Board of Governors of the Federal Reserve System

Monetary Policy Report to the Congress Pursuant to the 
Full Employment and Balanced Growth Act of 1978

July 22, 1997


Letter of Transmittal
---------------------
Board of Governors of the
Federal Reserve System
Washington, D.C., July 22, 1997

THE PRESIDENT OF THE SENATE 
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES 

The Board of Governors is pleased to submit its Monetary Policy Report
to the Congress, pursuant to the Full Employment and Balanced Growth
Act of 1978. 
        
Sincerely, 
Alan Greenspan, Chairman
------------------------  


Section 1: Monetary Policy and the Economic Outlook     

The economy continued to perform exceptionally well in the first half of 1997. Real output grew
briskly, while inflation ebbed. Sizable further increases in payrolls pushed the unemployment rate
below 5 percent for the first time in nearly twenty-five years. Although growth in real gross
domestic product appears to have slowed in the spring, this slackening came on the heels of a
dramatic surge in the opening months of the year; all indications are that the expansion remains
well intact. The members of the Board of Governors and the Reserve Bank presidents anticipate
that the economy will grow at a moderate pace in the second half of this year and in 1998 and that
inflation will remain low. Conditions in financial markets are supportive of continued growth:
Longer-term interest rates are in the lower portion of the range observed in this decade, the stock
market has registered all-time highs, and credit remains readily available to private borrowers.     

Since the February report on monetary policy, Federal Reserve policymakers have revised upward
their expectations for growth of real activity in 1997 and trimmed their forecasts of inflation. This
combination of revisions highlights the extraordinarily positive conditions still prevailing more
than six years into the current economic expansion. In part, the recent confluence of
higher-than-expected output and lower inflation has reflected the favorable influences on prices of
retreating oil prices and a strong dollar. But it may also be attributable to more durable changes in
our economy, notably a greater flexibility and competitiveness in labor and product markets and
more rapid, technology-driven gains in efficiency. In essence, the economy may be experiencing
an upward shift in its longer-range output potential.     

To the extent that aggregate supply is expanding more rapidly, monetary policy can accommodate
extra growth in demand without fostering increased inflationary pressures. In late March,
however, the Federal Open Market Committee concluded that there was a significant risk that
aggregate demand would grow faster in the coming quarters than available supply, which, with
utilization already at a very high level, would place the economy's resources under increasing
strain. If such unsustainable growth persisted, the resulting inflationary imbalances would
eventually undermine the health of the expansion--the all too frequent pattern of past business
cycles. To protect against the possibility of such an outcome, the Committee tightened policy
slightly. With the softening of demand in the spring, the Committee was able to maintain a steady
posture in the money market while closely monitoring economic developments. The ongoing
objective of monetary policy is to help the nation achieve maximum sustainable economic growth
and the highest average living standards. The Federal Reserve recognizes that it can best
accomplish this objective by keeping inflation in check, because an environment of price stability
is most conducive to sound, long-term planning by households and businesses.     


Monetary Policy, Financial Markets, and the Economy over the First Half of 1997     

The rapid economic growth observed in the closing months of 1996 continued in the first quarter
of this year, with real GDP advancing almost 6 percent at an annual rate. Consumer spending
surged, fueled by a significant increase in income, upbeat consumer attitudes, and the effects of
the huge run-up in equity prices over the past couple of years on household net worth. Business
fixed investment was strong, and companies restocked inventories that had become thin as sales
soared. The advance in real output provided support for considerable new hiring; rising pay and
greater job availability drew additional people into the workforce, lifting the labor force
participation rate to a new high during the first quarter of the year. The underlying trend in
consumer price inflation was still subdued. Inflation pressures were held in check by smaller food
price increases, declining prices for non-oil imports, the marked expansion of industrial capacity in
recent years, and continuing efforts by businesses to boost efficiency.     

At their meeting in late March, Federal Open Market Committee (FOMC) members expected that
the growth of economic activity would ease in the coming months, but they were uncertain about
the likely extent of that slowing. Although the first-quarter burst in production had owed
importantly to a number of temporary factors, many of the fundamentals underlying consumer and
business demand remained quite positive. The Committee was concerned about the risk that if
outsized gains in real output continued, pressures on costs and prices would emerge that could
eventually undermine the expansion. Therefore, to help foster more sustainable trends in output
and guard against potential inflationary imbalances, the Committee firmed policy slightly by
raising the expected federal funds rate from around 5-1/4 percent to around 5-1/2 percent.     

The unsustainably strong pace of economic growth in the first quarter weighed on financial
markets. Interest rates rose substantially, even before the System's action, despite favorable news
on inflation. Because the policy tightening was widely anticipated, rates were little affected by the
announcement, but they moved up a little more in the following weeks as incoming data
suggested persistent strength in economic activity. Equity prices rose early in the first quarter and
then declined, changing relatively little on net. The trade-weighted value of the dollar in terms of
the other G-10 currencies increased about 7 percent in the first quarter, reflecting the
unexpectedly strong economic growth in the United States and market uncertainty about
economic performance abroad.     

As the second quarter progressed, it became increasingly evident that economic activity had
indeed decelerated. The expansion of consumer spending eased considerably, while business fixed
investment remained strong. Employment continued to climb rapidly, pushing the unemployment
rate down below 5 percent on average in the second quarter--the lowest level since the early
1970s. Despite high levels of employment and production through the first half of the year, there
were few signs that inflation was deviating significantly from recent trends. Although overall
consumer price inflation dipped in the second quarter as energy prices declined, consumer prices
excluding food and energy increased at about the same pace in the first half of the year as in 1996. 

Continued favorable price movements and the slowing of economic growth suggested to financial
market participants that inflation might remain damped without a further tightening of financial
conditions, and this belief prompted a substantial drop in interest rates from late April to mid-July,
reversing the earlier advance. With resource utilization still at very high levels, and with economic
and financial conditions conducive to robust increases in spending, the FOMC at its May meeting
continued to view the risks as skewed toward the re-emergence of inflationary pressures. But the
moderation in aggregate demand and uncertainty about the relationship between utilization rates
and inflation led the Committee to leave reserve conditions unchanged in May and again in July.
The drop in market interest rates in the second quarter may also have been encouraged by
favorable news about this year's federal budget deficit and by the agreement between the President
and the Congress to balance the budget in fiscal year 2002. Spurred by lower rates and greater
optimism about the long-term outlook for earnings, the stock market surged in the second quarter
and into July. The value of the dollar rose somewhat further in foreign-exchange markets, on
balance, an increase more than accounted for by an appreciation against continental European
currencies.     

During the first half of the year, credit remained available on favorable terms to most households
and businesses. High delinquency rates for consumer loans encouraged many banks to tighten
standards, but consumer loan rates generally stayed fairly low relative to benchmark Treasury
rates, and consumer credit continued to grow faster than income and only a little below the pace
of 1996. Home mortgage debt advanced at a moderate rate, with home equity loans expanding
especially rapidly in the spring. Businesses continued to have access to ample external funding
both directly in capital markets and through financial intermediaries. The spreads between yields
on corporate bonds and Treasury securities stayed low or fell further, and, relative to market
rates, bank business loan rates held near the lower end of the range seen in the current expansion.  
  

Total domestic nonfinancial debt expanded more slowly in the first half of 1997 than in 1996,
mainly because of a reduced pace of federal borrowing. Trends in the monetary aggregates during
the first half of 1997 were similar to those in 1996, with M2 near the upper end of the range set
by the FOMC and M3 somewhat above its range. This outcome was in line with FOMC
expectations, because the ranges had been set to be consistent with conditions of price stability,
and inflation, while damped, remained above this level. The behavior of M2 in the first part of the
year was again reasonably well explained by changes in nominal GDP and interest rates.     


Economic Projections for 1997 and 1998     

After growing swiftly on balance over the first half of the year, economic activity is expected to
expand more moderately in the second half of 1997 and in 1998. For this year, the central
tendency of the GDP growth forecasts put forth by members of the Board of Governors and the
Reserve Bank presidents is 3 percent to 3-1/4 percent, measured as the change in real output
between the final quarter of 1996 and the final quarter of 1997. For 1998, most of the forecasts
anticipate growth of real GDP within a range of 2 percent to 2-1/2 percent. With this pace of
continued economic expansion over the next six quarters, the central tendency of forecasts for the
civilian unemployment rate remains a little under 5 percent through 1998, about the average for
the second quarter of this year.     

