FRB: Humphrey-Hawkins Report, February 17, 2000

Monetary Policy Report submitted to the Congress on February 17, 2000, pursuant to the Full Employment and Balanced Growth Act of 1978

Section 1


The U.S. economy posted another exceptional performance in 1999. The ongoing expansion appears to have maintained strength into early 2000 as it set a record for longevity, and--aside from the direct effects of higher crude oil prices--inflation has remained subdued, in marked contrast to the typical experience during previous expansions. The past year brought additional evidence that productivity growth has improved substantially since the mid-1990s, boosting living standards while helping to hold down increases in costs and prices despite very tight labor markets.

The Federal Open Market Committee's pursuit of financial conditions consistent with sustained expansion and low inflation has required some adjustments to the settings of monetary policy instruments over the past two years. In late 1998, to cushion the U.S. economy from the effects of disruptions in world financial markets and to ameliorate some of the resulting strains, money market conditions were eased. By the middle of last year, however, with financial markets resuming normal functioning, foreign economies recovering, and domestic demand continuing to outpace increases in productive potential, the Committee began to reverse that easing.

As the year progressed, foreign economies, in general, recovered more quickly and displayed greater vigor than had seemed likely at the start of the year. Domestically, the rapid productivity growth raised expectations of future incomes and profits and thereby helped keep spending moving up at a faster clip than current productive capacity. Meanwhile, prices of most internationally traded materials rebounded from their earlier declines; this turnaround, together with a flattening of the exchange value of the dollar after its earlier appreciation, translated into an easing of downward pressure on the prices of imports in general. Core inflation measures generally remained low, but with the labor market at its tightest in three decades and becoming tighter, the risk that pressures on costs and prices would eventually emerge mounted over the course of the year. To maintain the low-inflation environment that has been so important to the sustained health of the current expansion, the FOMC ultimately implemented four quarter-point increases in the intended federal funds rate, the most recent of which came at the beginning of this month. In total, the federal funds rate has been raised 1 percentage point, although, at 5-3/4 percent, it stands only 1/4 point above its level just before the autumn-1998 financial market turmoil. At its most recent meeting, the FOMC indicated that risks appear to remain on the side of heightened inflation pressures, so it will need to remain especially attentive to developments in this regard.

Monetary Policy, Financial Markets, and the Economy over 1999 and Early 2000

The first quarter of 1999 saw a further unwinding of the heightened levels of perceived risk and risk aversion that had afflicted financial markets in the autumn of 1998; investors became much more willing to advance funds, securities issuance picked up, and risk spreads fell further--though not back to the unusually low levels of the first half of 1998. At the same time, domestic demand remained quite strong, and foreign economies showed signs of rebounding. The FOMC concluded at its February and March meetings that, if these trends were to persist, the risks of the eventual emergence of somewhat greater inflation pressures would increase, and it noted that a case could be made for unwinding part of the easing actions of the preceding fall. However, the Committee hesitated to adjust policy before having greater assurance that the recoveries in domestic financial markets and foreign economies were on firm footing.

By the May meeting, these recoveries were solidifying, and the pace of domestic spending appeared to be outstripping the growth of the economy's potential, even allowing for an appreciable acceleration in productivity. The Committee still expected some slowing in the expansion of aggregate demand, but the timing and extent of any moderation remained uncertain. Against this backdrop, the FOMC maintained an unchanged policy stance but announced immediately after the meeting that it had chosen a directive tilted toward the possibility of a firming of rates. This announcement implemented the disclosure policy adopted in December 1998, whereby major shifts in the Committee's views about the balance of risks or the likely direction of future policy would be made public immediately. Members expected that, by making the FOMC's concerns public earlier, such announcements would encourage financial market reactions to subsequent information that would help stabilize the economy. In practice, however, those reactions seemed to be exaggerated and to focus even more than usual on possible near-term Committee action.

