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FEDERAL RESERVE BANK OF CLEVELAND

2002 ANNUAL REPORT

The Federal Reserve System is responsible for formulating and implementing U.S. monetary policy. It also supervises
banks and bank holding companies, and provides financial services to depository institutions and the federal government.
The Federal Reserve Bank of Cleveland is one of 12 regional Reserve Banks in the United States that, together with the
Board of Governors in Washington, D.C., comprise the Federal Reserve System.
The Federal Reserve Bank of Cleveland, including its branch offices in Cincinnati and Pittsburgh and its check processing
center in Columbus, serves the Fourth Federal Reserve District (Ohio, western Pennsylvania, the northern panhandle of
West Virginia, and eastern Kentucky).
It is the policy of the Federal Reserve Bank of Cleveland to provide equal employment opportunity for all employees and
applicants without regard to race, color, religion, sex, national origin, age, or disability.

FEDERAL RESERVE BANK OF CLEVELAND

2002 ANNUAL REPORT

CONTENTS

President’s Foreword

Deflation

Management’s Report
on Responsibility
for Financial Reporting

Report of Independent
Accountants on
Financial Reporting

Report of Independent
Accountants on
Financial Statements

Comparative
Financial Statements

Notes to
Financial Statements

Officers and Consultants

Boards of Directors

2002 Operational Highlights

Business Advisory Council
and Community Bank
Advisory Council

President’s Foreword

he U.S. economy is still in the process of

recovering from a recession that began over two years ago. The official arbiter
of business cycle peaks and troughs, the National Bureau of Economic Research,
has not yet decided when the recession ended — or indeed, whether it has ended.
Many economists expect the latest recession’s trough to be dated near the end
of 2001, but considerable uncertainties about the future course of economic
activity remain.
The most immediate problem confronting the economy is an issue facing not
only our nation, but also the world. Terrorist activities and the strain of military
conflict weigh heavily on people everywhere. In the economic realm of our lives,
one consequence of these geopolitical tensions is a hesitation to take risks, particularly risks that involve significant capital expenditures. Capital spending requires
confidence in the future because the benefits of long-lived investments accrue
over time and, once made, are not easily reversed. Because we thrive in a global
trading environment, the U.S. economy is especially sensitive to developments
around the world.
Once geopolitical tensions ease, we will be in a better position to assess the
received a great deal of attention in the past few years is price stability— though
not for the usual reasons. Rather than worrying about inflation, some analysts
have been assessing the likelihood of deflation and its consequences. Because
deflation is rarely found in modern economies, its effects are not well understood.

2002 ANNUAL REPORT

economy’s underlying condition. One aspect of economic performance that has

David H. Hoag, chairman; Sandra Pianalto, first vice president; Jerry L. Jordan, president; and Robert W. Mahoney, deputy chairman.

The Great Depression, as well as Japan’s more recent experience with outright
deflation for four years and a flat price level for eight, have convinced some central
bankers that a little inflation is, in fact, desirable. In the essay that follows, we
defend deflation as an occasionally acceptable macroeconomic outcome, so long
as it is small in magnitude and accompanied by strong productivity growth.
The Bank could not have accomplished all that we did in 2002 without the guidance
provided by the directors of our Cincinnati, Cleveland, and Pittsburgh offices and
the members of our business and community bank advisory councils. We especially
want to thank those directors who completed their terms of service on our boards
FEDERAL RESERVE BANK OF CLEVELAND

in 2002. For their oversight and valuable contributions, we are truly grateful.

On our Cleveland Office board of directors, we are appreciative for the leadership of
David H. Hoag (retired chairman, LTV Corporation), who served as deputy chairman
and then chairman of the board during his term of service. During his tenure,
Mr. Hoag was an integral part of the search committee that selected my successor as
president, Sandra Pianalto. In addition, Tiney M. McComb (chairman and president,
Heartland BancCorp) and David L. Nichols (president and chief operating officer,
Rich’s/Lazarus/Goldsmith’s) completed their service on the Cleveland board.

On our Cincinnati Office board of directors, Mary Ellen Slone (chairman and chief
executive officer, Meridian Communications), completed a term as a director.
Special acknowledgment goes to George C. Juilfs (chairman and chief executive
officer, SENCORP), who served as chairman of that board for two terms. On our
Pittsburgh Office board of directors, Georgia Berner (president, Berner International
Corporation) and Peter N. Stephans (chairman and chief executive officer, Trigon,
Incorporated) each completed their second term as directors. We will miss the
valuable contributions of all of our departing board members.
In addition, I wish to express my sincere appreciation to the officers and staff of
the Federal Reserve Bank of Cleveland for their service during 2002 and throughout
my tenure as president. The employees of the Cleveland Bank have impressed
me with their commitment to efficiency, innovation, customer service, and good
public policy. Collectively and continuously, they have strengthened our banking
and payments systems, served the U.S. Treasury, and championed price stability.
For all of these reasons and more, I sincerely thank them.

2002 ANNUAL REPORT

Jerry L. Jordan
President

Deflation

ne of the most remarkable economic developments of the last two decades

has been the overwhelming success of central banks in the industrialized world
at reducing inflation. U.S. inflation, for instance, spiked at over 14 percent in 1980,
but by 2002, the consumer price index had fallen to 2.3 percent, and inflation
worries seemed nowhere to be found. This experience has not been unique to
the United States. The International Monetary Fund’s consumer price index for
industrialized countries peaked in excess of 13 percent in 1980. In sharp contrast,
inflation in the same nations registered 1.7 percent in 2002, an order of magnitude
lower than the pace set two decades earlier.1

Today, however, some fear that central banks risk

and lengthy periods of negative inflation. In our

becoming victims of their own success in the war

final analysis, the macroeconomic impact of negative

against inflation. Deflation has now replaced infla-

inflation hinges on other key aspects of the environ-

tion as the principle concern of many in the central

ment in which deflation arises—particularly price

banking community.

expectations, the return to capital, and the central

In simple terms, deflation is the opposite of inflation;
it describes a persistent decline in the general price

bank’s operating choices.
CORRECTING MISPERCEPTIONS

level or, from another perspective, a persistent

It is important to delineate what we mean by the

increase in the purchasing power of money. In the

term “deflation.” Deflation refers to a persistent

early 1980s, worrying about deflation was some-

decline in the average of a set of prices. Most of us,

thing like worrying about a shortage of pigeons in

of course, don’t observe the average of all prices

Trafalgar Square. But now, with annual inflation

directly, but rather some (typically small) subset of

rates near zero, periodic deflations are much more

prices. Price changes in our particular subset may

plausible. In fact, many analysts take the recent

reflect trends in all prices, or they may signal only

experience of Japan—which is in the midst of a

a change in that subset’s prices relative to all

decade-long period of economic stagnation accom-

others. The distinction is important in our dynamic

panied by a small deflation—as a cautionary

economy, in which some prices are always rising and

example of deflation’s dangers.

some falling in relation to the average price level.

Just how dangerous is deflation? This question
seems especially pertinent in light of modern central
banks’ near-universal commitment to low inflation
and their increasing use of inflation targeting as
an operational framework. If deflation is truly
perilous, how low should inflation targets—formal
or informal—be set? Is it more costly to undershoot
than to overshoot the target?

In an environment where the average rate of price
increase is large, the relative prices of some items
may decline even if the dollar prices of individual
goods or services do not actually fall. The lower the
general inflation rate, however, the more likely it
is that relative price changes will be associated with
some falling prices. It is natural—for producers
especially—to interpret these sorts of declining
prices as deflation. In fact, this situation is no

In this essay, we offer our understanding of deflation

different from the case in which some goods and

and its economic impact. First, we conclude that

services prices rise, but less rapidly than others.

deflation often is associated with economic problems
that are not, in fact, intrinsic to deflation. For that
reason, understanding the true costs of deflation
requires that we isolate the issues that are particular
to negative price-level growth. Furthermore, it is
apparent that small, periodic deflations are not
necessarily problematic, and that deflation can in
fact be compatible with a healthy economy. That
said, we also conclude there is a reasonable case
to be made that central bankers should avoid large

Producer equipment prices provide an interesting
illustration of this point. Figure 1 shows the rates
of absolute and relative price change in equipment
and software investments since 1947. Although
absolute prices have begun to decline recently,
relative price declines have been the rule for most
of the postwar period. This long-term trend reflects
greater technological progress in the production of
durable equipment—a boon to consumers and to
the economy, even if it is sometimes a matter of
2002 ANNUAL REPORT

consternation to the manufacturers of those goods.

1. Most recent data available, 12-month change from October 2001 to October 2002.
7

In addition to clarifying the distinction between

The tax interpretation is useful because it leads

relative price changes and deflation, this example

us to think explicitly in terms of public policy. In

highlights two important themes in our discussion

the production of any good, the “right” amount

of deflation: First, people attribute some economic

satisfies the condition that the marginal cost to the

consequences to deflation when deflation itself

public equals the social marginal cost of producing

is not really the issue. Second, there are circum-

the good. For cash, the social marginal cost of

stances in which deflation can be a characteristic

production is effectively zero; ideally, the cost of

of a healthy economy—namely, during productivity-

holding cash should be minimal as well. This require-

driven booms.

ment is met when the market nominal interest rate
is extremely low. How can central banks engineer

FIGURE 1: ABSOLUTE AND RELATIVE PRICE GROWTH IN EQUIPMENT
AND SOFTWARE

extremely low interest rates? Think of the nominal
interest rate as the sum of the real return to saving

Percent change
15

and the expected inflation rate. Because the real

Absolute price growth

return is usually positive, a very low nominal

interest rate can be achieved only if the rate of
5

decline in the price level matches the size of the
real interest rate. In short, the optimal rate of change

in the price level is negative—that is, deflation.
–5
Relative price growth

–10
1947

1952

1957

1962

1967

1972

1977

1982

1987

This particular justification for deflation is so
1992

1997

2002

SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis.

prominent in monetary theory that it has a special
name, the Friedman rule. To be sure, there are
respectable counterarguments to this rule; in fact, we

T H E C A S E F O R D E F L AT I O N

What is the most desirable rate of inflation?
According to economic theory, a common answer
is not “low,” or “zero,” but negative. In other words,
in many cases economic theory implies that deflation
is preferable to inflation, even to zero inflation.

of many economic models, and it remains the
benchmark for discussing the “appropriate” rate
of inflation. Why, then, do so many people blanch
at the thought of deflation? And why do we not
observe the Friedman rule in guiding the behavior
of the world’s central banks? Why would we, in

consisted of nothing but cash. The opportunity cost

fact, hesitate to suggest that the Friedman rule

of holding cash is the market interest rate—the

guide the course of U.S. monetary policy?

the form of cash instead of an interest-bearing
bank account or a mutual fund. The higher the
interest rate, the greater the incentive not to hold
FEDERAL RESERVE BANK OF CLEVELAND

rule has proven to be a remarkably resilient property

The reasoning is fairly intuitive: Suppose that money

return that people forgo by holding their funds in

will present one later in this essay. But the Friedman

cash. In other words, high nominal interest rates
act as an implicit tax on economic activities that
require currency.