Economic activity appears to have entered the second half with considerable positive momentum.
Households have experienced hefty gains in employment, income, and wealth, and their optimism
about the future is quite high. These factors seem likely to outweigh any drag on consumer
demand that might be associated with the debt-servicing problems that some households have
experienced. Lower mortgage rates are buttressing demand for homes. In the business sector,
healthy balance sheets and profits and a moderate cost of external funds, along with a continuing
desire to install new technology, are providing support and impetus for investment in equipment.
Meanwhile, investment in structures should follow last year's strong performance with further
increases, because of declining vacancy rates in some sectors and ready access to financing.     

Notwithstanding the economy's positive momentum, growth is expected to be more moderate in
the next year and a half than in the first half of 1997. In part, this deceleration is likely to reflect
the influence on demand of the substantial buildup of stocks of household durables and business
plant and equipment thus far in the expansion. As well, the pace of inventory investment will need
to slacken considerably relative to that observed in the first part of this year, lest stock-to-sales
ratios become uncomfortably high. In the external sector, the strength of the dollar on exchange
markets since last year could damp export sales and encourage U.S. firms and households to
purchase foreign-produced goods and services.     

Federal Reserve policymakers believe that this year's rise in the CPI will be smaller than that of
1996, mostly because of favorable developments in the food and, especially, energy sectors. After
last year's run-up, crude oil prices have dropped back significantly, pulling down the prices of
petroleum products. Food price increases also have been subdued this year, as the decline in grain
prices that began in the middle of last year has been working its way through to the retail level.
Looking ahead to next year, the governors and Reserve Bank presidents expect larger increases in
the CPI, with a central tendency from 2-1/2 percent to 3 percent. Food and energy prices are not
expected to repeat this year's salutary performance, and non-oil import prices may be less of a
restraining influence than in 1997, absent a continued uptrend in the dollar. Moreover, there is a
risk that high levels of resource utilization could begin putting upward pressure on business costs.  

As noted in past monetary policy reports, the CPI forecasts of Federal Reserve policymakers
incorporate the technical improvements that the Bureau of Labor Statistics is making to the CPI
in 1997 and 1998. A series of technical changes is estimated to have trimmed reported rates of
CPI inflation slightly in recent years, and the additional changes will affect the index this year and
next. In light of the challenges of accurately measuring price changes in a complex and dynamic
economy, the governors and Reserve Bank presidents will continue placing substantial weight on
other price indexes, along with the CPI, in gauging progress toward the long-run goal of price
stability.     

The Administration has not yet released an update of the economic projections contained in the
February Economic Report of the President. The earlier Administration forecasts were broadly
similar to those in the Federal Reserve's February report, with Administration forecasts for growth
and inflation within or near the range anticipated by Federal Reserve policymakers in February.
Because of developments in the economy since that time, the central tendency of forecasts for real
GDP growth put forth by the members of the Board of Governors and the Reserve Bank
presidents has moved higher, while their forecasts for the CPI have moved down.    


Money and Debt Ranges for 1997 and 1998     

At its meeting earlier this month, the Committee reaffirmed the ranges for 1997 growth of money
and debt that it had established in February: 1 percent to 5 percent for M2, 2 percent to 6 percent
for M3, and 3 percent to 7 percent for the debt of the domestic nonfinancial sectors. The
Committee also set provisional ranges for 1998 at the same levels as for 1997.     

In choosing the ranges for M2 and M3, the Committee recognized the continuing uncertainty
about the future behavior of the velocities of the two aggregates. For several decades until the
1990s, these aggregates exhibited fairly stable trends relative to nominal spending, and variations
in M2 growth around its trend were reasonably closely related to changes in the spread between
market rates and yields on the assets in M2. These relationships were disrupted in the first part of
this decade. Between 1991 and early 1994, the velocities of M2 and M3 climbed well above the
levels that were predicted by past experience, as households shifted substantial amounts out of
lower-yielding deposits into higher-yielding stock and bond mutual funds, and as banks and thrift
institutions sharply curtailed their lending to focus on rebuilding capital. Since mid-1994, the
velocities have been moving more nearly in line with their historical patterns with respect to
changes in opportunity costs--albeit at higher levels. This recent period of renewed stability is still
brief, however, and has occurred at a time of relatively stable financial and economic conditions,
leaving open the important question of whether the stability would be sustained in the future
under a wider variety of circumstances.     

In light of this uncertainty, the Committee again decided to view the ranges as benchmarks for
monetary growth rates that would be consistent with approximate price stability and historical
velocity relationships. If velocities change little over the next year and a half, Committee members'
expectations of nominal GDP growth in 1997 and 1998 imply that M2 and M3 will likely finish
around the upper boundaries of their respective ranges each year. The debt of the domestic
nonfinancial sectors is expected to remain near the middle of its range this year and next. The
Committee will continue to monitor the behavior of the monetary aggregates and domestic
nonfinancial debt--as well as a wide range of other data--for information about economic and
financial developments.    

  
 
 
Section 2: Economic and Financial Developments in 1997     
 
The economy has continued to perform exceptionally well this year. Real gross domestic product
surged almost 6 percent at an annual rate in the first quarter of 1997, and available data point to a
healthy, though smaller, increase in the second quarter. Financial conditions remained supportive
of spending. Despite a modest tightening of money market conditions by the System, most
interest rates were little changed or declined a bit on net during the first half of the year, and
equity prices surged ahead. With relatively few exceptions, credit remained readily available from
both intermediaries and financial markets on generally favorable terms. The rapid increases in
output led to a further tightening of labor markets in the first six months of 1997, and labor costs
accelerated a little from the pace of a year earlier. Price inflation has been subdued, held down in
part by declines in energy prices, smaller increases in food prices, and lower prices for non-oil
imports that have followed in the wake of the appreciation of the dollar. In addition, intense
competition, adequate plant capacity, and ongoing efficiency gains have helped to restrain
inflation pressures in the face of rising wages.      
 
 
The Household Sector     
 
Spending, Income, and Saving. After posting a sizable increase in 1996, real personal
consumption expenditures jumped 5-1/2 percent at an annual rate in the first quarter of 1997.
Although the advance in spending slowed thereafter--partly because of unusually cool weather in
late spring--underlying fundamentals for the household sector remain favorable to further solid
gains; notably, real incomes have continued to rise, and many consumers have benefited from
sizable gains in wealth. With this good news in hand, consumers have become extraordinarily
upbeat about the economy's prospects. Indexes of consumer sentiment--such as those compiled by
the Survey Research Center at the University of Michigan and the Conference Board--have soared
to some of the highest readings since the 1960s. Despite this generally healthy picture, some
households still face difficulties meeting debt obligations, and delinquency rates for consumer
loans have remained at high levels.    
 
Real outlays for consumer durables surged 18-3/4 percent (annual rate) in the first quarter of this
year but apparently slowed considerably in the second quarter. After changing little, on net, last
year, consumer purchases of motor vehicles increased rapidly early in the year, a result of sound
fundamentals, a bounceback from the strike-depressed fourth quarter, and enlarged incentives
offered by auto makers. In the second quarter, sales were once again held down noticeably by
strike-related supply constraints, as well as by some payback from the elevated first-quarter pace.
Smoothing through the ups and downs, the underlying pace of demand in the first half of the year
likely remained reasonably close to the 15 million unit rate that has prevailed since the second half
of 1995. Purchases of durable goods other than motor vehicles also took off in the first quarter;
computers and other electronic equipment were an area of notable strength, as households took
advantage of rapidly falling prices to acquire the latest technology. According to available
monthly data, purchases of durables other than motor vehicles and electronic equipment
moderated in the second quarter. Although a pause in the growth of spending is not surprising
after the strong first quarter, unusually cool spring weather, leading to the postponement of
purchases of some seasonal items, may also have contributed to the moderation.    
 
