Board of Governors of the Federal Reserve System 

MONETARY POLICY REPORT TO THE CONGRESS 

Report submitted to the Congress on July 16, 2002, pursuant to section
2B of the Federal Reserve Act


Letter of Transmittal

Board of Governors of the
Federal Reserve System
Washington, D.C., July 16, 2002

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 section 2B of the Federal Reserve Act.

Sincerely,
Alan Greenspan, Chairman



Monetary Policy Report to the Congress

SECTION 1

Monetary Policy and the Economic Outlook     

The pace of economic activity in the United States picked up
noticeably in the first half of 2002 as some of the powerful forces
that had been restraining spending for the preceding year and a half
abated.  With inventories in many industries having been brought into
more comfortable alignment with sales, firms began boosting production
around the turn of the year to stem further runoffs of their stocks.
And while capital spending by businesses has yet to show any real
vigor, the steep contraction of the past year or so appears to have
come to an end.  Household spending, as it has throughout this
cyclical episode, continued to trend up in the first half.  With
employment stabilizing, the increases in real wages made possible by
gains in labor productivity and the effects of a variety of fiscal
actions have provided noticeable support to disposable incomes.  At
the same time, low interest rates have buoyed the purchase of durable
goods and the demand for housing.  Growth was not strong enough to
forestall a rise in the unemployment rate, and slack in product and
labor markets, along with declining unit costs as productivity has
soared, has helped to keep core inflation low.  The exceptionally
strong performance of productivity over the past year provides further
evidence of the U.S. economy's expanded capacity to provide growth
over the longer haul.

The Federal Reserve had moved aggressively in 2001 to counter the
weakness that had emerged in aggregate demand; by the end of the year,
it had lowered the federal funds rate to 1-3/4 percent, the lowest
level in forty years.  With only tentative signs that activity was
picking up, the Federal Open Market Committee (FOMC) decided to retain
that unusual degree of monetary accommodation by leaving the federal
funds rate unchanged at its January meeting.  Confirmation of an
improvement in activity was evident by the time of the March meeting,
and the FOMC moved toward an assessment that the risks to the outlook
were balanced between its long-run goals of price stability and
maximum sustainable economic growth, a view maintained through its
June meeting.  The durability and strength of the expansion were
recognized to depend on the trajectory of final sales.  The extent of
a prospective strengthening of final sales was--and still
is--uncertain, however, and with inflation likely to remain contained,
the Committee has chosen to maintain an accommodative stance of
policy, leaving the federal funds rate at its level at the end of last
year.

The economy expanded especially rapidly early in the year.  As had
been anticipated, much of the first quarter's strength in production
resulted from the efforts of firms to limit a further drawdown of
inventories after the enormous liquidation in the fourth quarter of
2001.  With respect to first-quarter sales, purchases of light motor
vehicles dropped back from their extraordinary fourth-quarter level,
but other consumer spending increased substantially.  Housing starts,
too, jumped early in the year--albeit with the help of weather
conditions favorable for building in many parts of the country--and
spending on national defense moved sharply higher.  All told, real GDP
is now estimated to have increased at an annual rate in excess of 
6 percent in the first quarter.

Economic activity appears to have moved up further in recent months
but at a slower pace than earlier in the year.  Industrial production
has continued to post moderate gains, and nonfarm payrolls edged up in
the second quarter after a year of nearly steady declines.  However,
several factors that had contributed importantly to the outsized gain
of real output in the first quarter appear to have made more modest
contributions to growth in the second quarter.  Available data suggest
that the swing in inventory investment was considerably smaller in the
second quarter than in the first.  Consumer spending has advanced more
slowly of late, and while the construction of new homes has expanded
further, its contribution to the growth of real output has not matched
that of earlier in the year.

Notable crosscurrents remain at work in the outlook for economic
activity.  Although some of the most recent indicators have been
encouraging, businesses still appear to be reluctant to add
appreciably to workforces or to boost capital spending, presumably
until they see clearer signs of improving prospects for sales and
profits.  These concerns, as well as ongoing disclosures of corporate
accounting irregularities and lapses in corporate governance, have
pulled down equity prices appreciably on balance this year.  The
accompanying decline in net worth is likely to continue to restrain
household spending in the period ahead, and less favorable financial
market conditions could reinforce business caution.