H I S T O RY C O N F R O N T S E C O N O M I C T H E O RY

The difference between the Great Depression

World economic history provides some pretty good

and this earlier period, of course, is more than the

clues as to why the prospect of deflation makes

magnitude of the price declines—the environments

central bankers nervous. In their monumental

in which the price contractions occurred were

work A Monetary History of the United States,

completely different. The last half of the nineteenth

1867–1960, Milton Friedman and Anna Jacobson

century experienced what has become known

Schwartz observe that every significant real output

as a “growth deflation.” Textbooks roughly define

decline in the United States has been associated

inflation as “too much money chasing too few goods.”

with deflation. The most notorious episode, of

Growth deflation, however, can be thought of as a

course, is the Great Depression: Between 1929

situation in which too little money is chasing too

and 1933, the price level fell 24 percent (roughly

many goods. During periods of rapid technological

5 percent per year), while real GDP fell nearly

progress, output may expand quicker than the

40 percent (table 1). Furthermore, both output and

money supply, causing the price level to decline.

prices remained below their 1929 levels for the rest

The purchasing power of money increases, allowing

of the decade. Considering that the United Kingdom,

people to buy more goods and services. By contrast,

Germany, and France simultaneously experienced

deficient money supply and the resulting price

significant output declines and deflation, central

declines that occurred during the Great Depression

bankers’ intense concern with deflation today is

hardly can be described as growth deflation.

at least partly an outgrowth of this broad historical
TABLE 1: OUTPUT, PRICES, AND WAGES DURING THE GREAT DEPRESSION

perspective.
Although the weight of professional opinion favors
the idea that deflation played a central role in
the Great Depression, the claim that price deflation
was the initial cause is less obvious. The sharp
initial decline in output that occurred in 1929–30
(13.1 percent) was accompanied by almost no price
movement (table 1). If anything, the output data
tend to lead the price data. Nevertheless, as we will

1929

1930

1931

1932

1933

Real GDP

100

86.9

77.6

64.0

60.9

GDP deflator

100

97.5

88.5

79.5

77.5

Nominal wage, manufacturing

100

99.1

94.1

83.5

79.9

Real wage, manufacturing

100

102.1

106.8

106.5

104.2

Real wage, nonmanufacturing, nonmining

100

98.6

96.9

92.4

85.6

NOTE: Data are indexed to 1929 values.
SOURCE: Harold L. Cole and Lee E. Ohanian, “Re-Examining the Contributions of Money and Banking
Shocks to the U.S. Great Depression,” in NBER Macroeconomics Annual 2000, edited by Ben Bernanke
and Kenneth Rogoff (Cambridge, Mass.: MIT Press, 2001).

point out later, the magnitude of the deflation may
magnitude and severity of the economic contraction.

Rather than exhuming the bodies of history, why
not consider a few contemporary cases? Japan,

Even if we grant that deflation was a central cause

still struggling through a decade-long period of

of the Great Depression, we should not forget the

subpar growth, is cited most often in the case

positive experiences the United States and other

against deflation. From 1992 through 2001, that

countries have had during periods of mild deflation.

nation’s real GDP growth averaged a mere 1 percent

For example, from 1880 to 1896, the wholesale price

per year. The price level fell at an average rate of

level in the United States fell 30 percent—nearly

about 1/2 percent per year during that period, and,

2 percent per year. Far from being a period of gloom

by the beginning of 2003, Japan’s economy had

and doom, this deflation accompanied a period of

experienced deflation in four of the previous five

relative prosperity: Real income increased 85 percent

years (table 2).

over this time span, nearly 5 percent per year.

2. Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States 1867 – 1960 (Princeton, N.J.: Princeton
University Press, 1963).

2002 ANNUAL REPORT

have played an important role in determining the

3. For a discussion of this period in the United States and Canada, see Michael D. Bordo and Angela Redish, “Is Deflation Depressing?
Evidence from the Classical Gold Standard,” National Bureau of Economic Research, working paper no. w9520, March 2003.
9

How prominent a role does deflation play in the

concerned about deflation? To answer these ques-

explanation of Japan’s poor economic performance?

tions, it is necessary to look more closely at some of

Although that country’s economic malaise appears

the causal mechanisms that economists offer to

to have been triggered by other factors (such as

explain how deflation contributes to output

a malfunctioning banking system), many analysts

declines. We will find that, in hindsight, the prob-

believe mild deflation has inhibited its recovery.

lems that have been attributed to deflation are, in

This interpretation is reinforced by the seeming

many instances—most instances, perhaps—the

impotence of monetary policy—with nominal

result of phenomena that are distinct from or not

interest rates near zero—to reignite the economy.

confined to deflation.

TABLE 2: OUTPUT AND PRICES IN CHINA, 1990 – 2002 (percent change)
1990

1991

1992

1993

Real GNP

4.2

9.1

14.1

13.1

General retail price index

2.1

3.0

5.3

13.0

1994

1995

1996

1997

1998

1999

2000

2001

2002

12.6

9.0

9.8

8.6

7.8

7.2

8.4

7.0

n.a.

21.7

14.8

6.1

0.7

– 2.5

– 3.0

–1.5

– 0.8

–1.3

1995

1996

1997

1998

1999

2000

2001

2002

TABLE 3: OUTPUT AND PRICES IN JAPAN, 1990 – 2002 (percent change)
1990

1991

1992

1993

1994

Real GDP

5.2

3.3

0.9

0.4

1.0

1.9

3.6

1.8

–1.2

0.2

2.1

0.8

0.6

Consumer price index

3.1

3.3

1.7

1.3

0.7

– 0.1

0.1

1.7

0.7

– 0.3

– 0.7

– 0.8

– 0.9

SOURCES: China National Bureau of Statistics; China State Statistical Bureau; Japan Cabinet Office; Japan Ministry of Public Management, Home Affairs, Posts, and
Telecommunications; and Haver Analytics.

But the very visible example of Japan may have
overshadowed a neighboring counterexample. Those

Take, for example, the idea that nominal wages

who believe that deflation is everywhere and always

are downwardly rigid. This notion has a long history

associated with recession must account for the

in macroeconomic analysis, appearing in John

situation in the People’s Republic of China, where

Maynard Keynes’ 1936 analysis of the business cycle

real GDP has been growing between 6 percent and

(which was itself motivated by the experience of the

8 percent per annum for several years, despite

Great Depression). Clearly, deflation is problematic

deflation (table 3).

in such an environment. If employers cannot reduce

As we will see, the contrasts between Japan and
China—a struggling, mature economy versus a
robust, developing country with a relatively small
capital stock (hence, high return to investment)—

FEDERAL RESERVE BANK OF CLEVELAND

D E F L AT I O N A N D T H E L A B O R M A R K E T

nominal wages, even when prices are falling, the
relative cost of labor will increase and firms will
respond by using fewer workers—with the attendant
effect of income and production losses.

are central to our assessment of the impact of

But the problems associated with downwardly

falling prices. At this point, however, several

rigid dollar wages are not confined to deflationary

questions remain: To the extent that deflation

environments. Everyone’s wages do not move in

may emerge at some point in the United States,

tandem. Keeping labor markets in balance requires

which experiences provide a better reference point,

that workers’ wages continuously rise and fall in

the United States of the 1880s or the 1930s, China,

relation to one another, regardless of the overall

or Japan today? When should central bankers be

inflation rate. Even when inflation is positive,
changes in labor markets may require actual wage
reductions for some workers. If employees are
unwilling to accept nominal wage cuts, then their
relative wages will increase, resulting in some

4. John Maynard Keynes, The General Theory of Employment, Interest and Money (New York: Harcourt Brace, 1964), p. 232.
10

employment loss. Lower inflation obviously increases

A similar story holds true for net-debtor house-

the number of workers affected by downwardly

holds: A shock that weakens these consumers’

sticky nominal wages—and perhaps the magnitude

net worth positions will impair their ability to

matters—but deflation does not change the nature

service their existing debt burdens and borrow for

of the problem. It is reasonable to suppose that

additional consumption. Conventional textbook

the economic disruptions are nearly as large at low

macroeconomics points to a subsequent decline in

positive inflation rates as they would be at small

consumer spending as a source of output decline.

deflation rates.

More sophisticated treatments, however, might look

In any case, nominal wages may not be as downwardly sticky as one might suspect, especially
in situations where the economic burden of not
adjusting nominal payments is particularly high.
Evidence indicates that during the Great Depression,
for example, nominal wages did decline. One recent

to a surge in bankruptcies and more restrictive
borrowing constraints as a drag on growth because
of the associated reduction in productive financial
intermediation. In either case, the health of private
balance sheets is an essential component of macroeconomic fortunes.

study suggests that during the Depression, the

How might deflation affect the balance sheets of

aggregate real wage actually decreased 3 percent,

businesses and consumers? In short, by inducing

implying that nominal wages fell more than the

a redistribution of wealth from debtors to creditors.