Growth of real spending for nondurables also appears to have slowed considerably from a strong
first-quarter pace. Within services, weather conditions held down growth of real outlays for
energy services in the first quarter and boosted them in the second. Growth of real outlays for
other services--typically the steadiest component of consumption--picked up at the end of 1996
and appears to have stayed ahead of last year's 2-1/2 percent pace in the first half of 1997.     
 
Consumer spending continued to draw support from healthy advances in income this year, as
gains in wages and salaries boosted personal disposable income. These gains translated into a 4
percent annual rate advance in real disposable income in the first quarter, after a significant 2-3/4
percent advance last year. Although month-to-month movements were affected by unevenness in
the timing of tax payments, the underlying trend in real disposable income remained strong into
the second quarter.     
 
On top of rising incomes, further increases in net worth--primarily related to the soaring stock
market--have given many households the financial wherewithal to spend. In light of the very large
gains in wealth, the impetus to consumption appears to have been smaller than might have been
anticipated on the basis of historical relationships, suggesting that other factors may be offsetting
the effect of higher net worth. One such factor could be a greater focus on retirement savings,
particularly among the large cohort of the population reaching middle age. Concerns about the
adequacy of saving for retirement have likely been heightened by increased public discussion of
the financial problems of social security and federal health programs. In addition, debt problems
may be restraining the spending of some households.     
 
Residential Investment. The underlying pace of housing activity has remained at a high level this
year, even though some indicators suggest that activity has edged off a bit from last year's pace. In
the single-family sector, housing starts through June averaged 1.14 million units at an annual rate,
a shade below the pace of starts in 1996. Although starts dipped in the second quarter, the decline
was from a first-quarter level that, doubtless, was boosted by mild weather. Mortgage rates have
zig-zagged moderately this year; the average level has differed little from that in 1996. With
mortgage rates low and income growth strong, a relatively large proportion of families has been
able to afford the monthly cost of purchasing a home. Home sales have remained strong, helping
to keep inventories of unsold new units relatively lean--a favorable factor for prospective building
activity. Other indicators of demand remain quite positive. According to the latest survey by the
National Association of Homebuilders, builders' ratings of new home sales strengthened in recent
months to the highest level since last August. Moreover, consumers' assessments of conditions for
homebuying, as reported by the Survey Research Center at the University of Michigan, remained
very favorable into July. In addition, the volume of applications for mortgages to purchase homes
has moved up recently to a high level.     
 
The pace of multifamily starts has been well maintained. These starts averaged close to 320,000
units at an annual rate from January to June, a little above last year's figure for starts. Even so, the
pace of multifamily construction remains well below peaks in the 1970s and 1980s, partly because
of changes in the nation's demographic composition as the bulge of renters in the 1980s has
moved on to home ownership. Another factor that has restrained multifamily construction is the
growing popularity of manufactured housing ("mobile homes"), which provides an alternative to
rental housing for some households. In particular, the price of a typical manufactured unit is
considerably less than that of a new single-family house, making manufactured homes especially
attractive to first-time buyers and to people purchasing second houses or retirement homes.
Shipments of these homes trended up through last fall and then flattened out at a relatively high
level.     
 
Household Finance. Household balance sheets strengthened in the aggregate during the first half
of 1997, but debt-payment problems continued at a high level in several market segments.
Indebtedness grew less rapidly than it had in 1996, and further gains in equity markets pushed up
the ratio of household net worth to disposable personal income to its highest mark in recent
decades. Consumer credit increased at a 6-1/4 percent annual rate between December 1996 and
May 1997, compared with 8-1/4 percent in 1996. The growth of mortgage debt was somewhat
slower in the first quarter than in 1996 and, according to available indicators, probably stayed at
roughly the same rate during the second quarter.      
 
The estimated ratio of required payments of loan principal and interest to disposable personal
income remained high in the first quarter, after climbing rapidly between early 1994 and early
1996 and rising more slowly in the second half of last year. This measure of the debt-service
burden of households has nearly returned to the peak reached toward the end of the last business
cycle expansion. Adding estimated payments on auto leases to households' scheduled monthly
debt payments boosts the ratio a little more than 1 percentage point and places it just above its
previous peak.    
 
Indicators of households' ability to service their debt have been mixed. The delinquency rate for
mortgage loans past due sixty days or more is at its lowest level in two decades, but delinquency
rates for consumer loans are relatively high. According to data from the Report of Condition and
Income filed by banks (the Call Report), the delinquency rate for credit card loans was roughly
unchanged in the first quarter of 1997, remaining at its highest value since late 1992, when the
economy was in the midst of a sluggish recovery and the unemployment rate was more than 2
percentage points higher than today. For auto loans at the finance companies affiliated with the
major manufacturers, the delinquency rate rose again in the first quarter, continuing the steady
run-up in this measure over the past three years.     
 
Anecdotal evidence suggests that the recent increases in consumer credit delinquency rates had
been partly anticipated by lenders, reflecting the normal seasoning of loans as well as banks'
efforts to stimulate borrowing by making credit more broadly available and automakers' attempts
to stimulate sales using the same approach. During the past several years, lenders have
aggressively sought business from people who might not have been granted credit previously, in
part because of lenders' confidence in new "credit scoring" models that statistically evaluate an
individual's creditworthiness. Despite these new tools, banks evidently have been surprised by the
extent of the deterioration of their consumer loans and have tightened lending standards as a
result. Nearly half the banks responding to the Federal Reserve's May survey on bank lending
practices had imposed more stringent standards for new credit card accounts over the preceding
three months, with a smaller fraction reining in other consumer loans. About one-third more of
the responding banks expected charge-off rates on consumer loans to increase further over the
remainder of the year than expected charge-off rates to decrease; many of those expecting an
increase cited consumers' growing willingness to declare bankruptcy. Rising delinquency rates
have also put pressure on firms specializing in subprime auto loans, with some reporting reduced
profits and acute liquidity problems.     
 
According to the most recently available data, personal bankruptcies surged again in the first
quarter of the year after rising 30 percent in 1996. The rapid increases of late are partly related to
the same increase in financial stress evident in the delinquency statistics, but they may also be tied
to more widespread use of bankruptcy as a means of dealing with such stress. Changes in federal
bankruptcy law effective at the start of 1995 increased the value of assets that may be protected
from liquidation, and there may also be a secular trend toward less stigma being associated with
declaring bankruptcy.     
 
 
The Business Sector     
 
Investment Expenditures. Following a fifth year of sizable increases in 1996, real business fixed
investment rose at an annual rate of 11 percent in the first quarter. The underlying determinants of
investment spending remain solid: strong business sales, sizable increases in cash flow, and a
favorable cost of capital, especially for high-tech equipment. To be sure, a significant portion of
this investment has been required to update and replace depreciated plant and equipment;
nevertheless, the current pace of investment implies an appreciable expansion of the capital stock.  

Real outlays for producers' durable equipment jumped at an annual rate of 12-3/4 percent in the
first quarter of this year after rising 9-3/4 percent last year. As in recent years, purchases of
computers and other information processing equipment contributed importantly to this gain. The
computer sector has been propelled by declining prices of new and more powerful products and
by a drive in the business sector to improve efficiency with these latest technological
developments. Real purchases of communications equipment also have been robust, boosted by
rapidly growing demand for wireless phone services and Internet connections as well as by
upgrades to telephone switching and transmission equipment in anticipation of eventual
deregulation of local phone markets. In addition, purchases of aircraft by domestic airlines moved
higher on net in 1995 and 1996 and--on the basis of orders and production plans of aircraft
makers--are expected to rise considerably further this year. For the second quarter, data on orders
and shipments of nondefense capital goods in April and May imply that healthy increases in
equipment investment have continued.     
 
Real business spending for nonresidential structures posted another sizable increase in the first
quarter after advancing a hefty 9 percent in 1996. Although the latest data suggest a slowing of
the pace of advance in the second quarter, the economic factors underlying this sector point to
continued increases. Vacancy rates have been falling and rents have been improving. Financing for
commercial construction reportedly is in abundant supply, especially with substantial amounts of
capital flowing to real estate investment trusts (REITs).     
 
