protection Act limits
a creditor's right to require private
mortgage insurance once a consumer's
equity in his or her home reaches a
certain level. The act grants consumers
the right to request cancellation of the
private mortgage insurance on their residence once their loan balance reaches
80 percent of the property's original
value. The accumulated equity in the
home is calculated on the basis of either
amortization schedules or actual payments. Before terminating private mortgage insurance a lender may ensure that
the value of the home has not declined,
that the individual has a good payment
history, and that the equity in the home
is unencumbered. The act also requires
lenders to cancel private mortgage insurance automatically when the loan balance reaches 78 percent of the property's original value but also contains
exceptions for high-risk loans. A consumer's right to cancel private mortgage
insurance must be disclosed at loan
consummation and annually thereafter. Once the insurance is canceled,
the mortgage servicer must return any
Legislation Enacted 237
unearned premiums to the consumer.
Finally, the act imposes civil liability on
servicers, lenders, and insurers who violate the act and requires federal banking
agencies to enforce the act.
Money Laundering and Financial
Crimes Strategy Act
The Money Laundering and Financial
Crimes Strategy Act requires the Secretary of the Treasury and the Attorney
General to develop a national strategy
for combating money laundering and
related financial crimes. In general, the
aims of the national strategy are to develop research-based goals, objectives,
and priorities for reducing and preventing money laundering and related financial crimes in the United States. The act
requires that the Secretary of the Treasury, in developing the national strategy,
consult with the Board of Governors,
among other parties. In addition, the act
requires that the national strategy identify areas where money laundering and
related financial crimes are extensive or
present a substantial risk, so that a comprehensive approach to combating such
crime in those areas can be developed.
U.S. Holocaust Assets
Commission Act
The U.S. Holocaust Assets Commission
Act establishes the Presidential Advisory Commission on Holocaust Assets
in the United States to conduct a thorough study of, and develop a historical
record of, the collection and disposition
of certain types of assets that came into
the possession or control of the federal
government, including the Board of
Governors or any Federal Reserve Bank,
after January 30, 1933.
.
239
Banking Supervision and Regulation
The overall condition of the U.S. banking system remained strong during
1998, though problems in certain emerging markets and the ensuing volatility
in world financial markets posed challenges for larger, internationally active
banks. For most banking organizations,
profitability and asset quality remained
robust, supported by the U.S. economic
expansion. In contrast, several internationally active organizations reported
reduced profitability and asset quality
related to their foreign lending, trading,
and investment-banking activities. Nevertheless, given the unusual severity of
market volatility, the larger global firms
showed remarkable resilience and, like
the rest of the industry, generally maintained historically high capital ratios and
adequate loss reserves.
Over the course of the year, industry
consolidation continued as large and
small banking firms sought to tap potential synergies and efficiencies. At the
same time, competition to meet the rising demand for credit from businesses
and consumers continued to intensify
and to place pressure on loan terms and
conditions. However, market volatility
in the second half of the year caused
many firms to reevaluate their practices,
leading to a firming in the pricing and
conditions for certain loan categories to
reflect greater economic uncertainty.
As an important part of its supervisory role, the Federal Reserve has promoted the strengthening of bank riskmanagement systems, including the use
of stress-testing. The recent turmoil
in international financial markets has
helped to underscore the need for
improvement and has led many organizations to evaluate the underlying
assumptions and adequacy of their riskmanagement systems. More work will
need to be done in this critical area for
bank safety and soundness.
Recent events have also underscored
the importance of capital for the safety
and soundness of individual institutions
and the stability of financial systems
both here and abroad. Over the past
decade, the international risk-based
capital standards established in 1988
through the Basle Capital Accord have
served the U.S. and international banking systems well. To preserve the usefulness of the standards, the Federal
Reserve and other international supervisors are evaluating ways of modernizing
the standards to better address changes
in rapidly evolving financial markets,
products, and institutions.
Toward that end, and as part of its
overall supervisory efforts, the Federal
Reserve has intensified its evaluation
of the techniques that banks are using
to monitor and quantify their risk exposures and to allocate capital. In particular, the Federal Reserve has dedicated
resources to studying bank practices
for establishing internal risk grades for
loans and other exposures, bank statistical modeling techniques for quantifying
credit risk, and evolving methods for
quantifying operational risk. Work is
also under way to understand the range
of practices banks are employing to
internally allocate capital among business lines and to establish their own
target capitalization on a firm-wide
basis.
These hands-on evaluations of bank
risk-measurement and capital-allocation
practices not only have improved our
understanding of individual institution
240 85th Annual Report, 1998
safety and soundness, but have provided
valuable comparative insights on the
state of industry practices. These lessons
are being shared with supervisors internationally and may serve as an important foundation in efforts to revise the
capital standards that are now being
considered by the Basle Committee on
Banking Supervision.
In response to the increasing scope
and complexity of banking activities, the
Federal Reserve has not only intensified
its focus on internal risk-management
practices but has also placed greater
emphasis on planning and examiner
training, to ensure that supervisory
efforts are targeted toward areas posing
the highest risk to financial institutions. Work is also under way to provide
staff with technology that facilitates
more-continuous supervisory oversight
and enables better coordination across
Reserve Banks.
As part of its efforts to promote sound
practices and to improve the quality and
consistency of supervision, the Federal
Reserve in 1998 undertook reviews of
certain banking practices at several large
institutions of similar size and characteristics. These coordinated supervisory
reviews provided valuable comparative
information on how well banking organizations are managing risk. For example, a detailed review of commercial
lending standards at several of the
largest banking organizations resulted
in additional guidance to examiners
and the industry. This review quantified
trends in lending standards, described
sound practices, and noted areas needing increased supervisory attention.
Along with these ongoing efforts
to improve supervisory oversight and
banking practices, the Federal Reserve
has continued its extensive program for
ensuring that institutions recognize their
obligations to be ready for the century
date change. During 1998, the Federal
Reserve reviewed every bank subject to
its supervisory oversight for Year 2000
readiness. In addition, working with
regulators both here and abroad, the
Federal Reserve issued numerous public
statements and held, as well as cosponsored, several conferences to provide
guidance to the industry. Work in this
area will continue throughout 1999.
Another significant area of supervisory attention during 1998 stemmed
from the escalation of problems in certain Asian countries and the rapid spread
of difficulties across other markets subsequent to the Russian bond default. In
response to these problems, the Federal
Reserve built on its strong relationships
with domestic and international regulatory bodies to gain a better understanding of the extent of U.S. financial institutions' exposures to internationally active
organizations and to formulate appropriate remedial actions. Efforts focused
on both the foreign operations of U.S.
banks in troubled economies and the
U.S. operations of banks based in those
countries.
These and other efforts detailed in
this chapter form the basis by which the
bank supervision function supports the
Federal Reserve's mission of promoting
financial stability, containing systemic
risk, and providing a safe and sound
banking system.
Scope of Responsibilities
for Banking Supervision
and Regulation
The Federal Reserve is the federal
supervisor and regulator of all U.S. bank
holding companies and of statechartered commercial banks that are
members of the Federal Reserve System. In overseeing these organizations,
the Federal Reserve primarily seeks to
promote their safe and sound operation
and their compliance with laws and
Banking Supervision and Regulation 241
regulations, including the Bank Secrecy
Act and regulations on consumer and
community affairs.1 The Federal Reserve also examines the specialized
activities of these institutions, such as
information technology, fiduciary activities, capital markets activities, and
government securities dealing and
brokering.
In addition, the Federal Reserve 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.2
The Federal Reserve exercises important regulatory influence over the entry
into, and the structure of, the U.S. banking system through its administration
of the Bank Holding Company Act,
the Bank Merger Act for state member
banks, the Change in Bank Control Act
for bank holding companies and state
member banks, and the International
Banking Act. The Federal Reserve is
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 these laws and regulations. To carry out this
responsibility, the Federal Reserve specifically
trains a number of its bank examiners to evaluate institutions with regard to such compliance.
The chapter of this REPORT covering consumer
and community affairs describes these regulatory
responsibilities. Compliance with other statutes
and regulations, which is treated in this chapter, is
the responsibility of the Board's Division of Banking Supervision and Regulation and the Reserve
Banks, whose examiners also check for safety
and soundness. Several regulatory organizations
enforce compliance with the Board's securities
credit regulations, which are administered by the
Board's Legal Division.
2. Edge Act corporations are chartered by the
Federal Reserve, and agreement corporations are
chartered by the states, to provide all segments of
the U.S. economy with a means of financing international trade, especially exports.
also responsible for imposing margin
requirements on securities transactions.
In carrying out these responsibilities, the
Federal Reserve coordinates its supervisory activities with other federal and
state regulatory agencies and with 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, Edge
Act corporations, and agreement corporations. Because many aspects of the
reviews at bank holding companies and
their nonbank subsidiaries differ from
bank examinations, the Federal Reserve
conducts inspections of holding companies and their subsidiaries. Preexamination planning and on-site review
of operations are integral parts of ensuring the safety and soundness of financial
institutions. Regardless of 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 risk
exposures; (2) an appraisal of the quality of the institution's assets; (3) an evaluation of management, including an
assessment of internal policies, procedures, controls, 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.
242 85 th Annual Report, 1998
State Member Banks
At the end of 1998, 994 state-chartered
banks (excluding nondepository trust
companies and private banks) were
members of the Federal Reserve System. These banks represented about
11.4 percent of all insured U.S. commercial banks and held about 24.2 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. For most
of these banks, a full-scope, on-site
examination is required at least once
during each twelve-month period; certain well-capitalized and well-managed
institutions with assets of less than
$250 million may be examined every
eighteen months.
During 1998, the Federal Reserve
Banks conducted 540 examinations
of state member banks (some of them
jointly with the state agencies), and state
banking departments conducted 293
independent examinations of state member banks.
Bank Holding Companies
At year-end 1998, the number of U.S.
bank holding companies totaled 5,979.
These organizations controlled 6,829
insured commercial banks and held
approximately 95.4 percent of all insured commercial bank assets.
Federal Reserve guidelines call for
annual inspections of large bank holding
companies and smaller companies that
have significant nonbank assets. In judging the financial condition of subsidiary
banks, Federal Reserve examiners con-
sult the examination reports of 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 1998, Federal Reserve
examiners conducted 1,057 bank holding company inspections, 76 of which
were conducted off site, and state examiners conducted 76 independent inspections. These inspections were conducted
at 917 bank holding companies.
Certain small, noncomplex 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. The program permits a
more flexible approach to supervising
those entities in a risk-focused environment and is designed to improve the
overall effectiveness and efficiency of
the Federal Reserve's bank supervisory
efforts. Each such holding company is
subject to off-site review once during
each supervisory cycle, which corresponds to the mandated examination
cycle for the company's lead bank. In
1998, the Federal Reserve conducted
2,662 reviews of these companies.
Enforcement Actions,
Civil Money Penalties, and
Suspicious Activity Reporting
In 1998, the Federal Reserve Banks recommended, and members of the Board's
staff initiated and worked on, 103 enforcement cases involving 186 separate
actions, such as cease-and-desist orders,
written agreements, removal and prohibition orders, and civil money penalties.
Of these, 35 cases involving 53 actions
were completed by year-end.
Banking Supervision and Regulation 243
One of the final actions taken by the
Board of Governors with regard to the
illegal activities of the Bank of Credit
and Commerce International (BCCI)
was an agreement with Clark Clifford
and Robert Altman to settle the Board's
allegations that Messrs. Clifford and
Altman had engaged in violations of
laws and regulations with regard to
BCCI's fraudulent activities. In settlement of the Board's charges, Messrs.
Clifford and Altman paid penalties of
approximately $5 million.
In other significant matters, the Board
of Governors assessed civil money penalties totaling more than $500,000. The
Board also issued two formal enforcement actions against institutions that
exhibited less than satisfactory progress
in addressing Year 2000 deficiencies.
All final enforcement orders issued
by the Board of Governors and all written agreements executed by the Federal
Reserve Banks in 1998 are available to
the public and can be accessed from the
Board's public web site.
In addition to formal enforcement
actions, the Federal Reserve Banks in
1998 completed fifty-eight informal
enforcement actions, such as memorandums of understanding and resolutions
from boards of directors.
Specialized Examinations
The Federal Reserve conducts specialized examinations of banking organizations in the areas of information
technology, fiduciary activities, transfer
agent activities, government and municipal securities dealing, and securities
underwriting and dealing through socalled section 20 subsidiaries of bank
holding companies. As part of the technology review, examiners in 1998 also
conducted targeted reviews of preparedness for the century date change. The
Federal Reserve also conducts special-
ized examinations of certain persons,
other than banks, brokers, or dealers,
who extend securities credit subject to
the Board's margin regulations.
Information Technology
The Federal Reserve examines the information technology activities of state
member banks, U.S. branches and agencies of foreign banks, Edge Act and
agreement corporations, and independent data centers that provide electronic
data processing services to these institutions. These examinations are conducted
in recognition of the importance of information technology to the financial
industry and help to ensure that banking
organizations conduct their operations
in a safe and sound manner. During
1998, the Federal Reserve conducted
278 examinations that focused on
information technology and electronic
data processing systems. The Federal
Reserve was also the lead agency
on two examinations of large, multiregional data processing servicers examined in cooperation with the other federal banking agencies.
Year 2000 Compliance
The Year 2000 supervision program is
divided into three phases and assesses
the progress of three types of entities in
preparing for the century date change:
financial institutions, service providers,
and software vendors. (The program is
described more fully later in the discussion of the Federal Financial Institutions
Examination Council.) Phase 1, which
ended June 30, 1998, included the
review of 1,569 financial institutions
and 49 service providers and software
vendors. Phase 2 began July 1, 1998,
and will run through March 1999. By
year-end 1998, reviews of 837 financial
institutions and 28 service providers and
244 85th Annual Report, 1998
software vendors had been conducted
as part of phase 2. Phase 3 is currently
being developed and is to run from April
1999 until early 2000.
Fiduciary Activities
The Federal Reserve has supervisory
responsibility for institutions that together hold more than $11.5 trillion of
assets in various fiduciary capacities.
This group of institutions comprises 319
state-chartered member banks and trust
companies, 71 nonmember trust companies that are subsidiaries of bank holding companies, and 18 entities that are
either branches or agencies of foreign
banking organizations or Edge corporation subsidiaries of domestic banking
institutions.
During on-site examination of an
institution's fiduciary activities, examiners evaluate the institution's management and operations, including its asset
and account management, risk management, and audit and control procedures,
and review its compliance with laws,
regulations, general fiduciary principles,
and potential conflicts of interest. In
1998, Federal Reserve examiners conducted 219 on-site trust examinations.
Transfer Agents and
Securities-Clearing Agencies
The Federal Reserve conducts specialized examinations of those state member banks and bank holding companies
that serve as registered 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 transfer agent
operations and compliance with relevant
securities regulations. During 1998,
Federal Reserve examiners conducted
examinations at 53 of the 143 state
member banks and bank holding companies that were registered as transfer
agents.
In addition, during 1998, the Federal
Reserve examined two state member
limited-purpose trust companies that
acted as national securities depositories
to ensure the safety and soundness of
their operations and their compliance
with applicable laws and regulations.
These institutions, which were registered as clearing agencies with the Securities and Exchange Commission, held
dematerialized and immobilized securities in custody on behalf of participants and their customers and facilitated
the settlement of securities transactions
through electronic book entry accounting. During 1998, one of the institutions,
the Participants Trust Company, which
provided depository and settlement
services for mortgage-backed securities,
became a division of the other, the
Depository Trust Company, which is the
national securities depository for most
corporate and municipal securities
Government and Municipal Securities
Dealers and Brokers
The Federal Reserve is responsible for
examining the government securities
dealer and broker activities of state
member banks and foreign banks for
compliance with the Government Securities Act of 1986 and with Department
of the Treasury regulations. Thirty-six
state member banks and nine state
branches of foreign banks have notified
the Board that they are government
securities dealers or brokers not exempt
from Treasury's regulations. During
1998, the Federal Reserve conducted
fourteen examinations of broker-dealer
activities in government securities at
these institutions.
Banking Supervision and Regulation 245
Under the Securities Act Amendments of 1975, the Federal Reserve is
also responsible for the supervision of
state member banks and bank holding
companies that act as municipal securities dealers. The Federal Reserve supervises thirty-six banks that act as municipal securities dealers. In 1998, thirteen
of these institutions were examined.
equity security, two were permitted to
underwrite any debt security, and nine
were permitted to underwrite only the
limited types of debt securities first
approved by the Board in 1987. The
Federal Reserve follows specialized
inspection procedures to review the
operations of these securities subsidiaries; it conducted twenty-three such
inspections in 1998.
Securities Subsidiaries of
Bank Holding Companies
Securities Credit Regulation
All subsidiaries of bank holding companies established pursuant to section 20
of the Banking Act of 1933 are required
to conduct business subject to uniform
operating standards, consistent with safe
and sound operations. To ensure that
section 20 firms will not be engaged
principally in underwriting and dealing
in securities, the Board limits revenues
derived from such activities to less than
25 percent of the total revenues of the
section 20 subsidiary.
As the structure of the financial services industry has continued to evolve, a
trend toward acquisition of independent
securities firms by banking organizations has emerged. As a result, significant Federal Reserve resources have
been devoted to monitoring and supervising such mergers and acquisitions
to ensure that banking organizations
develop and maintain the necessary risk
management and corporate oversight to
avoid any negative effect on the banking
organization and its banking operations.
At year-end 1998, forty-six bank
holding companies and foreign banking
organizations owned a total of fiftythree section 20 subsidiaries authorized
to underwrite and deal in ineligible securities; largely because of mergers and
acquisitions, six of these institutions
owned more than one section 20 subsidiary. Of the forty-six, thirty-five were
permitted to underwrite any debt or
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 the Board's margin 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 1998, 829 lenders other
than banks, brokers, or dealers were
registered with the Federal Reserve;
of these, 584 were under the Federal
Reserve's supervision. The Federal
Reserve regularly inspects 270 of these
lenders either biennially or triennially,
according to the type of credit they
extend; during 1998, Federal Reserve
examiners inspected 143 of them for
compliance with Regulation U. The
remaining 314 lenders were exempt
from periodic on-site inspections by the
Federal Reserve but were monitored
through the filing of periodic regulatory
reports.
246 85th Annual Report, 1998
International Activities
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 1998, the
Federal Reserve conducted examinations of nine foreign branches of state
member banks and eighty-two foreign
subsidiaries of Edge Act corporations
and bank holding companies. All of 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. Also, examiners made twentythree visits to the overseas offices of
U.S. banks to obtain financial and
operating information and, in some
instances, to evaluate their compliance
with corrective measures or to testcheck their adherence to safe and sound
banking practices.
Foreign Branches of Member Banks
At the end of 1998, eighty-three member banks were operating 881 branches
in foreign countries and overseas areas
of the United States; fifty-three national
banks were operating 693 of these
branches, and thirty state member banks
were operating the remaining 188
branches. In addition, twenty-two
nonmember banks were operating 47
branches in foreign countries and overseas areas of the United States.
Edge Act and Agreement Corporations
Edge Act corporations are international
chartered by the
Digitizedbanking organizations
for FRASER
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 agreements with the Board not to exercise
any power that is impermissible for an
Edge Act corporation.
Under sections 25 and 25A of the
Federal Reserve Act, Edge Act and
agreement corporations may engage in
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.
At year-end 1998, there were eightyfive Edge Act and agreement corporations with thirty-three branches.
During the year, the Federal Reserve
examined all of these corporations.
U.S. Activities of Foreign Banks
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
1998, 246 foreign banks from 58
countries operated 421 state-licensed
branches and agencies (of which 20
were insured by the Federal Deposit
Insurance Corporation) as well as 62
Banking Supervision and Regulation 247
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
65 U.S. commercial banks. Altogether,
these U.S. offices of foreign banks at the
end of 1998 controlled approximately
20 percent of U.S. banking assets. These
foreign banks also operated 216 representative offices; an additional 87 foreign banks operated in the United States
solely through a representative office.
The Federal Reserve has acted to
ensure that all state-licensed and federally licensed branches and agencies are
examined on site at least once during
each twelve-month or eighteen-month
period, either by the Federal Reserve
or by a state or other federal regulator.
On-site examinations of state- and federally licensed branches and agencies are
usually conducted at least once during
a twelve-month period, 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 431 examinations
during 1998.
Joint Program for
Supervising the U.S. Operations of
Foreign Banking Organizations
In 1995 the Federal Reserve, in cooperation with the other federal and state
banking supervisory agencies, formally
adopted a joint program for supervising
the U.S. operations of foreign banking
organizations (FBOs). The program has
two major parts. One part focuses on the
examination process for those FBOs that
have multiple U.S. operations and is
intended to improve coordination among
Digitizedthe FRASER U.S. supervisory agencies.
for various
The other part is a review of the financial and operational profile of each FBO
to assess its general ability to support its
U.S. operations and to determine what
risks, if any, the FBO poses through its
U.S. operations. Together, these two processes provide critical information to the
U.S. supervisors in a logical, uniform,
and timely manner. During 1998, the
Federal Reserve continued to implement
program goals through coordination
with other supervisory agencies and
the development of financial and risk
assessments of foreign banking organizations and their U.S. operations.
Technical Assistance
In 1998, the Federal Reserve System
continued to provide staff for technical
assistance missions covering bank
supervisory matters to an increasing
number of central banks and supervisory authorities around the world. Technical assistance takes a wide variety
of forms, ranging from official visits
by foreign supervisors to the Board and
Reserve Banks for the purpose of learning about U.S. supervisory practices and
procedures to secondments of Federal
Reserve System staff to overseas supervisory authorities for the purpose of
advising on strengthening the bank
supervisory process in a foreign country.
In 1998, technical assistance was concentrated primarily 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 on
site in a number of foreign jurisdictions
exclusively for staff of 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,
and the Basle Committee on Banking
Supervision.
248 85 th Annual Report, 1998
Risk-Focused Supervision
Over the past several years the Federal
Reserve has initiated a number of 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.
In 1998, the Federal Reserve continued to revise its supervisory process to
improve the effectiveness of its examinations and inspections as well as to
address changes in the banking industry.
As of October 1, 1998, pre-membership
examinations of state nonmember
banks, national banks, and savings associations seeking to convert to state membership status are no longer required if
the bank or savings association seeking
membership meets the criteria for "eligible bank" as set forth in the Board's
Regulation H.
During the year, two of the Federal
Reserve's risk-focused supervision programs for banks—one for large, complex banking organizations and the other
for community banks—were reviewed
for effectiveness and the need for further
enhancements. Both programs rely on
gaining an understanding of the institution, performing risk assessments,
developing a supervisory plan, and
tailoring examination procedures to the
institution's risk profile.
Risk-Focused Supervision of
Community Banks
Implementation of the risk-focused
supervision program for community
banks was reviewed at each of the
twelve Reserve Banks. The primary
objective was to identify best practices,
procedures, and processes as well as
those that might require improvement
or further clarification. The reviews
emphasized that certain elements are
key to the risk-focused supervision
process, including adequate planning
time, completion of a pre-examination
visit, preparation of a detailed scope-ofexamination memorandum, thorough
documentation of the work done, and
preparation of an examination report
tailored to the scope of the examination.
The findings from the reviews are
expected to be distributed to the Reserve
Banks in early 1999.