Falling prices imply an increase in the real debt

price level.

burden of firms and households, weakening their
D I S T I N G U I S H I N G D E F L AT I O N
F R O M D I S I N F L AT I O N

The tendency to blame deflation for economic
distress extends as much—or more —to capital

financial condition and reducing the prospects for
sustaining the pace of economic activities that rely
on access to credit markets.

markets. In 1933, the famous economist Irving Fisher

But the debt-deflation problem we’ve just described

proposed an explanation known as “debt-deflation”

is not unique to episodes during which the general

as the root cause of the Great Depression. Modern

price level literally falls. It is also a problem when

versions of the debt-deflation story begin with the

the rate of price-level change is below people’s

observation that firms typically rely on external

expectations. If borrowers and lenders expect the

funds to finance current operations and investment

price level to march upward 10 percent per year

spending, and the cost of these funds is inversely

(10 percent inflation), then a decline in the actual

related to the firm’s position on its balance sheet.

pace of price change to 5 percent (5 percent inflation)

Firms with substantial positive net worth can obtain

will distribute wealth away from borrowers and

financing at a low cost, while the converse is true

toward lenders. Unanticipated disinflation in the

of firms with weak asset positions. Shocks that

early 1980s and again in the early 1990s created just

redistribute wealth away from firms may impede

such a situation. In this respect, the effect of a drop

their ability to borrow and invest, creating a barrier

in the inflation rate from 10 percent to 5 percent

to productive activity that contributes to overall

is the same as if the price level unexpectedly fell

economic weakness.

5 percent (5 percent deflation) when everyone
expected it to remain constant (zero inflation).
Thus, the burden that deflation places on debtors
from the deflation itself.

5. Harold L. Cole and Lee E. Ohanian, “Re-Examining the Contributions of Money and Banking Shocks to the U.S. Great Depression,”
in NBER Macroeconomics Annual 2000, edited by Ben Bernanke and Kenneth Rogoff (Cambridge, Mass.: MIT Press, 2001).

2002 ANNUAL REPORT

stems from the fact that it is unanticipated, not

6. Irving Fisher, “The Debt-Deflation Theory of Great Depressions,” Econometrica, vol. 1, no. 4 (1933), pp. 337–57.
11

T H E C A S E A G A I N S T D E F L AT I O N

rates can only move higher. This short-circuits

To this point, it may seem that we are reluctant

the natural market processes that, under normal

to ascribe any negative effects at all to deflation.

circumstances, would push real interest rates even

Thus far, we have not identified a set of economic

lower. Rising real interest rates, engendered by

links through which deflation could pose a unique

growing deflationary expectations at the zero

macroeconomic risk. In our examples, deflation

nominal interest rate bound, are the exact opposite

is inappropriately blamed because (1) it coincides

of what the doctor would order in times of economic

with events that actually have little or nothing

stress. Now the only way that real interest rates

to do with deflation (relative price movements);

can be made to fall—thus spurring the market

(2) complications arise from institutional features

forces that contribute to a rebound in economic

that are not unique to deflation (as in downward

activity—is for the central bank to credibly

inflexibility of wages); or (3) output losses following

engineer future inflation.

from unanticipated disinflation (a class of pricechange outcomes in which deflation has no special
status). Do any circumstances remain in which
a perfectly anticipated, reasonably stable rate of
deflation might pose a problem? Yes.
Recall that the nominal market interest rates we

The central bank’s inability to lower nominal
rates that already reside at zero, along with the
implications for real rates if deflationary pressures
continued to build, is the strongest case against
policies that engineer (or allow) persistently negative
inflation rates. But just how strong a case is it?

observe have two components: a real return to
saving and an adjustment for the expected rate of
price change. If the anticipated deflation rate is large
enough and the real return to saving low enough,
then nominal rates might plunge toward zero, and
may even be “pressed” against that floor. This
result, many believe, could create an undesirable
7

macroeconomic outcome.

The large deflation of the Depression occurred
because the (relatively inexperienced) Federal Reserve
allowed the money supply to contract. This deflation
was long enough and severe enough that it became
embedded in people’s expectations, and thus in
nominal interest rates. Separately, the real interest

If nominal interest rates fall to zero, the symmetry

rate—or the real return to capital—was also low

between inflation and deflation may break down.

because of forces that were depressing economic

There is, presumably, no upper bound on nominal

activity. Because the nominal interest rate is the sum

interest rates, but there is a lower bound: They

of the real component and (in this case) a negative

cannot fall below zero. If the nominal interest rate

“premium” for expected deflation, short-term

were negative, no one would bother to hold the

nominal interest rates were near zero during most

usual interest-bearing assets because the return from

of the Depression.

simply putting money under the mattress would
be greater. Obviously, once nominal interest rates
FEDERAL RESERVE BANK OF CLEVELAND

Z E R O I N T E R E S T R AT E S
AND THE LIQUIDITY TRAP

reach the zero bound, the central bank’s capacity
to reduce that rate is gone. Worse yet, once the
nominal interest rate is zero, expectations of additional deflationary pressure mean that real interest

If low real interest rates and deflationary monetary
policy contributed to the problem, why not simply
expand the money supply, reversing the forces
that set the wheels in motion in the first place?
Unfortunately, this is a situation in which the normal
processes don’t necessarily work. The problem is
that the increased money supply may have trouble
finding its way out of banks and into the economy,

7. While the Friedman rule suggests that nominal interest rates should be very low, this analysis suggests that actually reducing
them to zero could be problematic.
12

THE CRUX OF THE PROBLEM

thereby preventing “reflation.” Some observers
maintain that Japan has been pursuing what it

The practical relevance of the liquidity trap is a

regards as an aggressively expansionary monetary

matter of considerable debate among economists

policy for the past two years, but to no avail, because

and policymakers, and central banks have little

its approach has been too conventional. Although

experience with zero nominal interest rates. This

nonstandard tactics might be more successful, their

brings us back to the central question posed earlier

very idiosyncrasies illustrate why a central bank

in this essay: How dangerous is deflation? Should

might be reluctant to try them. The challenge is to

we view it in light of the experience of the United

find ways for the increased money supply to move

States during the 1880s or China today? Or should

out of the banking system and into the economy.

This problem may arise because, when the interest

we think of it more in the light of the United States
during the 1930s and Japan today?

rate is zero, interest-bearing assets and money are

Perhaps the answer to these questions is “all of the

nearly indistinguishable. Even if the central bank

above.” The liquidity trap is not typically a problem

created more money, commercial banks would not

in times of optimism and rapid growth. The key is

necessarily lend this money. Banks could simply

the real interest rate: In good times, the productivity

hold the money as reserves and earn the same

of capital is rising and the demand for funds to

return as if they loaned the money to those seeking

finance consumption and investment is high. In bad

to finance investment projects and consumption.

times, the opposite is true. Accordingly, real interest

This condition, or one like it, is sometimes referred

rates tend to rise during good times and fall during

to as the “liquidity trap.”

The only way for a central bank to get out of a
liquidity trap, it seems, is to promise to significantly
expand the money supply both today and in the

bad times. To the extent that zero nominal interest
rates and liquidity traps represent the real dangers
of deflation, the problems are most likely to occur
in times of economic distress.

future —and to deliver on that promise. With

Deflation alone—even anticipated deflation—does

enough monetary expansion, some of this money

not necessarily imply zero nominal interest rates

eventually will find its way into the economy,

and liquidity traps, provided the real interest rate

increasing inflationary expectations and, in turn,

is sufficiently positive (the normal state of affairs).

nominal interest rates. This instrument is very blunt,

In some sense, then, we have come full circle: There

however, and fine-tuning inflation expectations is

is nothing special about deflation in and of itself.

extremely difficult even in the best of times. Over-

The greater and more anticipated the pace of price-

shooting is likely, and the cost of this inflationary

level decline, the greater the chance that we will

policy may be the central bank’s hard-won credibility.

find ourselves with a problem. Again, however,
the danger is not deflation itself, but the liquidity
traps that might arise when nominal interest rates

8. Bennett McCallum discusses several nonstandard approaches in his paper “Japanese Monetary Policy, 1991–2001,” Federal
Reserve Bank of Richmond Economic Quarterly, vol. 89, no. 1 (2003), pp. 1–32.
9. Federal Reserve Governor Ben Bernanke suggests several ways that a central bank could operate if short-run policy rates hit
zero. See “Deflation: Making Sure it ‘It’ Doesn’t Happen Here,” remarks before the National Economists’ Club, Washington D.C.,
November 21, 2002, available at http://www.federalreserve.gov/boarddocs/speeches/2002/ 20021121/default.htm.

2002 ANNUAL REPORT

approach zero.

10. A formal model in which low nominal interest rates can dampen economic activity by reducing the level of financial intermediation can be found in Bruce Smith, “Taking Intermediation Seriously,” Journal of Money, Credit, and Banking, forthcoming.
13

CONCLUSION

Other economists contend, however, that such a

It seems certain to us that a good deal of deflation

solution is unnecessarily restrictive. Should a few

angst is misplaced. Some businessmen mistakenly

bad deflation experiences make central banks wary

fear deflation when it is only the relative prices

of any growth deflation? How strong is the evidence

of the goods or services they produce that are

that small deflations are harmful, especially if the

declining. Second, some of the disruptions attributed

central bank can credibly commit to ensuring these

to deflation arise, not because the price level is

episodes are short-lived? Should central banks avoid

actually falling, but because prices are rising more

targeting near-zero inflation rates simply because

slowly than was anticipated. Unexpectedly low

doing so inevitably implies the actual inflation rate

inflation raises the debt burdens of borrowers

occasionally may be negative?

and the real labor costs to employers as much as
unexpected deflation. Clearly, each of these effects
can have a negative influence on aggregate economic
activity, but they arise from the unanticipated
nature of the price event, not deflation itself.