Trends in construction continue to differ among sectors. Increases in office construction were
especially robust in recent quarters, as vacancy rates fell for both downtown and suburban
properties. With office-based employment expanding, this sector has continued to recover from
the severe slump of the late 1980s and early 1990s; even so, the level of construction activity is
barely more than half that of the mid-1980s. Construction of other commercial buildings has
increased steadily during the past five years, and the gain in the first quarter of this year was
sizable. Since the current expansion began, the non-office commercial sector has provided a large
contribution to overall construction spending. Industrial construction dropped back in the first
quarter after jumping at the end of last year; the trend for this sector has been relatively flat on
balance in recent years.     
 
During 1996, investment in real nonfarm business inventories was modest compared with the
growth of sales, and the year ended with lean inventories in many sectors. In the first quarter of
this year, businesses moved to rebuild stocks, and inventory investment picked up substantially.
Outside of motor vehicles, stocks rose in the first quarter, with particularly sizable increases
coming from a continued ramp-up in production of aircraft and from a restocking of petroleum
products during a period when prices eased. Nevertheless, with extraordinarily strong sales,
inventory-sales ratios still moved down further in the major sectors. Available monthly data
suggest that vigorous inventory investment outside of motor vehicles continued through
mid-spring, as firms responded to strength in current and prospective sales. For motor vehicles,
inventories moved up some in the first quarter of this year, after strike-related reductions in the
fourth quarter. In the second quarter, the monthly pattern of motor vehicles stocks was bounced
around somewhat by strikes; cutting through the noise, inventories of light vehicles still appear to
be in balance.     
 
Corporate Profits and Business Finance. The continued rapid advance of business investment
this year has been financed through both strong cash flow and substantial borrowing at relatively
favorable terms. Economic profits (book profits after inventory valuation and capital consumption
adjustments) in the first quarter were 7-3/4 percent higher than a year earlier. For the nonfinancial
sector, domestic profits were more than 9 percent higher, reaching their highest share of those
firms' domestic output in the current expansion. Despite abundant profits, the financing gap for
these companies--the excess of capital expenditures (including inventory investment) over
internally generated funds--has widened somewhat since the middle of 1996. To fund that gap,
and the ongoing net retirement of equity shares, nonfinancial corporations increased their debt
6-1/2 percent at an annual rate in the first quarter, compared with 5-1/4 percent during 1996.     
 
External funding has remained readily available to businesses on favorable terms. The spreads
between yields on investment-grade bonds and yields on Treasury securities have stayed low since
the beginning of the year, while the spreads on high-yield bonds have declined further to
historically narrow levels. Price-earnings ratios are high, implying a low cost of equity financing.
Further, banks remain accommodative lenders to businesses. According to the Federal Reserve's
most recent survey of business lending, the spreads between loan rates and market rates have held
about steady for borrowers of all sizes, with rate spreads for large loans near the lower end of the
range seen over the past decade. Moreover, surveys by the National Federation of Independent
Business indicate that small businesses have not had difficulty obtaining credit.      
 
The plentiful supply of credit probably stems from several factors. Most banks are well positioned
to lend: Their profits are strong, rates of return on equity and on assets are high, and capital is
ample. In addition, continued substantial inflows into stock and high-yield bond mutual funds
suggest that investors may now perceive less risk in these areas or may be more willing to accept
risk. In fact, businesses generally are in very good financial condition, with the estimated ratio of
operating cash flow to interest expense for the median nonfinancial corporation remaining quite
high in the first part of the year. Moreover, delinquency rates for business loans at banks have
stayed extremely low, as has the default rate on speculative-grade debt.     
 
The increase in the pace of business borrowing in the first half of 1997 was widespread across
sources of finance. Nonfinancial corporations stepped up their borrowing from banks. The
outstanding commercial paper of these corporations also increased on net from December through
June, after declining a little in 1996. Meanwhile, these businesses' net issuance of long-term bonds
in the first half of the year exceeded last year's pace, with speculative-grade offerings accounting
for the highest share of gross issuance on record.     
 
At the same time, the pace of gross equity issuance by nonfinancial corporations dropped
considerably in the first half of this year. In particular, the market for initial public offerings has
been cooler than in 1996, despite some pickup of late; new issues have been priced below the
intended range more often than above it, and first-day trading returns have been relatively low.
Net equity issuance has been deeply negative again this year, as gross issuance has been more than
offset by retirements through share repurchases and mergers. The bulk of merger activity in the
1980s involved share retirements financed by borrowing, but the recent surge--which largely
involves friendly intra-industry mergers--has been financed about equally through borrowing and
stock swaps. Structuring deals as stock swaps can reduce shareholders' tax liabilities and enable
the combined firm to use a more advantageous method of financial accounting. The dollar value
of nonfinancial mergers in which the target firm was worth more than a billion dollars set a record
in 1996, and merger activity appears to be on a very strong track this year as well.     
 
 
The Government Sector     
 
Federal. The federal budget deficit has come down considerably in recent years and should
register another substantial decline this fiscal year. Over the first eight months of fiscal year
1997--the period October through May--the deficit in the unified budget was $65 billion, down
$43 billion from the comparable period of fiscal 1996. The recent reduction in the deficit primarily
reflected extremely rapid growth of receipts for the second year in a row, although a continuation
of subdued growth in outlays also contributed to the improvement. Given recent developments,
the budget deficit as a share of nominal GDP this fiscal year is likely to be at its lowest level since
1974.     
 
Federal receipts were almost 8-1/2 percent higher in the first eight months of fiscal year 1997 than
in the year-earlier period and apparently are on track to outpace the growth of nominal GDP for
the fifth year in a row. Individual income tax payments have risen sharply this fiscal year--on top
of a hefty increase last year--reflecting strong increases in households' taxable labor and capital
income; preliminary data from the Daily Treasury Statement indicate that individual income tax
revenues remained strong in June. Moreover, corporate tax payments posted another sizable
advance through May of this fiscal year.     
 
Federal outlays during the first eight months of the fiscal year rose 3-1/2 percent in nominal terms
from the comparable period last year. Although this increase is up from the restrained rate of
growth in fiscal 1996--which was held down by the government shutdown--spending growth
remained subdued across most categories. Outlays for income security programs rose modestly in
the first eight months of the fiscal year, partly as a result of the continued strong economy, and
spending on the major health programs grew somewhat more slowly than their average pace in
recent years. Although still restrained, outlays for defense have ticked up this fiscal year after
trending down for several years.    
 
As for the part of federal spending that is included directly in GDP, real federal expenditures on
consumption and gross investment declined 3-1/4 percent in the first quarter of 1997, a shade
more than the average rate of decline in recent years. An increase in real nondefense spending was
more than offset by a decline in real defense outlays.     
 
The substantial drop in the unified budget deficit reduced federal borrowing in the first half of
1997 compared with the first half of 1996. The Treasury responded to the smaller-than-expected
borrowing need by reducing sales of bills; this traditional strategy of allowing borrowing swings
to be absorbed primarily by variation in bill issuance enables the Treasury to have predictable
coupon auctions and to issue sufficient quantities of coupon securities to maintain their liquidity.
The result this past spring was an unusually large net redemption of bills, which pushed yields on
short-term bills down relative to yields on other Treasury securities and on short-term private
paper.     
 
The issuance of inflation-indexed securities at several maturities has been a major innovation in
federal debt management this year. The Treasury sold indexed ten-year notes in January and April
and added five-year notes earlier this month. A small number of agency and other borrowers
issued their own inflation-indexed debt immediately after the first Treasury auction, and the
Chicago Board of Trade recently introduced futures and options contracts based on
inflation-indexed securities. As one would expect at this stage, however, the market for indexed
debt has not yet fully matured: Trading volume as a share of the outstanding amount is much
smaller than for nominal debt, and a market for stripped securities has yet to emerge.     
 
State and Local. The fiscal condition of state and local governments has remained positive over
the past year, as the surplus of receipts over current expenditures has been stable at a relatively
high level. Strong growth in sales and incomes has led to robust growth in revenues, despite
numerous small tax cuts, and many states have held the line on spending in the past several years.
Additionally, the welfare reform legislation passed in August 1996, while presenting long-term
challenges to state and local governments, actually has eased fiscal pressures in recent quarters:
Block grants to states are based largely on 1992-94 grant levels, but caseloads more recently have
been falling. Overall, at the state level, accumulated surpluses--current surpluses plus those from
past years--were on track to end fiscal year 1997 at a healthy level, according to a survey by the
National Association of State Budget Officers taken shortly before the end of most states' fiscal
years.     
 