Selected interest rates

Over subsequent weeks, economic activity continued to expand vigorously, labor markets remained very tight, and oil and other commodity prices rose further. In this environment, the FOMC saw an updrift in inflation as a significant risk in the absence of some policy firming, and at the June meeting it raised the intended level of the federal funds rate 1/4 percentage point. The Committee also announced a symmetric directive, noting that the marked degree of uncertainty about the extent and timing of prospective inflationary pressures meant that further firming of policy might not be undertaken in the near term, but that the Committee would need to be especially alert to emerging inflation pressures. Markets rallied on the symmetric-directive announcement, and the strength of this response together with market commentary suggested uncertainty about the interpretation of the language used to characterize possible future developments and about the time period to which the directive applied.

In the period between the June and August meetings, the ongoing strength of domestic demand and further expansion abroad suggested that at least part of the remaining easing put in place the previous fall to deal with financial market stresses was no longer needed. Consequently, at the August meeting the FOMC raised the intended level of the federal funds rate a further 1/4 percentage point, to 5-1/4 percent. The Committee agreed that this action, along with that taken in June, would substantially reduce inflation risks and again announced a symmetric directive. In a related action, the Board of Governors approved an increase in the discount rate to 4-3/4 percent. At this meeting the Committee also established a working group to assess the FOMC's approach to disclosing its view about prospective developments and to propose procedural modifications.

At its August meeting, the FOMC took a number of actions that were aimed at enhancing the ability of the Manager of the System Open Market Account to counter potential liquidity strains in the period around the century date change and that would also help ensure the effective implementation of the Committee's monetary policy objectives. Although members believed that efforts to prepare computer systems for the century date change had made the probability of significant disruptions quite small, some aversion to Y2K risk exposure was already evident in the markets, and the costs that might stem from a dysfunctional financing market at year-end were deemed to be unacceptably high. The FOMC agreed to authorize, temporarily, (1) a widening of the pool of collateral that could be accepted in System open market transactions, (2) the use of reverse repurchase agreement accounting in addition to the currently available matched sale-purchase transactions to absorb reserves temporarily, and (3) the auction of options on repurchase agreements, reverse repurchase agreements, and matched sale-purchase transactions that could be exercised in the period around year-end. The Committee also authorized a permanent extension of the maximum maturity on regular repurchase and matched sale-purchase transactions from sixty to ninety days.

The broader range of collateral approved for repurchase transactions--mainly pass-through mortgage securities of government-sponsored enterprises and STRIP securities of the U.S. Treasury--would facilitate the Manager's task of addressing what could be very large needs to supply reserves in the succeeding months, primarily in response to rapid increases in the demand for currency, at a time of potentially heightened demand in various markets for U.S. government securities. The standby financing facility, authorizing the Federal Reserve Bank of New York to auction the above-mentioned options to the government securities dealers that are regular counterparties in the System's open market operations, would encourage marketmaking and the maintenance of liquid financing markets essential to effective open market operations. The standby facility was also viewed as a useful complement to the special liquidity facility, which was to provide sound depository institutions with unrestricted access to the discount window, at a penalty rate, between October 1999 and April 2000. Finally, the decision to extend the maximum maturity on repurchase and matched sale-purchase transactions was intended to bring the terms of such transactions into conformance with market practice and to enhance the Manager's ability over the following months to implement the unusually large reserve operations expected to be required around the turn of the year.

Incoming information during the period leading up to the FOMC's October meeting suggested that the growth of domestic economic activity had picked up from the second quarter's pace, and foreign economies appeared to be strengthening more than had been anticipated, potentially adding pressure to already-taut labor markets and possibly creating inflationary imbalances that would undermine economic performance. But the FOMC viewed the risk of a significant increase in inflation in the near term as small and decided to await more evidence on how the economy was responding to its previous tightenings before changing its policy stance. However, the Committee anticipated that the evidence might well signal the need for additional tightening, and it again announced a directive that was biased toward restraint.