Positions in this debate obviously depend on one’s
view of how desirable deflation is in normal times,
how dangerous one thinks liquidity traps are, and
how quickly and credibly one believes central banks
can act to avoid them. Countries whose central

One of our goals in this essay has been to highlight

banks have explicit inflation targets already have

situations in which deflation has been confounded

had to decide whether to include zero in their target

with other circumstances and effects. We do so, not

ranges and under what circumstances, if any,

to argue that deflation is always innocuous, but to

deflation is acceptable. In the United States, more

focus the discussion on the problems that are truly

attention is being paid to the desirability of inflation

unique to negative rates of inflation. We conclude

targeting and the setting of explicit, transparent

that deflation is not everywhere and always some-

goals for monetary policy. Because participants in

thing to be feared and avoided. Nevertheless, we

that discussion must come to terms with deflation,

recognize that central bankers must be wary of

we hope this essay plays a constructive role in

circumstances in which nominal interest rates

shaping the future course of U.S. monetary policy.

approach the zero bound.
We find that we are left with more questions than
answers. If the implications of deflation differ with
the context, should monetary policy be tailored to
the specific types of deflation? Or is a one-size-fitsall policy approach the better alternative? In either
case, what might the policy regimes look like?
Many economists believe so strongly that liquidity
traps threaten the economy that they want central
FEDERAL RESERVE BANK OF CLEVELAND

banks to avoid the zero interest rate bound altogether.

Consequently, they advocate gearing policy to
always avoid deflation—and even zero inflation as
a further cushion. These supporters claim it is best
to commit to low but positive inflation rates.

11. See, for example, Federal Reserve Governor Ben Bernanke’s speech, “A Perspective on Inflation Targeting,” presented at the
Annual Washington Policy Conference of the National Association of Business Economists, Washington, D.C., March 25, 2003,
available at http://www.federalreserve.gov/boarddocs/speeches/2003/20030325/default.htm.

FINANCIAL CONTENTS

Management’s Report on Responsibility for Financial Reporting

Report of Independent Accountants on Financial Reporting

Report of Independent Accountants on Financial Statements

Comparative Financial Statements

Notes to Financial Statements

M A N A G E M E N T ’ S R E P O RT O N R E S P O N S I B I L I T Y F O R F I N A N C I A L R E P O RT I N G

March 5, 2003
To the Board of Directors of the Federal Reserve Bank of Cleveland:
The management of the Federal Reserve Bank of Cleveland (“FRBC”) is responsible for the preparation
and fair presentation of the Statement of Financial Condition, Statement of Income, and Statement
of Changes in Capital as of December 31, 2002 (the “Financial Statements”). The Financial Statements
have been prepared in conformity with the accounting principles, policies, and practices established
by the Board of Governors of the Federal Reserve System and as set forth in the Financial Accounting
Manual for the Federal Reserve Banks (“Manual”), and as such, include amounts, some of which are
based on judgments and estimates of management. To our knowledge, the Financial Statements are,
in all material respects, fairly presented in conformity with the accounting principles, policies and
practices documented in the Manual and include all disclosures necessary for such fair presentation.
The management of the Federal Reserve Bank of Cleveland is responsible for maintaining an effective
process of internal controls over financial reporting including the safeguarding of assets as they relate
to the Financial Statements. Such internal controls are designed to provide reasonable assurance to
management and to the Board of Directors regarding the preparation of reliable Financial Statements.
This process of internal controls contains self-monitoring mechanisms, including, but not limited to,
divisions of responsibility and a code of conduct. Once identified, any material deficiencies in the
process of internal controls are reported to management, and appropriate corrective measures are
implemented.
Even an effective process of internal controls, no matter how well designed, has inherent limitations,
including the possibility of human error, and therefore can provide only reasonable assurance with
respect to the preparation of reliable financial statements.
The management of the Federal Reserve Bank of Cleveland assessed its process of internal controls over
financial reporting including the safeguarding of assets reflected in the Financial Statements, based upon
the criteria established in the “Internal Control–Integrated Framework” issued by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment, we believe
that the Federal Reserve Bank of Cleveland maintained an effective process of internal controls over

President and Chief Executive Officer
Federal Reserve Bank of Cleveland

Senior Vice President and Chief Financial Officer
Federal Reserve Bank of Cleveland

2002 ANNUAL REPORT

financial reporting including the safeguarding of assets as they relate to the Financial Statements.

R E P O RT O F I N D E P E N D E N T A C C O U N TA N T S O N F I N A N C I A L R E P O RT I N G

PricewaterhouseCoopers L.L.P.

To the Board of Directors of the Federal Reserve Bank of Cleveland:
We have examined management’s assertion that the Federal Reserve Bank of Cleveland (“FRB Cleveland”)
maintained effective internal control over financial reporting and the safeguarding of assets as they
relate to the financial statements as of December 31, 2002, based on criteria described in “Internal
Control–Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway
Commission included in the accompanying Management’s Assertion. FRB Cleveland’s management
is responsible for maintaining effective internal control over financial reporting and the safeguarding
of assets as they relate to the financial statements. Our responsibility is to express an opinion on the
assertion based on our examination.
Our examination was conducted in accordance with attestation standards established by the American
Institute of Certified Public Accountants, and accordingly, included obtaining an understanding of the
internal control over financial reporting, testing, and evaluating the design and operating effectiveness
of the internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our examination provides a reasonable basis for our opinion.
Because of inherent limitations in any internal control, misstatements due to error or fraud may occur
and not be detected. Also, projections of any evaluation of the internal control over financial reporting
to future periods are subject to the risk that the internal control may become inadequate because of
changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assertion that the FRB Cleveland maintained effective internal control
over financial reporting and over the safeguarding of assets as they relate to the financial statements
as of December 31, 2002, is fairly stated, in all material respects, based on criteria described in
“Internal Control–Integrated Framework” issued by the Committee of Sponsoring Organizations of

FEDERAL RESERVE BANK OF CLEVELAND

the Treadway Commission.

March 3, 2003
Cleveland, Ohio

R E P O RT O F I N D E P E N D E N T A C C O U N TA N T S O N F I N A N C I A L S TAT E M E N T S

PricewaterhouseCoopers L.L.P.

To the Board Governors of the Federal Reserve System
and the Board of Directors of the Federal Reserve Bank of Cleveland:
We have audited the accompanying statements of condition of the Federal Reserve Bank of Cleveland
(the “Bank”) as of December 31, 2002 and 2001, and the related statements of income and changes in
capital for the years then ended, which have been prepared in conformity with the accounting principles,
policies, and practices established by the Board of Governors of the Federal Reserve System. These
financial statements are the responsibility of the Bank’s management. Our responsibility is to express
an opinion on the financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States
of America. 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 audits provide
a reasonable basis for our opinion.
As discussed in Note 3, the 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 accounting
principles generally accepted in the United States.
In our opinion, the financial statements referred to above present fairly, in all material respects, the
financial position of the Bank as of December 31, 2002 and 2001, and results of its operations for the
years then ended, in conformity with the basis of accounting described in Note 3.

2002 ANNUAL REPORT

March 3, 2003
Cleveland, Ohio

Comparative Financial Statements

S TAT E M E N T S
OF CONDITION

As of December 31, 2002

As of December 31, 2001

(in millions)

ASSETS

Gold certificates
Special drawing rights certificates
Coin

522
104

538
104

764

219

35,264

32,885

1,531

996

Accrued interest receivable

301

334

Bank premises and equipment, net

182

181

$ 38,775

$ 35,380

$ 28,170

$ 30,620

1,164

—

1,393

1,103

685

224

5,818

2,008

Items in process of collection
U.S. government and federal agency securities, net
Investments denominated in foreign currencies

Other assets
Total assets

L I A B I L I T I E S A N D C A P I TA L

Liabilities:
Federal Reserve notes outstanding, net
Securities sold under agreements to repurchase
Deposits:
Depository institutions
Other deposits
Deferred credit items
Interest on Federal Reserve notes due U.S. Treasury

FEDERAL RESERVE BANK OF CLEVELAND

Interdistrict settlement account

Accrued benefit costs
Other liabilities

$ 37,371

$ 34,050

Capital paid-in

702

665

Surplus

702

665

1,404

1,330

$ 38,775

$ 35,380

Total liabilities

Capital:

Total capital
Total liabilities and capital

The accompanying notes are an integral part of these financial statements.

S TAT E M E N T S
OF INCOME
(in millions)

For the year ended
December 31, 2002

For the year ended
December 31, 2001

$ 1,410

$ 1,708

Interest income:
Interest on U.S. government and federal agency securities
Interest on investments denominated in foreign currencies
Interest on loans to depository institutions
Total interest income

—

1,434

1,731

—

1,433

1,731

Interest expense:
Interest expense on securities sold under agreements to repurchase
Net interest income

Other operating income (loss):
Income from services
Reimbursable services to government agencies

194

(98)

U.S. government securities gains, net

Other income

Foreign currency gains (losses), net

Total other operating income

294

Operating expenses:
Salaries and other benefits

Occupancy expense

Equipment expense

Assessments by Board of Governors

Other expenses

196

200

$ 1,531

$ 1,544

Total operating expenses

Net income prior to distribution
Distribution of net income:
Dividends paid to member banks
Transferred to surplus

193

1,452

1,321

$ 1,531

$ 1,544

Payments to U.S. Treasury as interest on Federal Reserve notes
Total distribution

S TAT E M E N T S O F
CHANGES IN CAPITAL
For the years ended December 31, 2002 and December 31, 2001
Capital paid-in

Balance at January 1, 2001 (9.4 million shares)

Net income transferred to surplus

—

Net change in capital stock issued (3.9 million shares)
Balance at December 31, 2001 (13.3 million shares)

472

Surplus

193

193
$

665

472

Total capital

944
193

—

193

665

$ 1,330

Net income transferred to surplus

—

Net change in capital stock issued (0.7 million shares)

—

702

$ 1,404

Balance at December 31, 2002 (14 million shares)

702

2002 ANNUAL REPORT

(in millions)

The accompanying notes are an integral part of these financial statements.
21

Notes to Financial Statements

1. STRUCTURE
The Federal Reserve Bank of Cleveland (“Bank”) is 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 System consists of the Board of Governors of the Federal Reserve System (“Board of Governors”) and twelve Federal Reserve Banks (“Reserve Banks”).
The Reserve Banks are chartered by the federal government and possess a unique set of governmental, corporate, and central bank characteristics. The Bank and its branches in Cincinnati and
Pittsburgh serve the Fourth Federal Reserve District, which includes Ohio and a portion of Kentucky, Pennsylvania, and West Virginia. Other major elements of the System are 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. 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.
Board of Directors
In accordance with the Federal Reserve Act, supervision and control of the Bank are exercised by a Board of Directors. 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.
2 . O P E R AT I O N S A N D S E RV I C E S
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 (“ACH”) operations and check processing; distributing coin and currency; performing 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 and state member banks; and administering other regulations of the Board of Governors. The Board of Governors’
operating costs are funded through assessments on the Reserve Banks.
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 securities, matched sale-purchase transactions, the purchase of securities under agreements to resell, the sale of securities under agreements
to repurchase, and the lending of U.S. government securities. The FRBNY is also authorized by the FOMC to hold balances of, and to execute spot and forward foreign exchange (“F/X”) and securities
contracts in nine 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.