Nevertheless, a number of factors are likely to boost activity as the
economy moves into the second half of 2002.  With the
inflation-adjusted federal funds rate barely positive, monetary policy
should continue to provide substantial support to the growth of
interest-sensitive spending.  Low interest rates also have allowed
businesses and households to strengthen balance sheets by refinancing
debt on more favorable terms.  Fiscal policy actions in the form of
lower taxes, investment incentives, and higher spending are providing
considerable stimulus to aggregate demand this year.  Foreign economic
growth has strengthened and, together with a decline in the foreign
exchange value of the dollar, should bolster U.S. exports.  Finally,
the exceptional performance of productivity has supported household
and business incomes while relieving pressures on price inflation, a
combination that augurs well for the future.



Monetary Policy, Financial Markets, and the Economy over the First Half of 2002

The information reviewed by the FOMC at its meeting of January 29 
and 30 seemed on the whole to indicate that economic activity was
bottoming out and that a recovery might already be under way.
Consumer spending had held up remarkably well, and the rates of
decline in manufacturing production and business purchases of durable
equipment and software had apparently moderated toward the end of
2001.  In addition, the expectation that the pace of inventory runoff
would slow after several quarters of substantial and growing
liquidation constituted another reason for anticipating that economic
activity would improve in the period immediately ahead.  Nonetheless,
looking beyond the near term, the FOMC faced considerable uncertainty
about the strength of final demand.  Because household spending had
not softened to the usual extent during the recession, it appeared
likely to have only limited room to pick up over coming quarters.
Intense competitive pressures were thought to be constraining the
growth of profits, which could damp investment and equity prices.  At
the same time, the outlook for continued subdued inflation remained
favorable given the reduced utilization of resources and the further
passthrough of earlier declines in energy prices.  Taken together,
these conditions led the FOMC to leave the stance of monetary policy
unchanged, keeping its target for the federal funds rate at 
1-3/4 percent.  In light of the tentative nature of the evidence suggesting
that the upturn in final demand would be sustained, the FOMC decided
to retain its assessment that the more important risk to achieving its
long-run objectives remained economic weakness--the possibility that
growth would fall short of the rate of increase in the economy's
potential and that resource utilization would fall further.

When the FOMC met on March 19, economic indicators had turned even
more positive, providing encouraging evidence that the economy was
recovering from last year's recession.  Consumer spending had remained
brisk in the early part of the year, the decline in business
expenditures on equipment and software appeared to have about run its
course, and housing starts had turned back up.  Industrial production,
which had been falling for nearly a year and a half, increased in
January and February as businesses began to meet more of the rise in
sales from current production and less from drawing down inventories.
Indications that an expansion had taken hold led to noticeable
increases in broad stock indexes and in long-term interest rates.  But
the strength of the recovery remained unclear.  The outlook for
business fixed investment--which would be one key to the strength of
economic activity once the thrust from inventory restocking came to an
end--was especially uncertain, with anecdotal reports indicating that
businesses remained hesitant to enter into major long-term
commitments.  While the FOMC believed that the fiscal and monetary
policies already in place would continue to stimulate economic
activity, it considered the questions surrounding the outlook for
final demand over the quarters ahead still substantial enough to
justify the retention of the current accommodative stance of monetary
policy, particularly in light of the relatively high unemployment rate
and the prospect that the lack of price pressures would persist.
Given the positive tone of the available economic indicators, the FOMC
announced that it considered the risks to achieving its long-run
objectives as now being balanced over the foreseeable future.