Risk-Focused Supervision of Large,
Complex Banking Organizations
In an effort to build on the Federal
Reserve's Framework for Risk-Focused
Supervision of Large, Complex Financial Institutions, a group of Reserve
Bank and Board senior supervisory staff
in 1998 codified best practices across
the System for supervising the largest,
most complex of these financial institutions. The key features of the program
for implementing risk-focused supervision at these large, complex banking
organizations (LCBOs) 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
LCBOs to keep current the Federal
Reserve's assessment of each organization's condition; (3) instituting a
defined, stable supervisory team for
each LCBO composed of Reserve Bank
staff who have skills appropriate for the
organization's unique risk profile, led
by a Reserve Bank central point of
contact who has responsibility for only
one LCBO, and supported by specialists skilled in evaluating the risks of
highly complex LCBO business activi-
Banking Supervision and Regulation 249
ties and functions; and (4) promoting
information-sharing on a Systemwide
and interagency basis through an automated system.
Technology Initiatives for the
Risk-Focused Supervision Program
To assist in the supervision of large U.S.
banking organizations and the U.S.
branches and agencies of foreign banking organizations, the Federal Reserve
in 1998 introduced the Large Bank
Desktop and expanded the FBO Desktop. These automated systems are vehicles for sharing information used in
the supervision of these organizations
throughout the Federal Reserve System
and with other federal and state banking
supervisors.
Additionally, development of the
Banking Organization National Desktop (BOND) has begun, with the aim
of providing the high degree of
information-sharing and ongoing collaboration necessary to support the riskfocused supervision of the largest, most
complex banking organizations. BOND
will expand on the capabilities of the
Large Bank and FBO Desktops to provide immediate, user-friendly access to
a full range of internal and third-party
information and to risk-assessment and
other decision-support tools. It will also
serve to foster collaboration among Federal Reserve staff and other bank supervisors. BOND is expected to facilitate
the analysis of trends for like organizations and to improve the Federal
Reserve's ability to identify and manage the risks posed by these banking
organizations.
Risk-Focused Supervision of
Small Shell Bank Holding Companies
During 1998, the Board implemented
surveillance screens for small shell bank
holding companies that identify trends
that may adversely affect individual
companies. These screens support the
risk-focused supervision program for
small shell bank holding companies,
which tailors supervisory activities to an
assessment of each company's reported
condition and activities and the condition of its subsidiary banks. Under the
program, Reserve Banks are expected to
perform a risk assessment of each small
shell bank holding company at least
once during each supervisory cycle,
which depends on the examination frequency for the holding company's lead
bank. If a preliminary assessment identifies no unusual supervisory issues or
concerns, no special follow-up with the
company is necessary. However, if it
supports the assignment of a supervisory rating (that is, a BOPEC rating)
of 3 or worse or a management rating
of less than satisfactory, a full-scope,
on-site inspection is expected to be
performed. New companies will still be
subject to a full-scope, on-site inspection within the first twelve to eighteen
months of operation.
Surveillance and Risk Assessment
The Federal Reserve monitors the financial condition and performance of individual banking organizations and of the
banking system as a whole to identify
areas of supervisory concern. This is
accomplished, in part, through the use
of automated screening systems. Surveillance screens address a number of
aspects of banking performance, including capitalization, growth, loan quality,
loan concentrations, liquidity, and capital markets activities. Information from
these screens assists in allocating examination resources to deteriorating institutions and is also used in planning examinations. The systems used to monitor
bank performance include two econo-
250 85th Annual Report, 1998
metric models that use quarterly Call
Report data to estimate examination ratings for all banks and to identify banks
having the potential to become critically
undercapitalized over the subsequent
two years.
During 1998, the Federal Reserve
also initiated efforts to refine reports
used in monitoring the international
activities of domestic and foreign banking organizations. These efforts included
expanding stock price monitoring efforts
for global institutions and enhancing
reports on the foreign exposure of U.S.
banking institutions.
In addition, the Federal Reserve
broadened the supervisory staffs electronic access to data on U.S. branches
and agencies of foreign banking organizations through enhancements to the
Performance Report Information and
Surveillance Monitoring application
(PRISM). PRISM is a PC-based application that supports financial analysis
by facilitating access to supervisory and
structure data housed in the National
Information Center (NIC) and by electronically distributing surveillance and
monitoring results.
To assist supervisory staff in evaluating individual bank holding companies, the Federal Reserve produces and
distributes the quarterly Bank Holding Company Performance Report
(BHCPR). This report includes detailed
information on current and historic bank
holding company conditions and performance. During the year, the Federal
Reserve implemented a web version
of the BHCPR to make nonconfidential
versions of the report more accessible to
the public.
The Federal Reserve actively works
with the other federal banking agencies
to enhance surveillance tools through its
representation on the Federal Financial
Institutions Examination Council Task
Force on Surveillance Systems.
Supervisory Policy
The supervisory policy function develops guidance for examiners and financial institutions as well as regulations
for financial institutions under the
supervision of the Federal Reserve.
Supervisory function staff members also
participate in international supervisory
forums and provide significant support
for the work of the FFIEC. The following discussion summarizes the work of
this function.
Trading and
Capital Markets Activities
In 1998, the Board's Division of Banking Supervision and Regulation issued a
significantly revised and expanded version of its Trading and Capital Markets Activities Manual, which provides
examiners with guidance for reviewing
capital markets and trading activities at
financial institutions of all types and
sizes. The revised guidance takes a functional approach to activities, as opposed
to a legal-entity focus. The manual includes new chapters on basic treasury
functions and other capital markets
activities, capital adequacy, and settlement risk and contains thirty-five new
profiles of capital markets products.
Chapters on market risk, pre-settlement
risk, legal risk, financial performance,
accounting and regulatory reporting, and
ethics have been revised and updated to
reflect new regulatory guidance and best
practices.
The manual codifies current procedures used in reviewing capital markets
and trading activities. It discusses the
risks involved in various activities,
risk-management and risk-measurement
techniques, appropriate internal controls, and examination objectives and
procedures. The manual is updated
Banking Supervision and Regulation 251
periodically as products and activities
evolve.
Capital Adequacy Guidelines
During 1998, the Federal Reserve,
together with the other federal banking
agencies, issued two final rules that
amended their capital standards. One
rule permits institutions to include up to
45 percent of unrealized gains on certain equity securities in tier 2 capital.
The other raises the tier 1 capital limitation for mortgage-servicing assets
from 50 percent to 100 percent of tier 1
capital.
Market Risk/Specific Risk
During 1998 the Federal Reserve, together with the FDIC and the OCC,
worked to develop a final rule to amend
their respective risk-based capital standards for market risk applicable to certain institutions having significant trading activities. The rule would finalize
an interim rule issued by the agencies in
December 1997. The interim rule permits institutions to use qualifying internal models to determine their capital
requirements in relation to specific risk
(an element of market risk) without
comparing the requirements generated
by their internal models with the socalled standardized specific-risk capital
requirement. The final rule being developed, which is similar in substance to
the interim rule, is expected to be finalized in early 1999.
Servicing Assets
On August 10, 1998, the federal banking agencies issued a final rule amending their risk-based and tier 1 leverage
capital guidelines for banks, bank holding companies, and thrift institutions to
address the accounting treatment of ser
vicing assets on both mortgage assets
and financial assets other than mortgages. The final rule reflects changes
in accounting standards for servicing
assets made in Statement of Financial
Accounting Standard (FAS) No. 125,
Accounting for Transfers and Servicing
of Financial Assets and Extinguishments
of Liabilities. FAS 125 extends the
accounting treatment for mortgage
servicing to servicing on all financial
assets. The final rule raises the capital
limitations on the sum of all servicing
assets (mortgage and nonmortgage)
and purchased credit card relationships
(PCCRs) from 50 percent of tier 1 capital to 100 percent of tier 1 capital. It also
subjects nonmortgage servicing assets
and PCCRs to a further sublimit of
50 percent of tier 1 capital.
Unrealized Gains on
Certain Equity Securities
On September 1, 1998, the federal banking agencies issued a joint final rule that
amended the risk-based capital rules and
allows banking organizations to include
up to 45 percent of their net unrealized
holding gains on certain available-forsale equity securities in tier 2 capital.
The rule became effective on October 1,
1998. The full amount of net unrealized
gains on available-for-sale securities
is included as a component of equity
capital under U.S. generally accepted
accounting principles (GAAP), but until
the adoption of this interagency rule
such gains had not been included in
regulatory capital. The agencies' capital
rules, consistent with GAAP, continue
to require banking organizations to
deduct the amount of net unrealized
losses on their available-for-sale equity
securities from tier 1 capital. To be consistent with a restriction in the Basle
Accord, the agencies have limited the
inclusion of net unrealized gains on
252 85th Annual Report, 1998
equity securities in tier 2 capital to no
more than 45 percent of such net unrealized gains.
resulting from cash flow hedges should
not be included in regulatory capital.
The guidance further notes that the
existing risk-based capital treatment
for derivatives affects a banking orgaLeverage Capital Ratios
nization's risk-based and tier 1 capital
On June 4, 1998, the Federal Reserve leverage ratios. The changes in the fair
issued a final rule that amended its value of derivatives may indirectly
leverage standard for bank holding com- affect retained earnings, thus affecting
panies. Under the rule, bank holding tier 1 capital. In addition, the on-balancecompanies that either are rated a com- sheet recorded amount of derivatives
posite 1 under the BOPEC rating system may affect the total assets reported
or have implemented the Board's risk- by banking organizations, thus directly
based capital market risk measure are affecting the leverage ratio.
subject to a minimum 3 percent leverage
ratio. All other bank holding companies
are subject to a minimum 4 percent Development of International
Guidance on Supervisory Policies
leverage ratio.
Accounting for Derivative
Instruments and Hedging Activities
(FAS 133)
On December 29, 1998, the federal
banking agencies issued a joint release
that describes the appropriate interim
regulatory capital treatment of derivatives for those banking organizations
choosing to early-adopt Statement of
Financial Accounting Standard (FAS)
No. 133, Accounting for Derivative
Instruments and Hedging Activities.
Banking organizations are not required
to adopt FAS 133 until fiscal years
beginning after June 15, 1999. The new
accounting standard requires that all
derivatives be recorded on the balance
sheet as assets or liabilities at fair value.
It also requires that a specific portion of
cash flow hedges be reflected as a separate component of equity. Moreover, it
significantly alters the accounting for
derivatives used for hedging purposes
and for financial instruments having specific types of embedded derivatives.
The interagency guidance states that
until the agencies determine otherwise,
the separate component of equity capital
As a member of the Basle Committee on
Banking Supervision (Basle Supervisors
Committee) and the Joint Forum on
Financial Conglomerates (Joint Forum),
the Federal Reserve has a key role in
developing supervisory guidance on a
wide range of international supervisory
policies. The Federal Reserve's goal is
to work toward the adoption and implementation of sound supervisory policies
for banking institutions and to ensure
the stability of the international banking system. During 1998, the Federal
Reserve actively played a central role in
developing a number of supervisory policy papers, reports, and recommendations that were issued, or are in the
process of being issued, by the Basle
Supervisors Committee and the Joint
Forum, including the following:
• The Basle Committee undertook in
the latter part of 1998 a major effort to
revisit the various parts of the Basle
Accord to ensure the continued vigor
of this international capital framework. The Committee is considering
this issue in light of changes in financial institutions and their activities
in the financial markets, as well as
Banking Supervision and Regulation 253
•
•
•
•
•
•
the development of advanced risk
management approaches, since the
Accord's adoption in 1988.
The Basle Committee undertook to
study banking institutions' interaction
with highly leveraged institutions
(HLIs) such as hedge funds, particularly in light of the near-collapse of
Long-Term Capital Management. A
major part of this work was to assess
the quality of banking institutions'
risk-management practices related to
HLIs and appropriate supervisory
responses to address any weaknesses
identified.
The Basle Committee issued in October 1998 an interpretation of the
Accord for capital adequacy regarding
the capital instruments eligible for
inclusion in tier 1 capital. The interpretation set forth the essential characteristics that capital instruments must
have to warrant their inclusion in
tier 1 capital under the Accord.
The Basle Committee published in
September 1998 the results of its survey of major banking institutions in
member countries on their approaches
to measuring, monitoring, and controlling operational risks arising from
their financial activities.
The Basle Committee conducted a
survey on cross-border supervision
focusing on two principal issues:
access by home country supervisors
to information on the activities of
home country banking institutions in
other countries, and the ability of
supervisors to conduct cross-border
inspections.
In 1998, the Basle Committee extensively developed a consultative paper
setting forth essential principles for
the measurement and management of
credit risk.
The Joint Forum, with international
participation by supervisors of the
banking, securities, and insurance
industries, continued its work toward
improving supervisors' cooperation
and coordination in an effort to ensure
the sound oversight of international
financial conglomerates crossing national and traditional industry lines.
Recourse
During 1998, the Federal Reserve,
together with the OCC, FDIC, and OTS
(Office of Thrift Supervision), continued
to work on revisions to the rules regarding risk-based capital standards to
address the regulatory capital treatment
of recourse obligations and direct credit
substitutes that expose banks, bank
holding companies, and thrift institutions to credit risk. The proposed revisions would use credit ratings to match
the risk-based capital assessment more
closely to an institution's relative risk of
loss in certain asset securitizations.
Technical Modifications
The federal banking agencies continued
in 1998 to work to amend their capital
adequacy guidelines to eliminate differences among the agencies. At year-end
1998, several technical modifications
were still outstanding. These addressed
the risk-based capital treatment of
(1) construction loans for presold oneto four-family residential properties,
(2) second liens on one- to four-family
residential properties, and (3) investments in mutual funds and to simplify
the agencies' leverage capital rules for
banks and thrifts. The first proposal
would permit a 50 percent risk weight
for construction loans on all presold
one- to four-family residential properties. The second proposal would treat
first and second liens issued by the same
institution (where there are no intervening liens) as a single extension of credit
for purposes of determining loan-to-
254 85th Annual Report, 1998
value percentages as well as risk weighting. These two proposed amendments
would not change current Federal
Reserve treatment of these assets for
capital purposes. For investments in
mutual funds, the proposed amendments
would give institutions the option of
assigning mutual fund investments on a
pro rata basis among the risk categories
according to the investment limits in the
mutual fund prospectus. With regard to
the tier 1 leverage ratio, the proposed
amendment on mutual funds would permit certain institutions with the highest
supervisory rating to have a 3 percent
minimum leverage ratio; all other banks
and thrift institutions would be required
to have a minimum leverage ratio of
4 percent. The agencies are working to
finalize these proposed amendments in
early 1999.
Interagency Statement on the
Allowances for Loan Losses
In November, the Federal Reserve, the
Securities and Exchange Commission,
and the other federal banking agencies
issued a joint interagency statement on
allowances for the loan losses of depository institutions. The statement reiterates the agencies' position that allowances for loan losses should be established and maintained in a manner that
is consistent with generally accepted
accounting principles and with the banking agencies' December 1993 interagency policy statement on the allowance for loan losses. The joint statement
emphasizes the importance of prudent,
conservative, but not excessive loanloss allowances that fall within an
acceptable range of estimated losses.
The statement also states that the agencies will continue to fulfill their responsibility to ensure that allowances for
loan losses are appropriately determined
and that earnings are not improperly
managed, consistent with the objectives
of safety and soundness and investor
protection.
Interagency Policy Statement on
Income Tax Allocation in a
Holding Company Structure
The Board and the other federal banking
agencies in December 1998 issued a
joint policy statement regarding intercompany tax allocations for banking
organizations and savings associations
that file an income tax return as a member of a consolidated group. The statement provides guidance to institutions
regarding the allocation and payment of
taxes among a bank holding company
and its depository institution subsidiaries, and related internal policies. In
general, the guidance is consistent with
the Federal Reserve's pre-existing policies on income taxes, but it has been
updated to reflect current tax terminology and to ensure a uniform interagency
approach. Consistent with long-standing
policy, the statement adheres to the general principle that intercorporate tax
settlements between an institution and
its parent company should be conducted
in a manner that is no less favorable to
the institution than if it were a separate
taxpayer.
International Guidance on
Internal Control, Accounting,
and Disclosures
As a member of the Basle Committee on
Banking Supervision (Basle Supervisors
Committee), the Federal Reserve has a
key role in the development of supervisory guidance on best accounting and
best reporting practices among banking
organizations. The objectives of this
guidance are to promote greater transparency in financial statements, to
encourage sound risk management, and
Banking Supervision and Regulation 255
to improve disclosures of qualitative and
quantitative information on bank risk
exposures and risk-management policies and practices. During 1998, the
Federal Reserve contributed to several
papers and reports on internal controls, accounting, and disclosure that
were issued by the Basle Supervisors
Committee:
• "Framework for Supervisory Information about Derivatives and Trading Activities" (September) discusses
the types of information supervisory
authorities should obtain for their
evaluations of the derivatives activities of banks and securities firms. The
paper builds on the supervisory information framework that was jointly
published in May 1995 by the Basle
Supervisors Committee and the Technical Committee of the International
Organization of Securities Commissions (IOSCO) and addresses more
comprehensively the market risk
exposures arising from trading in both
cash and derivatives instruments.
• "Enhancing Bank Transparency:
Public Disclosure and Supervisory
Information That Promote Safety and
Soundness in Banking Systems"
(September) discusses the role of
information in effective market discipline and banking supervision. It provides general guidance to banking
supervisors and regulators on ways
to formulate and improve regulatory
frameworks for public disclosure and
supervisory reporting; it also provides
general guidance to the banking industry on core disclosures that should
be provided to the public.
• "Framework for Internal Control
Systems in Banking Organizations"
(September) outlines a comprehensive
framework for the supervisory evaluation of banks' internal controls,
including management's responsi
bility for maintaining the system of
internal control, the role of the board
of directors in establishing a corporate
culture that emphasizes the importance of internal controls, and the
monitoring activities and communication systems that are necessary to correct deficiencies. It also includes principles to guide supervisory authorities
when evaluating banks' internal control systems.
• "Sound Practices for Loan Accounting, Credit Risk Disclosure and
Related Matters" (October) provides
guidance to banks, banking supervisors, and those who set accounting
standards on the recognition and measurement of loans, the establishment
of allowances for loan losses, credit
risk disclosure, and related matters.
• "Trading and Derivatives Disclosures
of Banks and Securities Firms:
Results of the Survey of 1997 Disclosures" (November) is the fourth
annual joint report of the Basle Supervisors Committee and IOSCO on the
public disclosure of trading and derivatives activities of banks and securities firms worldwide. The report provides an overview and analysis of the
disclosures about trading and derivatives activities presented in the 1997
annual reports of a sample of the largest internationally active banks and
securities firms in the G-10 countries,
and notes improvements since 1993.
In addition, a Federal Reserve official
is a participating observer at meetings of
the Financial Accounting Standards
Board's (FASB) Financial Instruments
Task Force. The task force was created
to help the FASB answer questions
related to its accounting and disclosure standards for financial instruments.
This Federal Reserve official is also a
participating observer at the board and
steering committee meetings of the
256 85th Annual Report, 1998
International Accounting Standards
Committee (IASC) as a designee of
the Basle Committee's Task Force on
Accounting Issues. The IASC's objectives are to formulate and publish, in the
public interest, accounting standards to
be observed in the presentation of financial statements and to promote their
worldwide acceptance and observance;
and to work generally for the improvement and harmonization of regulations,
accounting standards, and procedures
relating to the presentation of financial
statements.
Real Estate Appraisal Regulation
In November 1998, the Board adopted
a final rule amending its real estate
appraisal regulation for bank holding
companies and their nonbank subsidiaries. The final rule permits a bank holding company, or its nonbank subsidiary,
having the authority to underwrite or
deal in mortgage-backed securities, to
do so without demonstrating that the
loans underlying the securities are supported by appraisals that at origination
met the Board's appraisal regulation.
The amendment addresses concerns
raised by bank holding companies
regarding the inability of their nonbank
subsidiaries to actively participate in
the commercial mortgage-backed securities market because of the earlier
requirements.
Examination-Frequency Guidelines
In August 1998, the Federal Reserve
and the other federal banking agencies
issued an interim rule revising their
examination-frequency guidelines to
address provisions in the Riegle Community Development and Regulatory
Improvement Act of 1994 and the Economic Growth and Regulatory Paperwork Reduction Act of 1996. As a result
of the revision, certain U.S. branches
and agencies of foreign banking organizations may qualify for an eighteenmonth examination cycle rather than a
twelve-month cycle.
To qualify for consideration for lessfrequent examination, a U.S. branch
or agency must have total assets of
$250 million or less, must have received
a composite supervisory rating of 1 or 2
at its most recent examination, and must
not be subject to a formal enforcement
action. In addition, the U.S. branch or
agency must have satisfied the requirements that either (1) the foreign bank's
most recently reported capital adequacy
position consists of, or is equivalent to,
tier 1 and total risk-based capital ratios
of at least 6 percent and 10 percent
respectively, on a consolidated basis; or
(2) the office has maintained, on a daily
basis over the past three quarters, eligible assets (determined consistent with
applicable federal and state law) in an
amount not less than 108 percent of the
preceding quarter's average third-party
liabilities and sufficient liquidity is currently available to meet its obligations
to third parties. Finally, the foreign bank
must not have experienced a change in
control during the preceding twelve
months.
Guidance on
Credit Risk Management
During 1998, the Federal Reserve issued
guidance regarding the internal rating
systems banks use to support their
sophisticated credit risk management
systems. The guidance underlines the
need for supervisors and examiners,
both in their on-site examinations and
inspections and in their other contacts
with banking organizations, to emphasize the importance of developing
and implementing effective internal
credit-rating systems and the critical role
Banking Supervision and Regulation 257
such systems should play in the credit
risk management process at sound large
institutions. The study on which this
guidance is based is available in the
November 1998 Federal Reserve Bulletin and on the Federal Reserve's public
web site.
Also in 1998, the Federal Reserve
undertook an extensive study of lending
terms and standards. This study, involving several hundred loans from across
the country and many of the Federal
Reserve's most experienced examiners,
compared loans made in late 1995 with
loans made in late 1997. The study concluded that intense competition for loan
customers had led to a significant easing
of pricing and of some non-price terms
but that, on balance, the overall quality
of loans being made had not changed
significantly over the period, largely because of favorable economic conditions.
Risk Assessment of an Institution's
Information Technology
In April 1998, the Federal Reserve
issued guidance on assessing information technology in the risk-focused
frameworks for the supervision of community banks and large, complex banking organizations. The guidance highlights the critical dependence of the
financial services industry on information technology, reinforces the concept
that the risk-focused supervisory process must address the risks associated
with the use of information technology,
and provides a basic framework and a
common vocabulary for evaluating the
effectiveness of processes used to manage the risks associated with information technology.
Bank Holding Company Reports
As the federal supervisor and regulator
of all U.S. bank holding companies, the
Federal Reserve requires periodic regulatory reports from these organizations.
These reports provide essential information to assist the Federal Reserve in the
formulation of regulations and supervisory policies. The reports are also used
by the Federal Reserve to respond 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
(FR Y-9C, FR Y-9LP, and FR Y-9SP)
provides standardized financial statements for the consolidated bank holding
company and its parent. The Federal
Reserve uses these reports to detect
emerging financial problems, to review
performance and conduct pre-inspection
analysis, to monitor and evaluate risk
profiles and capital adequacy, to evaluate proposals for bank holding company
mergers and acquisitions, and to analyze
a bank holding company's overall financial condition to ensure safe and sound
operations. The FR Y-ll 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.
During 1998, revisions that reduce
reporting burden were made to the
FR Y-9C; the revisions generally conform with revisions to the FFIEC 031
Call Report, including the elimination
of several detailed items on investment
securities and trading portfolios and the
addition of items to monitor compliance
with risk-based capital standards for
market risk exposures and for low-level
recourse transactions.3 Revisions to the
3. Revisions to the Call Reports are discussed
later in this section in connection with the work of
Federal Reserve staff under the auspices of the
Federal Financial Institutions Examination Council (FFIEC).