FEDERAL RESERVE BANK OF CLEVELAND

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 accounting
principles generally accepted in the United States of America (“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
generally required by GAAP. In addition, the Bank has elected not to present a Statement of Cash Flows. The Statement of Cash Flows has not been included as the liquidity and cash position of the
Bank are not of primary concern to the users of these financial statements. Other information regarding the Bank’s activities is provided in, or may be derived from, the Statements of Condition,
Income, and Changes in Capital. Therefore, a Statement of Cash Flows would not provide any additional useful information. There are no other significant differences between the policies outlined
in the Financial Accounting Manual and GAAP.
Effective January 2001, the System implemented procedures to eliminate the sharing of costs by Reserve Banks for certain services a Reserve Bank may provide on behalf of the System. Major
services provided for the System by the Bank, for which the costs were not redistributed to the other Reserve Banks, include: Retail Payment Office, Savings Bonds Software, Check Standardization
Project, Cash Materials Handling Software, Audit Application Competency Center, and Electronic Access Products.
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, 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 accounts are lowered. The value of gold for purposes of backing the gold certificates is set by law at $42 2/9 a fine troy ounce. The Board of
Governors allocates the gold certificates among Reserve Banks once a year based upon average Federal Reserve notes outstanding in each District.

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 United States 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 accounts are 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. At the time SDR transactions occur, the Board of Governors allocates
SDR certificate transactions among Reserve Banks based upon Federal Reserve notes outstanding in each District at the end of the preceding year. There were no SDR transactions in 2002.
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 loans were ever deemed to be
uncollectible, an appropriate reserve would be established. Interest is accrued using 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 Governors. Reserve Banks retain the option to impose a surcharge above the basic rate in certain circumstances. There were no outstanding
loans to depository institutions at December 31, 2002 and 2001.
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 to meet other needs specified by the FOMC in carrying out the System’s central bank responsibilities. Such authorizations are
reviewed and approved annually by the FOMC.
In December 2002, the FRBNY replaced matched sale-purchase (“MSP”) transactions with securities sold under agreements to repurchase. MSP transactions, accounted for as separate sale
and purchase transactions, are transactions in which the FRBNY sells a security and buys it back at the rate specified at the commencement of the transaction. Securities sold under agreements
to repurchase are treated as secured borrowing transactions with the associated interest expense recognized over the life of the transaction.
The FRBNY has sole authorization 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 on behalf of the System, 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 FRBNY to take possession of collateral in excess of the market values of the securities loaned. The market values of the
collateral and the securities loaned are monitored by FRBNY on a daily basis, with additional collateral obtained as necessary. The securities loaned continue to be accounted for in the SOMA.
F/X 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 two 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 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 FRBNY 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 which contain varying degrees of off-balance sheet 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.

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 and federal
agency securities” or “Interest on investments denominated in 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 “U.S. government securities gains, net.” Foreign-currency-denominated assets are revalued daily at current foreign currency 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 daily, with the unrealized gain or loss reported by the FRBNY as a
component of “Other assets” or “Other liabilities,” as appropriate.
Balances of U.S. government and federal agency securities bought outright, securities sold under agreements to repurchase, securities loaned, investments denominated in foreign currency,
interest income and expense, securities lending fee income, amortization of premiums and discounts on securities bought outright, gains and losses on sales of securities, and realized and
unrealized gains and losses on investments denominated in foreign currencies, excluding those held under an F/X swap arrangement, are allocated to each Reserve Bank. Income from
securities lending transactions undertaken by the FRBNY are also allocated to each Reserve Bank. Securities purchased under agreements to resell and unrealized gains and losses on the
revaluation of foreign currency holdings under F/X swaps and warehousing arrangements are allocated to the FRBNY and not to other Reserve Banks.

2002 ANNUAL REPORT

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. Decisions regarding the securities and foreign currencies transactions, including their purchase and sale, are motivated by monetary policy objectives rather than profit.
Accordingly, market values, 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.

e. Bank Premises, Equipment, and Software
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 two to fifty
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. Costs incurred for software, either developed internally or acquired for internal use, during the application development stage are capitalized based on the
cost of direct services and materials associated with designing, coding, installing, or testing software.
f. Interdistrict Settlement Account
At the close of business each day, all Reserve Banks and branches assemble the payments due to or from other Reserve Banks and branches as a result of transactions involving accounts
residing in other Districts that occurred during the day’s operations. Such transactions may include funds settlement, check clearing and ACH operations, and allocations of shared expenses.
The cumulative net amount due to or from other Reserve Banks is reported as the “Interdistrict settlement account.”
g. Federal Reserve Notes
Federal Reserve notes are the circulating currency of the United States. These notes are issued through the various Federal Reserve agents (the Chairman of the Board of Directors of each
Reserve Bank) 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 federal agency securities, securities purchased under
agreements to resell, loans to depository institutions, 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, and securities purchased
under agreements to resell, which are valued at the contract amount. The par value of securities pledged for securities sold under agreements to repurchase is similarly deducted. The Board of
Governors may, at any time, call upon a Reserve Bank for additional security to adequately collateralize the Federal Reserve notes. The Reserve Banks have entered into an agreement which
provides for certain assets of the Reserve Banks to be jointly pledged as collateral for the Federal Reserve notes of all Reserve Banks in order to satisfy their obligation of providing sufficient
collateral for outstanding Federal Reserve notes. 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 United States government.
The “Federal Reserve notes outstanding, net” account represents the Bank’s Federal Reserve notes outstanding, reduced by its currency holdings of $4,417 million and $4,316 million at
December 31, 2002 and 2001, respectively.
h. Capital Paid-in
The Federal Reserve Act requires that each member bank subscribe to the capital stock of the Reserve Bank in an amount equal to 6 percent of the capital and surplus of the member bank.
As a member bank’s capital and surplus 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 percent 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.
i. 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. Pursuant to Section 16 of the Federal Reserve Act, 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.
In the event of losses or a substantial increase in capital, payments to the U.S. Treasury are suspended until such losses are recovered through subsequent earnings. Weekly payments to the
U.S. Treasury may vary significantly.
j. Income and Costs Related to Treasury Services
The Bank is required by the Federal Reserve Act to serve as fiscal agent and depository of the United States. By statute, the Department of the Treasury is permitted, but not required, to pay
for these services.

FEDERAL RESERVE BANK OF CLEVELAND

k. Taxes
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.”

4. U.S. GOVERNMENT AND FEDERAL AGENC Y SECURITIES
Securities bought outright are held in the SOMA at the FRBNY. An undivided interest in SOMA activity and the related premiums, discounts, and income, with the exception of securities purchased
under agreements to resell, is allocated to each Reserve Bank on a percentage basis derived from an annual settlement of interdistrict clearings. The settlement, performed in April of each year,
equalizes Reserve Bank gold certificate holdings to Federal Reserve notes outstanding. The Bank’s allocated share of SOMA balances was approximately 5.517 percent and 5.854 percent at
December 31, 2002 and 2001, respectively.
The Bank’s allocated share of securities held in the SOMA at December 31, that were bought outright, was as follows (in millions):
2002
Par value:
Federal agency
U.S. government:
Bills
Notes
Bonds
Total par value

Unamortized premiums
Unaccreted discounts
Total allocated to Bank

2001
$

12,507
16,436
5,784
34,728

10,659
15,569
6,069
32,298

594
(58)

662
(75)

35,264

32,885

Total SOMA securities bought outright were $639,125 million and $561,701 million at December 31, 2002 and 2001, respectively.
The maturity distribution of U.S. government and federal agency securities bought outright, which were allocated to the Bank at December 31, 2002, was as follows (in millions):
Maturities of Securities Held
Within 15 days
16 days to 90 days
91 days to 1 year
Over 1 year to 5 years
Over 5 years to 10 years
Over 10 years
Total

U.S. government securities

Par value
Federal agency obligations

1,514
8,509
7,826
9,532
2,941
4,405
34,727

—
—
1
—
—
—
1

Total
$

1,514
8,509
7,827
9,532
2,941
4,405
34,728

As mentioned in footnote 3, in December 2002, the FRBNY replaced MSP transactions with securities sold under agreements to repurchase. At December 31, 2002, securities sold under agreements
to repurchase with a contract amount of $21,091 million and a par value of $21,098 million were outstanding, of which $1,164 million and $1,164 million, respectively, were allocated to the Bank.
At December 31, 2001, MSP transactions involving U.S. government securities with a par value of $23,188 million were outstanding, of which $1,358 million was allocated to the Bank. Securities
sold under agreements to repurchase and MSP transactions are generally overnight arrangements.

2002 ANNUAL REPORT

At December 31, 2002 and 2001, U.S. government securities with par values of $1,841 million and $7,345 million, respectively, were loaned from the SOMA, of which $102 million and $430 million
were allocated to the Bank.

