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1 • • • • • • • FRB Cleveland • February 2000 The Economy in Perspective The price of success… The Federal Open Market Committee voted on February 2 to increase the federal funds target ¼ percentage point, to 5¾ %. The federal funds target (the price of overnight Federal Reserve credit that depository institutions charge one another) now stands a full percentage point above its level last June. Many financial market analysts have remarked on the number and timing of these policy actions: February’s funds rate target increase was the latest in a series of four upward adjustments, made in quick succession. Fewer commentators note, however, that today’s federal funds and discount rates are broadly similar to those prevailing from 1995 to mid-1998, a period when the funds rate ranged between 5¼ % and 6%, averaging 5½ %. This stability was also evident in most other U.S. interest rates. In market economies, prices equilibrate the interests of buyers and sellers. An interest rate balances the willingness of sellers, who consume less today in the expectation of enhanced future consumption, with buyers, who wish to shift some of their anticipated future consumption to the present. Ignoring the effects of inflation and inflation expectations, rising interest rates signify that people want to shift relatively more future consumption to the present—and that they must compensate savers more handsomely to get the wished-for resources immediately. A number of factors affect borrowers’ and lenders’ behavior. If some people suddenly expect to be wealthier in the future, they may wish to begin consuming some of their anticipated wealth right away. In these circumstances, they will reduce their saving and perhaps even borrow against future income. If many of a country’s people simultaneously try to alter the time patterns of their consumption in this way, the additional resources needed will have to come from abroad and the real interest rate will usually rise, encouraging lenders to defer their own consumption. But other circumstances can counteract these fundamental influences. For instance, market-driven U.S. interest rates plunged in the latter half of 1998 as investors around the world, seeking refuge from turbulent international financial markets, rushed to purchase U.S. dollar-denominated financial instruments. As international economic prospects gradually improved in 1999, this extraordinary demand for dollar liquidity receded, causing marketdriven interest rates to move back up toward their pre-panic levels. Federal Reserve-controlled interest rates matched these developments. All this activity occurred against a backdrop of very large capital inflows to the United States for nonliquidity purposes. Seeing good prospects for continued strong economic growth, together with low inflation, foreign investors have joined their U.S. counterparts in financing a capital spending and stock market boom. The influx of foreign capital also is reflected in our foreign trade accounts. Foreigners acquire dollar-denominated assets by exporting goods and services to the United States and investing the sales receipts rather than spending them on U.S.-produced items (that is, they are lending us what would otherwise be their current consumption). Since increased demand for dollar-based assets strengthens the dollar’s foreign exchange value, making imports more attractive to U.S. consumers, the capital inflow and merchandise import processes complement and reinforce one another. The most dramatic divergence between domestic spending and domestically generated income in this expansion has taken place in the last several years, as foreign economic activity languished and demand for dollar assets surged. With international financial jitters calmed and activity in many large foreign economies reviving, it seems reasonable to expect that global investors will broaden their portfolios beyond dollardenominated assets, and that foreign markets will come to absorb a larger fraction of global resources than they have for several years. Should these patterns emerge, it would also be reasonable to expect market-driven interest rates to firm, reflecting a more intense global pressure for additional investment and consumption spending. Monetary policy affects economic activity through a variety of channels that are not completely understood or predictable. Movements in the overnight federal funds rate reflect changes in the supply and demand for account balances at the Federal Reserve. How funds rate fluctuations affect other interest rates depends on several factors, including inflation expectations. When savers expect inflation to rise, they add a premium to the rate they charge borrowers, because they believe that future dollars will purchase fewer goods and services. If market participants think that the Federal Reserve will persistently oversupply liquidity to financial markets by keeping the funds rate too low, longer-term interest rates could rise even while the funds rate holds fixed. If the Fed has credible inflation goals, however, increases in the funds rate can actually reduce longer-term rates. So far during this expansion, funds rate movements have been followed by more prosperity. 2 • • • • • • • Monetary Policy Percent 6.50 IMPLIED YIELDS ON FEDERAL FUNDS FUTURES Percent 6.0 ACTUAL AND PREDICTED FEDERAL FUNDS RATE a Predicted three months earlier 5.8 6.25 January 24, 2000 5.6 January 3, 2000 6.00 December 30, 1999 5.4 5.2 5.75 Predicted one month earlier November 30, 1999 5.0 5.50 4.8 Actual 5.25 Nov. Dec. 1999 Jan. Feb. March April May 2000 June July Percent, weekly average 6.25 SHORT-TERM INTEREST RATES Aug. 4.6 1996 1998 1997 1999 2000 Percent, weekly average 9 LONG-TERM INTEREST RATES 1-year T-bill b 8 5.75 Conventional mortgage 7 5.25 3-month T-bill b 30-year Treasury b 4.75 6 4.25 5 10-year Treasury b 3.75 1996 1997 1998 1999 2000 4 1996 1998 1997 1999 2000 FRB Cleveland • February 2000 a. Predicted rates are 1-month and 3-month federal funds futures lagged one and three months, respectively. b. Constant maturity. SOURCES: Board of Governors of the Federal Reserve System; and Chicago Board of Trade. Implied yields on federal funds futures are often used to gauge market participants’ expectations for the future path of policy. Since late December, market participants consistently have priced in a 25 basis point (bp) increase for February and