Real expenditures for consumption and gross investment by state and local governments increased
moderately in the first quarter of this year, about the same as the pace of advance in the past two
years. For construction, the average level of real outlays during the first five months of the year
was a little higher than in the fourth quarter. Hiring by state and local governments over the first
half of the year was somewhat above last year's pace, with most of the increase at the local level.   

The pace of gross issuance of state and local debt was roughly the same in the first half of the year
as in 1996. Net issuance turned up noticeably, however, as retirements of debt that had been
pre-refunded in the early 1990s waned.     
 
 
The External Sector     
 
Trade and the Current Account. The nominal deficit on trade in goods and services was $116
billion at an annual rate in the first quarter, somewhat larger than the $105 billion in the fourth
quarter of last year. The current account deficit of $164 billion (annual rate) in the first quarter
exceeded the $148 billion deficit for 1996 as a whole because of the widening of the trade deficit
and further declines in net investment income. In April and May, the trade deficit was slightly
narrower than in the first quarter.      
 
The quantity of U.S. imports of goods and services surged in the first quarter at an annual rate of
about 20 percent. Continued strength in the pace of U.S. economic activity largely accounted for
the rapid growth, but a rebound in automotive imports from Canada from their strike-depressed
fourth-quarter level boosted imports as well. Preliminary data for April and May suggest that
strong real import growth continued. Non-oil import prices fell through the second quarter,
extending the generally downward trend that began in mid-1995.     
 
The quantity of U.S. exports of goods and services expanded at an annual rate a bit above 10
percent in the first quarter, about the same rapid pace as during the second half of last year.
Growth of output in our major trading partners, particularly the industrial countries, helped to
sustain the growth of exports, as did increased deliveries of civilian aircraft. Exports to western
Europe and to Canada grew strongly while those to the Asian developing countries declined
somewhat. Preliminary data for April and May suggest that real exports rose moderately.     
 
Capital Flows. Large gross capital inflows and outflows continued during the first quarter of
1997, reflecting the continued trend toward globalization of financial and product markets. Both
foreign direct investment in the United States and U.S. direct investment abroad were very strong,
swelled by mergers and acquisitions.     
 
Private foreign net purchases of U.S. securities amounted to $85 billion in the first quarter, down
somewhat from the very high figure in the previous quarter but still above the record pace for
1996 as a whole. Net purchases of U.S. Treasury securities were particularly robust. Private
foreigners also showed increased interest in the U.S. stock market in the first quarter of 1997.
U.S. net purchases of foreign securities amounted to $15 billion in the first quarter, down from
the strong pace of 1996. Private foreigners continued to add to their holdings of U.S. paper
currency in the first quarter, but at a rate substantially below earlier peaks.     
 
Foreign official assets in the United States, which rose a record $122 billion in 1996, increased
another $28 billion in the first quarter of 1997. Apart from the oil-producing countries, which
benefited from high oil prices, significant increases in holdings were associated with efforts by
some emerging-market countries to temper the impact of large private capital inflows on their
economies. Information for April and May suggests that official inflows have abated.     
 
Foreign Economies. Economic activity in the major foreign industrial countries has generally
strengthened so far this year from the pace in the second half of last year. In Japan, real GDP
accelerated to a 6-1/2 percent annual growth rate in the first quarter, boosted by extremely strong
growth of consumer spending ahead of an increase in the consumption tax on April 1. Activity
appears to have fallen in the second quarter, but continued improvement in business sentiment
suggests that the current weakness is only temporary. In Canada, growth of real output increased
to 3-1/2 percent at an annual rate in the first quarter. Final domestic demand more than accounted
for this expansion, as business investment, consumption, and residential construction all provided
significant contributions. Indicators suggest that output growth remained healthy in the second
quarter.     
 
Economic activity has remained vigorous so far this year in the United Kingdom and appears to
have strengthened in Germany and France. In the first quarter, U.K. real GDP grew at an annual
rate of 3-1/2 percent as domestic demand, particularly investment, accelerated from its already
strong pace in the fourth quarter. Strong household consumption spending supported demand in
the second quarter. Weak demand for exports, associated with the appreciation of the pound since
mid-1996, and some tightening of monetary conditions should moderate growth in the current
quarter. In Germany, economic expansion revived in the first quarter and appears to have firmed
in the second quarter. After growing very little in the fourth quarter of last year, German real
GDP rose at an annual rate of 1-3/4 percent in the first quarter, led by government consumption,
equipment investment, and exports. Manufacturing orders and indicators of business sentiment
suggest additional gains in the second quarter. French real GDP grew only three-quarters percent
at an annual rate in the first quarter, as declines in investment offset strong export growth, but
data on manufacturing output and consumption suggest a pick up in activity during the second
quarter.     
 
In most major Latin American countries, real output growth remained vigorous. In Mexico, real
economic expansion slowed some in the first quarter from its very rapid pace in the second half of
last year but remained robust. The industrial sector continued to be the source of strength, while
the service sector lagged. A pickup in import growth has resulted in a narrowing of the trade
surplus; through May, the trade balance of $1-3/4 billion was about half the size it was in the same
period last year. In Argentina, continued healthy economic growth in the first quarter has brought
real GDP back to its level before the recession induced by the Mexican crisis of 1995. In Brazil,
real output declined in the first quarter after three quarters of strong expansion.      
Economic growth in our major Asian trading partners other than Japan slowed a bit on average in
the first quarter but appears to have rebounded in the second quarter. Nationwide labor strikes in
Korea affected many of the country's key export industries and were partly responsible for
weakness in first-quarter output and a ballooning of the current account deficit. Data for April and
May show recovery in industrial production, and the trade balance improved in the second
quarter. Real output growth in Taiwan remains strong so far this year, though not quite so
vigorous as during the second half of 1996. In China, real GDP continues to expand at an annual
rate of nearly 10 percent, about the same brisk pace as last year.     
 
Despite the pickup in growth, considerable excess capacity remains in the major foreign industrial
countries. As a consequence, inflation has generally remained quiescent. The increase in the
Japanese consumption tax lifted the twelve-month change in the consumer price index to about
1-1/2 percent, but elevation of the inflation rate should be temporary. CPI inflation remains less
than 2 percent in Germany, France, Canada, and Italy. Only in the United Kingdom, where output
growth has resulted in tight labor markets and consumer prices are rising at an annual rate of
more than 2-1/2 percent, are inflation pressures currently a concern.     
 
In most major countries in Latin America, inflation either is falling or is already low. Mexican
inflation continues to improve: The monthly inflation rate was below 1 percent in May and June,
the lowest monthly rates since the 1994 devaluation. In Argentina, consumer prices were
essentially flat through the second quarter after almost no increase last year. Brazilian inflation has
declined to historically low rates. In contrast, Venezuelan inflation, though it has come down from
its 1996 rate of more than 100 percent per year, remains near 50 percent. Consumer price
inflation remains generally low in Asia, including in China, where it fell to less than 3 percent in
the twelve months through May.     
 
 
The Labor Market     
 
Payroll employment continued to expand solidly during the first half of 1997. The growth in
nonfarm payrolls averaged about 230,000 per month; this figure may overstate slightly the
underlying rate of employment growth in the first half because technical factors boosted payroll
figures in April. The strength in labor demand drew additional people into the job market, raising
the labor force participation rate to historical highs during the first half. Nevertheless, the civilian
unemployment rate moved down to 4.9 percent, on average, in the second quarter.     
 
Employment gains in the private service-producing sector, in which nearly two-thirds of all
nonfarm workers are employed, accounted for much of the expansion in payrolls through June of
this year. Within this sector, higher employment in services, transportation, and retail trade
contributed importantly to the gain. After advancing substantially for several years, payrolls in the
personnel supply industry--a category that includes temporary help agencies--actually turned
down in the second quarter; anecdotal reports suggest that some temporary help firms are having
difficulty finding workers, especially for highly skilled and technical positions.     
 