Information available through mid-November pointed toward robust growth in overall economic activity and a further depletion of the pool of unemployed workers willing to take a job. Although higher real interest rates appeared to have induced some softening in interest-sensitive sectors of the economy, the anticipated moderation in the growth of aggregate demand did not appear sufficient to avoid added pressures on resources, predominantly labor. These conditions, along with further increases in oil and other commodity prices, suggested a significant risk that inflation would pick up over time, given prevailing financial conditions. Against this backdrop, the FOMC raised the target for the federal funds rate an additional 1/4 percentage point in November. At that time, a symmetric directive was adopted, consistent with the Committee's expectation that no further policy move was likely to be considered before the February meeting. In a related action, the Board of Governors approved an increase in the discount rate of 1/4 percentage point, to 5 percent.

At the December meeting, FOMC members held the stance of policy unchanged and, to avoid any misinterpretation of policy intentions that might unsettle financial markets around the century date change, announced a symmetric directive. But the statement issued after the meeting also highlighted members' continuing concern about inflation risks going forward and indicated the Committee's intention to evaluate, as soon as its next meeting, whether those risks suggested that further tightening was appropriate.

The FOMC also decided on some modifications to its disclosure procedures at the December meeting, at which the working group mentioned above transmitted its final report and proposals. These modifications, announced in January 2000, consisted primarily of a plan to issue a statement after every FOMC meeting that not only would convey the current stance of policy but also would categorize risks to the outlook as either weighted mainly toward conditions that may generate heightened inflation pressures, weighted mainly toward conditions that may generate economic weakness, or balanced with respect to the goals of maximum employment and stable prices over the foreseeable future. The changes eliminated uncertainty about the circumstances under which an announcement would be made; they clarified that the Committee's statement about future prospects extended beyond the intermeeting period; and they characterized the Committee's views about future developments in a way that reflected policy discussions and that members hoped would be more helpful to the public and to financial markets.

Financial markets and the economy came through the century date change smoothly. By the February 2000 meeting, there was little evidence that demand was coming into line with potential supply, and the risks of inflationary imbalances appeared to have risen. At the meeting, the FOMC raised its target for the federal funds rate 1/4 percentage point to 5-3/4 percent, and characterized the risks as remaining on the side of higher inflation pressures. In a related action, the Board of Governors approved a 1/4 percentage point increase in the discount rate, to 5-1/4 percent.

Economic Projections for 2000

The members of the Board of Governors and the Federal Reserve Bank presidents, all of whom participate in the deliberations of the FOMC, expect to see another year of favorable economic performance in 2000, although the risk of higher inflation will need to be watched especially carefully. The central tendency of the FOMC participants' forecasts of real GDP growth from the fourth quarter of 1999 to the fourth quarter of 2000 is 3-1/2 percent to 3-3/4 percent. A substantial part of the gain in output will likely come from further increases in productivity. Nonetheless, economic expansion at the pace that is anticipated should create enough new jobs to keep the unemployment rate in a range of 4 percent to 4-1/4 percent, close to its recent average. The central tendency of the FOMC participants' inflation forecasts for 2000--as measured by the chain-type price index for personal consumption expenditures--is 1-3/4 percent to 2 percent, a range that runs a little to the low side of the energy-led 2 percent rise posted in 1999. 1 Even though futures markets suggest that energy prices may turn down later this year, prices elsewhere in the economy could be pushed upward by a combination of factors, including reduced restraint from non-oil import prices, wage and price pressures associated with lagged effects of the past year's oil price rise, and larger increases in costs that might be forthcoming in another year of tight labor markets.