By the time of the May 7 FOMC meeting, it had become evident that
economic activity had expanded rapidly early in 2002.  But the latest
statistical data and anecdotal reports suggested that the expansion
was moderating considerably in the second quarter and that the extent
to which final demand would strengthen was still unresolved.  Business
sentiment remained gloomy as many firms had significantly marked down
their own forecasts of growth in sales and profits over coming
quarters.  These revised projections, along with the uncertainty
surrounding the robustness of the overall economic recovery, had
contributed to sizable declines in market interest rates and weighed
heavily on equity prices, which had dropped substantially between the
March and May meetings.  The outlook for inflation had remained benign
despite some firming in energy prices, as excess capacity in labor and
product markets held the pricing power of many firms in check, and the
apparent strong uptrend in productivity reduced cost pressures.  In
these circumstances, the FOMC decided to keep the federal funds rate
at its accommodative level of 1-3/4 percent and maintained its view
that, against the background of its long-run goals of price stability
and sustainable economic growth, the risks to the outlook remained
balanced.

Over the next seven weeks, news on the economy did little to clarify
questions regarding the vigor of the ongoing recovery.  The
information received in advance of the June 25-26 meeting of the FOMC
continued to suggest that economic activity had expanded in the second
quarter, but both the upward impetus from the swing in inventory
investment and the growth in final demand appeared to have diminished.
In financial markets, heightened concerns about accounting
irregularities at prominent corporations and about the outlook for
profits had contributed to a substantial decline in equity prices and
correspondingly to a further erosion in household wealth.  But some
cushion to the effects on aggregate demand of the decline in share
prices had been provided by the fall in the foreign exchange value of
the dollar and the drop in long-term interest rates.  Although the
FOMC believed that robust underlying growth in productivity, as well
as accommodative fiscal and monetary policies, would continue to
support a pickup in the rate of increase of final demand over coming
quarters, the likely degree of the strengthening remained uncertain.
The FOMC decided to keep unchanged its monetary policy stance and its
view that the risks to the economic outlook remained balanced.


Economic Projections for 2002 and 2003

The members of the Board of Governors and the Federal Reserve Bank
presidents, all of whom participate in the deliberations of the FOMC,
expect the economy to expand rapidly enough over the next six quarters
to erode current margins of underutilized capital and labor resources.
The central tendency of the forecasts for the increase in real GDP
over the four quarters of 2002 is 3-1/2 percent to 3-3/4 percent, and
the central tendency for real GDP growth in 2003 is 3-1/2 percent to 
4 percent.  The central tendency of the projections of the civilian
unemployment rate, which averaged just under 6 percent in the second
quarter of 2002, is that it stays close to this figure for the
remainder of the year and then moves down to between 5-1/4 percent and
5-1/2 percent by the end of 2003.

Support from monetary and fiscal policies, as well as other factors,
should lead to a strengthening in final demand over coming quarters.
Business spending on equipment and software will likely be boosted by
rising sales, improving profitability, tax incentives, and by the
desire to acquire new capital embodying ongoing technological
advances.  Improving labor market conditions and a robust underlying
trend in productivity growth should further bolster household income
and contribute to an uptrend in spending.  In addition, the
liquidation of last year's inventory overhangs has left businesses in
a position to begin rebuilding stocks as they become more persuaded
that the recovery in final sales will be sustained.

Most FOMC participants expect underlying inflation to remain close to
recent levels through the end of 2003.  Core inflation should be held
in check by productivity gains that hold down cost increases, a lack
of pressure on resources, and well-anchored inflation expectations.
Overall inflation, which was depressed last year by a notable decline
in energy prices, is likely to run slightly higher this year.  In
particular, the central tendency of the projections of the increase in
the chain-type index for personal consumption expenditures over the
four quarters of both 2002 and 2003 is 1-1/2 percent to 1-3/4 percent,
compared with last year's pace of 1-1/4 percent.


SECTION 2

Economic and Financial Developments in 2002

The pace of economic activity picked up considerably in the first half
of 2002 after being about unchanged, on balance, in the second half of
2001.  Final sales advanced modestly as substantial gains in household
and government spending were partly offset by weak business fixed
investment and a widening gap between imports and exports.  In
addition, inventory liquidation slowed sharply as businesses stepped
up production to bring it more closely in line with the pace of final
sales.  The increase in real GDP was particularly rapid early in the
year, with the first-quarter gain elevated by a steep reduction in the
pace of the inventory run-off, a surge in defense spending, and a
weather-induced spurt in construction.  Real GDP is currently
estimated to have risen at an annual rate of just over 6 percent in
the first quarter and appears to have posted a more moderate gain in
the second quarter.