258 85th Annual Report, 1998
FR Y-9LP and FR Y-9SP during 1998
were minor and consisted mainly of the
addition of items to collect information
about nonbank subsidiaries of bank
holding companies. There were no substantive revisions to the FR Y-ll series
of reports during the year.
In December 1998, the Federal
Reserve announced proposed revisions
to the FR Y-9 and FR Y-ll series of
reports effective with the March 1999
reporting date. Most of the proposed
revisions pertain to the FR Y-9C and
attempt to minimize reporting burden by
generally paralleling proposed revisions
to the FFIEC 031 Call Report. The proposed revisions to the FR Y-9C include
the elimination of detailed items for
high-risk mortgage securities; implementation of the disclosure requirements
of Statement of Financial Accounting
Standard (FAS) No. 133, Accounting
for Derivative Instruments and Hedging
Activities, for cash flow hedges; and
implementation of items for monitoring
risk-based capital. The proposed revisions to the other FR Y-9 reports and
to the FR Y-ll series of reports consist
primarily of implementation of the
FAS 133 disclosure requirements for
cash flow hedges. The addition of a section for "Notes to the Financial Statements" has also been proposed for the
FR Y-ll series.
Federal Financial Institutions
Examination Council
Year 2000 Supervision Program
The Federal Reserve has worked closely
with the other federal banking agencies
to address the banking industry's readiness for the Year 2000. Under the auspices of the Federal Financial Institutions Examination Council, the Federal
Reserve and the other member agencies
continued in 1998 to assess the readiness of financial institutions, service
providers, and software vendors to ensure that Year 2000-related computer
problems and major service disruptions
to customers and the banking system
do not occur. The review program is
divided into three phases and emphasizes five components of preparedness.
Phase 1 (June 1997 through June 1998)
focused on evaluating an institution's
ability to understand the myriad issues
related to Year 2000 (the Awareness
and Assessment components) and its
progress in identifying necessary
changes to its computer programs to
ensure their correct operation during
the century date change and beyond.
During phase 2 (July 1998 through
March 1999), examiners are assessing
institutions' progress toward making,
and then testing, the necessary changes
to their computer programs and systems
(the Renovation and Validation components). Phase 3 (beginning in April 1999
and continuing into 2000) will concentrate on assessing the adequacy of the
final stages of testing and contingency
planning efforts (the Implementation
component).
As part of their efforts, the agencies
in 1998 issued a series of guidance
statements on important aspects of
Year 2000, including
• Guidance Concerning Institution Due
Diligence in Connection with Service Provider and Software Vendor
Year 2000 Readiness (March 17)
• Guidance Concerning the Year 2000
Impact on Customers (March 17)
• Guidance Concerning Testing for
Year 2000 Readiness (April 10)
• Guidance on Year 2000 Customer
Awareness Programs (May 13)
• Guidance Concerning Contingency
Planning in Connection with Year
2000 Readiness (May 13)
Banking Supervision and Regulation 259
• Questions and Answers Concerning
FFIEC Year 2000 Policy (August 31)
• Guidance Concerning Fiduciary Services and Year 2000 Readiness (September 2)
• Interagency Guidelines Establishing
Year 2000 Standards for Safety and
Soundness (October 15)
• Questions and Answers Concerning
Year 2000 Contingency Planning
(December 11).
To help institutions understand the
Year 2000 guidance statements and
review process, the agencies conducted
hundreds of banker and community outreach programs throughout the country.
The programs focused on supervisory
expectations and served to convey a
consistent message.
Finally, the member agencies of
the FFIEC participated in the President's Council on Year 2000 Conversion, which is coordinating the federal
government's efforts to address the
Year 2000 problem. The council is made
up of representatives of more than thirty
major federal executive and regulatory
agencies. Some agencies serve as sector
coordinators to promote action on the
Year 2000 problem within their policy
areas. The Federal Reserve Board is the
coordinator for the working group on
the finance sector, which comprises representatives of twenty-one organizations
involved in the financial services industry. This broad-based group has been
instrumental in furthering the goals of
the agencies and is making every effort
to ensure that financial institutions are
prepared for the century date change.
Policy Statement on
Investment Securities and
End-User Derivatives Activities
On April 23, 1998, the FFIEC issued a
Supervisory Policy Statement on Investment Securities and End-User Deriva
tives Activities (referred to as the 1998
Policy Statement). The policy statement, which was adopted by the Federal Reserve, provides guidance on
sound practices for managing the risks
involved in investment and end-user
activities. It rescinded the constraints on
investments in "high risk" mortgage
derivatives products contained in the
1992 FFIEC Supervisory Policy Statement on Securities Activities.
The guidance in the 1998 Policy
Statement reflects the agencies' move to
a more risk-focused approach to supervision. This approach considers the
appropriateness of an instrument held
for investment or end-user purposes in
light of a several factors, including management' s ability to measure and manage the risks of the institution's holdings and the effect of those holdings on
aggregate portfolio risk. The statement
reflects a supervisory focus on evaluating and controlling risks on an
investment-portfolio or an institutionwide basis.
Uniform Rating System for
Information Technology
On December 18, 1998, the FFIEC Task
Force on Supervision revised the Uniform Interagency Rating System for
Data Processing Operations, commonly
referred to as the Information Systems
rating system. The revised system,
whose formal name was changed to the
Uniform Rating System for Information
Technology (URS1T), reflects changes
in the data-processing-services industry
and in supervisory policies and procedures since the rating system was first
adopted in 1978. In the new system, the
numerical ratings have been revised to
conform to the language and tone of the
ratings definitions used in the Uniform
Financial Institutions Rating System,
commonly referred to as the CAMELS
260 85th Annual Report, 1998
rating system. Also, the component rating descriptions have been reformatted
and clarified, and the quality of riskmanagement processes is emphasized
in the descriptions of the rating components. In addition, two new component
categories—Development and Acquisition, and Support and Delivery—have
replaced two former categories (Systems Development and Programming,
and Operations). Finally, the new system explicitly identifies the types of risk
that are considered in assigning component ratings.
Uniform Interagency Trust
Rating System
On October 13, 1998, the FFIEC
adopted revisions to update the Uniform Interagency Trust Rating System
(UITRS), which became effective for
examinations beginning on or after January 1, 1999. The UITRS is a supervisory rating system, originally adopted
in 1978, used to promote consistency
among the federal banking agencies in
evaluating the fiduciary activities of
institutions under their supervisory jurisdiction. The Federal Reserve issued
implementing guidelines for the revised
UITRS for Federal Reserve examiners
in December 1998.
The major revisions to the UITRS
included (1) modifying the definitions
of the ratings to better align the UITRS
rating definitions with the language and
tone of the CAMELS and BOPEC ratings, (2) combining the Account Administration and Conflict of Interest rating components into a new Compliance
component, (3) requiring a rating of
Earnings only for those institutions that
are required to file schedule E of the
FFIEC 001 report (those with trust
assets of more than $100 million), and
(4) placing greater emphasis on riskmanagement processes.
Revisions to Call Reports
The FFIEC implemented changes to the
bank Reports of Condition and Income
(Call Reports), effective with the March
1998 report, to improve the banking
agencies' ability to monitor compliance
with certain regulations and to eliminate
items that were considered unnecessary
for safety and soundness or for other
public policy purposes. The changes
enable the agencies to more readily
monitor compliance with the risk-based
capital standards for market risk exposures and low-level recourse transactions and also reduce the burden of
reporting certain information on deposits, investment securities, and trading
portfolios. The FFIEC also revised the
Report of Assets and Liabilities of
U.S. Branches and Agencies of Foreign
Banks (FFIEC 002), effective with the
March 1998 report, to maintain consistency with the bank Call Reports.
In October, the Federal Reserve and
the other federal banking agencies proposed a small number of revisions to the
bank Call Reports to facilitate bank
supervision. The revisions would,
effective with the March 1999 report,
add items to conform with changes
in GAAP, specifically the disclosure
requirements of Statement of Financial
Accounting Standard No. 133, Accounting for Derivative Instruments and
Hedging Activities. The revisions would
also eliminate several detailed items on
bank investment portfolios and certain
agricultural loan information.
In November, the Federal Reserve
and the other federal banking agencies
announced the discontinuation of the
Monthly Consolidated Foreign Currency
Report of Banks in the United States
(FFIEC 035), effective with the December 1998 report. The agencies determined that the foreign exchange activities reported in the FFIEC 035 could
Banking Supervision and Regulation 261
be monitored through other supervisory
means. Some of the information once
collected through the report will be
collected by the Department of the
Treasury.
Supervisory Information
Technology
The Supervisory Information Technology (SIT) function was established
within the Board's Division of Banking
Supervision and Regulation to facilitate
management of the diverse information
technology (IT) requirements of 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.
The SIT function works through
assigned staff at the Board of Governors
and at selected Reserve Banks and
through a committee structure that
ensures that key staff members actively
participate in identifying requirements
and setting priorities for IT initiatives.
Large Bank Supervision
During 1998, significant progress was
made in developing a new information
system to support the supervision of
large, complex banking organizations.
The system, scheduled for implementation in September 1999, will
provide collaboration, messaging, and
document-management capabilities.
Community Bank Supervision
For the past three years, the Federal
Reserve has worked closely with the
FDIC, the Conference of State Bank
Supervisors, and several state banking
authorities to automate the examination
process for community banks. The agencies now have a set of automated examination tools that support a common
supervisory approach. The FDIC and
several states began using the first version of one of these tools in the fourth
quarter 1998. The Federal Reserve will
begin implementing this same tool in
the second quarter of 1999.
Document Management
The Federal Reserve is developing a
document repository using a commercial document-management software
system. The repository, which will be
part of the Federal Reserve's National
Information Center (NIC), will initially
contain all examination-related documents that result from the large, complex banking organization supervision
program. Examination documents from
the community bank supervision program will immediately follow. Other
supervisory documents will be added
to the repository as requirements are
defined.
National Information Center
During the past year, the Federal
Reserve further expanded the capabilities of the NIC. In January, the National
Examination Data (NED) system was
fully implemented. NED uses state-ofthe-art client/server technology to provide on-line access to NIC banking
structure, financial, and examination
data. NIC is accessible by supervision
staff across the Federal Reserve System over the System's intranet. Since
262 85th Annual Report, 1998
November, NIC has been accessible by
state banking authorities and the other
federal regulators that use the NED system over an extranet developed by the
Federal Reserve.
In March, the first version of a new
banking structure updating system was
implemented as part of NIC. When the
second version is complete, NIC will
have a new automation architecture that
provides for state-of-the-art client/server
and web technologies such that NIC can
be accessed easily and can be modified
quickly to respond to changing demands
in the financial services industry.
Finally, the capabilities of the NIC
public web site have been expanded.
The site (http://www.ffiec.gov/nic/) contains all NIC banking structure and
financial data and, since November
1998, all bank holding company performance ratios.
Staff Training
The Supervisory Education Program
trains staff members having supervisory
or regulatory responsibilities at the
Reserve Banks, at the Board of Governors, and at state banking departments.
Students from supervisory counterparts
in foreign countries attend the training
sessions on a space-available basis. The
program provides training at the basic,
Number of Sessions of Training Programs for Banking Supervision and Regulation, 1998
Total
Regional
Schools or seminars conducted by the Federal Reserve
Core schools
Introduction to examinations'
Banking and supervision elements
Financial institution analysis
Bank management
Effective writing for banking supervision staff2
Report writing
Management skills
Conducting meetings with management
5
3
9
5
12
3
10
16
3
2
6
3
12
3
9
16
Other schools
Loan analysis
Real estate lending seminar
Specialized lending seminar
Senior forum for current banking and regulatory issues
Banking applications
Bank holding company inspections
Basic entry-level trust
Advanced trust
Consumer compliance examinations I
Consumer compliance examinations II
CRA examination techniques
Fair lending
Foreign banking organizations
Information systems and emerging technology risk management
Information systems continuing education
Intermediate information systems examination
Capital markets seminars
Section 20 securities seminar
Internal controls
Seminar for senior supervisors of foreign central banks3
6
4
4
3
1
5
1
1
2
2
3
5
3
18
3
1
24
2
6
1
Other agencies conducting courses 4
Federal Financial Institutions Examination Council
Office of the Comptroller of the Currency
43
2
Program
NOTE. . . . Not applicable.
1. Replaced by Banking and Supervision Elements in
September.
1
1
1
2
18
18
' 5*
2. Replaced by Report Writing in August.
3. Conducted jointly with the World Bank.
4. Open to Federal Reserve employees.
Banking Supervision and Regulation 263
Federal Reserve trained 3,502 students
in System schools, 822 in schools sponsored by the FFIEC, and 75 in other
schools, for a total of 4,399, including
322 representatives from foreign central
banks. The number of student days of
training was 36,790, which was comparable to the amount of training provided
in recent years.
The Federal Reserve System also
gave scholarship assistance to the states
for training their examiners in Federal
Reserve and FFIEC schools. Through
this program 789 state examiners were
trained: 504 in Federal Reserve courses,
277 in FFIEC programs, and 8 in other
courses.
Every staff member seeking an examiner's commission is required to pass
proficiency examinations, which include a core content area and a specialty area of the student's choice—
safety and soundness, consumer affairs,
trust, or information technology. In
1998, 96 students took the examination
(see table).
The System continued in 1998 to
make revisions initiated in 1997 to the
training program that leads to the commissioning of assistant examiners. The
project was undertaken to give assistant
examiners a greater understanding of
risk-focused examination concepts, the
components of sound internal controls,
the importance of management information systems, the concept of risk as it
intermediate, and advanced levels for
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., or at regional locations and may
be held jointly with other regulators
of financial institutions. The program
is designed to increase the student's
knowledge of the total supervisory and
regulatory process and thereby provide
a higher degree of cross-training among
staff members.
The Federal Reserve System also
participates in training offered by the
Federal Financial Institutions Examination Council and by certain other
regulatory agencies. The System's involvement includes developing and
implementing basic and advanced training in various emerging issues as well as
in such specialized areas as trust activities, international banking, information
technology, municipal securities dealer
activities, 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.
During 1998, the Federal Reserve
conducted a variety of schools and seminars, and staff members participated in
several courses offered by or cosponsored with other agencies, as shown
in the accompanying table. In 1998, the
Status of Students Registered for the Core Proficiency Examination, 1998
Specialty area
Student status
In queue, year-end 1997
Test taken, 1998
Passed
Failed
In queue, year-end 1998
Core
23
96
83
13
33
Safety and
soundness
Consumer
Trust
Information
technology
13
63
53
10
22
9
34
28
6
10
0
3
2
1
1
1
2
2
0
0
NOTE. Students choose a test in one specialty area to accompany the core examination.
264 85th Annual Report, 1998
applies to banking, and the key supervisory issues related to integrated supervision. The changes will be implemented
over 1999.
Regulation of the
U.S. Banking Structure
The Federal Reserve administers the
Bank Holding Company Act, the Bank
Merger Act, the Change in Bank Control Act, and the International Banking
Act for bank holding companies, member banks, and foreign banking organizations. 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.
Bank Holding Company Act
Under the Bank Holding Company Act,
a company must obtain the Federal
Reserve's approval before forming a
bank holding company by acquiring
control of one or more banks in the
United States. Once formed, a bank
holding company must receive the Federal Reserve's approval before acquiring additional banks or nonbanking
companies. The act permits well-run
bank holding companies that satisfy specific criteria to commence certain nonbanking activities on a de novo basis
without prior Board approval and establishes an expedited prior notice procedure for other activities and for small
acquisitions.
In reviewing an application or notice
filed by a bank holding company
for prior Board approval, the Federal
Reserve considers several factors,
including the financial and managerial
resources of the applicant, the future
prospects of both the applicant and the
company to be 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.
In 1998, the Federal Reserve approved 310 proposals by foreign or
domestic companies to become bank
holding companies; approved 177 proposals by existing bank holding companies to merge with other bank holding companies; approved 319 proposals
by existing bank holding companies to
acquire or retain banks; approved 490
requests by existing bank holding companies to acquire nonbank firms engaged
in activities closely related to banking;
and approved 201 other bank holding
company applications or notices. Data
on these and all other decisions are
shown in the accompanying table.
Bank Merger Act
The Bank Merger Act requires that all
proposed mergers of 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
proposed merger, the Federal Reserve
considers factors relating to 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
Banking Supervision and Regulation 265
be served, and the competitive effects of
the proposal. It also considers the views
of certain other agencies regarding the
competitive factors involved in the
transaction. During 1998, the Federal
Reserve approved 162 merger applications. As required by law, each merger
is described in this REPORT (in table 15
of the "Statistical Tables" section).
When the FDIC, the OCC, or the
OTS has jurisdiction over a proposed
merger, the Federal Reserve is asked to
comment on the competitive factors to
ensure comparable enforcement of the
antitrust provisions of the Bank Merger
Act. The Federal Reserve and those
agencies have adopted standard terminology for assessing competitive factors
in merger cases to ensure consistency
in administering the act. The Federal
Reserve submitted 844 reports on competitive factors to the other federal banking agencies in 1998.
Change in Bank Control Act
The Change in Bank Control Act
requires that persons seeking control of
a U.S. bank or bank holding company
obtain approval from the appropriate
federal banking agency before completing the transaction. Under the act,
the Federal Reserve is responsible for
reviewing changes in control of state
member banks and of bank holding
companies. In doing so, the Federal
Reserve reviews the financial position,
competence, experience, and integrity
of the acquiring person; considers the
effect on the financial condition of the
bank or bank holding company to be
acquired; determines the effect on competition in any relevant market; assesses
the completeness of information submitted by the acquiring person; and considers whether the proposal would have an
adverse effect on the federal deposit
Decisions by the Federal Reserve, domestic and International Applications, 1998
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
Division of Banking Office
of the
Supervi sion and
Secretary
Regu ation
Permitted Approved
Denied
Federal
Reserve Banks
Total
Approved Approved Permitted
13
0
0
0
0
•5
210
82
310
16
0
0
0
0
23
91
47
177
32
0
0
0
0
29
182
76
319
3
15
2
0
0
0
132
0
0
0
0
0
0
0
0
62
14
0
2
133
0
291
0
165
490
162
167
22
239
0
0
1
34
0
28
0
0
0
387
0
1,177
1
148
24
2,013
342
0
167
28
0
520
1,795
810
3,662
266 85 th Annual Report, 1998
insurance funds. For certain proposals,
the notice process may involve conducting name checks with other agencies of
the U.S. government.
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 to be acquired.
In 1998, the Federal Reserve acted
on 167 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
Federal Reserve approval for the establishment of branches, agencies, commercial lending company subsidiaries,
and representative offices by foreign
banks in the United States. In reviewing
proposals, the Board generally considers
whether the foreign bank is subject to
comprehensive supervision or regulation on a consolidated basis by its home
country supervisor. It may also take into
account 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 concerning its
operations and activities will be made
available to the Board, if deemed necessary to determine and enforce compliance with applicable law; and the record
of the foreign bank with respect to compliance with U.S. law. The Board may
also consider the needs of the community, the foreign bank's history of operation, and its relative size in its home
country.
In 1998, the Federal Reserve approved applications by nine foreign
banks from seven foreign countries to
establish branches, agencies, and representative offices in the United States.
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 is 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, as are all applications and notices that have been received by the
Federal Reserve but not yet acted on.
Each of these matters is subsequently
reported in the Board's weekly H.2 statistical release (Actions of the Board, Its
Staff, and the Federal Reserve Banks;
Applications and Reports Received) and
in the monthly Federal Reserve Bulletin. The related H.2A release (Notice of
Formations and Mergers of, and Acquisitions by, Bank Holding Companies;
Change in Bank Control) contains the
ending comment periods for each pending application and notice. In 1998, the
Board's public web site was enhanced
to include not only the H.2 and the
H.2A, but also other information relevant to the applications process.
Timely Processing of Applications
The Federal Reserve maintains target
dates and procedures for the processing
Banking Supervision and Regulation 267
of applications. The setting of target
dates promotes efficiency at the Board
and the Reserve Banks and reduces the
burden on applicants. The time allowed
for final action ranges from twelve to
sixty days, depending on the type of
application or notice. In 1998, 93 percent of decisions met these deadlines.
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 Division of Banking
Supervision and Regulation, and to the
Secretary of the Board. In 1998, 86 percent of the applications processed were
acted on under delegated authority.
Banking and Nonbanking Proposals
Consolidation among some of the largest U.S. banking organizations continued in 1998. The Federal Reserve
approved five proposals for which public meetings were held in cities throughout the United States; as in earlier cases,
the proposals generated many comments, particularly with respect to Community Reinvestment Act, fair lending, and competitive issues. The Federal
Reserve also approved various proposals involving mutual bank holding
companies. In 1998, the Federal Reserve
continued to act on proposals involving
section 20 companies. The proposals
involved expansion on a de novo as well
as acquisition basis. Early in the year,
the Board also streamlined the restrictions applicable to bank holding companies that seek to act as a commodity
pool operator or otherwise to act as a
general partner of an investment fund.
Overseas Investments by
U.S. Banking Organizations
U.S. banking organizations, with the
authorization of the Federal Reserve,
may engage in a broad range of activities overseas. Most foreign investments
may be made under general consent procedures that involve only after-the-fact
notification to the Board; significant
investments must be reviewed by the
Board in advance. In 1998, the Board
approved thirty-eight proposals (excluding those related to recent large domestic mergers) by U.S. banking organizations to make significant investments
overseas.
The Federal Reserve also has authority to act on proposals involving Edge
Act and agreement corporations, which
are established by banking organizations to provide a means of engaging
in international business. In 1998, the
Board approved two proposals by member banks to increase their investment
in their Edge corporation subsidiaries
to more than 10 percent but less than
20 percent of the member bank's capital
and surplus. The Board also approved
four applications for the establishment
of new agreement corporations.
Applications by Member Banks
State member banks must obtain Board
approval to establish domestic branches,
and all member banks (including
national banks) must obtain Board
approval to establish foreign branches.
In considering proposals for domestic
branches, the Board reviews the scope
of the functions and the character of
the business to be conducted. In reviewing proposals for foreign branches, the
Board considers, among other things,
the condition of the bank and the bank's
experience in international business.
Once a member bank has received
268 85 th Annual Report, 1998
authority to open a branch in a particular
foreign country, the member bank may
open additional branches in that country
without prior Board approval. In 1998,
the Federal Reserve acted on new and
merger-related branch proposals related
to 1,473 domestic branches and granted
prior approval for the establishment
of 13 foreign branches (excluding
those related to recent large domestic
mergers).
Stock Repurchases by
Bank Holding Companies
A bank holding company may purchase
its own shares from its shareholders.
When the company borrows money to
buy the shares, the transaction increases
its debt and decreases its equity. Relatively larger purchases may undermine
the financial condition of a bank holding company and its bank subsidiaries.
The Federal Reserve may object to stock
repurchases by bank holding companies
that fail to meet certain standards,
including the Board's capital guidelines.
In 1998, the Federal Reserve reviewed
twenty-nine proposed stock repurchases
by bank holding companies, all of which
were approved under delegated authority by either a Reserve Bank or the
Secretary of the Board.
Recent Regulatory Changes
In July 1998, the Board approved various amendments to Regulation H, which
implements the Federal Reserve Act,
portions of the Federal Deposit Insurance Act, and related statutes. The
amendments were designed to reduce
regulatory burden and to simplify and
update the regulation. As part of the
final regulation, the Board adopted new
expedited procedures for membership
and branch applications, modified various criteria related to membership in the
Federal Reserve System, and provided
further guidance to member banks
regarding permissible investments in
securities. The Board also adopted new
definitions for various terms used in
the regulation, including those related
to capital stock and surplus and to a
branch.