at least one more such increase by June. Historically, federal funds futures do a fair job of predicting movements in the effective federal funds rate. Generally speaking, when the fed funds rate rises, futures tend to underpredict the rate’s level; when the rate falls, futures tend to overpredict. The average error for January 1996 to January 2000 is 13 bp for the 3-month future and 6 bp for the 1-month future. Short-term interest rates continue to rise briskly. The 3-month Treasury bill rate ended 1999 at 5.33%, up 75 bp on the year. Similarly, the 1-year Treasury bill rate finished at 5.95%, a substantial 135 bp increase. From year’s end through the week ending January 21, the 3-month and 1-year Treasury bill rates made identical 18 bp gains. The recent rise of short-term interest rates may have reflected the market’s anticipation of February federal funds rate increases. Long-term interest rates display a similar pattern. The 10-year and 30year Treasury rates ended the year at 6.41% and 6.46%, increases of 171 and 134 bp, respectively. Gains since January 1 are 36 bp for the 10-year rate and 27 bp for the 30-year rate. The Board of Governors of the (continued on next page) 3 • • • • • • • Monetary Policy (cont.) Trillions of dollars 6.6 THE M3 AGGREGATE 6.4 6.2 Breakdown of Recent Changes in M3 M3 growth, 1994–99 a 12 9 6 6.0 5.8 M2 71.9 35.3 Large time deposits 11.0 30.2 Repurchase liabilities 5.1 12.3 Eurodollars 2.6 4.4 Institutional moneymarket mutual funds 9.4 17.9 2% 0 6% 5.6 2% 6% 5.2 Percent of change Component 3 5.4 Percent of M3 6% 2% 5.0 4.8 1998 1997 1999 Trillions of dollars 4.7 THE M2 AGGREGATE Breakdown of Recent Changes in M2 M2 growth, 1994–99 a 9 5% Percent of M2 Percent of change M1 24.1 48.4 Savings deposits 37.3 –9.6 Small time deposits 20.4 15.3 Retail money-market mutual funds 18.2 45.9 Component 4.5 6 1% 3 4.3 0 5% 4.1 1% 5% 3.9 1% 3.7 1997 1998 1999 FRB Cleveland • February 2000 a. Growth rates are percentage rates calculated on a fourth-quarter over fourth-quarter basis. NOTE: Data are seasonally adjusted. Last plots for M2 and M3 are December 1999. Dotted lines for M2 and M3 are FOMC-determined provisional ranges. SOURCE: Board of Governors of the Federal Reserve System. Federal Reserve System constructs several different measures of the amount of money existing in the U.S. at any given time. The broad monetary aggregates (M2 and M3) include less liquid assets than do the narrow components. Growth rates for virtually all the monetary aggregates spiked in December. This is not terribly surprising, in view of the public concern that surrounded the century date change. Furthermore, careful examination of which components contributed to this growth suggests that much of the change, especially in the narrow monetary aggregates, can be attributed to Y2K. Annualized monthly growth of the M3 monetary aggregate soared to 18.8% in December; calculated on a fourth-quarter over fourth-quarter basis, it was a modest 7.6%. It is difficult to discern a clear pattern in the growth of M3 components. Annualized monthly M2 growth reached 9.1%, driven by nearly equal growth in M1 and retail moneymarket mutual funds, with offsetting changes in savings deposits and small time deposits. One would expect savings deposits to decrease if individuals withdrew cash in preparation for possible Y2K disruptions. Bear in mind that these data are seasonally adjusted — that is, they already account for the normal fluctuations associated with holiday shopping. (It may be helpful to think of increases in the monetary aggregates around Y2K as a fluctuation that cannot be accounted for be(continued on next page) 4 • • • • • • • Monetary Policy (cont.) Trillions of dollars 1.7 THE M1 AGGREGATE 1.6 Billions of dollars 600 THE MONETARY BASE Sweep-adjusted M1 growth, 1994–99 a 8 580 6 1.5 560 4 2 1.4 540 0 Sweep-adjusted base growth, 1994–99 a 14 Sweep-adjusted base b 12 10 8 6 4 2 0 5% 520 Sweep-adjusted M1 b 1.3 500 5% 1.2 480 1.1 5% –2% 460 –2% –2% 1.0 440 1997 1998 1999 Currency Traveler’s checks Demand deposits Other checkable deposits Percent of M1 Percent of change 45.9 0.7 31.9 21.5 68.4 0 9.9 21.6 Breakdown of Recent Changes in the Monetary Base Component 1999 Billions of dollars 520 CURRENCY Breakdown of Recent Changes in M1 Component 1998 1997 500 480 460 Currency growth, 1994–99 a 12 10 8 6 4 2 0 10% 5% 10% 440 5% 10% Percent of base Percent of change 87.6 7.0 5.4 55.9 1.6 42.5 420 5% Currency Total reserves Surplus vault cash 400 380 1997 1998 1999 FRB Cleveland • February 2000 a. Growth rates are percentage rates calculated on a fourth-quarter over fourth-quarter basis. The 1999 growth rates for sweep-adjusted M1 and the sweepadjusted base are calculated on a November over 1998:IVQ basis. b. Sweep-adjusted M1 contains an estimate of balances temporarily moved from M1 to non-M1 accounts. The sweep-adjusted base contains an estimate of required reserves saved when balances are shifted from reservable to nonreservable accounts. NOTE: Data are seasonally adjusted. Last plots for M1, the monetary base, and currency are December 1999. Last plots for sweep-adjusted M1 and the sweep-adjusted base are November 1999. Dotted lines represent growth rates and are for reference only. SOURCE: Board of Governors of the Federal Reserve System. cause it is a one-time event.) In addition, growth in FDIC-insured small time deposits would be consistent with a desire to earn interest in an essentially risk-free environment — just in case Y2K had brought major problems. Turning to narrower measures of money, we can see a clearer pattern of increased volume in highly liquid assets. Annualized monthly M1 growth leapt to 18.4% for December, spurred by an increase in the currency component. Currency con- tributed nearly 70% of growth for the month, although it accounts for only 45.9% of total M1. The most striking information comes from the monetary base, whose annualized monthly growth rate soared to 44.2% in December. Although currency contributed substantially (55.9%) to the change on the month, banks’ surplus vault cash contributed almost as much (42.5%) yet accounts for only about 5% of the monetary base. In 1998, the Federal Reserve, an- ticipating heightened demand for currency around the century date change, prepared by ordering $50 billion of extra currency to be printed in 1999. It injected the extra currency into the system during the rollover period to ensure that supplies would