Private payroll employment declined through April, and at midyear the
unemployment rate stood somewhat above its average in the fourth
quarter of 2001.  Core inflation--which excludes the direct influences
of the food and energy sectors--remained subdued through May, held
down by slack in resource utilization and continued sizable advances
in labor productivity.  Overall inflation was boosted by a surge in
energy prices in March and April, but energy prices have since
retreated a bit.  Inflation expectations remained in check in the
first half of this year.

As judged by declines in most interest rates over the first half of
the year, financial market participants have marked down their
expectation of the vigor of the economic expansion.  Interest rates,
along with most equity indexes, rose noticeably toward the end of the
first quarter in reaction to generally stronger-than-expected economic
data.  But Treasury yields and equity prices more than rolled back
those increases on renewed questions about the strength of the rebound
in the economy, including growing uncertainty regarding prospective
corporate profits and concerns about escalating geopolitical tensions
and about the governance and transparency of U.S. corporations.
Private demands on credit markets moderated in the first half the
year, as businesses substantially curbed their net borrowing.  For the
most part, this reduction reflected further declines in business
investment, a pickup in operating profits, and a return to net equity
issuance.  But, in addition, lenders became more cautious and
selective, especially for borrowers of marginal credit quality.

Market perceptions that the recovery in the United States might turn
out to be less robust than anticipated also put downward pressure on
the foreign exchange value of the dollar as measured against the
currencies of our major trading partners, especially during the second
quarter of 2002.  Central banks in some foreign countries, including
Canada, tightened policy as growth firmed.  The euro-area economy
recovered modestly during the first half, and some brighter signs were
evident in Japan.  In contrast, the dollar strengthened on balance
against the currencies of our other important trading partners; in
particular, the Mexican peso lost ground, and financial markets
reacted to political and economic problems in several South American
countries.


The Household Sector

Household spending began the year on a strong note and continued to
rise in the second quarter.  Further gains in disposable income have
supported a solid underlying pace of spending.  The decline in stock
prices in the first half of 2002 reduced household wealth, and the
debt-service burden remained high, but financial stress among
households to date has been limited.

Consumer Spending 

Real consumer expenditures increased at an annual rate of 
3-1/4 percent in the first quarter.  Demand for motor vehicles dropped from
an extraordinary fourth-quarter pace, but purchases remained supported
in part by continued large incentive packages.  Outlays for other
goods and services advanced smartly in the first quarter.  In the
second quarter, the rate of increase in consumer spending looks to
have eased somewhat.  Motor vehicle purchases were little changed, and
most other major categories of consumer spending likely posted smaller
gains than earlier in the year.

Real disposable personal income moved sharply higher in the first
quarter and appears to have risen a little further in the second
quarter.  Wages and salaries have increased only moderately this year.
But tax payments have fallen markedly; last year's legislation lowered
withheld tax payments again this year, and final payments this spring
on tax obligations for 2001 were substantially below last year's level
(likely related at least in part to a decline in capital gains
realized last year).  All told, real disposable income increased at an
annual rate of 8 percent between the fourth quarter of last year and
May.  However, household net worth has likely fallen further because
the negative effect of the decline in stock prices has been only
partly offset by an apparent continued appreciation in the value of
residential real estate.  According to the flow of funds accounts, by
the end of the first quarter, the ratio of household net worth to
disposable income had reversed close to two-thirds of its run-up in
the second half of the 1990s; this ratio has undoubtedly registered
additional declines since the end of March.  Consumer sentiment
improved over the first several months of the year, with indexes from
both the Conference Board and the Michigan Survey Research Center
reversing last fall's sharp deterioration.  However, both indexes have
given up some of those gains more recently.