Enforcement of Other Laws
and Regulations
Financial Disclosure 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
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 1998,
twenty-five state member banks, most of
them small or medium sized, were registered with the Board under the Securities Exchange Act.
Securities Credit
Under the Securities Exchange Act of
1934, 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 by securities brokers and dealers. The Board's Regulation U, which
had limited the amount of credit that
may be provided by commercial banks,
was amended effective April 1998 to
also cover lenders other than banks,
brokers, or dealers. Lenders other than
banks, brokers, or dealers were formerly
subject to Regulation G, which was
eliminated in April 1998. The Board's
Banking Supervision and Regulation 269
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
compliance with the Board's securities
credit regulations. The Securities and
Exchange Commission, 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; and the Federal
Reserve examines any other lenders.
Regulation T limits the amount of
credit that brokers and dealers may
extend when the credit is used to purchase or carry publicly held debt or
equity securities. Regulation U limits
the amount of credit that lenders other
than brokers and dealers may extend
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.
Since 1968, the Federal Reserve has
monitored the market activity of all
stocks traded over-the-counter (OTC) in
the United States to determine which of
them are subject to the Board's margin
regulations. Also since that time, the
Board has periodically published the
resulting "List of Marginable OTC
Stocks." In 1997, the Board amended
its margin regulations to eliminate the
OTC list by the end of 1998 and instead
to rely on the listing standards of the
Nasdaq Stock Market. The Board published the last OTC list in November
1998. It also published OTC lists in
February, May, and August 1998.
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 1998, the foreign list was
revised in February, May, August, and
November.
Bank Secrecy Act/Anti-Money
Laundering
The regulation (31 CFR Part 103) implementing the Currency and Foreign
Transactions Reporting Act, also known
as the Bank Secrecy Act, requires banks
and other types of financial institutions to file certain reports and to maintain certain records. The requirements
include the reporting of information
concerning persons involved in large
currency transactions as well as suspicious activity related to a possible violation of federal law. Records that must
be maintained include those kept in
the ordinary course of business as well
as the identity of persons who purchase
monetary instruments with currency and
those who send or receive funds transfers in substantive amounts. The act is
regarded as a primary tool in the fight
against money laundering; in part it creates a paper trail that helps law enforcement agencies and regulators identify
and trace the proceeds of illegal activity.
Pursuant to Regulation H, section
208.63, each banking organization
supervised by the Federal Reserve must
also develop a program for compliance
with the Bank Secrecy Act. The program, which must be in writing and
formally approved by the institution's
board of directors, must (1) establish
a system of internal controls to ensure
compliance with the act, (2) provide
for independent compliance testing,
(3) identify individual(s) responsible for
coordinating and monitoring day-to-day
compliance, and (4) provide training
270 85th Annual Report, 1998
for appropriate personnel. Through its
examination process, training, and other
off-site measures, the Federal Reserve
monitors compliance with the Bank
Secrecy Act and Regulation H by
the banking organizations under its
supervision.
In 1998, the Federal Reserve continued to provide expertise and guidance to
the Bank Secrecy Act Advisory Group,
a committee established at the Department of the Treasury by congressional
mandate to seek measures to reduce
unnecessary burdens created by the act's
requirements and to increase the utility
of data collected under the act to regulators and law enforcement agencies.
In October, in consultation with and
assistance from the Federal Reserve,
the Treasury Department issued final
rules revising exemption procedures to
reduce significantly the number of Currency Transaction Reports filed. The
Federal Reserve also led an interagency
group that revised the Suspicious Activity Report to make it more useful to law
enforcement as well as Year 2000 compliant. The new form is scheduled for
use in the spring of 1999.
The Federal Reserve in December
issued a proposed rule regarding Know
Your Customer programs. The proposal
was issued along with nearly identical
proposals by the Office of the Comptroller of the Currency, the Federal Deposit
Insurance Corporation, and the Office of
Thrift Supervision.
Through the Special Investigations
Section of the Division of Banking
Supervision and Regulation, the Federal
Reserve in 1998 assisted in the investigation of money laundering activities,
including Operation Casablanca, which
involved a number of foreign banking
organizations. The section also provided
anti-money-laundering training to designated staff members at each Reserve
Bank, to the domestic banking sector
through trade association conferences
and seminars, and to representatives of
law enforcement agencies.
Internationally, the section assisted
the State Department by providing antimoney-laundering training and technical
assistance to countries in Asia, eastern
Europe and the newly independent
states, South and Central America, and
the Caribbean. Board staff also participated extensively in numerous multilateral international anti-money-laundering
initiatives including the G-7, the Financial Action Task Force, and the Asia
Pacific Working Group on Money
Laundering.
Loans to Executive Officers
Under section 22(g) of the Federal
Reserve Act, a state member bank must
include in its quarterly Call Report
Loans by State Member Banks to their Executive Officers, 1997 and 1998
Number
Amount (dollars)
Range of interest
rates charged
(percent)
1997
October 1-December 31
695
38,279,000
4.8-20.0
7995
January 1-March 31
April 1-June 30
July 1-September 30
750
750
657
42,592,000
37,183,000
34,564,000
3.0-19.5
3.0-18.0
2.0-19.5
Period
SOURCE. Call Reports.
Banking Supervision and Regulation 271
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.
Federal Reserve Membership
At the end of 1998, 3,401 banks were
members of the Federal Reserve
System. At that time, member banks
were operating 46,112 branches and
additional offices and accounted for
39 percent of all commercial banks in
the United States and for 74 percent of
all commercial banking offices.
273
Regulatory Simplification
In 1978 the Board of Governors established a program of regulatory review to
help minimize the burden of regulation
on banking organizations. The objectives of the program are to ensure that
all regulations, existing and proposed,
represent the best course of action; to
afford interested parties the opportunity
to participate in the design of regulations and to comment on them; and to
ensure that regulations are written in
simple, clear language. Staff members
regularly review Federal Reserve regulations for their adherence to these
objectives and their consistency with the
Regulatory Flexibility Act, which also
requires that consideration be given to
the economic consequences of regulation on small business. In its review
process, the Board also follows the mandates of section 303 of the Riegle Community Development and Regulatory
Improvement Act.
In 1998 the Board, as part of this
review process, revised Regulation H
and Regulation I and eliminated Regulation P by incorporating its provisions
into the revised Regulation H. It also
modified Regulation D to reduce regulatory burden and initiated formal reviews
of two other major regulations, Regulations B arid C.
Comprehensive Revisions
Adopted
Regulations H and P
Membership in the Federal Reserve
System, and Bank Protection Act
The Board proposed in 1997 to amend
subpart A of Regulation H, which con-
cerns the general provisions for membership in the Federal Reserve System,
and the associated interpretations in subpart E; it also proposed to incorporate
Regulation P into Regulation H. In June
1998, on the basis of public comments,
the Board adopted a revised proposal,
effective October 1998. In general, the
amendments as adopted reorganized,
clarified, and reduced the burden of
compliance with subpart A. They did
away with obsolete procedures and other
unnecessary provisions, reflect the
requirements of the Community Reinvestment Act in applications to establish
branches, and provide expedited procedures in connection with certain membership and branch applications. In
adopting the amendments the Board also
eliminated a number of interpretations
that had been included in Regulation H.
Former Regulation P implemented the
requirements of the Bank Protection Act
of 1968. Although the amendments that
subsumed Regulation P into the revised
subpart A of Regulation H did not substantively amend the terms of Regulation P, the move has simplified compliance for state member banks by
consolidating the requirements into one
regulation.
Regulation I
Issue and Cancellation of Federal
Reserve Bank Capital Stock
In June 1998 the Board adopted amendments to Regulation I that had been
proposed in March 1997. The amendments, which took effect in October
1998, simplified, modernized, and condensed the regulation and reflect the
replacement of share certificates by a
274 85th Annual Report, 1998
book-entry system. They also codified
interpretations previously issued by the
Board of Governors and by staff members. Finally, the amendments eliminated references to specific forms, many
of which were obsolete.
of the Equal Credit Opportunity Act.
The act makes it unlawful for creditors
to discriminate against an applicant for
credit in any aspect of a credit transaction on the basis of race, color, religion,
national origin, sex, marital status, age,
or other specified bases. The review will
determine whether Regulation B needs
Other Revisions Adopted
to be revised to address technological
and other developments; will identify
Regulation D
parts of the regulation that could be
Reserve Requirements of
revised to achieve a better balance beDepository Institutions
tween consumer protections and indusIn March 1998 the Board adopted try burden; and will eliminate obsoamendments to Regulation D that had lete provisions. To gather information
been proposed in November 1997. The needed to accomplish these objectives,
revisions, which took effect in the sum- the notice requested comment on several
mer, improved the Board's ability to specific issues, including pre-application
estimate the need for reserves on a marketing practices, inquiry versus
timely basis and at the same time application, voluntary data collection on
reduced regulatory burden on certain specific characteristics of applicants, the
depository institutions. They moved definition of creditor, documentation for
institutions that report deposits weekly business credit, and business credit
from a system of contemporaneous exemptions.
reserve maintenance to a system under
which reserves are maintained on a
Regulation C
lagged basis. The reserve maintenance
Home Mortgage Disclosure
period for weekly reporters now begins
thirty days after the beginning of a In March 1998 the Board issued an
reserve computation period; it formerly advance notice of proposed rulemaking
began two days after the beginning of a as the first step in its review of Regucomputation period. The longer time lation C, which implements the Home
between computation and maintenance Mortgage Disclosure Act. The review
of reserves is expected to facilitate com- will identify ways in which the regulapliance by weekly reporting institutions. tion can be revised to reduce regulatory
burden and to respond to technological
and other developments. The advance
Comprehensive Revisions
notice solicited comment on such speProposed
cific issues as reporting pre-approvals,
reporting refinancings and home
Regulation B
improvement loans, geocoding purEqual Credit Opportunity
chased loans, reporting temporary
In March 1998 the Board issued an financing, reporting mobile home transadvance notice of proposed rulemaking actions as a separate category, and
as the first step in its review of Regula- reporting additional characteristics of
•
tion B, which implements the provisions mortgage loan transactions.
275
Federal Reserve Banks
A major activity of the Federal Reserve
Banks again in 1998 was preparation
for the century date change. Efforts
in that area as well as other activities
affecting the Reserve Banks are described in this chapter.
Century Date Change
The Federal Reserve Banks in 1998
made considerable progress toward ensuring that they continue to provide reliable service to the nation's banking system and financial markets at the turn
of the century. By year-end 1998, the
Reserve Banks had completed nearly all
changes to applications critical to their
mission, such as Fedwire funds transfer, Fedwire securities transfer, and
FedACH; system testing; and user
acceptance testing. The Federal Reserve
also took steps to meet a possible increase in the demand for currency as the
year 2000 nears.
In 1998, the Reserve Banks supported
extensive year 2000 testing by depository institutions. Testing facilities were
made available beginning in midyear,
and more than 5,000 depository institutions had tested with the Federal
Reserve by year-end. The Federal Reserve will continue to offer year 2000
testing through 1999.
Also during the year, the Reserve
Banks introduced programs focusing on
year 2000 contingency planning, planning for responding to customer disruptions, and event management. In addition, the Federal Reserve implemented
a change-management policy that will
provide a stable operations environment
at the millennium.
The Federal Reserve in 1998 continDigitized uedFRASER
for to educate the public on plans for
addressing the year 2000 problem and
continued to advise depository institutions of the Federal Reserve's plans and
schedules. The Reserve Banks participated in numerous domestic and international forums to help foster awareness
of year 2000 issues and to share experiences, ideas, and best practices. In
December, the Federal Reserve sponsored an interactive teleconference with
depository institution customers to discuss the Federal Reserve's contingency
planning for the year 2000. The Federal
Reserve also provided extensive information concerning its year 2000 activities to government oversight organizations, including the U.S. General
Accounting Office, the House and Senate Banking Committees, and the Office
of Management and Budget.
In anticipation that individuals may
hold extra cash during the century
rollover as a precaution, the Federal
Reserve in 1998 made plans to have
ample supplies of currency available in
late 1999 to meet potential demand. The
Federal Reserve will increase the value
of currency either in circulation or in
Federal Reserve vaults about 15 percent
over current levels, resulting in a cushion of about $200 billion. In addition,
the Reserve Banks have encouraged depository institutions to develop contingency plans to meet a possible increase
in cash demand.
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 indi-
276 85th Annual Report, 1998
rect costs of providing the services as
well as the imputed costs, such as the
income 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 Federal Reserve Banks have
recovered 100.7 percent of their priced
services costs, including the PSAF.
Overall, the price index for Federal Reserve services declined approximately 3.7 percent from 1997.2
Revenue from priced services was
$816.0 million, other income related to
priced services was $23.7 million, and
costs related to priced services were
$697.5 million, including the PSAF.
Income before income taxes was
$142.3 million; priced services recovered 103.7 percent of total costs. In
1997, revenue from priced services was
$97.3 million more than costs related to
priced services, including the PSAF, and
priced services recovered 101.5 percent
of total costs.3
1. In addition to income taxes and the return
on equity, the PSAF is made up of three 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
the Board of Governors that are related to priced
services; in the pro forma statements at the end of
this 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.
3. Financial data reported throughout this
document—revenue, other income, cost, net revenue, and income before taxes—can be linked to
the pro forma statements at the end of this chapter.
Other income is revenue from investment of clearing balances, net of earnings credits, an amount
termed net income on clearing balances. Total
costs are the sum of operating expenses, imputed
Check Collection
In 1998, total Reserve Bank operating
expenses and imputed costs for commercial check services were $577.3 million,
compared with $581.2 million in 1997.
Revenue from check operations totaled
$632.6 million, and other income
amounted to $19.1 million, resulting
in income before income taxes of
$74.5 million. The Reserve Banks
handled 16.6 billion checks, an increase
of 3.9 percent over 1997 (see table).
The volume of fine-sort check deposits,
which are presorted by the depositing bank according to paying bank,
decreased 3.6 percent in 1998, compared with an increase of 0.7 percent in
1997. The volume of checks deposited
that required processing by Reserve
Banks rose 5.3 percent; in 1998, the
Banks processed 85.6 percent of the
checks they presented, and they received
the remaining 14.4 percent in fine-sort
deposits.
Overall, the fees charged by the
Reserve Banks for paper and electronic
check products rose approximately
2.5 percent compared with 1997. Fees
for paper products rose about 3.4 percent, while fees for electronic products
(primarily payor bank information and
electronic check presentment) declined
approximately 6.2 percent.
The use of electronic check products
provided by the Reserve Banks has continued to grow rapidly. During 1998, the
Banks electronically presented 2.8 billion checks, or about 16.9 percent of
all checks presented to paying banks,
an increase of 24.7 percent over 1997.
The use of electronic check information
products declined 2.1 percent. Reserve
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.
Federal Reserve Banks 211
Banks provided data to paying banks
electronically for 25.4 percent of checks
presented. Thirty-seven offices, at least
one office in every Federal Reserve District, now offer products involving the
capture and storage of digital check
images. In 1998, images were captured
of approximately 3.9 percent of the
checks presented by the Reserve Banks.
In 1998, the Reserve Banks adopted a
strategy to standardize check-processing
environments across Banks and thereby
lower the operating costs of providing
check processing and provide greater
consistency in products and service
levels. The Banks plan to establish standard hardware platforms and to develop
software systems that can be used on
either of the System's check-processing
platforms, to consolidate processor
management, and to develop common
Reserve Bank check-processing applications. The Reserve Banks' Retail Payments Office, which directs check and
automated clearinghouse (ACH) services and the Interdistrict Transportation System for the Banks, will manage
this long-term initiative. During the
year, this office relocated to the Federal
Reserve Bank of Atlanta from the Federal Reserve Bank of Boston.
In March, the Board requested
comment on the effect of its sameday settlement rule on the interbank
check-collection market, on the checkcollection process, and, more broadly,
on the payments system. The Board also
requested comment on the benefits and
drawbacks of reducing legal disparities,
such as the later presentment time available to the Reserve Banks, between
Federal Reserve Banks and private collecting banks in the presentment and
settlement of checks. On the basis of an
analysis of the comments received, the
Board concluded that the costs associated with further reducing legal disparities would outweigh any payments
system efficiency gains and, in December, decided not to propose any specific
regulatory changes with respect to the
remaining legal differences between the
Reserve Banks and private collecting
banks.
Fedwire Funds Transfer and
Multilateral Settlement
Reserve Bank operating expenses and
imputed costs for Fedwire funds transfer and multilateral settlement services
totaled $72.7 million in 1998, compared
Activity in Federal Reserve Priced Services, 1998, 1997, and 1996
Thousands of items
Percentage change
Service
1998
1997
1996
1997 to 1998
Commercial checks
Funds transfers
Securities transfers
Commercial ACH
Noncash collection
Cash transportation
16,573,463
100,609
5,115
2,965,739
755
18
15,949,152
91,800
4,136
2,602,892
887
27'
NOTE. Components may not yield percentages shown
because of rounding. 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
15,486,833
84,871
4,125
2,372,108
1,069
36
1996 to 1997
3.9
9.6
23.7
13.9
-14.8
-32.6
3.0
8.2
.3
9.7
-17.1
-25.2'
of commercial items processed; in noncash collection, the
number of items on which fees are assessed; in cash
transportation, the number of registered mail shipments
and FRB-arranged armored carrier stops.
1. Restatements resulting from a change in definition
or to correct a previously reported error.
278 85th Annual Report, 1998
with $79.9 million in 1997. Revenue
from these operations totaled $92.2 million, and other income amounted to
$2.3 million, resulting in income before
income taxes of nearly $21.8 million.
Fedwire Funds Transfer
The number of Fedwire funds transfers
originated by depository institutions
increased 9.6 percent in 1998, to
100.6 million. The increase in volume
was due largely to sustained strong economic growth.
Fees charged for Fedwire funds
transfers were lowered 11.1 .percent in
January 1998, from $0.45 to $0.40 per
basic transfer. The reduction reflects
efficiencies resulting from the processing of funds transfers in a centralized
environment.
In December 1997, the Fedwire
funds transfer service began opening
at 12:30 a.m. eastern time instead of
8:30 a.m., thereby expanding the service
day to eighteen hours from the previous
ten hours. On average, the funds transfer
service processed 3.4 percent of its daily
transfer volume and about 0.5 percent of
daily value before 8:30 a.m.; approximately eighty Fedwire participants
originated funds transfers in the early
morning. The level of participation
and transfer activity before 8:30 a.m.
remained relatively constant throughout
1998.
Depository institutions that do not
have an electronic connection to the
Fedwire funds transfer system can originate transfers via "off-line" telephone
instructions. The volume of off-line Fedwire funds transfers has been declining
substantially in recent years. Because of
the decline and the small percentage of
transfers that are originated off line
(0.04 percent), the Federal Reserve jn
1998 began consolidating its Fedwire
off-line services at the Federal Reserve
Banks of Boston and Kansas City. Seven
Reserve Banks consolidated their offline activity during the year, and the
remaining three are scheduled to consolidate their activity by March 1, 1999.
Consolidation will allow the Reserve
Banks to streamline service and ensure
uniform service nationwide.
In response to a request by correspondent banks expressing difficulty managing their reserve positions because they
were receiving respondent transfers late
in the day, the Board in June requested
comment on a proposal to segment the
last half-hour of the Fedwire funds
transfer operating day into two settlement periods. Transfers to or from
respondent banks would have been prohibited during the last fifteen minutes of
the Fedwire operating day. Support for
the proposal was mixed. In December,
the Board concluded that the benefits
of a segmented settlement period did
not warrant the change, and it decided
not to adopt a segmented settlement
period. Rather, the Board believes that
correspondents can mitigate reservemanagement difficulties on their own by
imposing internal cutoff times for sending and receiving respondent transfers.
Multilateral Settlement
The Federal Reserve provides settlement services to approximately 130
local and national private-sector clearing and settlement arrangements. In
1998, the Reserve Banks processed
about 373,000 settlement entries for
these arrangements.
The Reserve Banks offer two types of
settlement services. In the "settlement
sheet" service, the settlement agent for
a clearinghouse provides a settlement
sheet to a Reserve Bank. The Reserve
Bank posts net debit and credit entries
Federal Reserve Banks 279
to the accounts of the settling participants. The entries are provisional until
the banking day after settlement. In the
Fedwire-based settlement service, the
clearinghouse uses a zero-balance settlement account to receive and send
Fedwire funds transfers to settle participants' obligations. Fedwire funds
transfers are final and irrevocable when
processed.
During 1998, the Reserve Banks prepared to offer an enhanced settlement
service that allows settlement agents to
submit settlement files electronically to
a Reserve Bank through a Fedline terminal or a computer interface connection.
The enhanced settlement service, to be
introduced in the first quarter of 1999,
will improve operational efficiency. It
will also reduce settlement risk to participants by granting settlement finality
on the settlement day and enable Reserve Banks to manage and limit risk
by incorporating risk controls that are
as robust as those used currently in
the Fedwire funds transfer service. The
Reserve Banks will continue to offer the
current settlement sheet and Fedwirebased settlement services. The settlement sheet service, however, will be
phased out by year-end 2001. The
Fedwire-based service will be available
indefinitely.
securities on the Fedwire book-entry
securities transfer system during the
year, a 23.7 percent increase from the
1997 level. The increase may be attributable to securities movements associated with mergers and with more mortgage refinancing than in 1997, creating
activity in the mortgage-backed securities market. Fees charged for Fedwire
book-entry securities transfers did not
change in 1998.4
In February 1998, the New York
Reserve Bank converted its Fedwire
securities transfer application to the
Federal Reserve's centralized application, the National Book-Entry System
(NBES), joining the eleven Reserve
Banks that had converted in 1996 and
1997. The NBES has generated several
benefits for the Fedwire book-entry
securities service, including (1) an
expanded account structure designed to
accommodate the different needs of
Federal Reserve customers and U.S.
government agencies, (2) modular, centralized application software designed
to facilitate a more rapid response to
changing industry needs, (3) improved,
standardized contingency and disaster
recovery capabilities, and (4) processing
efficiencies such as uniform operating
hours in all Districts. Full implementation of NBES has created scale econo-
Fedwire Book-Entry Securities
Reserve Bank operating expenses and
imputed costs for the Fedwire bookentry securities service totaled $13.0
million in 1998, compared with $15.5
million in 1997. Revenue from these
operations totaled $18.3 million, and
other income amounted to $0.4 million,
resulting in income before income taxes
of $5.7 million.
The Reserve Banks processed 5.1
million transfers of government agency
4. The revenues, expenses, 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 bookentry securities service also provides custody,
transfer, and settlement services for U.S. Treasury
securities. The Reserve Banks act as fiscal agents
of the United States when they provide transfer
and safekeeping of U.S. Treasury securities, and
the Treasury Department assesses fees on depository institutions for some of these services. For
more details, see the section "Marketable Treasury Securities."
280 85 th Annual Report, 1998
mies that have lowered per-item data
processing costs.
The volume of off-line Fedwire securities transfers, in which institutions that
do not have an electronic connection to
the Fedwire book-entry securities transfer system originate transfers through
telephone instructions, has been declining substantially over the past few years.
As a result of the decline and the small
percentage of transfers originated off
line (0.56 percent), the Federal Reserve
began in 1998 consolidating its Fedwire
off-line services at the Federal Reserve
Banks of Boston and Kansas City. The
consolidation will bring to securities
transfers the same benefits it offers for
funds transfers.