1. Economic projections for 2000
table rule
    Federal Reserve governors
and Reserve Bank presidents
1999 actual
Central tendency
Change, fourth quarter
to fourth quarter
Nominal GDP 5.9 5 to 6 5-1/4 to 5-1/2
Real GDP2 4.2 3-1/4 to 4-1/4 3-1/2 to 3-3/4
PCE chain-type price index 2.0 1-1/2 to 2-1/2   1-3/4 to 2

Average level, fourth quarter
Civilian unemployment
4.1 4 to 4-1/4 4 to 4-1/4
table rule

          1.  Change from average for fourth quarter of 1999 to average for fourth quarter of 2000.
          2.  Chain-weighted.


The performance of the economy--both the rate of real growth and the rate of inflation--will depend importantly on the course of productivity. Typically, in past business expansions, gains in labor productivity eventually slowed as rising demand placed increased pressure on plant capacity and on the workforce, and a similar slowdown from the recent rapid pace of productivity gain cannot be ruled out. But with many firms still in the process of implementing technologies that have proved effective in reorganizing internal operations or in gaining speedier access to outside resources and markets, and with the technologies themselves still advancing rapidly, a further rise in productivity growth from the average pace of recent years also is possible. To the extent that rapid productivity growth can be maintained, aggregate supply can grow faster than would otherwise be possible.

However, the economic processes that are giving rise to faster productivity growth not only are lifting aggregate supply but also are influencing the growth of aggregate spending. With firms perceiving abundant profit opportunities in productivity-enhancing high-tech applications, investment in new equipment has been surging and could well continue to rise rapidly for some time. Moreover, expectations that the investment in new technologies will generate high returns have been lifting the stock market and, in turn, helping to maintain consumer spending at a pace in excess of the current growth of real disposable income. Impetus to demand from this source also could persist for a while longer, given the current high levels of consumer confidence and the likely lagged effects of the large increments to household wealth registered to date. The boost to aggregate demand from the marked pickup in productivity growth implies that the level of interest rates needed to align demand with potential supply may have increased substantially. Although the recent rise in interest rates may lead to some slowing of spending, aggregate demand may well continue to outpace gains in potential output over the near term, an imbalance that contains the seeds of rising inflationary and financial pressures that could undermine the expansion.

In recent years, domestic spending has been able to grow faster than production without engendering inflation partly because the external sector has provided a safety valve, helping to relieve the pressures on domestic resources. In particular, the rapid growth of demand has been met in part by huge increases in imports of goods and services, and sluggishness in foreign economies has restrained the growth of exports. However, foreign economies have been firming, and if recovery of these economies stays on course, U.S. exports should increase faster than they have in the past couple of years. Moreover, the rapid rise of the real exchange value of the dollar through mid-1998 has since given way to greater stability, on average, and the tendency of the earlier appreciation to limit export growth and boost import growth is now diminishing. From one perspective, these external adjustments are welcome because they will help slow the recent rapid rates of decline in net exports and the current account. They also should give a boost to industries that have been hurt by the export slump, such as agriculture and some parts of manufacturing. At the same time, however, the adjustments are likely to add to the risk of an upturn in the inflation trend, because a strengthening of exports will add to the pressures on U.S. resources and a firming of the prices of non-oil imports will raise costs directly and also reduce to some degree the competitive restraints on the prices of U.S. producers.

Domestically, substantial plant capacity is still available in some manufacturing industries and could continue to exert restraint on firms' pricing decisions, even with a diminution of competitive pressures from abroad. However, an already tight domestic labor market has tightened still further in recent months, and bidding for workers, together with further increases in health insurance costs that appear to be coming, seems likely to keep nominal hourly compensation costs moving up at a relatively brisk pace. To date, the increases in compensation have not had serious inflationary consequences because they have been offset by the advances in labor productivity, which have held unit labor costs in check. But the pool of available workers cannot continue to shrink without at some point touching off cost pressures that even a favorable productivity trend might not be able to counter. Although the governors and Reserve Bank presidents expect productivity gains to be substantial again this year, incoming data on costs, prices, and price expectations will be examined carefully to make sure a pickup of inflation does not start to become embedded in the economy.

The FOMC forecasts are more optimistic than the economic predictions that the Administration recently released, but the Administration has noted that it is being conservative in regard to its assumptions about productivity growth and the potential expansion of the economy. Relative to the Administration's forecast, the FOMC is predicting a somewhat larger rise in real GDP in 2000 and a slightly lower unemployment rate. The inflation forecasts are fairly similar, once account is taken of the tendency for the consumer price index to rise more rapidly than the chain-type price index for personal consumption expenditures.