The personal saving rate increased in the first half of this year, as
the decline in wealth over the past two years likely held down
consumer spending relative to disposable personal income.  In May, the
saving rate stood at 3 percent of disposable income, up from an
average of 1-1/2 percent over 2001.  Movements in the saving rate have
been very erratic over the past year, reflecting cyclical factors, the
timing of tax cuts, and adjustments in incentives to purchase motor
vehicles.

Residential Investment

Real residential investment increased at an annual rate of about 
15 percent in the first quarter and the level of activity appears to have
remained robust in the second quarter.  The first-quarter surge was
spurred partly by unseasonably warm and dry winter weather, which
apparently encouraged builders to move forward some of their planned
construction.  At the same time, underlying housing activity has been
supported by the gains in income and confidence noted above, and,
importantly, by low interest rates on mortgages.  In the single-family
sector, starts averaged an annual rate of 1.35 million units over the
first five months of the year--up 6-1/2 percent from the already
buoyant pace registered in 2001.  Sales of existing homes jumped in
early 2002 after moving sideways during the preceding three years;
sales of new homes have also been running quite high in recent months.

Home prices have continued to move up strongly.  For example, over the
year ending in the first quarter, the constant-quality price index for
new homes rose 5-1/4 percent, and the repeat-sales price index for
existing homes was up 6-1/4 percent.  Despite these increases, low
mortgage rates have kept housing affordable.  Rates on thirty-year
conventional fixed-rate loans averaged less than 7 percent in the
first half of this year, and rates on adjustable-rate loans continued
the downtrend that began in early 2001.  The share of median household
income required to finance the purchase of a median-price house is
close to its average for the past ten years and well below the levels
that prevailed in the 1970s and 1980s.

In the multifamily sector, housing starts averaged 340,000 units at an
annual rate over the first five months of the year, a pace close to
the average of the previous five years.  However, conditions in this
market have deteriorated somewhat during the past year.  In the first
quarter, the vacancy rate for apartments spiked to the highest level
since the late 1980s, and rents and property values were below
year-earlier readings.

Household Finance

As it did last year, household debt appears to have expanded at more
than an 8 percent annual rate during the first half of 2002.  Although
consumer credit (debt not secured by real estate) has increased, the
bulk of the expansion in household debt has come from a sizable
buildup of home mortgage debt.  Refinancing activity has fallen below
last year's record pace, but it has remained strong as households have
continued to extract a portion of the accumulated equity in their
homes.

The aggregate household debt-service burden--the ratio of estimated
minimum scheduled payments on mortgage and consumer debt to disposable
personal income--although still elevated, has moved little this year.
The effect of the fast pace of household borrowing on the debt burden
has been offset by lower interest rates and the brisk growth in
disposable income.  On balance, indicators of credit quality do not
suggest much further deterioration in the financial condition of
households.  While delinquency rates for subprime borrowers have risen
further for auto loan pools and have stayed high for mortgages,
mortgage delinquencies for all borrowers have changed little, and
delinquencies on credit card accounts at banks have not risen
significantly since the mid-1990s.  The number of personal bankruptcy
filings also has essentially moved sideways this year, albeit at a
historically high rate.  Lenders have apparently reacted to these
indicators of household credit quality by tightening standards for
consumer loans, as reported on the Federal Reserve's Senior Loan
Officer Opinion surveys.  Standards for mortgage loans, however, have
changed little, and, on the whole, credit appears to have remained
readily available to the household sector.


The Business Sector

Spending in the business sector appears to have bottomed out recently,
but a strong recovery has not yet taken hold.  Real business fixed
investment, which declined sharply last year, fell again in the first
quarter, but seems to have firmed in the second quarter.  Excess
capacity in some sectors and uncertainty about the pace of the
economic expansion are likely still restraining equipment demand, but
rising output, improving corporate profits, and continuing
technological advances appear to be working in the opposite direction.
Many businesses have worked off their excess stocks, and the
substantial inventory runoff that began in the first quarter of last
year seems to be drawing to a close.  The combination of higher
profits and weak investment spending has led to a drop in borrowing by
the nonfinancial business sector thus far this year.