be sufficient to cover any surge in withdrawals. Currency did jump during December, with the annualized monthly growth rate reaching 27.8%. (continued on next page) 5 • • • • • • • Monetary Policy (cont.) Billions of dollars 52 VAULT CASH Billions of dollars 34 Billions of dollars 120 CURRENCY IN CIRCULATION: CHANGE FROM ONE YEAR EARLIER 48 28 Surplus vault cash b 44 100 22 80 40 16 Applied vault cash a 60 36 10 32 1996 4 1998 1997 1999 2000 Percent, weekly average 6.0 RESERVE MARKET RATES 5.8 July 1999 October January 2000 Basis points, daily 60 EFFECTIVE FEDERAL FUNDS RATE MINUS FOMC TARGET Intended federal funds rate Effective federal funds rate 5.6 40 April 0 5.4 5.2 –60 Discount rate 5.0 4.8 –120 4.6 4.4 4.2 1996 1997 1998 1999 2000 –180 September October November 1999 December January February 2000 FRB Cleveland • February 2000 a. Vault cash held by banks whose reserve requirements exceed their vault cash plus the amount used to satisfy requirements by banks whose vault cash exceeds their reserve requirements. b. Vault cash minus the amount used to satisfy reserve requirements. NOTE: Data are not seasonally adjusted. SOURCES: Board of Governors of the Federal Reserve System; and Chicago Board of Trade. It is important to note that levels of surplus vault cash were elevated relative to the previous year and remained so into January. Following the century date change, currency in circulation decreased as cash flowed back to banks. In fact, the Federal Reserve Board announced in August 1999 that it would be unnecessary to print new $50 or $100 bills for the coming year because sufficient inventories already would exist. The need to provide extraordinary liquidity around the century date change caused the Federal Open Market Committee to err on the side of caution by injecting surplus bank reserves. Briefly put, the FOMC selects a target federal funds rate, then adds or drains reserves from the system on a daily basis to match the effective federal funds rate to the target rate. Normally, the effective federal funds rate is very close to the target rate, but during the final week of 1999, the actual fed funds rate missed its target by an average of 76 bp, including a hefty 150 bp miss on December 31. In retrospect, one might argue that the Federal Reserve should have supplied less liquidity; paradoxically, however, by purposely supplying excess liquidity, the Fed may have helped prevent a currency crisis. 6 • • • • • • • Interest Rates Percent 8 YIELD CURVES a Percent 22 1-YEAR VS. 2-YEAR TREASURY BOND YIELD 20 7 18 January 28, 2000 b 16 2-year December 17, 1999 b 6 14 12 5 10 December 1998 c 8 4 6 4 3 0 5 10 15 20 Years to maturity 30 25 1-year 2 1976 1979 1981 1984 1986 1989 1992 1994 Percent 18 IMPLIED VS. ACTUAL 1-YEAR TREASURY BILL RATE Actual 1-year rate next period minus actual 1-year rate, percent 3 IMPLIED VS. ACTUAL CHANGES 16 2 D 14 1 Implied 12 0 10 –1 8 –2 6 DD 4 6/86 D DD D D D D D DD D D D D D DDD D DDDDDD D D D D D D D D D D D D D D D D D D D DD D D D D DD D D D D D D D D DD DDD D DD D D D D D D D D D D D D D DD D D D DD D D D D D D D D D D D D D D D DD D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D D DD DD DDDD D DD D D D DD D DD D D D D D D DD D D DD D D D DD D D D D D D D DD DD D DD D D D DD D DD D D D D D D DD D D D D –3 9/79 12/81 3/84 D 2000 D Actual 2 6/77 D 1997 9/88 12/90 3/93 6/95 9/97 12/99 –4 –2 D –1.5 –1.0 –0.5 0 0.5 1.0 1.5 Implied 1-year rate minus actual 1-year rate, percent 2.0 2.5 FRB Cleveland • February 2000 a. All yields are from constant-maturity series. b. Weekly averages. c. Monthly averages. SOURCE: Board of Governors of the Federal Reserve System, “Selected Interest Rates,” Federal Reserve Statistical Releases, H.15. The yield curve has moved upward and steepened since last month. The 3-month rate moved up 20 basis points (bp); the 5-year rate increased fully 49 bp. The 10-year, 3month spread now stands at 109 bp, up from 85 bp last month. Traditional factors such as expected inflation and future real activity may be influencing the yield curve. In addition, the supply of some maturities is declining as the Treasury Department begins to retire debt. A common question regarding the term structure of interest rates is the extent to which implied forward rates predict future interest rates. This question arises from the expectations hypothesis of the term structure, which posits that long-term rates are the average of expected future short-term rates. A look at 1and 2-year T-bond rates shows that the two move together closely. Plotting implied rates with actual rates apparently shows that a high implied rate reflects high current rates more often than it does high future rates. Extracting such information can be tricky, however, because interest rates have high serial correla- tion — that is, high rates today generally imply high rates tomorrow. Another approach is to look at changes: If the implied future rate exceeds the current rate, it predicts that the rate will increase. If the implied future rate is below the current rate, it predicts that the rate will decrease. Plotting the actual change against the predicted change indicates how well the prediction does. In the case of 1-year T-bill rates, the prediction works poorly. At this time horizon, at least, the expectations hypothesis does not do so well. 7 • • • • • • • Inflation and Prices 12-month percent change 3.75 TRENDS IN THE CPI December Price Statistics 3.50 Percent change, last: 1 mo.a 3 mo.a 12 mo. 1998 5 yr.a avg. Consumer prices All items Median CPI b 3.25 FOMC central tendency projection as of July 1999 c 3.00 2.9 2.2 2.7 2.4 1.6 2.75 Less food and energy Median b 1.4 2.0 1.9 2.4 2.5 2.50 2.5 2.8 2.2 2.9 2.9 2.25 CPI, all items Producer prices Finished goods 2.00 3.6 1.5 3.0 1.3 –0.1 1.6 1.6 0.9 1.3 2.5 1.75 Less food and energy 1.50 1.25 1995 1996 1997 1998 1999 2000 12-month percent change 7 CPI AND CPI LESS ENERGY U.S. dollars per barrel 28 CRUDE OIL SPOT AND FUTURES PRICES d CPI, all items 26 6 Spot price 24 Futures prices e 22 5 20 4 CPI less energy 18 3 16 14 2 12 10 1994 1995 1996 1997 1998 1999 2000 2001 1 1984 1986 1988 1990 1992 1994 1996 1998 2000 FRB Cleveland • February 2000 a. Annualized. b. Calculated by the Federal Reserve Bank of Cleveland. c. Upper and lower bounds for CPI inflation path as implied by the central tendency growth ranges issued by the FOMC and nonvoting Reserve Bank presidents. d. West Texas Intermediate crude oil. e. As