After requesting and receiving public comment on the issue, the Board
decided in April not to implement an
earlier opening time for the Fedwire
book-entry securities service, mainly
because of the anticipated cost and technical hurdles identified by industry
participants and because of concerns
expressed by the Department of the
Treasury. Over time, the industry may
eliminate some of these difficulties
by, for example, implementing realtime and straight-through processing or
improving contingency arrangements.
The Federal Reserve plans to monitor
developments in these areas and in the
securities transfer market; if market demand for expanded hours arises, it will
reconsider the issue of expanded operating hours for the Fedwire book-entry
securities service.
Automated Clearinghouse
Reserve Bank operating expenses and
imputed costs for commercial ACH services totaled $44.9 million in 1998,
compared with $52.3 million in 1997.
Revenue from ACH operations totaled
$66.7 million, and other income
Digitizedamounted to $1.7 million, resulting
for FRASER
in income before income taxes of
$23.5 million. The Reserve Banks processed 3.0 billion commercial ACH
transactions during the year, an increase
of 13.9 percent over 1997 volume. Several fees were reduced early in the year:
The fees for items originated in small
and large files, for items received, and
for addenda originated and received
were reduced one to two mill, or 14 percent to 33 percent, depending on the
product.
The Reserve Banks introduced several improvements to the ACH service
in 1998. In the fall, they began providing FedEDI, electronic data interchange
software that enables ACH customers
to translate information accompanying
ACH payments. The software supports
both the U.S. Treasury's initiative to
make most of its payments electronically and National Automated Clearing
House Association rules. In November,
the Reserve Banks began to test a commercial cross-border ACH service to
facilitate greater exchange of electronic
payments between the United States and
Canada. During the year, Reserve Banks
also worked with the U.S. Treasury,
the National Automated Clearing House
Association, and local ACH associations
to promote direct deposit and electronic
payments.
In December, the Board requested
comment on the benefits and drawbacks
of providing settlement finality on the
morning of the settlement day for ACH
credit transactions processed by the
Reserve Banks. Settlement day finality
would be conditioned on enhanced riskcontrol measures commensurate with
those used in other services that have
similar finality characteristics.
Noncash Collection
Reserve Bank operating expenses and
imputed costs for noncash collection
services totaled $2.1 million in 1998,
Federal Reserve Banks 281
compared with $3.2 million in 1997.
Revenue from noncash operations totaled $3.5 million, and other income
amounted to $0.1 million, resulting
in income before income taxes of
$1.5 million. The Reserve Banks processed 755,000 noncash collection
items (coupons and bonds), a decrease
of 14.8 percent from 1997 levels.
All noncash processing is centralized
at the Jacksonville Branch of the Atlanta
Reserve Bank.
other income amounted to $0.1 million,
resulting in income before income taxes
of $0.2 million.
Float
Federal Reserve float increased in 1998
to a daily average of $323.6 million,
from a daily average of $282.0 million
in 1997. The Federal Reserve recovers
the cost of float associated with priced
services as part of the fees for those
services.
Cash Services
Because providing high-quality currency and coin is a basic responsibility
of the Federal Reserve, the Reserve
Banks charge fees only for special cash
services and nonstandard access.5 Priced
special cash services represent a very
small portion (approximately 0.5 percent) of the cost of overall cash services
provided by the Reserve Banks to
depository institutions. Special cash services include wrapped coin, nonstandard packaging of currency and coin
orders and deposits, and registered mail
shipments of currency and coin.
The Cleveland District and the
Helena Branch of the Minneapolis
Reserve Bank provide wrapped coin as
a priced service. The Chicago District
provides currency in nonstandard packages, and the Helena Branch provides
coin in nonstandard packages. In addition, five Districts provide cash transportation by registered mail. Reserve
Bank operating expenses and imputed
costs for special cash services totaled
$2.4 million in 1998, compared with
$4.5 million in 1997. Revenue from cash
operations totaled $2.6 million, and
5. Nonstandard access is not treated as a priced
service; instead, fees for nonstandard access are
treated as a recovery of expenses. See the discussion under "Developments in Currency and Coin"
Digitizedbelow.
for FRASER
Developments in
Currency and Coin
The Federal Reserve continued in 1998
to work closely with the Treasury to
deter the counterfeiting of U.S. currency.
The Series 1996 currency design program continued with the introduction
of the new $20 note in September. The
Series 1996 $50 note, introduced in
October 1997, continued to gain acceptance and accounted for 49 percent of
the $50 notes in circulation by the end
of 1998. The Series 1996 $100 note,
introduced in March 1996, accounted
for 66 percent of $100 notes in circulation. Work on the Series 1996 $10
and $5 notes continued; distribution is
scheduled for 2000.
The Federal Reserve's cost of new
currency in 1998 was $409 million. The
Treasury's Bureau of Engraving and
Printing produced 9.8 billion notes during the year; 47 percent of the notes
produced were of the Series 1996 design
$100, $50, and $20 notes, 40 percent
were $1 notes, and the remaining 13 percent were $5 and $10 notes.
The Federal Reserve supplies currency and coin to approximately 9,700
depository institutions throughout the
United States; these institutions supply currency and coin to other depository institutions and the public. The
value of currency and coin in circula-
282 85th Annual Report, 1998
tion increased 7 percent in 1998 and
exceeded $517 billion at year-end.
During the year, the Federal Reserve
received more than 26.6 billion Federal
Reserve notes in deposits from depository institutions and sent more than
27.5 billion Federal Reserve notes to
depository institutions. Reserve Bank
operating expenses for processing and
storing currency and coin, including
priced cash services, totaled $293 million for the year.
In March, the Board revised its uniform cash access policy to clarify the
base level of free currency access to
all depository institutions in an interstate banking environment. The policy
became effective on May 4. The Board
clarified that each depository institution
may designate up to ten endpoints to
receive free currency access from each
Reserve Bank office but that an endpoint
may not receive free cash access from
more than one Reserve Bank office.6
Depository institutions that meet minimum volume thresholds are eligible
for more frequent free access; fees are
charged for additional access beyond the
free service level. The income from fees
charged for additional access is treated
as a recovery of expense rather than as
priced service revenue. To date, the policy has resulted in larger deposits and
larger orders of currency; Systemwide,
the overall volume of currency has
remained relatively stable.
Also in 1998, the Board approved the
Federal Reserve Bank of San Francisco's proposal to establish a currency
operations center in Phoenix, Arizona.
Arizona depository institutions currently
receive currency services from the
Los Angeles Branch. The operations
center will eliminate the need to trans6. A designated endpoint may be a branch, a
head office, a money room, or an armored carrier
used by the depository institution to provide cash.
port currency over the long distance
between Los Angeles and Phoenix and
will improve cash services and access
for all Arizona depository institutions.
Developments in
Fiscal Agency and
Government Depository Services
The Federal Reserve Act provides that
when required by the Secretary of the
Treasury, Reserve Banks will act as fiscal agents and depositories of the United
States. As fiscal agents, Reserve Banks
provide the Department of the Treasury
with services related to the federal debt.
For example, the Reserve Banks issue,
transfer, reissue, exchange, and redeem
marketable Treasury securities and savings bonds; they also process secondary
market transfers initiated by depository
institutions. As depositories, Reserve
Banks collect and disburse funds on
behalf of the federal government. They
also provide fiscal agency services on
behalf of several domestic and international government agencies.
The total cost of providing fiscal
agency and depository services to
the Treasury in 1998 amounted to
$250.9 million, compared with $255.4
million in 1997 (table). The cost of
providing services to other government
agencies was $46.6 million, compared
with $48.6 million in 1997.
The Federal Reserve controls collateral pledged to secure credit it extends
to depository institutions and, in its role
as fiscal agent for the U.S. Treasury, to
secure Treasury tax and loan deposits
held by depository institutions. In September, the Reserve Banks implemented
mark-to-market pricing for book-entry
collateral. If reliable and active markets
exist for the assets, collateral valuation
is generally based on market values; if
market information is insufficient, valuation takes into account risk factors such
Federal Reserve Banks 283
as credit quality, payment streams, interest rate risk, and unanticipated credit
or liquidity events. At the time mark-tomarket pricing was implemented, the
Federal Reserve was using a risk-based
matrix to determine the value of nonpriced collateral. Market pricing was
applied to definitive (paper) instruments
in 1995.
The Reserve Banks continued in 1998
to implement a policy, adopted in late
1996, to clarify the Reserve Banks'
unique statutory relationship with the
Treasury and other federal government
entities. The policy, among other things,
establishes uniform and consistent practices for accounting, reporting, and billing for the full costs of providing fiscal
agency and depository services to the
U.S. government. To capture these costs,
the Reserve Banks developed the Government Entity Accounting and Reporting System, which collects cost information from each District and issues
quarterly bills to the appropriate government entity. In 1998, total reimbursable
expenses for fiscal agency and depository services to the Treasury and other
government agencies were $297.5 million, a decrease of $6.5 million from
1997. Reimbursement has been received
or is expected for most of the expenses
billed.
Fiscal Agency Services
The Reserve Banks handle marketable
Treasury securities and savings bonds
Expenses of the Federal Reserve Banks for Fiscal Agency and Depository Services,
1998, 1997, and 1996
Thousands of dollars
Agency and service
1998
1997
1996
Bureau of the Public Debt
Savings bonds
Treasury Direct
Commercial book entry
Marketable Treasury issues
Definitive securities and Treasury coupons
Other services
Total
71,401.8
35,859.1
17,880.4
15,530.5
3,734.2
83.7
144,489.7
70,340.4
35,440.4
26,809.4
14,855.4
3,618.9
78,765.8
26,788.8
27,099.0
22,349.9
3,498.5
151,064.5
158,502.0
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
35,428.2
34,096.4
11,716.0
2,731.0
186.3
16,045.2
100,203.1
35,265.9
26,548.0
14,477.3
2,795.3
422.0
20,994.2
100,502.7
38,828.2
22,604.1
20,557.0
3,366.1
455.3
17,346.3
103,157.1
Other Treasury
Total ...'
Total, Treasury
6,237.6
250,930.4
3,840.0
255,407.2
3,554.6
265,213.6
24,452.4
25,495.7
25,287.6
5,275.3
6,108.7
5,722.9
16,850.6
46,578.3
17,042.1
48,646.5
18,788.8
49,799.3
297,508.7
304,053.7
315,012.9
DEPARTMENT OF THE TREASURY
OTHER FEDERAL AGENCIES
Department of Agriculture
Food coupons
United States Postal Service
Postal money orders
Miscellaneous agencies
Other services
Total, other agencies
Total reimbursable expenses
284 85 th Annual Report, 1998
and monitor the collateral pledged
by depository institutions to the federal
government.
Marketable Treasury Securities
Reserve Bank 1998 operating expenses
for activities related to marketable Treasury securities (Treasury Direct, commercial book entry, Treasury auctions
issues, and definitive securities and
coupons) amounted to $73.0 million, a
9.5 percent decrease from 1997. The
Reserve Banks processed more than
316,000 commercial tenders for government securities in Treasury auctions, a
23.2 percent decline from the 1997 volume level. Commercial tenders are processed at the New York, Chicago, and
San Francisco Reserve Banks using an
application known as the Treasury Automated Auction Processing System.
The Reserve Banks operate two bookentry securities systems for Treasury
securities: the Fed wire book-entry securities system, which provides custody
and transfer services, 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
1998, were maintained on Fedwire; the
remainder were maintained on Treasury
Direct. The Reserve Banks in 1998
processed 8.9 million Fedwire transfers of Treasury securities, a 1.9 percent
increase from the 1997 level. They also
processed 26.7 million interest and principal payments for Treasury and government agency securities, an increase of
11.4 percent over 1997.
7. The Fedwire book-entry securities mechanism is also used for safekeeping and transfer of
securities issued by federal government agencies,
government-sponsored enterprises, and international institutions. For more details, see the section
"Fedwire Book-Entry Securities" earlier in this
chapter.
Treasury Direct, operated by the
Philadelphia Reserve Bank, is a system
of book-entry securities accounts for
institutions and individuals planning to
hold their Treasury securities to maturity. The Treasury Direct system holds
more than 1.9 million accounts. During
1998, the Reserve Banks processed
more than 309,000 tenders for Treasury
Direct customers seeking to purchase
Treasury securities at Treasury auctions
and handled 1.1 million reinvestment
requests; the volume of tenders was
28.6 percent lower than in 1997, and
the volume of reinvestment requests
was 37.7 percent lower. The Philadelphia Reserve Bank issued 6.6 million
payments for discounts, interest, and
redemption proceeds; the Treasury
Direct facility was also used to originate
2.8 million payments for savings bonds
and almost 46,000 interest payments for
definitive Treasury issues.
As a service to Treasury Direct investors, the Chicago Reserve Bank, through
the Sell Direct program, sells investors'
Treasury securities on the secondary
market for a fee. In 1998, Sell Direct's
first full year of operation, the Bank sold
more than 16,000 securities worth
$510.6 million and collected more
than $550,000 in fees on behalf of the
Treasury.
In 1998, the Treasury started accepting tenders over the Internet and by
telephone for Treasury Direct investors
who pay for their Treasury securities
by ACH debits to their bank accounts.
Investors can also reinvest their maturing Treasury securities and request a
statement of their accounts electronically. Late in the year, the Reserve
Banks began to work with Treasury to
identify other electronic alternatives for
serving Treasury Direct investors and
to reduce the number of Reserve Bank
sites providing Treasury Direct customer service.
Federal Reserve Banks 285
Savings Bonds
Reserve Bank operating expenses for
savings bond activities amounted to
$71.4 million in 1998, an increase of
1.6 percent over 1997 expenses. The
Reserve Banks printed and mailed
45.2 million savings bonds on behalf
of the Treasury's Bureau of the Public
Debt, a 12.1 percent decline from 1997.
They processed 7.1 million originalissue transactions. They also processed
approximately 604,000 redemption,
reissue, and exchange transactions, a
10.4 percent decrease from 1997. In
addition, the Reserve Banks responded
to 1.7 million service calls from owners
of savings bonds, approximately the
same number as in 1997. Savings bond
operations are conducted at five Reserve
Bank offices: Buffalo, Pittsburgh, Richmond, Minneapolis, and Kansas City.
All five offices process savings bond
transactions, but only the Pittsburgh and
Kansas City offices print and mail
savings bonds.
The Reserve Banks made changes to
both their automated applications and
their processing procedures for the Treasury 's new inflation-indexed Series I
savings bond, which was introduced on
September 1. The earnings rate for the
Series I bond is the sum of the fixed rate
set at the time the bond is purchased
plus an inflation rate based on an annualized rate of inflation. Series EE and
HH savings bonds are still available.
The Reserve Banks, working with the
Treasury, also completed a long-range
automation study in 1998 and agreed
to adopt a distributed-processing automation platform for savings bonds in
the future to replace several current
mainframe applications. The Pittsburgh
Branch of the Cleveland Reserve Bank
completed a successful pilot project to
use digital scanning software to convert applications submitted on paper by
banks across the country into an electronic medium. After minimal operator
intervention, the resulting electronic file
can be used. The other four savings
bond processing sites expect to install
similar systems in 1999.
The Richmond Reserve Bank, on
behalf of the Treasury, introduced the
Easy Saver plan, which permits individuals who do not have access to a payroll
deduction plan to make recurring savings bond purchases. Current over-thecounter purchasers, employees of small
businesses, and retirees are expected to
benefit.
Other Initiatives
The St. Louis Reserve Bank fully implemented Cash Track in 1998. By consolidating information about receipts and
payments processed on behalf of the
Treasury, Cash Track makes it easier for
the Treasury to forecast its cash needs.
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 payment activities in
1998 totaled $35.4 million. The Banks
processed approximately 231,000 paper
and 5.0 million electronic advices of
credit from depository institutions
handling tax payments for businesses
and individuals. Advices of credit are
notices from depository institutions to
the Federal Reserve and the Treasury
summarizing taxes collected on a
given day. The volume of paper advices
286 85th Annual Report, 1998
of credit declined 30.8 percent from
1997 to 1998, and the volume of
tax payments submitted electronically
decreased 12.3 percent. The Reserve
Banks also received a small number of
tax payments directly.
Depository institutions that receive
tax payments may place the funds in a
Treasury tax and loan (TT&L) account
or remit the funds to a Reserve Bank.
The Minneapolis Reserve Bank operates
an automated system through which
businesses pay taxes that are due on the
same day the tax liability is determined.
These electronic tax payments, a part
of the Treasury's Electronic Federal Tax
Payment System, are invested in depository institutions' TT&L balances via the
Federal Reserve's TT&L mechanism. In
1998, this electronic tax application processed approximately 106,000 tax payments from 6.3 million taxpayers totaling $151.1 billion. Most Electronic
Federal Tax Payment System payments
are made via ACH to accounts maintained by two commercial banks as
Treasury's financial agents.
The St. Louis Reserve Bank, acting
on behalf of the Treasury, began planning to truncate paper tax coupons collected by all Reserve Banks when the
new Treasury Investment Program is
implemented in mid-2000. The Treasury
Investment Program, designed to replace
the twelve existing TT&L software
applications with a single application
and database, will process only electronic tax payments, which now constitute most business tax payments. A
separate application, called Patax (paper
tax system), will automate the handling
of paper tax payments.
Payments Processed for the Treasury
Reserve Bank operating expenses related to government payment operations
(check processing, ACH, agency depos-
its, and funds transfers) amounted to
$48.7 million in 1998. The Treasury
continued to encourage electronic payments: The number of ACH transactions
processed for the Treasury totaled
753 million, an increase of 11.2 percent
over 1997.8 Most government payments
made via the ACH are social security,
pension, and salary payments; some are
payments to vendors. All recurring
Treasury Direct payments and many
definitive securities interest payments
are made via the ACH.
The Treasury also continues to reduce
the number of payments it makes by
check. The Reserve Banks processed
321 million paper government checks in
1998, a decrease of 14.9 percent from
1997. The Reserve Banks also issued
more than 785,000 million fiscal agency
checks, a decrease of 24.9 percent. Fiscal agency checks were used primarily
to pay semiannual interest on registered,
definitive Treasury notes and bonds and
on Series H and HH savings bonds, but
they were also used to pay the principal
of matured securities and coupons and
to make discount payments to first-time
purchasers of government securities
through Treasury Direct.
In 1998, the Reserve Banks completed implementation of a check imaging system that captures and stores digital images of U.S. government checks
for the Treasury's Financial Management Service. Imaging all government
checks improves processing efficiency
for the U.S. Treasury while lowering its
operating costs.
Services Provided to Other Entities
When required to do so by the Secretary
of the Treasury or when required or
8. ACH nonvalue transactions processed for the
Treasury amounted to an additional 17.7 million
items, an increase of 105.5 percent over 1997.
Federal Reserve Banks 287
permitted to do so by federal statute,
the Reserve Banks provide fiscal agency
and depository services to other domestic and international agencies. Depending on the authority under which the
services are provided, the Reserve
Banks may (1) maintain book-entry
accounts of government agency securities and handle their transfer,9 (2) provide custody for the stock of unissued,
definitive securities, (3) maintain and
update balances of outstanding bookentry and definitive securities for
issuers, (4) perform other securitiesservicing activities, (5) maintain funds
accounts for some government agencies, and (6) provide various payments
services.
One such service is the provision
of food coupon services for the U.S.
Department of Agriculture. Reserve
Bank operating expenses for food coupon services in 1998 totaled $24.5 million, 4.1 percent less than in 1997. The
Reserve Banks redeemed 1.8 billion
food coupons, a decrease of 35.4 percent from 1997. As a result of the
Department of Agriculture's program to
provide benefits electronically, the volume of paper food coupons redeemed
by the Reserve Banks is expected to
continue to decline.
As fiscal agents of the United States,
the Reserve Banks also process all
postal money orders deposited by banks
for collection, 213 million in 1998, a
4.4 percent increase over 1997. Much of
this work is centralized at the Federal
Reserve Bank of St. Louis. In 1998, the
St. Louis Reserve Bank worked with the
U.S. Postal Service to design an image
capture service for postal money orders.
9. The Federal Reserve tracks the transfer and
account maintenance of agency securities as a
priced service to depository institutions; the
expenses of providing these services are not
charged to the agencies.
This service, which is similar to that
provided for Treasury checks, is scheduled to be implemented in 2000; digital
files of paid money orders will facilitate
the Postal Service's accounting, reconcilement, and claims processes.
Information Technology
In 1998, the Federal Reserve established
a Systemwide information technology
governance and management structure
that spans the full range of central bank
and financial services functions performed by the Reserve Banks and the
Board of Governors. An oversight committee was formed to establish the strategic direction for information technology Systemwide. The position of
Director of Federal Reserve Information
Technology was also established.
Federal Reserve Information Technology is composed of two operating units,
Federal Reserve Automation Services
and Information Technology Planning
and Standards. The former supports the
Federal Reserve's mainframe computing and national network services. The
latter is a new unit that develops information technology plans and standards
for the System and assists with information technology decisions.
Reserve Banks have made significant
progress in using the World Wide Web
as a new service-delivery channel.
Web technology provides new opportunities to improve depository institutions'
access to electronic services. The web is
well suited for programs that allow customers to submit forms-based information to the Federal Reserve or to retrieve
information stored on a Federal Reserve
database. Several trials were conducted
in 1998 to test customer acceptance of
this new service-delivery channel and
the security and network components
that allow customers secure access to
web-based services. Among the services
288 85th Annual Report, 1998
tested were cash and savings bond
ordering, on-line submission of statistical reports, and check image retrieval.
The Reserve Banks have completed
an extensive analysis of the encryption
techniques they use to ensure the security of payments information and other
information electronically transmitted
daily between Reserve Banks and financial institutions nationwide. As a consequence, they have adopted Triple DES
as the System's encryption standard.
Triple DES, an advanced application of
the Data Encryption Standard (DES),
is a complex scrambling technique. The
new standard is designed to bring even
greater protection to data that are transmitted electronically among Reserve
Banks and between the Federal Reserve
and financial institutions. The Federal
Reserve began installing Triple DES on
its internal network in 1998 and will
complete installation in 1999. Depository institutions will begin receiving
Triple DES in 1999.
Financial 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
assigns this responsibility to its Division
of Reserve Bank Operations and Payment Systems. The division engages
a public accounting firm to perform an
annual audit of the combined financial
statements of the Reserve Banks. (See
the following section, "Federal Reserve
Banks Combined Financial Statements.")
The public accounting firm also audits
the annual financial statements of
each of the twelve Banks. In 1998, the
Reserve Banks endorsed the Systemwide implementation of the framework
established by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO) for 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
these 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.
In 1998, the division's attentions at
the twelve Banks focused on rendering an opinion on each District's internal control system using a format
consistent with the integrated COSO
framework. The scope of these examinations included comprehensive reviews
of each Bank's internal control system in terms of the five COSO control components: control environment,
risk assessment, control activities, information and communication, and
monitoring.
Each year, the division assesses compliance with policies established by the
Federal Reserve's Federal Open Market
Committee (FOMC) by examining 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 year-end. 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 1997 and 1998.
Federal Reserve Banks 289
Income in 1998 was $28,149 million,
compared with $26,917 million in 1997.
Revenue from priced services was
$816 million. Total expenses were
$2,011 million ($1,487 million in operating expenses, $346 million in earnings
credits granted to depository institutions,
and $178 million in assessments for expenditures by the Board of Governors).