Fixed Investment

Real business spending on equipment and software (E&S) was little
changed in the first quarter after having dropped sharply last year.
In the high-tech category, real expenditures moved up in the first
quarter after a double-digit decline in 2001.  Outlays for computers
posted large gains in inflation-adjusted terms in both the fourth and
first quarters; many businesses apparently postponed computer
replacement over much of last year but now seem to be taking advantage
of ongoing technological progress and the associated large declines in
prices.  In contrast, real expenditures for communications equipment
were little changed in the first quarter after having plunged by
one-third during 2001.  Excess capacity in the provision of telecom
services is continuing to weigh heavily on the demand for
communications equipment.  Business outlays for software edged down in
real terms in the first quarter.

Real spending on transportation equipment dropped in the first
quarter.  Outlays for aircraft shrank dramatically as the reduction in
orders after last year's terrorist attacks began to show through to
spending.  Outlays for motor vehicles fell sharply early in the year
owing to weakness in the market for heavy trucks and a reported
reduction in fleet sales to rental companies related to the downturn
in air travel.  Real E&S spending outside of the high-tech and
transportation categories moved up in the first quarter after sizable
declines in the three preceding quarters.  This pattern probably
reflects the deceleration and subsequent acceleration in business
output, which is an important determinant of spending in this
category.

In the second quarter, real E&S spending likely rose, borne along by
increases in sales and a rebound in profits.  Incoming data on orders
and shipments suggest that real outlays for high-tech equipment
advanced and that expenditures for other nontransportation equipment
also rose.  Spending on aircraft probably contracted further, but
orders for heavy trucks surged this spring, as some companies
reportedly shifted purchases forward in anticipation of stricter
emissions requirements that are scheduled to take effect in the fall.
Because of lags in the ordering and building of new equipment, the
provision for partial expensing in the Job Creation and Worker
Assistance Act passed by the Congress in early March will likely
bolster investment spending gradually.

Real outlays for nonresidential structures registered a very large
decline in the first quarter after having slipped appreciably in 2001.
Outlays for office and industrial structures, lodging facilities, and
public utilities dropped substantially.  Vacancy rates for offices
jumped in the first quarter to their highest level since the
mid-1990s; in addition, rents and property values were noticeably
below their levels one year earlier.  Vacancy rates have risen
dramatically in the industrial sector as well.  Construction of
drilling structures also contracted sharply in the first quarter,
thereby continuing the downtrend that began in the middle of last year
in the wake of the decline in the prices of oil and natural gas from
their peaks a few quarters earlier.  Incoming data point to further
declines in spending for nonresidential structures in the second
quarter.

Inventory Investment

Businesses ran off inventories at an annual rate of nearly $30 billion
in the first quarter.  This drawdown followed a much larger
liquidation--at an annual rate of roughly $120 billion--in the fourth
quarter, and the associated step-up in production contributed almost
3-1/2 percentage points to the first-quarter increase in real GDP.
Book-value data on inventories outside of the motor vehicle sector
point to a further slackening of the drawdown more recently.  Since
last fall, inventory-sales ratios have more than reversed the run-up
that occurred as the economy softened.  Currently, inventories do not
appear to be excessive for the economy as a whole, although industry
reports suggest that overhangs persist in a few areas.  In contrast to
inventories in other sectors, motor vehicle stocks increased in the
first half of this year, as automakers boosted production in order to
rebuild stocks that had been depleted by the robust pace of sales in
late 2001.  Motor vehicle inventories were no longer lean as of the
middle of this year.

Corporate Profits and Business Finance

The economic profits of the U.S. nonfinancial corporate sector grew 
5 percent at a quarterly rate in the first quarter of this year after a
surge of 13-3/4 percent in the fourth quarter of 2001.  The
corresponding ratio of profits to sector GDP has edged up to 
8-3/4 percent, reversing a portion of the steep decline registered over the
preceding few years but remaining well below its peak in the
mid-1990s.  Early indicators point to further profit gains in the
second quarter.