of January 31, 2000. SOURCES: U.S. Department of Labor, Bureau of Labor Statistics; Federal Reserve Bank of Cleveland; Bloomberg Financial Information Services; and Dow Jones Energy Service. Monthly inflation data continued to point higher at year’s end, evidenced by a nearly 3% annualized rise in the Consumer Price Index (CPI) in December. For 1999 as a whole, the CPI rose 2.7%, more than a percentage point higher than its 1998 increase. Indeed, last year’s CPI performance was about ¼ percentage point above the upper end of the FOMC’s projected growth range for 1999. However, the 1999 run-up in retail price growth does not appear to have been broadbased. The median CPI, which re- duces the influence of extreme price movements, moderated in 1999 (up 2.2% compared to 2.9% in 1998). Perhaps the single most influential price development in 1999 was the dramatic (140%) spike in crude oil prices, which greatly affected energyrelated expenditures. Excluding energy items in the CPI, retail price increases were actually a bit lower last year than in 1998. The impact of energy costs on prices this year is still very uncertain. Higher energy costs will likely affect a broader range of consumer goods prices, at least temporarily. But a reading of the crude oil futures market suggests that these effects are likely to be short-lived, as investors have priced in a nearly 20% drop in crude oil costs over the course of 2000. The CPI’s behavior last year was also influenced by recent changes in its construction. Since 1978, 20 adjustments to the index have been made, including three major revisions to its market basket. At least six alterations have occurred in just the last three years, the cumulative impact of which is estimated to have (continued on next page) 8 • • • • • • • Inflation and Prices (cont.) 12-month percent change 3.75 TRENDS IN THE CPI RESEARCH SERIES Effects of Recent Revisions on the CPI Effect on CPI growth rate Year (percentage introduced points) Components affected by methodology change Generic prescription drugs Food at home Home ownership Rent All items (store sample) Hospital services Personal computers All items (updated market basket) All items (averaging technique) All items (item sample) Total 1995 1995 1995 1995 1996 1997 1998 –0.01 –0.04 –0.10 0.03 –0.10 –0.06 –0.06 1998 –0.15 3.50 3.25 FOMC central tendency projection as of July 1999 b Median CPI-RS a 3.00 2.75 2.50 2.25 2.00 1.75 CPI-RS (all items) 1.50 1999 1999 –0.20 –0.05 –0.74 1.25 1.00 1995 12-month percent change 7 OWNERS’ EQUIVALENT RENT 1996 1997 1998 1999 2000 4-quarter percent change 16 PRICE INDEXES 14 6 CPI, all items 12 CPI 5 10 4 8 Owners’ equivalent rent 6 3 4 2 2 PCE chain-type price index 1 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 0 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 FRB Cleveland • February 2000 a. Calculated by the Federal Reserve Bank of Cleveland. b. Upper and lower bounds for CPI inflation path as implied by the central tendency growth ranges issued by the FOMC and nonvoting Reserve Bank presidents. SOURCES: U.S. Department of Labor, Bureau of Labor Statistics; U.S. Department of Commerce, Bureau of Economic Analysis; and Federal Reserve Bank of Cleveland. reduced the CPI growth rate by about 0.6 percentage point per year. To better distinguish changes in the construction of the CPI from changes in actual inflation, the Bureau of Labor Statistics recently introduced the CPI Research Series—a retail price index dating back to 1978 that is based on current methodology. According to this measure, the recent 12-month trend in retail prices has reverted to its 1995–96 growth rate. A slightly different interpretation of the inflation trend is reflected in a methodologically consistent median CPI. According to this measure, retail price increases are tracking about ½ percentage point under their 1995–96 average. Recent changes in CPI methodology appear to have been motivated, in part, by growing criticism from government officials and economists. Chairman Alan Greenspan has been one critic of the index, most recently questioning the weights the index assigns to certain items. These weights are derived from survey data in which consumers may under-report spending on some items (like tobacco and alcohol) and over-report spending on other items, notably housing. This latter component was a major contributing force in the upward movement of the CPI between 1997 and 1998. An alternative inflation measure, called the Chain-type Price Index for Personal Consumption Expenditures, is constructed by the Bureau of Economic Analysis based on the spending patterns reported by businesses. Because this index gives less weight to housing costs (among other methodological differences), it has tended to track about ½ percentage point below the CPI since 1994. 9 • • • • • • • Economic Activity Annualized percent change from previous quarter 7 GDP AND BLUE CHIP FORECAST a a,b Real GDP and Components, 1999:IVQ (Advance estimate) Change, billions of 1996 $ Real GDP Consumer spending Durables Nondurables Services Business fixed investment Equipment Structures Residential investment Government spending National defense Net exports Exports Imports Change in private inventories Percent change, last: Four Quarter quarters 126.3 77.9 23.3 26.6 30.0 5.8 5.3 11.8 6.1 3.5 4.2 5.4 10.2 5.4 4.5 7.6 12.1 – 3.3 –1.1 31.2 15.4 –17.9 17.6 35.6 2.5 4.9 – 5.3 – 1.2 8.4 18.9 — 6.8 10.6 7.0 11.0 –5.0 3.1 4.8 5.5 — 4.0 13.1 27.4 — — Actual percent change 6 Blue Chip forecast, January 10, 2000 5 30-year average 4 3 2 1 0 IVQ 1998 Percent 4.0 BLUE CHIP FORECASTS FOR 2000 2.5 IIIQ 1999 IVQ IQ IIQ 2000 IIIQ CONTRIBUTION TO GDP GROWTH 1.5 10/10/99 11/10/99 3.0 IIQ Portion of GDP growth rate 2.0 NONDURABLES AND FOOD: 9/10/99 3.5 IQ Nondurables 12/10/99 1.0 1/10/2000 0.5 2.0 Food 0 1.5 –0.5 1.0 –1.0 0.5 0 IQ IIQ IIIQ –1.5 1990:IQ 1992:IQ 1994:IQ 1996:IQ 1998:IQ 2000:IQ FRB Cleveland • February 2000 a. Chain-weighted data in billions of 1996 dollars. b. Components of real GDP need not add to totals because current dollar values are deflated at the most detailed level for which all required data are available. NOTE: All data are seasonally adjusted. SOURCES: U.S. Department of Commerce, Bureau of Economic Analysis; and Blue Chip Economic Indicators, January 10, 2000. Gross domestic product (GDP) increased at a 5.8% annual rate in 1999:IVQ, according to the advance (first) estimate, released late in January. Most