Employment gains were also posted in the goods-producing sector. In the construction industry,
payrolls increased substantially between December and June. Factory employment moved
somewhat higher in the first part of the year after declining a little during 1996, and manufacturing
overtime hours remained at a high level. Producers of durable goods increased employment
further between December and June, while makers of nondurable goods continued to reduce
payrolls. Since the end of 1994, factory employment and total hours worked in manufacturing
have changed little. Even so, manufacturers have boosted output considerably over this period,
primarily through ongoing improvements in worker productivity.     
 
Although productivity for the broader nonfarm business sector rose substantially in the first
quarter, it was just 1 percent above its value a year earlier. Moreover, output per hour changed
little from the end of 1992 to the last quarter of 1995. The average rate of measured productivity
growth in the 1990s is still somewhat below that of the 1980s and is even further below the
average gains realized in the twenty-five years after World War II. The slower reported
productivity growth during this expansion could partly reflect measurement problems.
Productivity is the ratio of real output to hours worked, and official productivity indexes rely on a
measure of real output based on expenditures. In theory, a matching measure of real output
should be derivable by summing labor and capital inputs on the "income side" of the national
accounts. However, the income-side measure of real output has increased considerably faster than
the expenditure-side measure in recent years, raising the possibility that productivity growth has
been somewhat better than reported in the official indexes.     
 
Measurement difficulties may also affect estimates of the longer-term trajectory of productivity
growth. In particular, if inflation were overstated by official measures--as a considerable amount
of recent research suggests it is--then real output growth would be understated. This
understatement would arise because too much inflation would be removed from nominal output
growth in the calculation of real output growth. Indeed, productivity growth for nonfinancial
corporations--a sector for which output growth arguably is measured more accurately than in
broader sectors--has been more rapid than for nonfarm business overall. In particular, productivity
for nonfinancial corporations increased at an average annual pace of about 1-1/2 percent between
1990 and 1996, while productivity in the nonfarm business sector rose a little less than 1 percent
per year over the same period. This difference--which implies very weak measured productivity
growth outside of the nonfinancial corporate sector--raises the possibility that overall productivity
growth is stronger than indicated by official indexes for nonfarm business.1 Of course, a
critical--and still unanswered--question is the extent to which any understatement of productivity
growth has become larger over time. If productivity growth were more rapid than indicated by
official statistics, then the economy's capacity to produce goods and services would be increasing
faster than indicated by current official statistics. But if the amount of mismeasurement has not
increased over time, then the economy's productive capacity also increased more rapidly in earlier
years than shown by published measures. In this case, the official statistics on productivity
growth--though perhaps understated--would not give a misleading impression about changes in
productivity trends.     
 
After changing little, on net, since the late 1980s, the labor force participation rate turned up early
last year; it reached a record high 67.3 percent in March of this year and remained at an elevated
67.1 percent in the second quarter. Better employment opportunities have drawn additional
people into the workforce. Although the recent welfare reform legislation probably has not yet
had a large effect on aggregate labor force dynamics, it may generate an additional, albeit small,
boost to labor force participation rates over the next few years. Since the beginning of 1996, the
increases in the labor force associated with a higher participation rate have eased pressures on
labor markets, as additional workers have stepped in to satisfy continuing strong demand for
labor. Nevertheless, hiring was sufficiently brisk during the first half of this year to pull the
unemployment rate down about one-quarter percentage point between December and June.     
 
Just as the low unemployment rate points to tightness in labor markets, anecdotal reports from
many regions and industries mention the difficulties firms are having hiring workers, especially
workers with specialized skills. With this tightness, labor compensation costs have accelerated
slightly. Although hourly labor costs, as measured by the employment cost index (ECI), increased
only 2.5 percent at an annual rate during the first three months of this year, they were up 3.0
percent over the twelve months ended in March, compared with 2.7 percent over the preceding
twelve months. These increases are smaller than might have been expected based on historical
relationships, perhaps partly reflecting persistent worker concerns about job security. In addition,
modest increases in employer-paid benefits have partly offset faster increases in wages and salaries
in the past couple of years. With smaller increases in health care costs than earlier in the decade,
shifts of employees into managed care plans, and requirements that employees assume a greater
share of health care costs, employer costs for health-related benefits have been well contained.
However, growth in employer health care costs may be in the process of bottoming out, as
reports of rising premiums for health insurance have become more common. Moreover, the wages
and salaries component of the ECI has continued to accelerate, rising 3.4 percent during the
twelve months ending in March 1997, about one-quarter percentage point faster than during the
previous twelve months and roughly half a percentage point faster than in 1994 and 1995.     
 
 
Prices     
 
The underlying trend of price inflation has remained favorable this year. In particular, the CPI
excluding food and energy--often referred to as the "core" CPI--increased at an annual rate of
2-1/2 percent over the first two quarters of the year, about the same pace as in 1996. The overall
CPI registered a smaller increase than the core CPI during the first half of this year. Both the
overall CPI and the core CPI have been affected by a series of technical changes implemented by
the Bureau of Labor Statistics over the past two and one-half years to obtain a more accurate
measure of price changes. If not for these changes, increases in the CPI since 1994 would be
marginally larger.     
 
Other measures of prices also suggest that favorable inflation trends continued into 1997.
Measured from the first quarter of last year to the first quarter of this year, the chain price index
for personal consumption expenditures excluding food and energy rose 2 percent, the same as in
the four-quarter period a year earlier.2 Similarly, the chain price index for overall GDP--which
covers prices of all goods and services produced in the United States--and the chain measure for
gross domestic purchases--which covers prices of all goods purchased in the United
States--increased the same amount over the year ending in the first quarter of 1997 as during the
previous four quarters.     
 
All of these price measures indicate that inflation remains muted, despite high levels of resource
utilization. Several factors have contributed to the recent favorable performance of price inflation.
Energy prices have declined this year. Non-oil import prices also have fallen significantly,
reducing input costs for some domestic companies and likely restraining the prices charged by
domestic businesses that compete with foreign producers. Besides being restrained by some price
competition from imported materials and supplies, prices of manufactured goods at earlier stages
of processing have been held in check by an expansion of industrial capacity that has been rapid
enough to restrain increases in utilization rates over the past year. Also, to the extent that firms
have succeeded in their efforts to realize large efficiency gains and reduce unit costs, upward
pressure on prices may be reduced. Finally, an extended period of relatively low and steady
inflation has reinforced a belief among households and businesses that the trend of inflation should
remain muted, and consequently helped to hold down inflation expectations.      
 
Developments in the food and energy sectors were favorable to consumers in the first half of
1997. Consumer energy prices declined in the first half of the year as the price of crude oil
dropped back following last year's run-up. In 1996, the price of crude oil was boosted by refinery
disruptions, uncertainty about the timing of Iraqi oil sales, and unusual weather patterns that
increased energy demand for heating and cooling. As these factors receded this year, crude oil
prices fell. Although the downward trend was interrupted by some transitory spikes in prices--as
in May when tensions in the Middle East flared up--the price of crude is now roughly back to the
range that prevailed before last year's run-up. Since December, gasoline prices have tumbled more
than 16 percent at an annual rate, and heating oil prices have fallen significantly. Natural gas
prices also fell as stocks, which had dwindled over the winter, were replenished. Reflecting the
declines in fuel prices, the CPI for energy fell about 9 percent at an annual rate between December
1996 and June 1997.     
 
Consumer food prices increased at an annual rate of only about 1 percent in the first half of the
year. Although coffee prices jumped, the prices of many other food items were flat or edged
lower. Most notably, declines in grain prices that began in mid-1996 have been working their way
to the retail level and have held down prices for a variety of grain-dependent foods, such as beef,
poultry, and dairy products. Prices of foods that depend more heavily on labor costs have been
rising modestly this year.     
 
Consumer prices for goods other than food and energy rose a restrained three-quarters percent at
an annual rate between December and June of this year, a touch below last year's pace. Declining
prices for non-oil imports helped contain prices of goods in the CPI in the first half of the year, in
part by constraining U.S. businesses in competition with importers. For example, prices of new
and used passenger cars declined in the first six months of the year, and prices of light trucks were
essentially flat. Also, prices of house furnishings were about unchanged, on balance, in the first
half of the year, although apparel prices moved up after declining in recent years.     
 