The cost of new currency was $409 million. Unreimbursed expenses for services provided to the Treasury and
other government entities amounted to
$8 million.10
The profit and loss account showed a
net gain of $1,914 million. The gain was
due primarily to realized and unrealized
profits on assets denominated in foreign
currencies that were revalued to reflect
current exchange rates. Statutory dividends paid to member banks totaled
$343 million, $43 million more than in
1997; the increase reflects an increase in
the capital and surplus of member banks
and a consequent 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 $26,561 million in 1998, up from
$20,659 million in 1997; 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 REPORT, table 5 details the income
and expenses of each Federal Reserve
Bank for 1998, and table 6 shows a
condensed statement for each Bank
for 1914-98. A detailed account of
the assessments and expenditures of
the Board of Governors appears in the
section "Board of Governors Financial
Statements."
Holdings of Securities and Loans
10. The Reserve Banks bill the Treasury and
other government entities for the cost of certain
services, and the portions of the bills that are not
paid are reported as unreimbursed expenses.
The Reserve Banks' average daily holdings of securities and loans during 1998
amounted to $447,095 million, an
Income, Expenses, and Distribution of Net Earnings
of Federal Reserve Banks, 1998 and 1997
Millions of dollars
Item
1998
1997
Current income
Current expenses
Operating expenses'
Earnings credits granted
28,149
1,833
1,487
26,917
1,976
1,618
346
359
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
26,316
1,914
24,941
-2,577
8
587
178
409
35
539
174
364
Net income before payments to Treasury
Dividends paid
Transferred to surplus
27,636
21,790
343
732
300
832
Payments to Treasury . . .
26,561
20,659
NOTE. In this and the following table, components
may not sum to totals because of rounding.
1. Includes a net periodic credit for pension costs of
$288 million in 1998 and $200 million in 1997.
290 85th Annual Report, 1998
Securities and Loans of Federal Reserve Banks, 1996-98
Millions of dollars, except as noted
Item and year
Average daily holdings3
1996
1997
1998
Earnings
1996
1997
1998
Total
U.S.
government
390,268
417,805
447,095
390,063
417,529
446,933
206
277
161
23,895
25,714
26,851
23,884
25,699
26,842
11
15
9
6.12
6.15
6.01
6.12
6.16
6.01
Average interest rate (percent)
1996
1997
1998
1. Includes federal agency obligations.
2. Does not include indebtedness assumed by the Federal Deposit Insurance Corporation.
increase of $29,289 million over 1997
(see table). Holdings of U.S. government securities increased $29,404 million, and holdings of loans decreased
$116 million.
The average rate of interest earned on
Reserve Banks' holdings of government
securities declined to 6.01 percent, from
6.16 percent in 1997, and the average
rate of interest earned on loans rose to
5.44 percent from 5.27 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 1994
through 1998.
Federal Reserve Bank Premises
The expansion and renovation of the
Cleveland Reserve Bank's headquarters
Loans 2
5.27
5.27
5.44
3. Based on holdings at opening of business.
building was completed in 1998. Also,
the design of the Atlanta Reserve Bank's
new Birmingham Branch building was
completed and construction was begun.
The Atlanta Bank sold the existing
Branch building but will continue to
lease it until the new facility is completed. Design of the Bank's new headquarters building continued.
Multiyear renovation programs continued for the New York Reserve Bank's
headquarters building and for buildings
for the Kansas City Bank's Oklahoma
City Branch and the San Francisco
Bank's Seattle, Portland, and Salt Lake
City Branches. Also, the multiyear
leasehold improvements program was
begun for the New York Reserve Bank's
new leased office space in New York
City.
Federal Reserve Banks 291
Pro Forma Financial Statements for Federal Reserve Priced Services
Pro Forma Balance Sheet for Priced Services, December 31, 1998 and 1997
Millions of dollars
Item
19971
1998
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
725.3
6,527.7
76.8
4.4
20.4
4,272.5
Long-term assets (Note 2)
Premises
Furniture and equipment
Leases and leasehold improvements ..
Prepaid pension costs
Total long-term assets
398.6
127.6
26.8
437.3
Long-term liabilities
Obligations under capital leases
Long-term debt
Postretirement/postemployment
benefits obligation
Total long-term liabilities
11,170.3
11,626.9
389.2
137.4
31.8
350.2
990.4
908.5
12,617.3
Total assets
Short-term liabilities
Clearing balances and balances
arising from early credit
of uncollected items
Deferred-availability items
Short-term debt
Total short-term liabilities
658.0
5,922.0
72.8
2.8
9.0
4,505.8
12,078.9
7,289.0
3,796.9
84.5
8,011.8
3,513.7
101.5
11,170.3
11,626.9
.7
188.8
.0
193.6
217.4
Total liabilities
205.0
411.0
394.5
12,037.9
11,564.8
579.4
514.0
Total liabilities and equity (Note 3 ) . .
12,617.3
12,078.9
NOTE. Components may not sum to totals because of
rounding.
The priced services financial statements consist of these
tables and the accompanying notes.
1. Some of these data have been revised.
Equity
292 85th Annual Report, 1998
Pro Forma Income Statement for Federal Reserve Priced Services, 1998 and 1997
Millions of dollars
Item
1998
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 (Note 9)
MEMO: Targeted return on equity (Note 10)
1997
789.1
672.6
116.4
816.0
654.1
161.9
16.2
17.0
8.7
1.4
14.6
17.5
9.8
6.9
43.4
48.9
118.5
352.0
-328.2
NOTE. Components may not sum to totals because of
rounding.
23.7
142.3
45.7
96.6
66.8
67.6
367.7
-338.0
29.7
97.3
31.2
66.1
54.3
The priced services financial statements consist of these
tables and the accompanying notes.
Pro Forma Income Statement for Federal Reserve Priced Services, by Service, 1998
Millions of dollars
Commercial
check
collection
Funds
transfer
and net
settlement
Bookentry
securities
Commercial
ACH
Noncash
collection
Cash
services
Revenue from operations
816.0
632.6
92.2
18.3
66.7
3.5
2.6
Operating expenses
(Note 5)
654.1
540.0
69.5
12.4
42.8
1.9
2.4
1.6
Income from operations
161.9
92.6
22.7
5.9
23.9
Imputed costs (Note 6)
43.4
37.3
3.2
.6
2.1
.2
b
to
Total
Item
Income from operations
after imputed costs
118.5
55.3
19.5
5.3
21.8
1.4
.1
23.7
19.1
2.3
.4
1.7
.1
142.3
74.5
21.8
5.7
23.5
1.5
Other income and expenses,
net (Note 7)
Income before income taxes .
NOTE. Components may not sum to totals because of
rounding.
.2
The priced services financial statements consist of these
tables and the accompanying notes.
Federal Reserve Banks 293
FEDERAL RESERVE BANKS
NOTES TO 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 $87.1 million in 1998 and $62.8 million in
1997 and corresponding increases in this asset account.
(3) LIABILITIES AND EQUITY
Under the matched-book capital structure for assets that
are not "self-financing," short-term assets are financed
with short-term debt. 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 $2.8 million in 1998 and
$2.9 million in 1997. 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 except for income
taxes. 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 1998 and 1997 as follows:
1998
1997
Check
ACH
Funds transfer
Book entry
Noncash collection
Special cash services
27.1
0
19.6
.0
.1
.1
30.7
.0
12.3
.0
.0
.3
Total
46.9
43.3
Total operating expense on the income statement by
service does not equal the sum of operating expenses for
each service because of the effect of SFAS 87. Although
the portion of the SFAS 87 credit related to the current
year is allocated to individual services, the amortization
of the initial effect of implementation is reflected only at
the System level.
(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.
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).
294 85th Annual Report, 1998
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
float by the Reserve Banks for 1998 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
632.7
18.3
614.4
61.3
309.1
137.2
106.8
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 are midweek closing float and interterritory check float, which
may be recovered from depositing institutions through
adjustments to the institution's reserve or clearing balance or by valuing the float at the federal funds rate and
billing the institution directly. Float recovered through
per-item fees is valued at the federal funds rate and has
been added to the cost base subject to recovery in 1998.
(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.
Because clearing balances relate directly to the Federal
Reserve's offering of priced services, the income and cost
associated with these balances are allocated to each service based on each service's ratio of income to total
(8) INCOME TAXES
Imputed income taxes are calculated at the effective tax
rate derived from the PSAF model (see note 3). Taxes
have not been allocated by service because they relate to
the organization as a whole.
(9) ADJUSTMENTS TO NET INCOME FOR PRICE SETTING
In setting fees, certain costs are excluded in accordance
with the System's overage and shortfalls policy and its
automation consolidation policy. Accordingly, to compare the financial results reported in this table with the
projections used to set prices, adjust net income as follows (amounts shown are net of tax):
1998
Net income
Amortization of the initial
effect of implementing
SFAS87
Deferred costs of automation
consolidation
Adjusted net income
(10)
1997
96.6
66.1
-10.2
-10.2
-14.5
71.9
-8.5
47.4
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). This
amount is adjusted to reflect the recovery of $14.5 million
of automation consolidation costs for 1998 and $8.5 million for 1997. The Reserve Banks plan to recover these
amounts, along with a finance charge, by the end of the
year 1999. After-tax return on equity has not been allocated by service because it relates to the organization as a
whole.
295
Federal Reserve Banks
Combined Financial Statements
The combined financial statements of the Federal Reserve Banks were audited by
PricewaterhouseCoopers LLP, independent accountants, for the years ended
December 31, 1998 and 1997.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Governors of The Federal Reserve System
and the Board of Directors of each of The Federal Reserve Banks:
We have audited the accompanying combined statements of condition of The
Federal Reserve Banks (the "Reserve Banks") as of December 31, 1998 and 1997,
and the related combined statements of income and changes in capital for the years
then ended. These financial statements are the responsibility of the Reserve Banks'
management. Our responsibility is to express an opinion on the financial statements
based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting the
amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management,
as well as evaluating the overall financial statement presentation. We believe that
our audits provide a reasonable basis for our opinion.
As discussed in Note 3, the combined financial statements were prepared in
conformity with the accounting principles, policies, and practices established by
the Board of Governors of The Federal Reserve System. These principles, policies,
and practices, which were designed to meet the specialized accounting and reporting needs of The Federal Reserve System, are set forth in the Financial Accounting
Manual for Federal Reserve Banks and constitute a comprehensive basis of
accounting other than generally accepted accounting principles.
In our opinion, the financial statements referred to above present fairly, in all
material respects, the combined financial position of the Reserve Banks as of
December 31, 1998 and 1997, and combined results of their operations for the
years then ended, on the basis of accounting described in Note 3.
Washington, D.C.
March 12, 1999
296
85th Annual Report, 1998
THE FEDERAL RESERVE BANKS
COMBINED STATEMENTS OF CONDITION
December 31, 1998 and 1997
(in millions)
ASSETS
Gold certificates
Special drawing rights certificates
Coin
Items in process of collection
Loans to depository institutions
U.S. government and federal agency securities, net
Investments denominated in foreign currencies
Accrued interest receivable
Bank premises and equipment, net
Other assets
Total assets
1998
11,046
9,200
1997
$ 11,047
9,200
358
460
6,933
488,911
19,768
4,680
1,787
1.942
7,800
2,035
458,555
17,046
4,386
1,781
1,612
$544,642
$513,922
$491,657
$457,469
26,306
6,086
30,838
5,444
17
LIABILITIES AND CAPITAL
LIABILITIES
Federal Reserve notes outstanding, net
Deposits
Depository institutions
U.S. Treasury, general account
Other deposits
Deferred credit items
Surplus transfer due U.S. Treasury
Accrued benefit cost
Other liabilities
Total liabilities
413
681
5,924
1,373
7,239
780
199
653
747
198
532,738
503,269
5.952
5,952
11,904
$544,642
5,433
5,220
CAPITAL
Capital paid-in ...
Surplus
Total capital ,
Total liabilities and capital
The accompanying notes are an integral part of these financial statements.
10,653
$513,922
Federal Reserve Banks Combined Financial Statements 297
THE FEDERAL RESERVE BANKS
COMBINED STATEMENTS OF INCOME
for the years ended December 31, 1998 and 1997
(in millions)
1998
Interest income
Interest on U.S. government securities
Interest on foreign currencies
Interest on loans to depository institutions
Total interest income
1997
$26,842
435
9
$25,699
375
15
27,286
26,089
Other operating income (loss)
Income from services
Reimbursable services to government agencies
Foreign currency gains (losses), net
Government securities gains, net
Other income
Total other operating income (loss)
789
224
816
299
1,870
1,870
(2,593)
44
72
1
3
61
3,101
(1,506)
1,358
1,300
181
244
8
587
374
184
261
35
539
474
2,752
2,793
$27,635
$21,790
$
343
$
$
732
831
8,774
17,786
20,659
$27,635
$21,790
Operating expenses
Salaries and other benefits
Occupancy expense
Equipment expense
Cost of unreimbursed Treasury services
Assessments by Board of Governors
Other expenses
Total operating expenses
Net income prior to distribution
Distribution of net income
Dividends paid to member banks
Transferred to surplus
Payments to U.S. Treasury as interest
on Federal Reserve notes
Payments to U.S. Treasury as required by statute
Total distribution
The accompanying notes are an integral part of these financial statements.
300
298
85th Annual Report, 1998
THE FEDERAL RESERVE BANKS
COMBINED STATEMENTS OF CHANGES IN CAPITAL
for the years ended December 31, 1998 and 1997
(in millions)
Capital
paid-in
Balance at January 1, 1997
(92 million shares)
Net income transferred to surplus
Statutory surplus transfer to the U.S. Treasury
Net change in capital stock issued
(17 million shares)
Balance at December 31, 1997
(109 million shares)
Net income transferred to surplus
Net change in capital stock issued
(10 million shares)
Balance at December 31, 1998
(119 million shares)
$4,602
Jurplus
Total
capital
$4,496
831
(107)
$9,098
831
(107)
831
831
$5,433
$5,220
732
$10,653
732
519
$5,952
519
$5,952
$11,904
The accompanying notes are an integral part of these financial statements.
NOTES TO THE COMBINED FINANCIAL STATEMENTS OF THE FEDERAL RESERVE BANKS
(1) ORGANIZATION AND BASIS OF PRESENTATION
Board of Directors
The twelve Federal Reserve Banks (Reserve Banks) are
part of the Federal Reserve System (System) created by
Congress under the Federal Reserve Act of 1913 (Federal
Reserve Act), which established the central bank of the
United States. The Reserve Banks are chartered by the
federal government and possess a unique set of governmental, corporate, and central bank characteristics. Other
major elements of the System are the Board of Governors
of the Federal Reserve System (Board of Governors), the
Federal Open Market Committee (FOMC), and the Federal Advisory Council. The FOMC is composed of members of the Board of Governors, the president of the
Federal Reserve Bank of New York (FRBNY), and, on a
rotating basis, four other Reserve Bank presidents.
Although the Reserve Banks are chartered as independent organizations overseen by the Board of Governors,
the Reserve Banks work jointly to carry out their statutory responsibilities. The majority of the assets, liabilities,
and income of the Reserve Banks is derived from central
bank activities and responsibilities with regard to monetary policy and currency. For this reason, the accompanying combined set of financial statements for the twelve
independent Reserve Banks is prepared, adjusted to eliminate interdistrict accounts and transactions.
The Federal Reserve Act specifies the composition of the
board of directors for each of the Reserve Banks. Each
board is composed of nine members serving three-year
terms: three directors, including those designated as
Chairman and Deputy Chairman, are appointed by the
Board of Governors, and six directors are elected by
member banks. Of the six elected by member banks, three
represent the public and three represent member banks.
Member banks are divided into three classes according
to size. Member banks in each class elect one director
representing member banks and one representing the public. In any election of directors, each member bank
receives one vote, regardless of the number of shares of
Reserve Bank stock it holds.
Structure
The Reserve Banks serve twelve Federal Reserve Districts nationwide. In accordance with the Federal Reserve
Act, supervision and control of each Reserve Bank is
exercised by a Board of Directors. Banks that are members of the System include all national banks and any
state-chartered bank that applies and is approved for
membership in the System.
(2) OPERATIONS AND SERVICES
The System performs a variety of services and operations.
Functions include formulating and conducting monetary
policy; participating actively in the payments mechanism,
including large-dollar transfers of funds, automated clearinghouse operations, and check processing; distribution
of coin and currency; fiscal agency functions for the U.S.
Treasury and certain federal agencies; serving as the
federal government's bank; providing short-term loans to
depository institutions; serving the consumer and the
community by providing educational materials and information regarding consumer laws; supervising bank holding companies, state member banks, and U.S. offices of
foreign banking organizations; and administering other
regulations of the Board of Governors. The Board of
Governors' operating costs are funded through assessments on the Reserve Banks.
Federal Reserve Banks Combined Financial Statements 299
NOTES TO THE COMBINED FINANCIAL STATEMENTS OF THE FEDERAL RESERVE BANKS—CONTINUED
The FOMC establishes policy regarding open market
operations, oversees these operations, and issues authorizations and directives to the FRBNY for its execution of
transactions. Authorized transaction types include direct
purchase and sale of U.S. government and federal agency
securities, matched sale-purchase transactions, the purchase of securities under agreements to resell, and the
lending of U.S. government securities. Additionally, the
FRBNY is authorized by the FOMC to hold balances of
and to execute spot and forward foreign exchange and
securities contracts in fourteen foreign currencies, maintain reciprocal currency arrangements (F/X swaps) with
various central banks, and "warehouse" foreign currencies for the U.S. Treasury and Exchange Stabilization
Fund (ESF) through the Reserve Banks.
(3) SIGNIFICANT ACCOUNTING POLICIES
Accounting principles for entities with the unique powers
and responsibilities of the nation's central bank have not
been formulated by the Financial Accounting Standards
Board. The Board of Governors has developed specialized accounting principles and practices that it believes
are appropriate for the significantly different nature and
function of a central bank as compared to the private
sector. These accounting principles and practices are
documented in the Financial Accounting Manual for Federal Reserve Banks {Financial Accounting Manual),
which is issued by the Board of Governors. All Reserve
Banks are required to adopt and apply accounting policies
and practices that are consistent with the Financial
Accounting Manual.
The financial statements have been prepared in accordance with the Financial Accounting Manual. Differences
exist between the accounting principles and practices of
the System and generally accepted accounting principles
(GAAP). The primary differences are the presentation of
all security holdings at amortized cost, rather than at the
fair value presentation requirements of GAAP, and the
accounting for matched sale-purchase transactions as
separate sales and purchases, rather than secured borrowings with pledged collateral, as is required by GAAP. In
addition, the Board of Governors and the Reserve Banks
have elected not to include a Statement of Cash Flows or
a Statement of Comprehensive Income. The Statement of
Cash Flows has not been included as the liquidity and
cash position of the Reserve Banks are not of primary
concern to users of these financial statements. The Statement of Comprehensive Income, which comprises net
income plus or minus certain adjustments, such as the fair
value adjustments for securities, has not been included
because as stated above the securities are repoited at
amortized cost and there are no other adjustments in the
determination of Comprehensive Income applicable to
the Reserve Banks. Other information regarding the
Reserve Banks' activities is provided in, or may be derived from, the Statements of Condition, Income, and
Changes in Capital. Therefore, a Statement of Cash Flows
or a Statement of Comprehensive Income would not
provide any additional useful information. There are no
other significant differences between the policies outlined
in the Financial Accounting Manual and GAAP.
The preparation of the financial statements in conformity with the Financial Accounting Manual requires
management to make certain estimates and assumptions
that affect the reported amounts of assets and liabilities
and disclosure of contingent assets and liabilities at the
date of the financial statements and the reported amounts
of income and expenses during the reporting period.
Actual results could differ from those estimates. Unique
accounts and significant accounting policies are explained
below.
(A) Gold Certificates
The Secretary of the Treasury is authorized to issue gold
certificates to the Reserve Banks to monetize gold held by
the U.S. Treasury. Payment for the gold certificates by the
Reserve Banks is made by crediting equivalent amounts
in dollars into the account established for the U.S. Treasury. These gold certificates held by the Reserve Banks
are required to be backed by the gold of the U.S. Treasury. The U.S. Treasury may reacquire the gold certificates at any time, and the Reserve Banks must deliver
them to the U.S. Treasury. At such time, the U.S. Treasury's account is charged, and the Reserve Banks' gold
certificate account is lowered. The value of gold for
purposes of backing the gold certificates is set by law at
$42% a fine troy ounce.
(B) Special Drawing Rights Certificates
Special drawing rights (SDRs) are issued by the International Monetary Fund (Fund) to its members in proportion to each member's quota in the Fund at the time of
issuance. SDRs serve as a supplement to international
monetary reserves and may be transferred from one
national monetary authority to another. Under the law
providing for U.S. participation in the SDR system, the
Secretary of the U.S. Treasury is authorized to issue
SDR certificates, somewhat like gold certificates, to the
Reserve Banks. At such time, equivalent amounts in
dollars are credited to the account established for the U.S.
Treasury, and the Reserve Banks' SDR certificate account
is increased. The Reserve Banks are required to purchase
SDRs, at the direction of the U.S. Treasury, for the
purpose of financing SDR certificate acquisitions or for
financing exchange stabilization operations.
(C) Loans to Depository Institutions
The Depository Institutions Deregulation and Monetary
Control Act of 1980 provides that all depository institutions that maintain reservable transaction accounts or
nonpersonal time deposits, as defined in Regulation D
issued by the Board of Governors, have borrowing privileges at the discretion of the Reserve Banks. Borrowers
execute certain lending agreements and deposit sufficient collateral before credit is extended. Loans are evaluated for collectibility, and currently all are considered
collectible and fully collateralized. If any loans were
deemed to be uncollectible, an appropriate reserve would
be established. Interest is recorded on the accrual basis
and is charged at the applicable discount rate established
at least every fourteen days by the boards of directors of
the Reserve Banks, subject to review by the Board of
300 85th Annual Report, 1998
NOTES TO THE COMBINED FINANCIAL STATEMENTS OF THE FEDERAL RESERVE BANKS—CONTINUED
Governors. However, Reserve Banks retain the option to
impose a surcharge above the basic rate in certain circumstances.
(D) U.S. Government and Federal Agency Securities and
Investments Denominated in Foreign Currencies
The FOMC has designated the FRBNY to execute open
market transactions on its behalf and to hold the resulting securities in the portfolio known as the System Open
Market Account (SOMA). In addition to authorizing and
directing operations in the domestic securities market,
the FOMC authorizes and directs the FRBNY to execute
operations in foreign markets for major currencies in
order to counter disorderly conditions in exchange markets or other needs specified by the FOMC in carrying out
the System's central bank responsibilities.
Purchases of securities under agreements to resell and
matched sale-purchase transactions are accounted for as
separate sale and purchase transactions. Purchases under
agreements to resell are transactions in which the FRBNY
purchases a security and sells it back at the rate specified
at the commencement of the transaction. Matched salepurchase transactions are transactions in which the
FRBNY sells a security and buys it back at the rate
specified at the commencement of the transaction.
Reserve Banks are authorized by the FOMC to lend
U.S. government securities held in the SOMA to U.S.
government securities dealers and to banks participating
in U.S. government securities clearing arrangements in
order to facilitate the effective functioning of the domestic securities market. These securities-lending transactions are fully collateralized by other U.S. government
securities. FOMC policy requires the lending Reserve
Bank to take possession of the collateral in amounts in
excess of the market values of the securities loaned. The
market values of the collateral and the securities loaned
are monitored by the lending Reserve Bank on a daily
basis, with additional collateral obtained as necessary.
The securities loaned continue to be accounted for in the
SOMA.