analysts were surprised at the strength of this measure of domestic real output, although many had raised their forecasts ahead of the release. Also, the back-to-back 5.7% and 5.8% growth rates of the past two quarters intensified the anxiety of those who suspect that, in this unprecedented ninth year of continuous economic expansion, the U.S. economy might soon be pushing the unknown limits of noninflationary output growth. Advance estimates often change significantly—upward or downward—as more complete information is incorporated into the preliminary and final estimates released over the succeeding two months. However, 90% of the time, changes fall within a range of –1.0 to +1.6 percentage points, so revisions are unlikely to alter the perception that strong economic growth persisted through the end of 1999. Some of the apparent sources of GDP strength in 1999:IVQ are probably one-time events. In their absence, growth should ease off to a less sizzling pace in 2000, as forecasts now suggest. For example, the nondurable component of personal consumption expenditures, in which food plays a prominent part, is unlikely to continue contributing more than 1 percentage point to GDP growth rates. Likewise, inventory accumulation may not persistently (continued on next page) 10 • • • • • • • Economic Activity (cont.) Portion of GDP growth rate 2.50 NONFARM INVENTORY: CONTRIBUTION TO GDP GROWTH Ratio 2.20 2.00 2.18 Nonfarm inventory/final sales 1.50 2.16 1.00 2.14 Portion of GDP growth rate 1.5 NATIONAL DEFENSE AND TOTAL FEDERAL SPENDING: CONTRIBUTION TO GDP GROWTH 1.0 Total federal spending National defense 0.5 0.50 2.12 0 2.10 –0.50 2.08 –1.00 2.06 0 –0.5 2.04 –1.50 –1.0 Nonfarm inventory 2.02 –2.00 –2.50 1990:IQ 1992:IQ 1994:IQ 1996:IQ 1998:IQ 2.00 2000:IQ Portion of GDP growth rate 3.0 FIXED INVESTMENT: CONTRIBUTION TO GDP GROWTH –1.5 1990:IQ 1992:IQ 1994:IQ 1996:IQ 1998:IQ 2000:IQ Percent 0 PRICE INDEXES a 2.5 Personal consumption expenditures on computers and peripherals –0.05 Fixed equipment and software 2.0 –0.10 Nonresidential investment on computers and peripherals 1.5 –0.15 1.0 –0.20 0.5 –0.25 0 –0.30 Final sales of computers –0.5 –0.35 –1.0 1990:IQ 1992:IQ 1994:IQ 1996:IQ 1998:IQ 2000:IQ –0.40 1993:IQ 1994:IQ 1995:IQ 1996:IQ 1997:IQ 1998:IQ 1999:IQ 2000:IQ FRB Cleveland • February 2000 a. Annualized percent change. NOTE: All data are seasonally adjusted. SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis. contribute more than 1¼ percentage points to growth as it has in the past two quarters, although the aggregate inventory/sales ratio does not seem particularly high. In addition, both defense and nondefense spending by the federal government happened to hit high quarterly levels, providing almost 1 percentage point of GDP growth. Of course, anomalies in other sectors of the economy may have dampened growth, and their reversal will contribute to continued strength in 2000. Computer sales are a frequently cited example of this. Growth in personal consumption expenditures on computers and peripherals fell by half between the first and fourth quarters of 1999, although retail holiday spending on personal computers was reportedly very strong. Also, fixed investment expenditures on computers and peripherals weakened in 1999:IVQ, with businesses said to have post- poned computer expenditures in order to focus on Y2K preparedness. Firming price conditions also may have played a role. The price index for fixed investment in computers and peripherals declined at only a 12% annual rate in 1999:IVQ, less than half the rate of decline registered between 1994 and early 1999. A similar pattern is apparent for the analogous component of personal consumption expenditures. 11 • • • • • • • Labor Markets Change, thousands of workers 400 AVERAGE MONTHLY NONFARM Labor Market Conditions EMPLOYMENT GROWTH Average monthly change (thousands of employees) 350 300 250 200 1996 1997 1998 1999 Jan. 2000 Payroll employment 234 Goods-producing 32 Mining 1 Construction 28 Manufacturing 3 Durable goods 10 Nondurable goods –7 281 48 2 21 25 27 –2 244 8 –3 30 –19 –9 –10 227 –7 –3 18 –21 –10 –11 387 131 2 116 13 10 3 233 16 20 24 141 17 235 18 26 32 119 27 233 18 12 38 121 29 256 16 –9 43 152 35 Service-producing a TPU FIREb Retail trade Services Government 150 100 202 8 14 43 117 11 50 Average for period (percent) Civilian unemployment 5.4 4.9 4.5 4.3 4.0 0 1992 1993 1994 1995 1996 1997 1998 1999 IVQ Nov. Dec. Jan. 1999 2000 Percent 65.0 LABOR MARKET INDICATORS c Percent 8.0 64.5 7.5 64.0 7.0 63.5 6.5 63.0 6.0 Millions of people 18 AVAILABLE LABOR SUPPLY 17 16 15 14 13 62.5 5.5 Civilian unemployment rate Employment-topopulation ratio 12 62.0 5.0 61.5 4.5 61.0 1991 4.0 1992 1993 1994 1995 1996 1997 1998 1999 2000 11 10 9 1988 1990 1992 1994 1996 1998 FRB Cleveland • February 2000 a. Transportation and public utilities b. Finance, insurance, and real estate. c. Vertical line indicates break in data series due to survey redesign. NOTE: All data are seasonally adjusted. SOURCE: U.S. Department of Labor, Bureau of Labor Statistics. Payroll employment continued to surge in January, recording a net increase of 387,000 jobs. The proportion of the population with jobs increased 0.4%, reaching a record 64.8%. The unemployment rate fell 0.1% to hit 4.0%, its lowest level since January 1970. Average hourly earnings rose 6 cents to $13.50, a 3.5% increase since January 1999. Buoyed by strong gains in construction, employment in the goodsproducing sector, which had average monthly losses of 7,000 in 1999, increased 31,000 last month. Because of unseasonably warm weather during the survey reference period, construction employment increased 116,000 in January. Employment growth in the goods-producing sector was not limited to construction, however; the manufacturing sector gained 13,000 jobs last month. Rapid employment growth continued in the service-producing sector. Despite a significant drop in department store employment, there was a net increase of 43,000 jobs in retail trade. Following four months of stagnant growth, business services also posted strong gains, adding 63,000 jobs in January. Many analysts express increased concern about impending labor shortages. The tight labor market is reflected in the unemployment rate and in the pool of available workers, which has shrunk from about 16 million in 1992 to fewer than 10 million today. This count includes individuals aged 16 to 64 who are either