The rise in profits since late 2001, combined with weak capital
expenditures and low share repurchase and cash-financed merger
activities, have helped keep nonfinancial corporations' need for
external funds (the financing gap) below the average of last year.  In
addition, corporations have turned to the equity markets to raise a
portion of their needed external funds: Corporations have sold more
new equity than they have retired this year--the first period of net
equity issuance in nearly a decade.  They have used much of these
funds to repay debt.  As a result, the growth of nonfinancial business
debt appears to have slowed considerably in the first half of 2002
after rapid gains in preceding years.

Much of the growth in nonfinancial business debt this year has been
concentrated in the corporate bond market (though issuance has not
been quite so strong as in 2001), as firms have taken advantage of
historically attractive yields.  Many corporations have used the
proceeds of their bond offerings to pay down commercial and industrial
(C&I) loans at banks and commercial paper.  In recent months, however,
net corporate bond issuance has slowed, and the contraction in
short-term funding appears to have moderated.  About one fifth of
total bond offerings over the first half of 2002 have been in the
speculative-grade market.  This fraction is about unchanged from last
year but still well below the proportions seen in the latter half of
the 1990s, and speculative-grade bond offerings have been concentrated
in the higher quality end of that market.  Troubles in the two largest
sectors of the market-- telecommunications and energy--have continued
to weigh on issuance this year.

Although many businesses have apparently substituted bond debt for
shorter-term financing by choice, others, especially investment-grade
firms in the telecommunications sector, have done so by necessity:
They were pushed out of the commercial paper market or otherwise
encouraged by investors and credit-rating agencies to curb their
reliance on short-term sources of financing to limit the associated
rollover risk.  Indeed, commercial paper outstanding ran off sharply
in February and early March, when several companies that were
perceived as having questionable accounting practices were forced to
tap bank lines to pay off maturing commercial paper.  With
lower-quality borrowers leaving the market in the face of elevated
risk spreads, commercial paper outstanding shrank nearly 30 percent in
the first half of the year after a sizable decline in 2001.

Some firms that exited the commercial paper market turned, at least
temporarily, to banks as an alternative.  Nonetheless, on net,
commercial and industrial loans at banks have declined this year,
reflecting borrowers' preference for lengthening the maturity of their
liabilities and the overall reduction in the demand for external
financing, noted earlier.  To a more limited extent, a somewhat less
receptive lending environment probably also weighed on business
borrowing at banks.  In particular, banks continued to tighten terms
and standards on C&I loans on net over the first half of this year,
although the fraction of banks that reported having done so fell
noticeably in the Federal Reserve's Senior Loan Officer Opinion survey
in April.  Banks have also imposed stricter underwriting standards and
higher fees and spreads on backup lines of credit for commercial paper
over most of 2001 and early 2002; banks cited increased concerns about
the creditworthiness of issuers and a higher likelihood of lines being
drawn down.

Indicators of credit quality still point to some trouble spots in the
nonfinancial business sector.  The ratio of net interest payments to
cash flow has trended up since the mid-1990s for the nonfinancial
corporate sector as a whole, with increases most pronounced for weaker
speculative-grade firms.  The default rate on outstanding corporate
bonds has remained quite elevated by historical standards.  By
contrast, although the delinquency rate on C&I loans at banks has
risen a bit further this year, it has stayed well below rates observed
in the early 1990s. In part, however, this performance may be
attributable to more aggressive loan sales and charge-offs than in the
past.  It may be that problems have risen more for large firms than
for smaller ones, as the increase in C&I loan delinquencies over
recent quarters was limited to large banks, where loans to larger
firms are more likely to be held.  Credit rating downgrades continued
to outpace upgrades by a substantial margin, as was the case in the
last quarter of 2001.  Spreads of corporate bond yields over those on
comparable Treasuries have remained high by historical standards and
have risen considerably across the credit-quality spectrum for telecom
firms.  Corporate bond spreads also widened, though to a much smaller
extent, for a few highly rated firms in other industries owing to
concerns about their accounting practices.