5 . I N V E S T M E N T S D E N O M I N AT E D I N F O R E I G N C U R R E N C I E S
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 purchased under agreements to resell. These investments are guaranteed as to principal and
interest by the foreign governments.
Each Reserve Bank is allocated a share of foreign-currency-denominated assets, the related interest income, and realized and unrealized foreign currency gains and losses, with the exception
of unrealized gains and losses on F/X swaps and warehousing transactions. This allocation is based on the ratio of each Reserve Bank’s capital and surplus to aggregate capital and surplus at
the preceding December 31. The Bank’s allocated share of investments denominated in foreign currencies was approximately 9.053 percent and 6.844 percent at December 31, 2002 and 2001,
respectively.
The Bank’s allocated share of investments denominated in foreign currencies, valued at current foreign currency market exchange rates at December 31, was as follows (in millions):
2002
European Union Euro:
Foreign currency deposits
Government debt instruments including
agreements to resell

Japanese Yen:
Foreign currency deposits
Government debt instruments including
agreements to resell

505

314

299

185

162

129

558

364

Accrued interest
Total

2001

7
$

1,531

4
$

996

Total investments denominated in foreign currencies were $16,913 million and $14,559 million at December 31, 2002 and 2001, respectively.
The maturity distribution of investments denominated in foreign currencies which were allocated to the Bank at December 31, 2002, was as follows (in millions):
Maturities of investments denominated in foreign currencies
Within 1 year
Over 1 year to 5 years
Over 5 years to 10 years
Over 10 years
Total

1,413
82
36
—

1,531

At December 31, 2002 and 2001, there were no open foreign exchange contracts or outstanding F/X swaps.
At December 31, 2002 and 2001, the warehousing facility was $5,000 million, with zero balance outstanding.
6. BANK PREMISES AND EQUIPMENT
A summary of bank premises and equipment at December 31 is as follows (in millions):
2002
Bank premises and equipment:
Land
Buildings
Building machinery and equipment
Construction in progress
Furniture and equipment

7
150
45
2
71

2001
$

FEDERAL RESERVE BANK OF CLEVELAND

275

Accumulated depreciation
Bank premises and equipment, net

273

(93)
$

182

7
149
43
1
73
(92)

181

Depreciation expense was $11 million and $12 million for the years ended December 31, 2002 and 2001, respectively.
The Bank leases unused space to outside tenants. Those leases have terms ranging from one to thirteen years. Rental income from such leases was $1 million for each of the years ended
December 31, 2002 and 2001. Future minimum lease payments under noncancelable agreements in existence at December 31, 2002, were (in millions):
2003
2004
2005
2006
2007
Thereafter

1
1
1
1
1
5

7. COMMITMENTS AND CONTINGENCIES
At December 31, 2002, the Bank was obligated under noncancelable leases for premises and equipment with terms ranging from one to approximately five 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 $1 million for each of the years ended December 31, 2002 and 2001. Certain of the Bank’s leases have options to renew.
Future minimum rental payments under noncancelable operating leases and capital leases, net of sublease rentals, with terms of one year or more, at December 31, 2002, were (in thousands):
Operating
2003
2004
2005
2006
2007
Thereafter

140
144
147
151
102
0

684

At December 31, 2002, the Bank, acting on behalf of the Reserve Banks, had contractual commitments through the year 2005 totaling $27 million, none of which has been recognized. These contracts
represent equipment, maintenance, software, and other miscellaneous costs for Check operations and the Check Modernization project that will be allocated annually to other Reserve Banks. It is
estimated that the Bank’s allocation share will be $6 million.
Under the Insurance Agreement of the Federal Reserve Banks dated as of March 2, 1999, each of the Reserve Banks has agreed to bear, on a per incident basis, a pro rata share of losses in excess of
1 percent of the capital paid-in of the claiming Reserve Bank, up to 50 percent of the total capital paid-in of all Reserve Banks. Losses are borne in the ratio that a Reserve Bank’s capital paid-in
bears to the total capital paid-in of all Reserve Banks at the beginning of the calendar year in which the loss is shared. No claims were outstanding under such agreement at December 31, 2002
or 2001.
The Bank is 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 Bank.
8. RETIREMENT AND THRIFT PLANS
Retirement Plans
The Bank currently offers two defined benefit retirement plans to its employees, based on length of service and level of compensation. Substantially all of the Bank’s employees participate
in the Retirement Plan for Employees of the Federal Reserve System (“System Plan”) and the Benefit Equalization Retirement Plan (“BEP”), and certain Bank officers participate in a
Supplemental Employee Retirement Plan (“SERP”). 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. The Bank’s projected benefit obligation and net pension costs for the BEP at December 31, 2002 and 2001, and for the
SERP at December 31, 2002, and for the years then ended, are not material.
Thrift Plan
Employees of the Bank may also participate in the defined contribution Thrift Plan for Employees of the Federal Reserve System (“Thrift Plan”). The Bank’s Thrift Plan contributions totaled
$3 million for each of the years ended December 31, 2002 and 2001, and are reported as a component of “Salaries and other benefits.”
9 . P O S T R E T I R E M E N T B E N E F I T S O T H E R T H A N P E N S I O N S A N D P O S T E M P LOY M E N T B E N E F I T S
Postretirement Benefits Other Than Pensions
In addition to the Bank’s 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 Bank funds benefits payable under the medical and life insurance plans as due and, accordingly, has no plan assets. Net postretirement benefit costs are actuarially determined using
a January 1 measurement date.
Following is a reconciliation of beginning and ending balances of the benefit obligation (in millions):
2001

40.8
1.1
2.8
1.6
0.2
(2.0)
—

39.4
1.0
2.7
0.4
0.2
(1.9)
(1.0)

Accumulated postretirement benefit obligation at December 31

44.5

40.8

2002 ANNUAL REPORT

2002
Accumulated postretirement benefit obligation at January 1
Service cost-benefits earned during the period
Interest cost of accumulated benefit obligation
Actuarial loss
Contributions by plan participants
Benefits paid
Plan amendments

Following is a reconciliation of the beginning and ending balance of the plan assets, the unfunded postretirement benefit obligation, and the accrued postretirement benefit costs (in millions):
2002
Fair value of plan assets at January 1
Actual return on plan assets
Contributions by the employer
Contributions by plan participants
Benefits paid

—
—
1.8
0.2
(2.0)

2001
$

—
—
1.7
0.2
(1.9)

Fair value of plan assets at December 31

—

Unfunded postretirement benefit obligation
Unrecognized initial net transition asset (obligation)
Unrecognized prior service cost
Unrecognized net actuarial gain

44.5
—
0.9
6.3

40.8
—
1.0
8.2

Accrued postretirement benefit costs

51.7

50.0

Accrued postretirement benefit costs are reported as a component of “Accrued benefit costs.”
At December 31, 2002 and 2001, the weighted average discount rate assumptions used in developing the benefit obligation were 6.75 percent and 7.00 percent, respectively.
For measurement purposes, a 9.00 percent annual rate of increase in the cost of covered health care benefits was assumed for 2003. Ultimately, the health care cost trend rate is expected
to decrease gradually to 5.00 percent by 2008, and remain at that level thereafter.
Assumed health care cost trend rates have a significant effect on the amounts reported for health care plans. A one percentage point change in assumed health care cost trend rates would
have the following effects for the year ended December 31, 2002 (in millions):
One percentage point increase
Effect on aggregate of service and interest cost components of
net periodic postretirement benefit costs
Effect on accumulated postretirement benefit obligation

One percentage point decrease

0.8
7.5

(0.6)
(5.9)

The following is a summary of the components of net periodic postretirement benefit costs for the years ended December 31 (in millions):
2002
Service cost-benefits earned during the period
Interest cost of accumulated benefit obligation
Amortization of prior service cost
Recognized net actuarial loss
Net periodic postretirement benefit costs

1.1
2.8
(0.1)
(0.2)
3.6

2001
$

1.0
2.7
—
(0.6)
3.1

Net periodic postretirement benefit costs are reported as a component of “Salaries and other benefits.”
Postemployment Benefits
The Bank offers 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 self-insured workers’ compensation expenses. 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 Bank at December 31, 2002 and 2001, were $7 million and $6 million, respectively. This cost is included as a component of
“Accrued benefit costs.” Net periodic postemployment benefit costs included in 2002 and 2001 operating expenses were $1 million for each of the years ended December 31, 2002 and 2001.

FEDERAL RESERVE BANK OF CLEVELAND

10. S U B S E Q U E N T E V E N T
In January 2003, the System announced plans to restructure its check collection operations. The restructuring plans include streamlining the check management structure, reducing staff, decreasing
the number of check-processing locations, and increasing processing capacity in other locations. The restructuring, which is expected to begin in 2003 and conclude by the end of 2004, will result in
the Bank discontinuing its check operations at the Pittsburgh office, increasing its check processing capacity at the Cleveland and Cincinnati offices, and consolidating its check adjustment function
at the Cleveland office. At this time, the Reserve Banks have not developed detailed estimates of the cost of the restructuring plan in the aggregate or for the individual Reserve Banks affected.