Foreign exchange contracts are contractual agreements
between two parties to exchange specified currencies, at a
specified price, on a specified date. Spot foreign contracts
normally settle two days after the trade date, whereas the
settlement date on forward contracts is negotiated
between the contracting parties but will extend beyond
two days from the trade date. The FRBNY generally
enters into spot contracts, with any forward contracts
generally limited to the second leg of a swap/warehousing
transaction.
The FRBNY, on behalf of the Reserve Banks, maintains renewable, short-term F/X swap arrangements with
authorized foreign central banks. The parties agree to
exchange their currencies up to a pre-arranged maximum
amount and for an agreed upon period of time (up to
twelve months), at an agreed upon interest rate. These
arrangements give the FOMC temporary access to foreign
currencies that it may need for intervention operations to
support the dollar and give the partner foreign central
bank temporary access to dollars it may need to support
its own currency. Drawings under the F/X swap arrangements can be initiated by either the FRBNY or the partner
foreign central bank, and must be agreed to by the
drawee. The F/X swaps are structured so that the party
initiating the transaction (the drawer) bears the exchange
rate risk upon maturity. The Bank will generally invest
the foreign currency received under an F/X swap in
interest-bearing instruments.
Warehousing is an arrangement under which the
FOMC agrees to exchange, at the request of the Treasury,
U.S. dollars for foreign currencies held by the Treasury or
ESF over a limited period of time. The purpose of the
warehousing facility is to supplement the U.S. dollar
resources of the Treasury and ESF for financing purchases of foreign currencies and related international
operations.
In connection with its foreign currency activities, the
FRBNY, on behalf of the Reserve Banks, may enter into
contracts that contain varying degrees of off-balancesheet market risk because they represent contractual commitments involving future settlement and counter-party
credit risk. The FRBNY controls credit risk by obtaining
credit approvals, establishing transaction limits, and performing daily monitoring procedures.
While the application of current market prices to the
securities currently held in the SOMA portfolio and
investments denominated in foreign currencies may result
in values substantially above or below their carrying
values, these unrealized changes in value would have no
direct effect on the quantity of reserves available to the
banking system or on the prospects for future Reserve
Bank earnings or capital. Both the domestic and foreign
components of the SOMA portfolio from time to time
involve transactions that can result in gains or losses
when holdings are sold prior to maturity. However, decisions regarding the securities and foreign currencies transactions, including their purchase and sale, are motivated
by monetary policy objectives rather than profit. Accordingly, earnings and any gains or losses resulting from the
sale of such currencies and securities are incidental to the
open market operations and do not motivate its activities
or policy decisions.
U.S. government and federal agency securities and
investments denominated in foreign currencies comprising the SOMA are recorded at cost, on a settlement-date
basis, and adjusted for amortization of premiums or accretion of discounts on a straight-line basis. Interest income
is accrued on a straight-line basis and is reported as
"Interest on U.S. government securities" or "Interest
on foreign currencies," as appropriate. Income earned on
securities lending transactions is reported as a component
of "Other income." Gains and losses resulting from sales
of securities are determined by specific issues based on
average cost. Gains and losses on the sales of U.S. government and federal agency securities are reported as
"Government securities gains, net." Foreign currency
denominated assets are revalued monthly at current market exchange rates in order to report these assets in U.S.
dollars. Realized and unrealized gains and losses on
investments denominated in foreign currencies are reported as "Foreign currency gains (losses), net." Foreign
currencies held through F/X swaps, when initiated by the
counter party, and warehousing arrangements are revalued monthly, with the unrealized gain or loss reported as
a component of "Other assets" or "Other liabilities," as
appropriate.
Federal Reserve Banks Combined Financial Statements 301
NOTES TO THE COMBINED FINANCIAL STATEMENTS OF THE FEDERAL RESERVE BANKS—CONTINUED
(E) Bank Premises and Equipment
Bank premises and equipment are stated at cost less
accumulated depreciation. Depreciation is calculated on a
straight-line basis over estimated useful lives of assets
ranging from 2 to 50 years. New assets, major alterations,
renovations, and improvements are capitalized at cost as
additions to the asset accounts. Maintenance, repairs, and
minor replacements are charged to operations in the year
incurred.
(F) Federal Reserve Notes
Federal Reserve notes are the circulating currency of the
United States. These notes are issued through the various
Federal Reserve agents to the Reserve Banks upon
deposit with such agents of certain classes of collateral
security, typically U.S. government securities. These notes
are identified as issued to a specific Reserve Bank. The
Federal Reserve Act provides that the collateral security
tendered by the Reserve Bank to the Federal Reserve
agent must be equal to the sum of the notes applied for
by such Reserve Bank. In accordance with the Federal
Reserve Act, gold certificates, special drawing rights
certificates, U.S. government and agency securities, loans
allowed under section 13, and investments denominated
in foreign currencies are pledged as collateral for net
Federal Reserve notes outstanding. The collateral value is
equal to the book value of the collateral tendered, with the
exception of securities, whose collateral value is equal
to the par value of the securities tendered. The Board of
Governors may, at any time, call upon a Reserve Bank for
additional security to adequately collateralize the Federal
Reserve notes. To satisfy the obligation to provide sufficient collateral for outstanding Federal Reserve notes, the
Reserve Banks have entered into an agreement that provides that certain assets of the Reserve Banks are jointly
pledged as collateral for the Federal Reserve notes of all
Reserve Banks. In the event that this collateral is insufficient, the Federal Reserve Act provides that Federal
Reserve notes become a first and paramount lien on all
the assets of the Reserve Banks. Finally, as obligations of
the United States, Federal Reserve notes are backed by
the full faith and credit of the U.S. government.
The "Federal Reserve notes outstanding, net" account
represents Federal Reserve notes reduced by cash held
in the vaults of the Reserve Banks of $120,030 million
and $92,131 million at December 31, 1998 and 1997,
respectively.
At December 31, 1998 and 1997, all gold certificates,
all special drawing rights certificates, and domestic
securities with par values of $471,411 million and
$437,222 million, respectively, were pledged as collateral. At December 31, 1998 and 1997, no loans or investments denominated in foreign currencies were pledged as
collateral.
changes, its holdings of the Reserve Bank's stock must be
adjusted. Member banks are those state-chartered banks
that apply and are approved for membership in the System and all national banks. Currently, only one-half of the
subscription is paid-in and the remainder is subject to
call. These shares are nonvoting with a par value of $100.
They may not be transferred or hypothecated. By law,
each member bank is entitled to receive an annual
dividend of 6% on the paid-in capital stock. This cumulative dividend is paid semiannually. A member bank is
liable for Reserve Bank liabilities up to twice the par
value of stock subscribed by it.
(H) Surplus
The Board of Governors requires Reserve Banks to maintain a surplus equal to the amount of capital paid-in as of
December 31. This amount is intended to provide additional capital and reduce the possibility that the Reserve
Banks would be required to call on member banks for
additional capital. Reserve Banks are required by the
Board of Governors to transfer to the U.S. Treasury
excess earnings, after providing for the costs of operations, payment of dividends, and reservation of an amount
necessary to equate surplus with capital paid-in. Payments made after September 30, 1998, represent payment
of interest on Federal Reserve notes outstanding.
The Omnibus Budget Reconciliation Act of 1993 (Public Law 103-66, Section 3002) codified the existing Board
surplus policies as statutory surplus transfers, rather than
as payments of interest on Federal Reserve notes, for
federal government fiscal years 1998 and 1997 (which
began on October 1, 1997 and 1996, respectively). In
addition, the legislation directed the Reserve Banks to
transfer to the U.S. Treasury additional surplus funds of
$107 million and $106 million during fiscal years 1998
and 1997 respectively. These transfers were made on
October 1, 1997 and 1996, respectively. Reserve Banks
were not permitted to replenish surplus for these amounts
during this time. The 1997 transfer is reported on the
Statement of Changes in Capital as "Statutory surplus
transfer to the U.S. Treasury."
In the event of losses, payments to the U.S. Treasury
are suspended until such losses are recovered through
subsequent earnings. Weekly payments to the U.S. Treasury vary significantly.
(I) Cost of Unreimbursed Treasury Services
Reserve Banks are required by the Federal Reserve Act to
serve as fiscal agents and depositories of the United
States. By statute, the Department of the Treasury is
permitted, but not required, to pay for these services. The
costs of providing fiscal agency and depository services
to the Treasury Department that have been billed but will
not be paid are reported as the "Cost of unreimbursed
Treasury services."
(G) Capital Paid-in
(J) Taxes
The Federal Reserve Act requires that each member bank
subscribe to the capital stock of the Reserve Bank in an
amount equal to 6% of the capital and surplus of the
member bank. As a member bank's capital and surplus
The Reserve Banks are exempt from federal, state, and
local taxes, except for taxes on real property, which are
reported as a component of "Occupancy expense."
302 85th Annual Report, 1998
NOTES TO THE COMBINED FINANCIAL STATEMENTS OF THE FEDERAL RESERVE BANKS—CONTINUED
(4) U.S. GOVERNMENT AND FEDERAL AGENCY
SECURITIES
Securities bought outright and held under agreements to
resell are held in the SOMA at the FRBNY.
Total securities held in the SOMA at December 31,
1998 and 1997, that were bought outright were as follows
(in millions):
1998
Par value
Federal agency
U.S. government
Bills
Notes
Bonds
Total par value
Unamortized premiums
Unaccreted discounts
Total
$
337
At December 31, 1998 and 1997, matched salepurchase transactions involving U.S. government
securities with par values of $20,927 million and
$17,027 million, respectively, were outstanding. Matched
sale-purchase transactions are generally overnight
arrangements.
At December 31, 1998 and 1997, US. government
securities with par values of $325 million and $887 million, respectively, were loaned.
1997
$
685
194,772
187,895
69,474
452,478
197,123
174,206
59,407
431.421
7,387
(3,198)
$456,667
6,197
(3,617)
$434,001
The maturities of U.S. government and federal agency
securities bought outright, which were held in the SOMA
at December 31, 1998, were as follows (in millions):
(5) INVESTMENTS DENOMINATED IN
FOREIGN CURRENCIES
The FRBNY, on behalf of the Reserve Banks, holds
foreign currency deposits with foreign central banks and
the Bank for International Settlements and invests in
foreign government debt instruments. Foreign government debt instruments held include both securities bought
outright and securities held under agreements to resell.
These investments are guaranteed as to principal and
interest by the foreign governments.
Total investments denominated in foreign currencies,
valued at current exchange rates at December 31, were as
follows (in millions):
Par value
Maturities of
securities held
U.S.
government
securities
Within 15 days .. . $ 1,158
99,127
16 days to 90 days .
91 days to 1 year . . 143,635
Over 1 year to
. 107,730
5 years
Over 5 years to
.
44,822
10 years
.
55,669
Over 10 years
. $452,141
Total
1998
Federal
agency
obligations
$. . .
27
75
Total
$
1,158
99,154
143,710
61
107,791
174
44,996
55,669
$452,478
$337
German marks
Foreign currency deposits
Government debt instruments,
including agreements
to resell
Japanese yen
Foreign currency deposits
Government debt instruments,
including agreements
to resell
$10,451
$ 8,271
2,373
3,215
666
575
6,196
4,902
Accrued interest
Total
Total securities held under agreements to resell at
December 31 1998 and 1997, respectively were as follows (in millions):
1997
97
86
$19,783
$17,049
In addition to the balances reported above, $15 million
and $3 million in unearned interest collected on certain
foreign currency holdings were also reported as "Investments denominated in foreign currencies" at December 31, 1998 and 1997, respectively.
1998
1997
Par value
Federal agency
U.S. government
Total par value
$10,702
19,674
30,376
$ 2,652
21,188
23,840
The maturities of investments denominated in foreign
currencies at December 31, 1998, were as follows (in
millions):
Unamortized premiums
Unaccreted discounts
Total
2,133
(265)
$32,244
996
(282)
$24,554
Maturities of Investments Denominated
in Foreign Currencies
The resell date for securities purchased under agreements to resell does not exceed fifteen days after the
purchase date.
Within 1 year
Over 1 year to 5 years
Over 5 years to 10 years
Total
$18,826
496
461
$19,783
Federal Reserve Banks Combined Financial Statements 303
NOTES TO THE COMBINED FINANCIAL STATEMENTS OF THE FEDERAL RESERVE BANKS—CONTINUED
At December 31, 1998 and 1997, there were no open
foreign exchange contracts or outstanding F/X swaps.
At December 31, 1998, the warehousing facility was
$5,000 million, with nothing outstanding.
(6) BANK PREMISES AND EQUIPMENT
A summary of bank premises and equipment at December 31 is as follows (in millions):
1998
Bank premises and equipment
Land
Buildings
Building machinery and
equipment
Construction in progress
Furniture and equipment
1997
$ 191
1,177
$ 194
1,100
271
41
1,244
255
61
1,258
2,924
Accumulated depreciation
Bank premises and
equipment, net
2,868
(1,137)
(1,087)
$1,787
$1,781
Depreciation expense was $184 million and $194 million for the years ended December 31, 1998 and 1997,
respectively.
Bank premises and equipment at December 31 include
the following amounts for leases that have been capitalized (in millions):
1998
Bank premises and equipment
Accumulated depreciation
Capitalized leases, net
1997
$89
£78)
$1J_
$95
(81)
$14
Certain of the Reserve Banks lease unused space to
outside tenants. Those leases have terms ranging from 1
to 16 years. Rental income from such leases totaled
$17 million for each of the years ended December 31, 1998 and 1997. Future minimum lease payments
under agreements in existence at December 31, 1998,
were (in millions):
1999
2000
2001
2002
2003
Thereafter
Total
$14
14
12
11
8
_23
$82
(7) COMMITMENTS AND CONTINGENCIES
At December 31, 1998, the Reserve Banks were obligated under noncancelable leases for premises and equipment with terms ranging from 1 year to approximately
25 years. These leases provide for increased rentals based
upon increases in real estate taxes, operating costs, or
selected price indices.
Rental expense under operating leases for certain operating facilities, warehouses, and data processing and
office equipment (including taxes, insurance, and maintenance when included in rent), net of sublease rentals, was
$64 million and $69 million for the years ended December 31, 1998 and 1997, respectively. Certain of the
Reserve Banks' leases have options to renew.
Future minimum rental payments under noncancelable
operating leases, net of sublease rentals, with terms of
one year or more, at December 31, 1998, were (in
millions):
Operating
1999
2000
2001
2002
2003
Thereafter
Total
$ 14
11
9
6
6
$119
$165
At December 31, 1998, the Reserve Banks had contractual commitments through the year 2007 totaling $243
million for the maintenance of currency processing machines, none of which has been recognized. One Reserve
Bank contracts for maintenance for these machines on
behalf of the System and allocates the costs, annually, to
each other Reserve Bank.
The Reserve Banks are involved in certain legal actions
and claims arising in the ordinary course of business.
Although it is difficult to predict the ultimate outcome of
these actions, in management's opinion, based on discussions with counsel, the aforementioned litigation and
claims will be resolved without material adverse effect
on the financial position or results of operations of the
Reserve Banks.
(8) RETIREMENT AND THRIFT PLANS
Retirement Plans
The Reserve Banks currently offer two defined benefit
retirement plans to their employees, based on length of
service and level of compensation. Substantially all of the
Reserve Banks' employees participate in the Retirement
Plan for Employees of the Federal Reserve System (System Plan) and the Benefit Equalization Retirement Plans
offered by each individual Reserve Bank (BEPs).
The System Plan is a multi-employer plan with contributions fully funded by participating employers. No separate accounting is maintained of assets contributed by the
participating employers. FRBNY acts as the sponsor of
this plan. The prepaid pension cost includes amounts
related to the participation of employees of the twelve
Reserve Banks, the Board of Governors, and the Plan
Administrative Office in the plan.
304 85th Annual Report, 1998
NOTES TO THE COMBINED FINANCIAL STATEMENTS OF THE FEDERAL RESERVE BANKS—CONTINUED
Following is a reconciliation of the beginning and
ending balances of the System Plan benefit obligations (in
millions):
1998
1997
Estimated actuarial present value
of projected benefit
obligation at January 1
$2,476
Service cost—benefits earned
during the period
79
Interest cost of projected
benefit obligation
169
Actuarial loss
140
Contributions by plan participants ..
4
Benefits paid
(125)
Special termination benefits
Plan amendments
31_
Estimated actuarial present value
of projected benefit
obligation at December 31 . . . . $2,774
1998
$2,270
71
160
80
4
(117)
4
4
$2,476
During 1997, a special retirement program was offered by
one of the employers to employees who were eligible to
retire in 1998.
Following is a reconciliation showing the beginning
and ending balance of the System Plan assets, the funded
status, and the prepaid pension benefit cost (in millions):
1998
1997
Estimated fair value of plan
assets at January 1
$5,031
Actual return on plan assets
888
Contributions by employer
•••
Contributions by plan participants ..
4
Benefits paid
(125)
$4,157
904
83
4
(117)
Estimated fair value of plan
assets at December 31
$5,031
$5,798
Funded status
$3,024
Unrecognized initial net
transition (obligation)
(136)
Unrecognized prior service cost
152
Unrecognized net actuarial (gain) .. (1,549)
Prepaid pension benefit cost
1,491
The components of net periodic pension benefit credit
for the System Plan as of December 31 are shown below
(in millions):
Service cost—benefits earned
during the period
Interest cost on projected
benefit obligation
Amortization of initial net
transition obligation
Amortization of prior service
cost
Recognized net (gain)
Expected return on plan assets
Cost of special termination
benefits
1997
$ 79
$ 71
169
160
(45)
(46)
15
(59)
(448)
13
(34)
(369)
•• •
Net periodic pension benefit (credit) . $(289)
4
$(201)
Net periodic pension benefit (credit) is reported as a
component of "Other expense."
The Reserve Banks' projected benefit obligation and
net pension costs for the BEP at December 31, 1998 and
1997, and for the years then ended, are not material.
Thrift Plan
Employees of the Reserve Banks may also participate in
the defined contribution Thrift Plan for Employees of the
Federal Reserve System (Thrift Plan). The Reserve
Banks' Thrift Plan contributions totaled $43 million and
$41 million for the years ended December 31, 1998 and
1997, respectively, and are reported as a component of
"Salaries and other benefits."
$2,555
(181)
135
(1,307)
(9) POSTRETIREMENT BENEFITS OTHER THAN PENSIONS
AND POSTEMPLOYMENT BENEFITS
1,202
Postretirement Benefits Other Than Pensions
Prepaid pension benefit cost is reported as a component
of "Other assets."
The weighted-average assumptions used in developing
the pension benefit obligation for the System Plan are as
follows:
1998
1997
Discount rate
Expected long-term rate of
return on plan assets
Rate of compensation increase
6.25%
7.00%
9.00%
4.25%
9.00%
5.00%
In addition to the Reserve Banks' retirement plans, employees who have met certain age and length of service
requirements are eligible for both medical benefits and
life insurance coverage during retirement.
The Reserve Banks fund benefits payable under the
medical and life insurance plans as due and, accordingly,
have no plan assets. Net postretirement benefit cost
is actuarially determined, using a January 1 measurement
date.
Federal Reserve Banks Combined Financial Statements 305
NOTES TO THE COMBINED FINANCIAL STATEMENTS OF THE FEDERAL RESERVE BANKS—CONTINUED
Following is a reconciliation of beginning and ending
balances of the benefit obligation (in millions):
1998
Accumulated postretirement benefit
obligation at January 1
Service cost—benefits earned during
the period
Interest cost of accumulated
benefit obligation
Actuarial loss (gain)
Contributions by plan participants
Benefits paid
Plan amendments, acquisitions,
foreign currency exchange rate
changes, business combinations,
diverstitures, curtailments,
settlements, special
termination benefits
Accumulated postretirement benefit
obligation at December 31
1997
$588
$582
15
15
39
41
3
(24)
39
(14)
3
(22)
Assumed health care cost trend rates have a significant
effect on the amounts reported for health care plans. A
1 percentage point change in assumed health care cost
trend rates would have the following effects for the year
ended December 31, 1998 (in millions):
(17)
$645
(15)
$588
Following is a reconciliation of the beginning and ending
balance of the plan assets, the unfunded postretirement
benefit obligation, and the accrued postretirement benefit
cost (in millions):
1998
1997
1 Percentage
Point Increase
Effect on aggregate
of service and
interest cost
components of
net periodic
postretirement
benefit cost
$ 10
Effect on accumulated
postretirement
benefit obligation . . . 106
1 Percentage
Point Decrease
$ (10)
(107)
The following is a summary of the components of net
periodic postretirement benefit cost for the years ended
December 31 (in millions):
1998
1997
$15
$16
39
(8)
1_1_.
40
(6)
1_1_.
Fair value of plan assets at January 1 . . . $ . . .
Actual return on plan assets
Contributions by the employer
21
Contributions by plan participants
3
Benefits paid
(24)
$ ...
...
19
3
(22)
Service cost—benefits earned during
the period
Interest cost of accumulated benefit
obligation
Amortization of prior service cost
Recognized net actuarial loss
Fair value of plan assets at
December 31
$•••
Net periodic postretirement benefit cost . . . $46
Unfunded postretirement benefit
obligation
Unrecognized initial net transition
asset (obligation)
Unrecognized prior service cost
Unrecognized net actuarial (loss)
$•••
$645
100
(50)
Accrued postretirement benefit cost . . . . $695
$588
(1)
92
(7)
$672
Accrued postretirement benefit cost is reported as a component of "Accrued benefit cost."
The weighted-average assumption used in developing
the postretirement benefit obligation as of December 31 is
as follows:
1998
1997
Discount rate
6.25%
7.00%
For measurement purposes, an 8.5% annual rate of
increase in the cost of covered health care benefits was
assumed for 1999. Ultimately, the health care cost trend
rate is expected to decrease gradually to 4.75% by 2006,
and remain at that level thereafter.
$50
Net periodic postretirement benefit cost is reported as a
component of "Salaries and other benefits."
Postemployment Benefits
The Reserve Banks offer benefits to former or inactive
employees. Postemployment benefit costs are actuarially
determined and include the cost of medical and dental
insurance, survivor income, disability benefits, and those
workers' compensation expenses self-insured by individual Reserve Banks. Costs were projected using the
same discount rate and health care trend rates as were
used for projecting postretirement costs. The accrued
postemployment benefit costs recognized by the Reserve
Banks at December 31, 1998 and 1997, were $84 million
and $76 million, respectively. This cost is included as
a component of "Accrued benefit cost." Net periodic
postemployment benefit costs included in 1998 and 1997
operating expenses were $19 million and $17 million,
respectively.
307
Board of Governors Financial Statements
The financial statements of the Board for 1998 were audited by Deloitte & Touche
LLP, independent auditors.
Deloitte &
Touche LLP
INDEPENDENT AUDITORS' REPORT
To the Board of Governors of the
Federal Reserve System
We have audited the accompanying balance sheet of the Board of Governors of
the Federal Reserve System (the Board) as of December 31, 1998, and the related
statements of revenues and expenses and fund balance, and of cash flows for the
year then ended. These financial statements are the responsibility of the Board's
management. Our responsibility is to express an opinion on these financial statements based on our audit. The financial statements of the Board for the year ended
December 31, 1997, were audited by other auditors whose report, dated March 16,
1998, expressed an unqualified opinion on those statements.
We conducted our audit in accordance with generally accepted auditing standards and the standards applicable to financial audits contained in Government
Auditing Standards, issued by the Comptroller General of the United States. Those
standards require that we plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides
a reasonable basis for our opinion.
In our opinion, the 1998 financial statements referred to above present fairly, in
all material respects, the financial position of the Board as of December 31, 1998,
and the results of its operations and its cash flows for the year then ended in
conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards, we have also issued our
report dated April 20, 1999, on our tests of the Board's compliance with certain
provisions of laws, regulations, contracts, and grants and our consideration of the
Board's internal control over financial reporting.