unemployed or not in the labor force, but who report that they want jobs. (continued on next page) 12 • • • • • • • Labor Markets (cont.) Percent of labor force 15 UNEMPLOYMENT RATES Percent of labor force 15 UNEMPLOYMENT RATES BY EDUCATIONAL ATTAINMENT, AGES 25–64 Blacks aged 16–25 12 12 Blacks aged 26–39 Less than high school diploma 9 9 High school diploma Total labor force age 16–25 6 6 Total labor force aged 26–39 Blacks aged 40–60 Some college 3 3 College degree or more Total labor force aged 40–60 0 1988 1990 1992 1994 1998 1996 Percent of female labor force 15 FEMALE UNEMPLOYMENT RATES BY AGE 0 1988 1990 1992 1994 1996 1998 Percent of labor force 9 COMPOSITION OF UNEMPLOYED PERSONS Job losers 8 Black females aged 16– 25 12 Re-entrants into labor force Job leavers 7 New entrants into labor force 6 9 Black females aged 26– 39 5 All females aged 16– 25 4 6 Black females aged 40– 60 All females aged 26– 39 3 2 3 All females aged 40– 60 0 1988 1990 1992 1 1994 1996 1998 0 1988 1990 1992 1994 1996 1998 2000 FRB Cleveland • February 2000 SOURCES: U.S. Department of Labor, Bureau of Labor Statistics, Handbook of U.S. Labor Statistics; and Bureau of the Census, Current Population Survey. The unemployment rate is at a 30-year low, but it varies with demographic factors like age, race, sex, and education. Young workers, who have less experience, predictably have much higher unemployment rates than older cohorts. Just as predictably, those with more education have significantly lower unemployment rates. In 1998, people who had not finished high school had quadruple the unemployment rate of those with four years of college or more. Females have slightly lower unemployment rates than males, while whites have significantly lower rates than African Americans. The unemployment rate is the number of unemployed as a percent of the civilian labor force. The unemployed are those who were available for — and made specific efforts to find — work in the four weeks prior to the monthly survey. Persons not in the labor force include those 16 years and older who are in school, retired, unable to work (due to conditions like disability or illness), homemakers, and workers marginally attached to the labor force. People in the last category, who totaled 1.2 million in January, are available for work and have sought it in the prior 12 months. Marginally attached workers are not counted in the labor force, so they do not affect the unemployment rate. Unemployment fell during the 1990s, primarily because the number of people who lost jobs decreased steadily from 1992 onward. 13 • • • • • • • Employment in the Fourth District UNEMPLOYMENT RATES a SHARE OF MANUFACTURING EMPLOYMENT, 1998 Less than 3.7% Less than 14.9% 3.7% to 4.7% 14.9% to 24.9% More than 4.7% More than 24.9% Percent 12 FOURTH DISTRICT AND U.S. UNEMPLOYMENT RATES CHANGE IN UNEMPLOYMENT RATES b 11 West Virginia 10 9 8 Pennsylvania Decreased more than 0.2% 7 U.S. About the same 6 Kentucky Increased more than 0.2% 5 4 1990 Ohio 1992 1994 1996 1998 2000 FRB Cleveland • February 2000 a. Average for August through October 1999. b. Difference between 1998 and 1999 averages for August through October. SOURCES: U.S. Department of Labor, Bureau of Labor Statistics; Ohio Bureau of Employment Services; Kentucky Department for Employment Services; Pennsylvania Department of Labor and Industry; and West Virginia Bureau of Employment Programs. Recent Fourth District unemployment rates show a distinct geographic pattern. Unemployment in the District’s southern and eastern counties generally exceeds the national average of 4.2%, while counties in the north and west have below-average rates. This may be related to shares of manufacturing employment, which follow roughly the opposite pattern. Counties in the south and east of the District tend to have lower shares of manufacturing employment (manufacturing calculated as a percent of total employment) than counties in the north and west. The greatest variance in unemployment rates was seen in Kentucky, which had the lowest—as well as the highest—county unemployment rate in the District. The Lexington suburbs of Jessamine and Woodford counties both had an extremely low unemployment rate (1.6%). The highest unemployment rate (12.9%) was in Harlan County, located in the Appalachian Mountains along the Virginia border. For unemployment rate changes, the geographic pattern is less clear. In counties where unemployment rates are currently low, there was not much change from the previous year. The largest changes, both negative and positive, were posted in counties that currently have high unemployment rates. The largest decrease occurred in Mercer County, Ohio, while the largest increase was seen in Letcher County, Kentucky. Throughout the 1990s, unemployment rates for Kentucky, Ohio, and Pennsylvania were fairly close to the (continued on next page) 14 • • • • • • • Employment in the Fourth District (cont.) Percent of total employment 24 MANUFACTURING EMPLOYMENT MANUFACTURING EMPLOYMENT BY INDUSTRY, 1999 West Virginia 22 Pennsylvania Kentucky Ohio Ohio 20 Kentucky Industrial machinery and equipment 18 U.S. Pennsylvania Transportation equipment 16 14 West Virginia Fabricated metal products 12 10 1990 Rubber and plastic products 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Index, 1992 = 100 260 INDUSTRIAL PRODUCTION BY INDUSTRY GROUP Primary metals 240 220 Printing and publishing Industrial machinery and equipment 200 180 Electronic and other electrical equipment Motor vehicles and parts 160 140 Chemicals and allied products Fabricated metals 120 100 Total industrial production Transportation equipment 80 1992 1993 1994 1995 1996 1997 1998 1999 2000 Food and kindred products 0 0.5 1.0 1.5 2.0 Percent of total employment 2.5 3.0 FRB Cleveland • February 2000 SOURCES: U.S. Department of Labor, Bureau of Labor Statistics; and Board of Governors of the Federal Reserve System. national average. In 1999, these rates converged at about 4.2%. West Virginia’s unemployment rate remains significantly higher (about 6.4%). However, from its peak in the early 1990s, West Virginia’s rate has fallen by a much higher amount than rates in other Fourth District states. The majority of the District’s counties have manufacturing shares that far exceed the U.S. average of 14.9%. (As we have seen, most of the counties with below-average manufacturing shares are in southern Ohio and eastern Kentucky.) The largest shares of