The CPI for non-energy services rose about 3 percent at an annual rate between December and
June, a touch below last year's pace. After rising markedly last year, airfares declined, on net, in
the first half of this year. Fares fell substantially early in the year when the excise tax on tickets
expired, and even with the reimposition of the tax in March, ticket prices were still lower in June
than in December. Increases in prices of medical services also continued to slow somewhat this
year.3 In addition, the CPI for auto finance fell in May and June as automakers sweetened
incentives. In contrast, price increases in the first half of the year picked up in some other areas;
shelter prices rose a bit more rapidly than last year, as did tuition and prices for personal care
services.     
 
 
Credit and the Monetary Aggregates     
 
Credit and Depository Intermediation. The total debt of domestic nonfinancial sectors increased
at an annual rate of about 4-3/4 percent from the fourth quarter of 1996 through May of this year,
placing the aggregate near the middle of the range for 1997 established by the FOMC. This pace
is more than half a percentage point below that for 1996, reflecting significantly slower growth of
borrowing by the federal government. The total debt of the other sectors has risen at a roughly
constant pace over the past few years, even though the growth rate of nominal output has been
increasing.    
 
Credit on the books of depository institutions rose more rapidly than total debt in the first half of
1997, indicating that their share of total debt outstanding increased. Credit growth at thrift
institutions eased late last year and early this year after increasing moderately in the first three
quarters of 1996. However, commercial bank credit grew at a brisk pace in the first half of the
year, with both securities and loans increasing more rapidly than they did last year. Real estate
lending at banks rose about 9 percent at an annual rate between the fourth quarter of 1996 and
June of this year, compared with 4 percent in 1996. In contrast, outstanding home mortgages at
thrift institutions grew little in the first part of the year after a large run-up in 1996. Home equity
credit lines from banks expanded especially rapidly in the spring, as some banks promoted these
loans as a substitute for consumer loans. The growth of consumer loans at banks (including loans
that were securitized as well as loans still on banks' books) fell from about 11 percent in 1996 to
3-1/4 percent at an annual rate between the fourth quarter of 1996 and June of this year.     
 
The Monetary Aggregates. Growth of the monetary aggregates during the first half of 1997 was
similar to growth in 1996. Between the fourth quarter of last year and June, M2 expanded at an
annual rate of almost 5 percent; as the Committee had anticipated, the aggregate was running
close to the upper bound of its growth cone, which had been chosen to be consistent with price
stability. The behavior of M2 over this period can be reasonably well explained by changes in
nominal GDP and interest rates, using historical velocity relationships. In the first quarter, the
velocity of M2 (defined as the ratio of nominal GDP to M2) increased a little more than might
have been anticipated from its recent relationship to the opportunity cost of holding M2--the
interest earnings forgone by owning M2 assets rather than market instruments such as Treasury
bills. M2 may have been held down a bit by savers' preferences for equity market funds, for which
inflows were quite strong. Growth of M2 was much slower in the second quarter than in the first
quarter (4-1/4 percent compared with 6 percent at an annual rate), consistent with the slowing of
the economy and almost unchanged M2 opportunity cost. The monthly pattern of M2 growth in
the second quarter was heavily influenced by unusually high individual non-withheld tax
payments. M2 surged in April, as households apparently accumulated additional liquid balances in
order to make the larger tax payments, and was about unchanged on a seasonally adjusted basis in
May as payments cleared and balances returned to normal.     
 
The correspondence between changes in M2 velocity and in opportunity cost during recent years
may represent a return to the roughly stable relationship observed for several decades until
1990--albeit at a higher level of velocity. The relationship was disturbed in the early 1990s by
households' apparent decisions to shift funds out of lower-yielding deposits into higher-yielding
stock and bond mutual funds. On one hand, the "credit crunch" at banks and the resolution of
troubled thrifts curbed the eagerness of these institutions to attract retail deposits, holding down
the rates of return offered on brokered deposits and similar accounts relative to the average
deposit rates used in constructing measures of opportunity cost. At the same time, the appeal of
longer-term assets was enhanced temporarily by the steeply sloped yield curve and more
permanently by the greater variety and lower cost of mutual fund products available to investors.
More recently, robust inflows into stock funds apparently have substituted to only a limited extent
for holdings of M2 assets, and M2 velocity and opportunity cost have again been moving roughly
together since mid-1994, although velocity has continued to drift up slightly. However, the period
of renewed stability in the behavior of M2--three years--is still fairly short, and whether the
stability will persist is unclear. Variations in opportunity cost and income growth during this
period have been rather small, leaving considerable doubt about how M2 would respond to more
significant changes in the financial and economic environment.     
 
M3 rose about 7 percent at an annual rate between the fourth quarter of 1996 and June of this
year. This pace is a little faster than last year's and again left M3 above the upper end of its
growth cone, which, like the growth cone for M2, was set to be consistent with price stability.
Large time deposits, which are not included in M2, continued to increase much more rapidly than
other deposits. Banks have been funding their asset growth disproportionately through wholesale
deposits, leaving interest rates on retail deposits further below market rates than they have been
historically. Growth of institution-only money market funds eased just a little from last year's
torrid pace, as the role of these funds in corporate cash management continued to increase.     
 
M1 contracted at a 2-1/2 percent annual rate between the fourth quarter of 1996 and June of this
year. Growth of this aggregate was again depressed by the spread of so-called sweep programs,
whereby balances in transactions accounts, which are subject to reserve requirements, are "swept"
into savings accounts, which are not. Sweep programs benefit depositories by reducing their
required holdings of reserves, which earn no interest. At the same time, they do not restrict
depositors' access to their funds for transactions purposes, because the funds are swept back into
transactions accounts when needed. Until late last year, most retail sweep programs were limited
to NOW accounts, but demand-deposit sweeps have expanded markedly since then. Adjusted for
the estimated total of balances swept owing to the introduction of new sweep programs, M1
expanded at a 4-3/4 percent annual rate between the fourth quarter of 1996 and June 1997, a little
below its sweep-adjusted growth rate in 1996.     
 
The drop in the amount of deposits held in transactions accounts in the first half of 1997 caused
required reserves to fall about 10 percent at an annual rate, close to the rate of decline last year.
Nonetheless, the monetary base has expanded at a moderate pace so far in 1997, because the
runoff in required reserves has been more than offset--as it was also last year--by an increase in
the demand for currency. Currency growth has been a little higher this year than last, as the effects
of strong domestic spending more than offset a slight drop in net shipments of U.S. currency
abroad in the first four months of the year.     
 
Further reductions in required reserves have the potential to diminish the Federal Reserve's ability
to control the federal funds rate closely on a day-to-day basis. Traditionally, the daily demand for
balances at the Federal Reserve largely reflected banks' needs for required reserves, which are
fairly predictable. As a result, the Federal Reserve has generally been able to supply the quantity
of balances that satisfies this demand at the intended funds rate. Moreover, reserve requirements
are specified in terms of an average level of balances over a two-week period, so if the funds rate
on a particular day moves above the level expected to prevail on ensuing days, banks can trim
their balances and thereby relieve some of the upward pressure on the funds rate. If required
reserves were to fall quite low, the demand for balances would become more linked to banks'
desire to avoid overnight overdrafts when conducting transactions through their accounts at
Reserve Banks. Demand from this source is more variable than is requirement-related demand,
and it also cannot be substituted across days; both factors would tend, all else equal, to increase
the volatility of the federal funds rate.     
 
The decline in required reserves over the past several years has not created serious problems in
the federal funds market, but funds-rate volatility has risen a little, and the risk of much greater
volatility would increase if required reserves were to fall substantially further. One factor
mitigating an increase in funds-rate volatility has been an increase in required clearing balances.
These balances, which banks can precommit to hold on a two-week average basis, earn credits
that banks use to pay for Federal Reserve priced services. Like required reserve balances, required
clearing balances are predictable by the Federal Reserve and can be substituted across days within
the two-week maintenance period. Funds-rate volatility has also been damped by banks' improved
management of their balances at Reserve Banks, which in part reflects the improved real-time
access to account information now provided by the Federal Reserve. Whether these factors could
continue to restrain funds-rate volatility if required reserve balances were to become much smaller
is as yet unclear. Also unclear is whether a moderate increase in funds-rate volatility would have
any serious adverse consequences for interest rates farther out on the yield curve or for the
macroeconomy. The Federal Reserve continues to monitor the situation closely.      
 