Officers and Consultants

Boards of Directors

2002 Operational Highlights

Business Advisory Council and
Community Bank Advisory Council

As of December 31, 2002

David E. Altig

Douglas A. Banks

President and Chief Executive Officer

Vice President and Associate Director of Research
Research

Assistant Vice President and
Consumer Affairs Officer
Supervision and Regulation

Sandra Pianalto
First Vice President and Chief Operating Officer

Terry N. Bennett
Vice President
Information Technology

Lawrence Cuy
Senior Vice President
Financial Management Services, Strategic Planning,
Information Technology, COSO

R. Chris Moore
Senior Vice President
Supervision and Regulation,
Credit Risk Management, Data Services

Robert W. Price
Senior Vice President
Retail Payments Office,
National Check Automation and Operations,
National Product Development

Susan G. Schueller
Senior Vice President and General Auditor
Audit

Samuel D. Smith
Senior Vice President
Cash, Treasury Services, Savings Bonds,
Facilities, Information Security, Protection,
Business Continuity

Mark S. Sniderman
Senior Vice President and Director of Research
Research, Corporate Communications,
Community Affairs

Peggy A. Velimesis
Senior Vice President
Human Resources, Payroll,
Internal Communications, Quality Process,
EEO Officer

Robert F. Ware
Senior Vice President
Check, Marketing, Electronic Payments,
Customer Satisfaction

Andrew W. Watts
Senior Vice President and General Counsel
Legal, Ethics Officer

Kelly A. Banks

James A. Blake

Assistant Vice President and
Public Information Officer
Corporate Communications and Public Information

Senior Consultant
Retail Payments Office

Stephen J. Geers

Raymond L. Brinkman

Assistant Vice President
Marketing, National Account Program

Vice President
Savings Bonds, EZ Clear

Patrick Geyer

Michael F. Bryan

Assistant Vice President
Electronic Payments,
Standard Cash Application User Support

Vice President and Economist
Research

Andrew C. Burkle, Jr.
Vice President
Supervision and Regulation

Ruth M. Clevenger
Vice President and Community Affairs Officer
Corporate Communications and Community Affairs

William D. Fosnight
Vice President and Associate General Counsel
Legal

Barbara B. Henshaw
Vice President
Cincinnati Location Officer,
Protection, Business Continuity

Kenneth J. Good
Assistant Vice President
Pittsburgh Check Operations

Felix Harshman
Assistant Vice President
Expense Accounting, Budget

Joseph G. Haubrich
Consultant and Economist
Research

Jon C. Jeswald
Assistant Vice President
Retail Payments Office

Paul E. Kaboth

Suzanne M. Howe

Assistant Vice President
Supervision and Regulation

Vice President
Electronic Payments

Kenneth E. Kennard

David P. Jager

Assistant Vice President
Protection

Vice President
Cash, Treasury Services, Electronic Payments

Dean A. Longo

Stephen H. Jenkins

Consultant
Information Technology

Vice President
Supervision and Regulation

Martha Maher

Rayford P. Kalich

Assistant Vice President
Retail Payments Office

Vice President
Accounting, Budget, Purchasing,
Strategic Planning, COSO

James W. Rakowsky

Stephen J. Ong
Vice President
Supervision and Regulation

David E. Rich
Senior Consultant
Information Technology

Edward E. Richardson
Vice President
Sales, Marketing, National Account Program

Terrence J. Roth
Vice President
Retail Payments Office, Check Products

Robert B. Schaub

Assistant Vice President
Facilities, Business Continuity

John P. Robins
Consultant
Supervision and Regulation

Elizabeth J. Robinson
Assistant Vice President
Human Resources

Jerome J. Schwing
Assistant Vice President
Cincinnati Check Operations

Stacey C. Talley
Assistant Vice President and Corporate Secretary
Office of the Corporate Secretary

Vice President
Pittsburgh Location Officer, Protection,
Business Continuity

Henry P. Trolio

Gregory L. Stefani

Michael Vangelos

Vice President
Credit Risk Management, Data Services

Assistant Vice President
Information Security

Edward J. Stevens

Lisa Vidacs

Senior Consultant and Economist
Research

Assistant Vice President
Cleveland and Pittsburgh Cash Operations

Assistant Vice President
Information Technology

James B. Thomson
Vice President and Economist
Research

Joseph C. Thorp
Vice President
Facilities, Business Continuity

Anthony Turcinov
Vice President
Cleveland Check Operations and Check Adjustments

Charles F. Williams
Vice President
Cincinnati and Columbus Check Operations

Darell R. Wittrup
Vice President
Accounting, Billing

2002 ANNUAL REPORT

Officers
and
Consultants

Jerry L. Jordan

2002 Operational Highlights

he mission of the Federal Reserve Bank of Cleveland

is to enable the economy to achieve maximum sustainable growth by preserving
the purchasing power of the dollar, promoting a strong financial system, and
providing efficient and innovative payments solutions to financial institutions,
the U.S. Treasury, and the public. This section summarizes the Bank’s operational
achievements in these three areas.

ECONOMIC RESEARCH
AND
MONETARY POLICY

In 2002, economic developments — including rising oil prices, low inflation, low interest rates, and
growing geopolitical tensions — presented new challenges and opportunities in fostering stable prices
and sustainable economic growth through monetary policy. In this environment of rapid change,
anticipating and preparing for such change is one of the Bank’s key responsibilities to the Fourth District
and to the nation.
The economic research staff are respected contributors to the discourse on topics that concern the Federal
Reserve System and promote constructive discussion of those issues in the public domain. Research staff
published articles and papers on monetary, economic, and banking topics in the Bank’s annual report, in its
Economic Commentary series, and in Policy Discussion Papers and working papers, as well as respected
academic journals. In addition, the Bank hosted a conference (together with the Journal of Money, Credit,

FEDERAL RESERVE BANK OF CLEVELAND

and Banking) on “Recent Developments in Monetary Economics.”

One of the Federal Reserve Bank of Cleveland’s key strategic initiatives has been the development of the
Central Bank Institute. The Institute was established in 2001 to foster greater understanding of the
monetary policy, supervisory, and payments aspects of central banking by promoting research and dialogue
and by forging partnerships among central banks. In 2002, the Institute hosted three conferences on current
monetary policy research and cosponsored two additional conferences with the Swiss National Bank and
the Chicago Reserve Bank; altogether, 150 scholars took part in these programs. As part of its staff exchange
program, the Institute hosted scholars from the central banks of Sweden, Austria, Azerbaijan, and the
Kyrgyz Republic, while Cleveland Fed economists traveled to the Sveriges Riksbank, Bank of England, and
Deutsche Bundesbank.

Public outreach is one of the Federal Reserve Bank of Cleveland’s key objectives, and the public tour program
and speakers bureau are the cornerstones of that program. In 2002, Fourth District staff delivered more than
55 speeches, reaching over 3,000 people. Although the Bank restricted its tour program during the first half
of the year, more than 2,000 visitors toured the Cleveland Fed’s historic building in 2002.
In the area of economic education, the Bank again sponsored the Fed Challenge competition, in which teams of
high school students participate in mock Federal Open Market Committee deliberations. In addition, the Bank
launched a new program, “Great Minds Think,” which traveled to four cities across the Fourth District. The
program—a partnership between the Cleveland Bank, the Ohio Department of Education, the Ohio Center for
Economic Education, the Cleveland Public Schools, Jump$tart, and the Foundation for Teaching Economics—
highlighted the importance of critical-thinking skills for students and educators and centered on the concept
of financial literacy. Nearly 300 students and 118 teachers (who teach 12,000 students annually) attended the
workshops. Altogether, participation in District educational programs increased 130 percent in 2002.
The Cleveland Reserve Bank continued to develop plans for a Learning Center, which will foster a better
understanding of the Bank’s purposes and functions and provide an infrastructure for its educational activities.
The centerpiece of the Learning Center will be a permanent Museum of Central Banking. In 2002, the Bank
installed a temporary exhibit on “What Gives Money Value?” in the Cleveland Office, and it reviewed proposals

2002 ANNUAL REPORT

to create a permanent exhibit that reflects the Bank’s educational visions.

SUPERVISION
AND REGULATION

Recent events and legislative changes have had a profound impact on the way bankers and supervisors
view corporate governance and risk management in the financial services industry. Changes in the
operations and credit quality of the banks and bank holding companies supervised by the Federal Reserve
Bank of Cleveland continue to present new challenges and opportunities for the Bank’s Supervision and
Regulation function. Prominent among these forces are emerging technologies, industry consolidation,
changes in the legal environment, and the ever-increasing need for information security.
The Federal Reserve System’s approach to supervision is founded on the principles of risk-focused supervision.
This approach balances the need to continuously evaluate and assess the effectiveness of enterprisewide
risk-management systems with the requirement to conduct adequate transaction testing. The Supervision
and Regulation function applies these principles inwardly as well in developing risk-focused supervisors and
examiners. Through its Risk Committee, supervision and regulation staff monitor emerging trends in the
financial services and legal environment to direct resources to areas of highest risk. Throughout 2002, staff
worked to improve their processes for assessing operations risk and corporate governance procedures at
Fourth District institutions, as well as the effectiveness of its risk-based examination procedures.
The Bank regards communication, outreach programs, and training for bankers and the public as a fundamental part of its responsibility. In conjunction with the Ohio Division of Financial Institutions, the Bank
developed a series of tailored programs to educate the board members and senior management of Fourth
District financial institutions. The programs, which deal with topics such as corporate governance, auditing
practices, risk management, liquidity, and current legislation, cover timely issues faced by the banking
industry and foster more meaningful, open communications with bankers. Supervision and Regulation staff
delivered 15 presentations throughout the Fourth District in 2002, and more are planned for 2003.
The Federal Reserve Bank of Cleveland is a strong advocate for fair lending, community economic development,

FEDERAL RESERVE BANK OF CLEVELAND

and equal access to credit. To support these goals, the Bank’s community affairs staff advised community-

based organizations on strengthening their capacity to work with financial services providers and improving
affordable housing and microenterprise opportunities in low- and moderate-income communities. The Bank
hosted a series of regulatory roundtable discussions on new provisions of the Community Reinvestment Act,
and it organized two major conferences, which together reached more than 700 community development
practitioners. Additionally, the community affairs function conducted research and published reports on
rural economic development, predatory lending, and access to credit and capital in low- and moderateincome communities.