April 20, 1999
Washington, DC
308
85th Annual Report, 1998
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
BALANCE SHEETS
As of December 31,
1998
1997
ASSETS
CURRENT ASSETS
Cash
Accounts receivable
Transfers receivable—surplus Federal Reserve Bank earnings (Note 1)
Prepaid expenses and other assets
58,438,555
64,220,105
$742,561,873
$ 8,231,187
7,745,624
0
7,493,533
135,205
2,034,129
$ 9,797,829
7,609,781
652,913,560
7,477,187
98,772
2,016,190
25,639,678
Totalassets
678,341,768
$80,675,544
PROPERTY, BUILDINGS, AND EQUIPMENT, NET (Note 5)
$ 23,364,834
1,071,278
652,913,560
992,096
22,236,989
Total current assets
$20,111,430
910,282
0
1,215,277
679,913,319
LIABILITIES AND FUND BALANCE
CURRENT LIABILITIES
Accounts payable and accrued liabilities
Accrued payroll and related taxes
Transfers payable—surplus Federal Reserve Bank earnings (Note 1)
Accrued annual leave
Capital lease payable (current portion)
Unearned revenues and other liabilities
Total current liabilities
CAPITAL LEASE PAYABLE (non-current portion)
406,773
516,228
ACCUMULATED RETIREMENT BENEFIT OBLIGATION (Note 2)
773,177
740,497
20,721,869
20,193,034
2,183,602
1,769,646
49,725,099
703,132,724
30,950,445
39,429,149
$80,675,544
$742,561,873
ACCUMULATED POSTRETIREMENT BENEFIT OBLIGATION (Note 3)
ACCUMULATED POSTEMPLOYMENT BENEFIT OBLIGATION (Note 4)
Total liabilities
FUND BALANCE
Total liabilities and fund balance
See notes to financial statements.
Board Financial Statements 309
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
STATEMENTS OF REVENUES AND EXPENSES
AND FUND BALANCE
For the years ended December 31,
1998
1997
BOARD OPERATING REVENUES
Assessments levied on Federal Reserve Banks for Board
operating expenses and capital expenditures
Other revenues (Note 6)
$
$ 174,406,600
9,460,475
186,353,987
183,867,075
110,455,527
18,684,301
17,913,599
13,013,690
6,843,836
5,170,630
4,798,940
4,344,064
4,257,297
3,280,615
2,138,315
3,931,877
108,870,919
19,835,377
10,735,745
9,306,428
4,261,161
4,680,031
4,172,795
4,130,603
4,291,093
2,895,097
2,707,738
3,665,738
194,832,691
Total operating revenues
178,008,900
8,345,087
179,552,725
BOARD OPERATING EXPENSES
Salaries
Retirement and insurance contributions
Contractual services and professional fees
Depreciation and net losses on disposals
Postage and supplies
Travel
Utilities
Software
Equipment and facilities rental
Repairs and maintenance
Printing and binding
Other expenses (Note 6)
Total operating expenses
BOARD OPERATING REVENUES OVER (UNDER) EXPENSES
(8,478,704)
4,314,350
ISSUANCE AND REDEMPTION OF FEDERAL RESERVE NOTES
Assessments levied on Federal Reserve Banks
for currency costs
Expenses for currency printing, issuance,
retirement, and shipping
408,544,472
408,544,472
363,738,623
0
CURRENCY ASSESSMENTS OVER (UNDER) EXPENSES
363,738,623
0
TOTAL REVENUE OVER (UNDER) EXPENSES
(8,478,704)
4,314,350
FUND BALANCE, Beginning of year
39,429,149
35,114,799
18,438,855,572
(18,438,855,572)
20,765,972,296
(20,765,972,296)
$
$
TRANSFERS TO THE U.S. TREASURY
Transfers and accrued transfers from surplus Federal Reserve Bank
earnings (Note 1)
Transfers and accrued transfers to the U.S. Treasury (Note 1)
FUND BALANCE, End of year
See notes to financial statements.
30,950,445
39,429,149
310 85th Annual Report, 1998
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
STATEMENTS OF CASH FLOWS
For the years ended December 31,
1998
1997
CASH FLOWS FROM OPERATING ACTIVITIES
Board operating revenues over (under) expenses
$ (8,478,704)
$ 4,314,350
Adjustments to reconcile operating revenue over (under) expenses
to net cash provided by operating activities:
Depreciation and net losses on disposals
(Increase) decrease in accounts receivable, prepaid expenses
and other assets
(Increase) decrease in transfers receivable—surplus Federal Reserve
Bank earnings
Increase (decrease) in accounts payable and accrued liabilities
Increase (decrease) in payroll payable and related taxes
Increase (decrease) in transfers payable—surplus Federal Reserve Bank
earnings
Increase (decrease) in accrued annual leave
Increase (decrease) in capital lease payable
Increase (decrease) in unearned revenues and other liabilities
Increase (decrease) in accumulated retirement benefits
Increase (decrease) in accumulated postretirement benefits
Increase (decrease) in accumulated postemployment benefits
13,013,690
9,306,428
(62,185)
2,745,993
652,913,560
(1,566,642)
135,843
6,949,042
(637,716)
805,103
(652,913,560)
16,346
(73,022)
17,939
32,680
528,835
413,956
(6,949,042)
510,860
0
(247,148)
274,441
2,021,312
360,303
Net cash provided by operating activities
3,978,736
19,453,926
Proceeds from disposals of furniture and equipment
Capital expenditures
16,400
(7,248,540)
18,301
(11,819,651)
Net cash used in investing activities
(7,232,140)
(11,801,350)
NET INCREASE (DECREASE) IN CASH
(3,253,404)
CASH BALANCE, Beginning of year
23,364,834
15,712,258
$ 20,111,430
$23,364,834
$
$
CASH FLOWS FROM INVESTING ACTIVITIES
CASH BALANCE, End of year
7,652,576
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Capital lease obligations incurred
See notes to financial statements.
0
615,000
Board Financial Statements
311
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
NOTES TO FINANCIAL STATEMENTS FOR THE
YEARS ENDED DECEMBER 31, 1998 AND 1997
(1) SIGNIFICANT ACCOUNTING POLICIES
Board Operating Revenues and Expenses—
Assessments made on the Federal Reserve Banks for
Board operating expenses and capital expenditures are
calculated based on expected cash needs. These assessments, other operating revenues, and operating expenses
are recorded on the accrual basis of accounting.
Issuance and Redemption of Federal Reserve Notes—
The Board incurs expenses and assesses the Federal
Reserve Banks for the costs of printing, issuing, shipping,
and retiring Federal Reserve Notes. These assessments
and expenses are separately reported in the statements of
revenues and expenses because they are not Board operating transactions.
Property, Buildings and Equipment—The Board's
property, buildings and equipment are stated at cost less
accumulated depreciation. Depreciation is calculated on a
straight-line basis over the estimated useful lives of the
assets, which range from 4 to 10 years for furniture and
equipment and from 10 to 50 years for building equipment and structures. Upon the sale or other disposition of
a depreciable asset, the cost and related accumulated
depreciation are removed from the accounts and any gain
or loss is recognized.
Federal Reserve Bank Surplus Earnings—The Omnibus Budget Reconciliation Act of 1993 required that
surplus Federal Reserve Bank earnings be transferred
from the Banks to the Board and then to the U.S. Treasury
for the period October 1, 1996, to September 30, 1998.
Prior to October 1, 1996 and after September 30, 1998,
the Federal Reserve Banks made their transfers directly to
the Treasury. The Board accounted for these transfers
when earned and due, which may result in transfers
receivable and payable as of the balance sheet date.
Estimates—The preparation of financial statements in
conformity with generally accepted accounting principles
requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities
and the disclosure of contingent assets and liabilities
at the date of the financial statements and the reported
amounts of revenues and expenses during the reporting
period. Actual results could differ from those estimates.
Reclassifications—Certain 1997 amounts have been
reclassified to conform with the 1998 presentation.
(2)
RETIREMENT BENEFITS
Substantially all of the Board's employees participate
in the Retirement Plan for Employees of the Federal
Reserve System (System Plan). The System Plan is a
multiemployer plan which covers employees of the Federal Reserve Banks, the Board, and the Plan Administrative Office. Employees of the Board who entered on duty
prior to 1984 are covered by a contributory defined benefits program under the System Plan. Employees of the
Board who entered on duty after 1983 are covered by a
non-contributory defined benefits program under the System Plan. Contributions to the System Plan are actuarially
determined and funded by participating employers at
amounts prescribed by the System Plan's administrator.
Based on actuarial calculations, it was determined that
employer funding contributions were not required for the
years 1998 and 1997, and the Board was not assessed a
contribution for these years. Excess Plan assets will continue to fund future years' contributions. The Board is not
accountable for the assets of this plan.
A relatively small number of Board employees participate in the Civil Service Retirement System (CSRS) or
the Federal Employees' Retirement System (FERS). The
Board matches employee contributions to these plans.
These defined benefits plans are administered by the
Office of Personnel Management. The Board's contributions to these plans totaled $233,000 and $196,000 in
1998 and 1997, respectively. The Board has no liability
for future payments to retirees under these programs, and
it is not accountable for the assets of the plans.
Employees of the Board may also participate in the
Federal Reserve System's Thrift Plan. Under the Thrift
Plan, members may contribute up to a fixed percentage
of their salary. Board contributions are based upon a
fixed percentage of each member's basis contribution
and were $4,794,000 and $4,772,000 in 1998 and 1997,
respectively.
Effective January 1, 1996, Board employees covered
under the System Plan are also covered under a Benefits
Equalization Plan (BEP). Benefits paid under the BEP
are limited to those benefits that cannot be paid from the
System Plan because of limitations imposed by Sections
401(a)(17), 415(b), and 415(e) of the Internal Revenue
Code of 1986. Pension costs attributed to the BEP reduce
the pension costs of the System Plan. Activity for 1998
and 1997 is summarized in the following table:
1998
Change in benefit obligation
Benefit obligation at
beginning of year
Service cost
Interest cost
Plan participants'
contributions
Plan amendments
Actuarial (gain)Aoss
Benefits paid
Benefit obligation at
end of year
1997
$528,000
65,000
21,000
$1,118,000
133,000
81,000
0
0
320,000
(36,000)
$898,000
0
(820,000)
16,000
0
$ 528,000
312 85th Annual Report, 1998
1998
Change in plan assets
Fair value of plan assets
at beginning
of year
Actual return on plan
assets
Employer contributions .
Plan participants'
contributions
Benefits paid
Fair value of plan assets
at end of year
Reconciliation of funded
status at end of year
Funded status
Unrecognized net
actuarial (gain)/
loss
Unrecognized prior
service cost
Unrecognized net
transistion
obligation
Prepaid/(accrued)
postretirement
benefit cost
$
0
$
The Board provides certain defined benefit health and
life insurance for its active employees and retirees. Activity for 1998 and 1997 is summarized in the following
table:
0
0
36,000
0
0
0
(36,000)
0
0
$
0
$
0
($ 898,000)
($ 528,000)
(609,177)
(476,497)
(424,000)
(996,000)
1,158,000
1,260,000
($ 773,177)
Weighted-average
assumptions as of
December 31
Discount rate
Rate of compensation
increase
Components of net
periodic expense
for year
Service cost
Interest cost
Expected return
on pian assets
Amortization of
net liability
Amortization of prior
service cost
Recognized net
actuarial gain
Special termination
benefit
Total net periodic
expense
(3) POSTRETIREMENT BENEFITS
1997
($ 740,497)
6.25%
7.00%
4.25%
5.00%
65,000
21,000
$ 133,000
81,000
0
0
103,000
103,000
(73,000)
(14,000)
(48,000)
(29,000)
$
0
$
0
68,000
$ 274,000
1998
1997
Change in benefit
obligation
Benefit obligation at
beginning of year .. $22,973,898
Service cost
133,733
Interest cost
1,397,922
Plan participants'
contributions
195,272
Plan amendments
0
Actuarial (gain)/loss . . . .
(549,800)
Benefits paid
(1,204,713)
Benefit obligation
at end of year
$22,946,312
Change in plan assets
Fair value of plan
assets at beginning
of year
$
0
Actual return on
plan assets
0
Employer contributions .
1,009,441
Plan participants'
contributions
195,272
Benefits paid
(1,204,713)
Fair value of plan
assets at end
of year
$
0
Reconciliation of
funded status
at end of year
Funded status
Unrecognized net
actuarial
(gain)/loss
Unrecognized prior
service cost
Unrecognized net
transition
obligation
Prepaid/(accrued)
postretirement
benefit cost
Components of net
periodic expense
for year
Service cost
Interest cost
Amortization of prior
service cost
Amortization of
(gains)/losses
Total net periodic
expense
$21,329,126
154,474
1,474,782
187,788
1,161,618
(251,176)
(1,082,714)
$22,973,898
$
0
0
894,926
187,788
(1,082,714)
$
0
($22,946,312) ($22,973,898)
2,224,443
2,780,864
0
0
0
0
($20,721,869) ($20,193,034)
$
133,733
1,397,922
0
$
154,474
1,474,782
0
6,621
1,286,982
$ 1,538,276
$ 2,916,238
Board Financial Statements 313
1998
Effect of a onepercentage point
increase in
health care cost
trend rate on:
Year-end benefit
obligation
Total of service
and interest cost
components
Effect of a onepercentage point
decrease in
health care cost
trend rate on:
Year-end benefit
obligation
Total of service
and interest cost
components . . . .
1997
$ 2,382,383
$ 1,777,007
97,751
172,488
(4) POSTEMPLOYMENT BENEFIT PLAN
The Board provides certain postemployment benefits to
eligible employees after employment but before retirement. Effective January 1, 1994, the Board adopted
Statement of Financial Accounting Standards No. 112,
Employers' Accounting for Postemployment Benefits,
which requires that employers providing postemployment
benefits to their employees accrue the cost of such
benefits. Prior to January 1994, postemployment benefit
expenses were recognized on a pay-as-you-go basis. The
postemployment benefit expense was $614,000 and
$516,000 for 1998 and 1997, respectively.
(5) PROPERTY, BUILDINGS AND EQUIPMENT
$(1,885,077)
$(2,536,859)
(156,553)
The following is a summary of the components of the
Board's fixed assets, at cost, net of accumulated
depreciation.
(152,179)
The liability and costs for the postretirement benefit
plan were determined using discount rates of 6.25 percent
as of December 31, 1998 and 7.00 percent as of December 31, 1997. Unrecognized losses of $2,224,443 and
$2,780,864 as of December 31, 1998 and 1997, respectively, result from changes in the discount rate used to
measure the liabilities. Under Statement of Financial
Accounting Standards No. 106, Employers' Accounting
for Postretirement Benefits Other Than Pensions, the
Board may have to record some of these unrecognized
losses in operations in future years. The assumed health
care cost trend rate for measuring the increase in costs
from 1998 to 1999 was 8.50 percent. These rates were
assumed to gradually decline to an ultimate rate of
4.75 percent in the year 2006 for the purpose of calculating the December 31, 1998 accumulated postretirement
benefit obligation. The assumed salary trend rate for
measuring the increase in postretirement benefits related
to life insurance was an average of 5 percent.
The above accumulated postretirement benefit obligation is related to the Board sponsored health benefits
and life insurance programs. During 1997, a special
retirement program was offered to employees who were
eligible to retire by May 31, 1998. This resulted in a
curtailment loss of $1,174,489 for 1997, comprised of
$1,044,096 for 62 employees covered by the Board sponsored health benefits plan, and $130,393 for 78 employees covered by the Board sponsored life insurance plan.
The Board has no liability for future payments to employees who continue coverage under the federally sponsored programs upon retiring. Contributions for active
employees participating in federally sponsored programs
totaled $3,839,000 and $3,667,000 in 1998 and 1997,
respectively.
The medical component of the benefit obligation at end
of year 1998 was $18,538,000. Pursuant to the Federal
Employees Health Care Act of 1998, on January 11,
1999, the Board paid the Office of Personnel Management $16,100,000 to compensate the Employee Health
Benefits Fund for the costs of providing future health care
benefits. Coverage for Board employees and retirees
enrolled in the Federal Reserve System Health Plan terminated involuntarily on December 31, 1998.
As of December 31,
1998
1997
Land and
improvements
Buildings
Furniture and
equipment
Less accumulated
depreciation .
Total property,
buildings and
equipment ...
S 1,301,314
43,162,040
$
1,301,314
65,611,228
46,133,411
90,596,765
63,486,071
130,398,613
(32,158,210)
(66,178,508)
$ 58,438,555
$ 64,220,105
Furniture and equipment and accumulated depreciation as of December 31, 1998 includes $615,000, and
$102,500, respectively, for capitalized leases, which were
acquired during 1997.
During 1998 the Board increased the threshold for
capitalization of furniture and equipment from $1,000 to
$5,000 per item. The Board expensed the undepreciated
value of previously capitalized furniture and equipment
not meeting the new capitalization threshold. The Board
also simplified the method of capitalizing major building
modifications, eliminating the previously used depreciation recovery method of reporting. For 1998, these
changes increased depreciation expense $4,033,000,
decreased cost by $44,112,000, and decreased accumulated depreciation by $40,079,000.
314 85th Annual Report, 1998
(6) OTHER REVENUES AND OTHER EXPENSES
(7) COMMITMENTS
The following are summaries of the components of
Other Revenues and Other Expenses.
The Board has entered into several operating leases to
secure office, training, and warehouse space for periods
ranging from one to ten years. Minimum future commitments under those leases having an initial or remaining
noncancelable lease term in excess of one year at December 31, 1998, are as follows:
For the years
ended December 31,
1998
1997
Other Revenues
Data processing
revenue
National Information
Center
Subscription
revenue
Reimbursable
services to
other agencies . . .
Miscellaneous
Total Other
Revenues
Other Expenses
Tuition, registration,
and membership
fees
Cafeteria operations,
net
Subsidies and
contributions
Miscellaneous
Total Other
Expenses
$4,332,513
$5,184,075
2,052,273
2,156,191
1,248,121
1,394,394
147,491
564,689
399,426
326,389
$8,345,087
1999
2000
2001
2002
after 2002
$ 4,148,000
4,851,000
4,846,000
4,820,000
15,757,000
$34,422,000
$9,460,475
Rental expenses under the operating leases were
$3,873,000 and $3,960,000 in 1998 and 1997,
respectively.
(8) FEDERAL FINANCIAL INSTITUTIONS
EXAMINATION COUNCIL
$1,428,717
$1,118,683
756,548
794,019
666,843
1,079,769
653,207
1,099,829
$3,931,877
$3,665,738
The Board is one of the five member agencies of the
Federal Financial Institutions Examination Council (the
"Council"). During 1998 and 1997, the Board paid
$249,000 and $228,000, respectively, in assessments for
operating expenses of the Council. These amounts are
included in other expenses for 1998 and 1997. During
1998 and 1997, the Board paid $159,000 and $158,000,
respectively, for office space subleased from the
Council.
•
Statistical Tables
316 85th Annual Report, 1998
1. Statement of Condition of Each Federal Reserve Bank,
December 31, 1998 and 1997
Million of dollars
Boston
Total
Item
1998
1997
1998
1997
11,046
9,200
358
11,047
9,200
17
0
2,035
0
Federal agency obligations
Bought outright
Held under repurchase agreements
338
10,702
685
2,652
18
0
42
0
U.S. Treasury securities
Bought outright'
Held under repurchase agreements
Total loans and securities
452,141
19,674
482,872
430,736
21,188
457,295
24,625
0
24,643
26,259
0
26,322
7,582
1,301
8,378
1,272
539
94
441
94
19,769
16,628
17,046
13,722
958
683
637
697
0
0
1,172
-3,621
548,756
518,420
29,225
25,746
491,657
457,469
26,417
22,984
26,306
6,086
167
1,619
34,179
30,838
5,444
457
897
37,636
1,568
0
7
68
1,643
1,544
0
5
2
1,551
6,574
4,442
7,817
4,845
392
238
412
283
536,852
507,767
28,690
25,231
5,952
5,952
0
5,433
5,220
0
267
267
0
262
254
0
548,756
518,420
29,225
25,746
611,688
120,030
491,657
549,600
92,131
457,469
30,296
3,879
26,417
27,943
4,959
22,984
11,046
9,200
0
471,412
11,047
9,200
0
437,222
491,657
457,469
ASSETS
Gold certificate account
Special drawing rights certificate account
Coin
Loans
To depository institutions
Other
460
582
530
23
624
530
23
21
0
Acceptances bought outright and held
under repurchase agreements
Items in process of collection
Bank premises
Other assets
Denominated in foreign currencies 2
Allother 3
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 Federal Reserve 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 317
1—Continued
N e w York
1997
1998
1998
Richmond
Cleveland
Philadelphia
1997
1998
1997
1998
1997
323
282
23
350
282
53
643
574
16
669
574
27
807
792
53
965
792
64
0
0
0
16
0
0
0
0
0
0
0
0
0
125
10,702
221
2,652
10
0
23
0
22
0
47
0
27
0
65
0
167,582
19,674
198,083
139,322
21,188
164,848
13,145
0
13,155
14,400
0
14,438
29,386
0
29,408
29,794
0
29,842
35,617
0
35,644
40,983
0
41,048
745
158
1,026
156
266
50
222
51
527
158
352
132
624
125
474
126
4,002
8,465
3,885
5,941
1,034
475
1,014
384
1,271
815
1,083
764
3,066
1,083
1,177
1,157
-5,656
16,310
2,181
-162
-4,170
-1,888
4,985
-8,468
213,219
199,322
17,790
16,632
29,242
31,556
47,179
37,336
194,182
179,316
16,456
13,970
26,164
28,441
41,577
32,459
7,533
6,086
9,257
5,444
1,720
1,574
1,815
1,898
2,062
53
484
346
360
0
9
11
0
9
89
0
9
54
0
22
188
0
10
77
14,156
15,406
433
0
8
147
588
1,740
1,672
1,879
2,109
2,149
4,206
3,202
3,934
3,202
15
20
0
0
1,465
809
794
1,654
1,643
242
151
184
181
334
275
235
316
676
342
650
427
210,802
197,159
17,437
16,075
28,445
30,871
44,704
35,684
1,208
1,208
1,108
1,055
284
273
0
399
399
0
349
335
0
1,238
1,238
0
0
177
177
0
0
833
818
0
213,219
199^22
17,790
16,632
29,242
31,556
47,179
37,336
239,794
45,611
194,182
209,843
30,527
179,316
18,434
1,978
16,456
16,784
2,815
13,970
29,535
3,370
26,164
31,706
3,265
50,920
9,343
41,577
39,172
6,713
32,459
28,441
318 85th Annual Report, 1998
1. Statement of Condition of Each Federal Reserve Bank,
December 31, 1998 and 1997—Continued
Millions of dollars
Chicago
Atlanta
Item
1998
1997
1998
1997
ASSETS
Gold certificate account
Special drawing rights certificate account
Coin
717
602
44
Loans
To depository institutions
Other
723
602
45
998
900
35
163
0
1,069
900
52
13
0
Acceptances bought outright and held
under repurchase agreements
Federal agency obligations
Bought outright
Held under repurchase agreements
21
0
46
0
32
0
73
0
U.S. Treasury securities
Bought outright'
Held under repurchase agreements
Total loans and securities
27,504
0
27,529
28,743
0
28,952
43,406
0
43,442
45,944
0
46,031
Items in process of collection
Bank premises
1,0