manufacturing employment are found in Union County, Ohio, and Scott County, Kentucky (both about 54%). Each of these counties is home to an automobile assembly plant. During the 1990s, the manufacturing share of employment declined in every Fourth District state, which was consistent with the national trend. Only West Virginia has a share that lags the national average. The largest proportions of Fourth District manufacturing workers are employed in the production of in- dustrial machinery, transportation equipment, and fabricated metals. The production of industrial machinery has grown more than twice as fast as total industrial production since 1992, while that of transportation equipment and fabricated metals has grown a bit more slowly than total industrial production. However, growth in the production of motor vehicles and parts, which makes up the bulk of the Fourth District’s transportation equipment industry, has proceeded at a faster rate than total industrial production. 15 • • • • • • • Earnings of Banks and Savings Institutions Billions of dollars 20 NET INCOME OF FDIC-INSURED BANKS Percent 1.6 RETURN ON ASSETS AND EQUITY OF FDIC-INSURED BANKS 18 Quarterly return on assets Quarterly return on equity 1.4 Securities and other gains Percent 24 21 16 Net operating income 1.2 18 12 1.0 15 10 0.8 12 0.6 9 0.4 6 0.2 3 14 8 6 4 2 0 0 0 IQ IIIQ 1995 IQ IIIQ 1996 IQ IIIQ 1997 IQ 1998 IIIQ IQ 1999 IIIQ Billions of dollars 3.5 NET INCOME OF FDIC-INSURED SAVINGS INSTITUTIONS IQ IQ IIIQ 1996 IQ IIIQ 1997 IQ IIIQ 1998 IQ IIIQ 1999 Percent 1.2 RETURN ON ASSETS AND EQUITY OF Percent 24 FDIC-INSURED SAVINGS INSTITUTIONS Securities and other gains 3.0 IIIQ 1995 21 1.0 Net operating income 18 2.5 0.8 15 2.0 0.6 1.5 12 0.4 1.0 9 0.2 0.5 6 0 0 –0.5 –0.2 Quarterly return on assets 3 Quarterly return on equity IQ IIIQ 1995 IQ IIIQ 1996 a IQ IIIQ 1997 IQ IIIQ 1998 IQ IIIQ 1999 0 IQ IIIQ 1995 IQ IIIQ 1996 a IQ IIIQ 1997 IQ IIIQ 1998 IQ IIIQ 1999 FRB Cleveland • February 2000 a. The sharp decline in 1996 was driven in part by a special insurance assessment on the deposits of savings institutions. SOURCE: Federal Deposit Insurance Corporation, Quarterly Banking Profile. Third-quarter earnings for FDICinsured commercial banks reached record levels. For 1999:IIIQ, commercial banks’ net income rose to $19.4 billion, surpassing the previous quarterly record of $18.0 billion, set in 1999:IQ. Third-quarter profits were $4.4 billion stronger than the previous quarter. The FDIC attributes the rise in profits to strong revenues in noninterest income and to containment of overhead expenses, resulting in the best efficiency ratio on record for banks. For the third quarter of 1999, both the average return on assets (ROA) and the rate of return on equity reached record levels (1.42% and 16.62%, respectively). The largest banks experienced the most dramatic improvements in profitability. However, nearly two-thirds of all banks reported ROAs exceeding 1% for the quarter. FDIC-insured savings institutions reported slightly lower earnings in 1999:IIIQ; the decrease is attributed to reduced gains from securities sales. Savings institutions recorded a third-quarter ROA of 1%, down from the record 1.14% reported a year ago. Nonetheless, approximately 60% of savings institutions experienced increases in earnings over a year ago, and nearly one-third reported ROAs of more than 1%. 16 • • • • • • • Real Estate Loans Percent of loans 2.2 NONCURRENT REAL ESTATE LOANS a Billions of dollars 600 LOANS TO INDIVIDUALS b 2.0 Other consumer loans 500 1.8 Credit card plans Commercial 1.6 400 1.4 Construction and land 300 1.2 1.0 200 Total 1- to 4-family residences 0.8 100 Multifamily residences 0.6 0.4 0 IQ IIQ IIIQ 1997 IVQ IQ IIQ IIIQ 1998 IVQ IQ IIQ 1999 IIIQ 1990 1992 1994 1996 1998 IQ Mean response c 5 DEMAND FOR COMMERCIAL REAL ESTATE LOANS Mean response c 5 DEMAND FOR HOME MORTGAGE LOANS 4 4 3 3 2 IIQ IIIQ 1999 2 1 1 All banks Large banks d Other banks All banks Large banks d Other banks FRB Cleveland • February 2000 a. Noncurrent loans represent the percent of loans in each category that are past due 90 days or more or are in nonaccrual status. b. As of December for each year except 1999; data for 1999 are quarterly. c. Mean response of banks where 1= substantially weaker; 2 = moderately weaker; 3 = about the same; 4 = moderately stronger; and 5 = substantially stronger. d. Total domestic assets of $20 billion or more. SOURCES: Board of Governors of the Federal Reserve System, Senior Loan Officer Opinion Survey on Lending Practices; and Federal Deposit Insurance Corporation, Quarterly Banking Profile. The continued downward trend in noncurrent real estate loans is another indication of health in the banking system. However, noncurrent loans of all types witnessed a minor increase (from 0.94% in the second quarter of 1999 to 0.96% in the third quarter). Total assets in the banking system grew at the slowest rate reported in five years. Although total loans to individuals fell for the third straight quarter, commercial real estate loans rose slightly. The Federal Reserve’s quarterly Senior Loan Officer Opinion Survey, updated in November, substantiates these findings. Loan officers indicated little change in demand for commercial real estate loans, but reported a slight decrease in the demand for home mortgage loans. This represents the second consecutive quarter in which loan officers reported a softening of home mortgage loan demand. Loan officers also indicated a moderate weakening of demand for consumer loans. 