FOURTH DISTRICT OPERATING STATISTICS
2002

2001

Volume

Currency processed
Savings bonds issued

PAYMENTS SERVICES

1,585,299
1,111,922,668
9,981,873

Value

Volume

1,493,551

1,538,948

$ 14,539,956,399

1,092,064,249

1,787,393,659

9,852,923

Value

1,447,973

$ 14,179,668,069
$

1,772,809,623

The current financial services landscape is characterized by increased competition, rapid change, and
technological innovation. As customers demand new, more efficient payment mechanisms and move
away from traditional paper-based payments, the Federal Reserve has adapted by developing more
sophisticated electronic payments services and by increasing its use of Web-based communications and
business processes. Despite these challenges, in 2002 the Federal Reserve Bank of Cleveland continued
its tradition of strong performance combined with responsive and innovative solutions to marketplace
and customer needs.
Like most of the 12 Reserve Banks, the Cleveland Bank faced significant challenges in the financial performance
of its check processing function in 2002. As a result of declining check volumes, unexpectedly low interest rates,
and costs associated with the Check Modernization initiative, the Bank fell short of its local net revenue
target in this area. However, through a collaborative effort among Bank employees to reduce operating and
discretionary expenses, the Bank was able to minimize this shortfall by year-end. Nevertheless, total revenues
earned from all of the Bank’s financial services exceeded its target by more than $1 million, and the Cleveland
Bank continued to rank among the Federal Reserve System’s most efficient operations (measured by overall
unit cost).
In partnership with the Federal Reserve Bank of Atlanta, the Cleveland Bank’s Retail Payments Office
continued to manage the System’s Check Modernization initiative. This four-part initiative standardizes
check processing at all Reserve Bank offices nationwide, implements common software for processing and
researching check adjustment cases, creates a national archive and retrieval system for check images, and
delivers Web-based check services to customers. Two projects—Enterprise-Wide Adjustments and FedLine ®
for the Web–Check Services—were completed and fully functional in 2002, and the two remaining projects—
Check Standardization and FedImageSM Services—are poised for a successful finish in 2003.
As part of the Check Modernization Project, several service enhancements were launched in 2002, including
a national electronic archive of check adjustments information, large-image file delivery, and a customer
gateway for accessing the FedImage Services archive. These innovations provide superior check services to
meet the needs of financial institutions across the country. The Retail Payments Office also took a lead role
in developing more centralized product and pricing strategies across the Reserve Banks, a reflection of the
increasingly national banking environment.
2002 ANNUAL REPORT

Commercial checks processed

FedLine is a registered trademark of the Federal Reserve Banks.
FedImage Services is a service mark of the Federal Reserve Banks.
37

The firm engaged by the Board of Governors for the audits of the individual and combined financial statements of the Reserve Banks for 2002 was PricewaterhouseCoopers LLP (PwC). Fees for these services totaled
$1 million. In order to ensure auditor independence, the Board of Governors requires that PwC be independent
in all matters relating to the audit. Specifically, PwC may not perform services for the Reserve Bank or
others that would place it in a position of auditing its own work, making management decisions on behalf
of the Reserve Banks, or in any other way impairing its audit independence. In 2002, the Bank engaged PwC
for advisory services totaling $176,600 for services related to the national Check Modernization project.
The Bank believes these advisory services do not directly affect the preparation of the financial statements
audited by PwC and are not incompatible with the services provided by PwC as an independent auditor.
The Bank implemented two innovative electronic payments services for the U.S. Treasury in 2002. Pay.gov
uses state-of-the-art technologies to authorize and settle government payments over the Internet; by year-end,
the service was serving 14 government agencies and had processed 155,000 ACH and wire transfer transactions
totaling $3.6 billion. The Paper Check Conversion service, which electronically converts checks presented at
the point of sale at government locations worldwide, was serving 25 agencies in 58 locations by the end of
2002, and it processed 163,000 transactions ($78 million). The Cleveland Bank is the System’s lead operating
site for both initiatives. The Bank’s savings bond function is the largest of the five Federal Reserve processing
sites as well as the most efficient, evidenced by its lowest unit cost in the System for 2002. In 2002, this
function completed the programming phase for a new processing application that will improve the efficiency
and flexibility of savings bond processing throughout the Federal Reserve System.
The Fourth District’s cash function led the implementation of the Standard Cash Application—which automates cash accounting, control, and reporting functions nationwide—in 11 Federal Reserve System offices.
The Cleveland Bank is also home to the application’s user support function. The Bank’s cash processing
function achieved objectives for productivity and quality, operated within budget, and maintained a low unit
FEDERAL RESERVE BANK OF CLEVELAND

cost ranking within the System (third-lowest among Reserve Banks).

For a third year, the Cleveland Bank hosted a Payments Symposium, “Using New Technologies to Transform
the Future of Payments.” During the program, which featured nationally recognized payments industry
experts from the U.S. Treasury, the FBI, and the Federal Reserve System, discussion focused on banking
industry trends, the evolution of the payments system, and new products and services that are changing the
way financial institutions do business. More than 130 Fourth District financial industry presidents and chief
executive officers attended the symposium.

In 2002, the Federal Reserve Bank of Cleveland unveiled a new strategic vision: To create value for
customers, stakeholders, and the Federal Reserve System by becoming a recognized leader in the evolution
of central banking, the practice of banking supervision, and the development of retail payments systems.
This vision will guide the Bank’s operations over the next three to five years and provides a common
picture of its future.
The Bank continues to employ the balanced scorecard in all functional areas to track performance against
objectives. For a second consecutive year, the Bank achieved all key System quality measures and servicelevel objectives.
The Cleveland Bank seeks to provide efficient and effective solutions to customers and to build valuable
business partnerships. In 2002, the Bank worked to ensure a seamless transition to national service provision
for its customers. To gauge its progress in meeting customer expectations, the Bank regularly surveys the
financial institutions it serves. It exceeded aggressive targets for overall customer satisfaction and customers’
perception of the Bank as a valued business partner, as well as the provision of flexible financial services.
In 2002, the Cleveland and St. Louis Reserve Banks joined forces in a business development merger, which
combines the two Banks’ sales, sales support, product development, and customer communications functions.
The partnership, overseen by a regional business development team, will allow each Bank to provide superior
customer sales support at a lower cost and with fewer resources while maintaining growth in the financial
services industry.
The Bank launched a new public Web site in 2002—www.clevelandfed.org —with improved navigation,
search tools, and content organization. The design of the site makes it easier for users to locate the latest
economic and financial data, research papers and Bank publications, news releases, Bank-sponsored
conferences and events, background information about the Cleveland Bank and the Federal Reserve System,
and consumer and financial services information.

2002 ANNUAL REPORT

QUALITY
IMPROVEMENTS

Business
Advisory
Council

FEDERAL RESERVE BANK OF CLEVELAND

Community
Bank
Advisory
Council

William E. Adams

Robert A. Gray

P. C. Miller

Chairman and Chief Executive Officer
Adams Manufacturing Corporation
Portersville, Pennsylvania

President
Gray Printing Company
Fostoria, Ohio

President and Chief Executive Officer
Duramax Marine LLC
Hiram, Ohio

Barbara A. Bissett

D. Michael Hartley

Cynthia Moore-Hardy

President and Chief Executive Officer
Bissett Steel Company
Valley View, Ohio

Chairman and Chief Executive Officer
Standard Bent Glass Corporation
Butler, Pennsylvania

President and Chief Executive Officer
Lake Hospital System
Willoughby, Ohio

R. Douglas Cowan

R. Duane Hord

Frederick D. Pond

Chairman and Chief Executive Officer
Davey Tree Expert Company
Kent, Ohio

President
Hord Livestock Company, Inc.
Bucyrus, Ohio

President
Ridge Tool Company, Inc.
Elyria, Ohio

Tanny Crane

John M. Kahl

C. David Snyder

President and Chief Executive Officer
Crane Plastics Company, LP
Columbus, Ohio

Chief Executive Officer
Henkel Consumer Adhesives, Inc.
Avon, Ohio

Chairman and Chief Executive Officer
Acero, Inc.
Cleveland, Ohio

Joseph A. Graviss

James R. Leake

President
Graviss McDonalds Restaurants
Versailles, Kentucky

President and Chief Executive Officer
James R. Leake & Son, Inc.
Richmond, Kentucky

Marlene K. Barkheimer

G. Courtney Haning

Dennis W. Rich

President and Chief Executive Officer
Farmers State Bank
West Salem, Ohio

Chairman, President,
and Chief Executive Officer
Peoples National Bank
New Lexington, Ohio

President and Chief Executive Officer
Eagle Bank
Williamstown, Kentucky

Dallas C. Hipple

President and Chief Executive Officer
Citizens National Bank of Bluffton
Bluffton, Ohio

Michael M. Cottle
President and Chief Executive Officer
First National Bank of Blanchester
Blanchester, Ohio

Luther Deaton, Jr.

President and Chief Executive Officer
Mars National Bank
Mars, Pennsylvania

Chairman, President,
and Chief Executive Officer
Central Bank and Trust Company
Lexington, Kentucky

G. W. Holden

Charles K. Graham

Orval H. Homan

President and Chief Executive Officer
Progressive Bank, N.A.
Wheeling, West Virginia

Chairman, President,
and Chief Executive Officer
Minster Bank
Minster, Ohio

Dorsey G. Hall, II
Chairman, President,
and Chief Executive Officer
Somerset National Bank
Somerset, Kentucky

President
RFC Banking Company
Findlay, Ohio

Edward J. McKeon
President and Chief Executive Officer
Western Reserve Bank
Medina, Ohio

J. Michael Romey

Jeffrey E. Smith
President and Chief Executive Officer
Ohio Valley Bank Company
Gallipolis, Ohio

Charles G. Urtin
President and Chief Executive Officer
Irwin Bank and Trust Company
Irwin, Pennsylvania

CLEVELAND
1455 East 6th Street
Cleveland, OH 44114
(216) 579-2000
C I N C I N N AT I
150 East 4th Street
Cincinnati, OH 45202
(513) 721-4787

This annual report was prepared by the Corporate Communications and
Community Affairs Department and the Research Department of the Federal

PITTSBURGH

Reserve Bank of Cleveland.

717 Grant Street

For additional copies, contact the Corporate Communications and Community

Pittsburgh, PA 15219

Affairs Department, Federal Reserve Bank of Cleveland, P.O. Box 6387,

(412) 261-7800

Cleveland, OH 44101, or call 1-800-543-3489 (OH, PA, WV) or 216-579-2001.
COLUMBUS
The annual report is also available electronically through the Cleveland Fed’s

965 Kingsmill Parkway

home page, www.clevelandfed.org.

Columbus, OH 43229
(614) 846-7494

ACKNOWLEDGMENTS
Manager, Communications Support:
Patricia DeMaioribus
Editor: Deborah Ring Zorska
Design: Michael Galka
Portrait Photography: Bill Pappas

Full text of Annual Report of the Federal Reserve Bank of Cleveland : 2002 Annual Report

FRASER