Money and Debt Ranges for 2000

At its most recent meeting, the FOMC reaffirmed the monetary growth ranges for 2000 that were chosen on a provisional basis last July: 1 percent to 5 percent for M2, and 2 percent to 6 percent for M3. As has been the case for some time, these ranges were chosen to encompass money growth under conditions of price stability and historical velocity relationships, rather than to center on the expected growth of money over the coming year or serve as guides to policy.

2. Ranges for growth of monetary and debt aggregates
table rule
M2 1 to 5 1 to 5 1 to 5
M3 2 to 62 to 6 2 to 6
Debt 3 to 7 3 to 7 3 to 7
table rule

      Note. Change from average for fourth quarter of preceding year
to average for fourth quarter of year indicated.


Given continued uncertainty about movements in the velocities of M2 and M3 (the ratios of nominal GDP to the aggregates), the Committee still has little confidence that money growth within any particular range selected for the year would be associated with the economic performance it expected or desired. Nonetheless, the Committee believes that money growth has some value as an economic indicator, and it will continue to monitor the monetary aggregates among a wide variety of economic and financial data to inform its policy deliberations.

M2 increased 6-1/4 percent last year. With nominal GDP rising 6 percent, M2 velocity fell a bit overall, although it rose in the final two quarters of the year as market interest rates climbed relative to yields on M2 assets. Further increases in market interest rates early this year could continue to elevate M2 velocity. Nevertheless, given the Committee's expectations for nominal GDP growth, M2 could still be above the upper end of its range in 2000.

M3 expanded 7-1/2 percent last year, and its velocity fell about 1-3/4 percent, a much smaller drop than in the previous year. Non-M2 components again exhibited double-digit growth, with some of the strength attributable to long-term trends and some to precautionary buildups of liquidity in advance of the century date change. One important trend is the shift by nonfinancial businesses from direct holdings of money market instruments to indirect holdings through institution-only money funds; such shifts boost M3 at the same time they enhance liquidity for businesses. Money market funds and large certificates of deposit also ballooned late in the year as a result of a substantial demand for liquidity around the century date change. Adjustments from the temporarily elevated level of M3 at the end of 1999 are likely to trim that aggregate's fourth-quarter-to-fourth-quarter growth this year, but not sufficiently to offset the downward trend in velocity. That trend, together with the Committee's expectation for nominal GDP growth, will probably keep M3 above the top end of its range again this year.

Domestic nonfinancial debt grew 6-1/2 percent in 1999, near the upper end of the 3 percent to 7 percent growth range the Committee established last February. This robust growth reflected large increases in the debt of businesses and households that were due to substantial advances in spending as well as to debt-financed mergers and acquisitions. However, the increase in private-sector debt was partly offset by a substantial decline in federal debt. The Committee left the range for debt growth in 2000 unchanged at 3 percent to 7 percent. After an aberrant period in the 1980s during which debt expanded much more rapidly than nominal GDP, the growth of debt has returned to its historical pattern of about matching the growth of nominal GDP over the past decade, and the Committee members expect debt to remain within its range again this year.


1.   In past Monetary Policy Reports to the Congress, the FOMC has framed its inflation forecasts in terms of the consumer price index. The chain-type price index for PCE draws extensively on data from the consumer price index but, while not entirely free of measurement problems, has several advantages relative to the CPI. The PCE chain-type index is constructed from a formula that reflects the changing composition of spending and thereby avoids some of the upward bias associated with the fixed-weight nature of the CPI. In addition, the weights are based on a more comprehensive measure of expenditures. Finally, historical data used in the PCE price index can be revised to account for newly available information and for improvements in measurement techniques, including those that affect source data from the CPI; the result is a more consistent series over time. This switch in presentation notwithstanding, the FOMC will continue to rely on a variety of aggregate price measures, as well as other information on prices and costs, in assessing the path of inflation.


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