17 • • • • • • • Household Financial Conditions Percent 7 CREDIT CARD LOSS RATES AND PERSONAL BANKRUPTCY FILINGS Thousands 400 Percent 6 CONSUMER DELINQUENCIES a 350 6 Personal bankruptcy filings Mortgages 5 300 5 250 4 4 Net charge-off rate 200 3 150 2 Bank credit cards 3 100 2 1 Installment loans 50 0 1984 0 1986 1988 1990 1992 1994 1996 1998 Mean response b 5 CHANGES IN CREDIT CARD TERMS 2000 1 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Percent 10.0 CONSUMER INTEREST RATES 9.5 Credit limits Interest rate spreads from banks’ costs of funds 9.0 Minimum payments 8.5 Home equity line of credit 4 Other 8.0 30-year fixed-rate mortgage 7.5 3 7.0 6.5 15-year fixed-rate mortgage 2 6.0 5.5 Adjustable-rate mortgage 1 All banks Large banks c Other banks 5.0 1995 1996 1997 1998 1999 2000 FRB Cleveland • February 2000 a. Loans past due 30 days or more as a percentage of loans outstanding. b. Mean response of banks where 1= substantially weaker; 2 = moderately weaker; 3 = about the same; 4 = moderately stronger; and 5 = substantially stronger. c. Total domestic assets of $20 billion or more. SOURCES: Board of Governors of the Federal Reserve System, Senior Loan Officer Opinion Survey on Lending Practices; Federal Deposit Insurance Corporation, Quarterly Banking Profile; American Bankers Association, Consumer Credit Delinquency Bulletin; Mortgage Bankers Association of America, National Delinquency Survey; and Bank Rate Monitor. Household financial indicators show little change compared to previous months. Personal bankruptcy filings declined slightly, dropping 21,014 to 314,564, while credit card loss rates increased somewhat to 4.38%. Consumer delinquencies on bank credit cards and installment loans scarcely increased. Late payments on mortgage loans showed no change from previous figures. Bank loan officers indicated a minor tightening in the credit card terms offered to customers. Credit limits remained steady at large banks and tightened slightly at other banks. Minimum payments on credit cards displayed a minor increase. Interest rates increased slightly relative to the cost of funds at all reporting banks. During the last few weeks of 1999, interest rates on home mortgages continued the upward trend seen throughout 1999. The overall increase during 1999 in 15- and 30year home mortgage rates was approximately 130 basis points (bp). During the same period, one-year adjustable-rate mortgages increased approximately 100 bp, whereas interest rates on home equity lines of credit rose nearly 50 bp. 18 • • • • • • • The Current-Account Deficit Billions of dollars 100 CURRENT ACCOUNT Billions of dollars 100 COMPONENTS OF THE CURRENT ACCOUNT 50 50 Investment income 0 0 –50 Unilateral transfers –50 –100 –150 –100 Goods and services –200 –150 –250 –200 –300 –250 –350 –400 3/75 3/79 3/83 3/87 3/91 3/95 3/99 Billions of dollars 600 CAPITAL FLOWS –300 3/75 3/79 3/83 3/87 3/91 3/95 3/99 Billions of dollars 400 Percent of GDP 10 INTERNATIONAL INVESTMENT POSITION 200 500 5 Private 0 400 –200 0 300 –400 200 –5 –600 –800 100 –10 –1,000 0 Official –1,200 –15 –100 –1,400 –200 3/75 –1,600 –20 3/79 3/83 3/87 3/91 3/95 3/99 1984 1986 1988 1990 1992 1994 1996 1998 FRB Cleveland • February 2000 SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis. The U.S. current-account deficit has increased sharply since 1997 and is likely to top $360 billion (approximately 3.5% of GDP) when final data for 1999 become available. Most economists expect the deficit to rise further this year and next. For the most part, the deficit in the U.S. current account moves in tandem with the deficit in our country’s goods and services trade, but a growing shortfall in our net investment income could quickly become another important element. This shortfall results from the financing of trade deficits. The U.S. has been importing more than it exports and has been paying for the surfeit by issuing securities, such as bonds and stocks, that give foreigners a claim on our future income. The process requires an inflow of foreign capital to the U.S. Since 1997, private —rather than official — capital inflows have risen dramatically. In 1988, foreign claims on the U.S. exceeded this country’s claims on foreigners, making ours a debtor country. By the end of 1998, our international indebtedness totaled $1.5 trillion (17.5% of GDP). As our indebtedness grew, so did our interest and dividend payments to foreigners. By 1997, they exceeded U.S. earnings from foreign investments, creating a shortfall in the investment-income component of (continued on next page) 19 • • • • • • • The Current-Account Deficit (cont.) Percent 5 GROWTH DIFFERENTIAL AND CURRENT ACCOUNT Percent of GDP 1.0 4 0.5 3 0 2 –0.5 Annual percent change 10 ECONOMIC GROWTH b Trade-weighted GDP c 8 U.S. GDP 6 1 GDP differential a –1.0 0 –1.5 –1 –2.0 –2 –2.5 4 2 0 Current account –3.0 –3 –3.5 –4 1980 1984 1988 1992 1996 –2 –4 2000 1980 Index, March 1973 = 100 Percent of GDP 125 2 TRADE-WEIGHTED DOLLAR AND CURRENT ACCOUNT Broad Dollar Index 120 1984 1988 1992 1996 2000 Percent of GDP 25 GROSS DOMESTIC INVESTMENT 24 Foreign saving 1 115 Current account 110 0 23 Gross domestic saving 22 21 105 20 –1 100 19 –2 95 90 –3 –4 1975 1978 1981 1984 1987 1990 1993 1996 1999 18 17 85 16 80 15 1975 1978 1981 1984 1987 1990 1993 1996 FRB Cleveland • February 2000 a. The GDP differential equals the difference between foreign and U.S. GDP growth. b. Projections for 1999–2001 utilize various sources. c. The top 15 U.S. trading partners in 1992–97 were Canada, Japan, Mexico, Germany, U.K., China, Taiwan, Korea, France, Singapore, Italy, Hong Kong, Malaysia, Netherlands, and Brazil. d. Gross domestic investment is the sum of gross domestic saving and foreign saving. SOURCES: U.S. Department of Commerce, Bureau of Economic Analysis; Board of Governors of the Federal Reserve System; International Monetary Fund, International Financial Statistics; Blue Chip Economic Indicators, January 10, 2000; and The Economist, January 21–27, 2000. the current account. If interest payments on our foreign indebtedness were to exceed GDP growth, our international indebtedness would grow even if the trade deficit vanished. Prospects for narrowing the trade deficit depend, in large measure, on our major trading partners’ prospects for economic growth. Economists expect foreign economic growth, at approximately 3.5%, to outpace U.S. growth next year. Although rapid foreign eco- nomic growth favors U.S. export expansion, the small differential will have little effect on the currentaccount deficit overall. Typically, foreign economic growth must exceed U.S. growth by 1½ to 2 percentage points before the trade deficit begins to narrow. There is no such growth differential in the immediate outlook. Most people consider the currentaccount deficit detrimental to economic welfare, but they fail to appre- ciate the benefits of the associated foreign-capital inflow. Since the early 1990s, the inflow of foreign capital to the U.S. has helped finance an investment boom, with interest rates below what they otherwise might have been. The ratio of investment to GDP has risen from 17.5% to 20.3%. To the extent that this investment increase supports a higher standard of living, the U.S. will be able to service its international debts without reducing consumption.
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