Interest Rates, Equity Prices, and Exchange Rates     
 
Interest Rates. Interest rates on Treasury securities were little changed or declined a bit, on
balance, between the end of 1996 and mid-July. Yields rose substantially in the first quarter as
evidence mounted that the robust economic activity observed in the closing months of 1996 had
continued into 1997. By the time of the March FOMC meeting, most participants in financial
markets were anticipating some tightening of monetary policy, and rates moved little when the
increase in the intended federal funds rate was announced. Beginning in late April, key data
pointed to continued low inflation and a slowing of economic growth in the second quarter, and
interest rates retraced their earlier advance.     
 
The yield on the inflation-indexed ten-year Treasury note was little changed between mid-April
and mid-July, suggesting that at least part of the roughly 60-basis-point drop in the nominal
ten-year yield over that period reflected a reduction in expected inflation or in uncertainty about
future inflation, or both. Yet, relative movements in these two yields should be interpreted
carefully, as the market's experience in trading indexed debt is relatively brief, making its prices
potentially vulnerable to small shifts in market sentiment. Moreover, the Treasury announced this
spring a reduction in the frequency of nominal ten-year note auctions, perhaps putting downward
pressure on their nominal yields, and some investors may have paid renewed attention to
upcoming technical adjustments to the CPI, which will reduce measured inflation. Survey-based
measures of expected inflation showed little change in the second quarter.     
 
The interest rate on the three-month Treasury bill was held down in recent months by the reduced
supply of bills associated with the smaller federal deficit. Between mid-March and mid-July, the
spread between the federal funds rate and the three-month yield averaged about 15 basis points
above the average spread in 1996. Interest rates on private short-term instruments increased a
little in the second quarter after the small System tightening in March.     
 
Equity Prices. Equity markets have advanced dramatically again this year. Through mid-July,
most broad measures of U.S. stock prices had climbed between 20 percent and 25 percent since
year-end. Stocks began the year strongly, with the major indexes reaching then-record levels in
late January or February. Significant selloffs ensued, partly occasioned by the backup in interest
rates, and by early April the NASDAQ index was well below its year-end mark and the S&P 500
composite index was barely above its. Equity prices began rebounding in late April, however,
soon pushing these indexes to new highs. Stock prices have been somewhat more volatile this
year than last.     
 
The run-up in stock prices in the spring was bolstered by unexpectedly strong corporate profits
for the first quarter. Still, the ratio of prices in the S&P 500 to consensus estimates of earnings
over the coming twelve months has risen further from levels that were already unusually high.
Changes in this ratio have often been inversely related to changes in long-term Treasury yields,
but this year's stock price gains were not matched by a significant net decline in interest rates. As
a result, the yield on ten-year Treasury notes now exceeds the ratio of twelve-month-ahead
earnings to prices by the largest amount since 1991, when earnings were depressed by the
economic slowdown. One important factor behind the increase in stock prices this year appears to
be a further rise in analysts' reported expectations of earnings growth over the next three to five
years. The average of these expectations has risen fairly steadily since early 1995 and currently
stands at a level not seen since the steep recession of the early 1980s, when earnings were
expected to bounce back from levels that were quite low.     
 
Exchange Rates. The weighted average foreign exchange value of the dollar in terms of the other
G-10 currencies rose sharply in the first quarter from its level in December and has moved up
somewhat further since then. On balance, the nominal dollar is more than 10 percent above its
level at the end of December. A broader measure of the dollar that includes currencies from
additional U.S. trading partners and adjusts for changes in relative consumer prices shows
appreciation of about 7 percent. After rising nearly 10 percent in terms of the Japanese yen to a
recent peak in late April, the dollar retreated; it is currently about unchanged from its value in
terms of yen at the end of December. In contrast, the dollar has risen about 17 percent in terms of
the German mark since the end of last year.      
 
Early in the year, data showing continued strengthening of U.S. economic activity surprised
market participants, raised their expectations of some tightening of U.S. monetary policy, and
contributed to upward pressure on the dollar. In light of the FOMC action in late March and the
tendency for subsequent economic indicators to suggest a slowing of the growth of U.S. real
output, pressure for dollar appreciation abated. While robust economic activity in the United
States generated a rise in U.S. long-term interest rates through April, market uncertainty about
the strength of output growth in several foreign industrial countries led to little change, on
balance, in average long-term (ten-year) rates in other G-10 countries. Since then, U.S. rates have
returned to near year-end levels, while rates abroad have moved down. Accordingly, the
long-term interest differential, on balance, has shifted further in favor of dollar assets since
December, consistent with the net appreciation of the dollar this year.     
 
Despite indications of further recovery of output in Japan, the dollar rose against the yen early in
the year as planned fiscal policy in Japan appeared to be more restrictive than had been expected,
and Japanese long-term interest rates declined in response. Statements by G-7 officials at their
meeting in Berlin in February and on subsequent occasions suggested some concern that the
dollar's strength and the yen's weakness not become excessive. The dollar moved back down in
terms of the yen in May and has since fluctuated narrowly. The yen has been supported by data
showing a widening of Japanese external surpluses and by a partial retracing by Japanese
long-term rates of their earlier decline, as indicators have suggested that the fiscal measures may
not be as contractionary as previously expected.     
 
The dollar also rose sharply early in the year in terms of the German mark and other continental
European currencies. Market participants have been disappointed that the pace of economic
activity has not strengthened further in continental European countries. In addition, uncertainties
about the prospects for European Monetary Union, including the possibility of delay and the
question of which countries will be in the first group proceeding to Stage Three, have resulted in
fluctuations in the mark and, on balance, appear to have strengthened the dollar. German
long-term interest rates have declined somewhat on balance this year.     
 
Short-term market interest rates in most of the major foreign industrial countries have changed
little on average since the end of last year. Rates in the United Kingdom have risen somewhat as
the new government increased the official lending rate one-quarter percentage point in May and
the Bank of England raised it by the same amount in June and again in July. Short-term rates in
Italy and Switzerland have eased. Stock prices have risen sharply so far this year in the major
foreign industrial countries, particularly in continental Europe.     
 
The dollar has changed little on balance in terms of the Mexican peso since December, as
improved investor sentiment toward Mexico, reflected in narrowing yield spreads between
Mexican and U.S. dollar-denominated bonds, has supported the peso. The trend in Mexican
inflation has declined this year; nevertheless, the excess of Mexican inflation over U.S. inflation
implies about a 7 percent real appreciation of the peso since December.     
 
Since mid-May, financial pressures in Thailand, which caused authorities there to raise interest
rates and have led to depreciation of the currency, have spilled over to influence financial markets
in some of our Asian trading partners, particularly the Philippines and Malaysia. Interest rates in
both of these countries rose sharply. Philippine officials relaxed their informal peg of the peso in
terms of the dollar, and the currency declined significantly; the Malaysian ringgit and Indonesian
rupiah have also depreciated.        
 
 
 FOOTNOTES _______  
 
   1. More detail is provided in a paper by Lawrence Slifman and Carol Corrado, "Decomposition
of Productivity and Unit Costs," Board of Governors of the Federal Reserve System, November
18, 1996.     
 
 
 _______  
 
   2. The price measure for personal consumption expenditures (PCE) is closely related to the CPI
because components of the CPI are key inputs in the construction of the PCE price measure.
Nevertheless, the PCE price measure has the advantage that by using chain weighting rather than
fixed weights it avoids some of the substitution bias that affects the CPI.     
 
 
 _______  
 
   3. In January 1997, the Bureau of Labor Statistics introduced a new measure of the prices of
hospital services--which account for roughly one-third of the CPI for medical services--and this
new measure should, over time, provide a more accurate gauge of price movements in this area.