After having surged late last year, growth in commercial mortgage debt
dropped back in the first half of this year amid a sharp decline in
construction activity.  Issuance of commercial mortgage backed
securities (CMBS), a major component of commercial mortgage finance,
has been especially weak.  Nonetheless, investor appetite for CMBS has
apparently been strong, as yield spreads have narrowed this year.
Delinquency rates on CMBS pools, which had been rising during the
early part of the year, seem to have stabilized in recent months, and
delinquency rates on commercial mortgages held by banks and insurance
companies have remained near their historical lows.

The low level of risk spreads for CMBS suggests that concerns about
terrorism insurance have not been widespread in the market for
commercial mortgages, and responses to the Federal Reserve's Senior
Loan Officer Opinion survey in April indicate that most domestic banks
required insurance on less than 10 percent of the loans being used to
finance high-profile or heavy-traffic properties.  Nonetheless, that
fraction was much higher at a few banks, and some credit-rating
agencies have placed certain CMBS issues--mainly those backed by
high-profile properties--on watch for possible downgrade because of
insufficient terrorism insurance.


The Government Sector 

The federal unified budget moved into deficit in
fiscal 2002 after having posted a substantial surplus in fiscal 2001.
The deterioration reflects a sharp drop in tax collections (resulting
in part from the effects of the economic downturn, the decline in
stock prices, and legislated tax cuts) and unusually large
supplemental spending measures.  As a consequence, federal debt held
by the public increased in the first half of the year after rapid
declines during the previous several years.  The budgets of states and
localities have also been strained by economic events, and many state
and local governments have taken steps to relieve these pressures.

Federal Government

Over the first eight months of fiscal year 2002 (October through May)
the unified budget recorded a deficit of $147 billion, compared with a
surplus of $137 billion over the same period of fiscal year 2001.
Nominal receipts were 12 percent lower than during the same period of
fiscal 2001, and daily Treasury data since May suggest that receipts
have remained subdued.  Individual tax payments are running well below
last year's pace; this weakness reflects general macroeconomic
conditions, the legislated changes in tax policy, and the decline in
stock prices and consequent reduction in capital gains realizations in
2001.  The extent of the weakness was not widely anticipated--this
spring's nonwithheld tax payments, which largely pertain to last
year's liabilities, generated the first substantial negative April
surprise in revenue collections in a number of years.  Corporate tax
payments have also dropped from last year's level because of weak
profits and the business tax provisions included in the Job Creation
and Worker Assistance Act of 2002.

Nominal federal outlays during the first eight months of fiscal 2002
were 10 percent higher than during the same period last year;
excluding a drop in net interest payments owing to the current low
level of interest rates, outlays were up 14 percent.  The rate of
increase was especially large for expenditures on income security,
health, and national and homeland defense.  Real federal expenditures
for consumption and gross investment, the part of government spending
that is a component of real GDP, rose at an annual rate of roughly
11-1/2 percent in the first calendar quarter of 2002 as defense
spending surged.  The available data suggest that real federal
expenditures for consumption and gross investment increased further in
the second quarter.

Federal saving, which equals the unified budget surplus adjusted to
conform to the accounting practices followed in the national income
and product accounts, has fallen considerably since the middle of last
year.  Net federal saving, which accounts for the depreciation of
government capital, turned negative in the first quarter of this year.
At the same time, the net saving of households, businesses, and state
and local governments has moved up from its trough of last year.  On
balance, net national saving as a share of GDP has held roughly steady
in the past several quarters after having moved down sharply since
1999.

Federal debt held by the public, which had been declining rapidly over
the past few years, grew at a 3-1/4 percent annual rate in the first
quarter of 2002 and is estimated to have increased considerably more
in the second quarter.  The ratio of federal government debt held by
the public to nominal GDP fell only slightly in the first quarter
following several years of steep declines.  In response to the
changing budget outlook, the Treasury suspended its buyback operations
through mid-August and increased the number of auctions of new
five-year notes and ten-year indexed securities.

During the second quarter, the Treasury took unusual steps to avoid
breaching its statutory borrowing limit of $5.95 trillion.  In early
April, it temporarily suspended investments in the Government
Securities Investment Fund--the so called G-fund of the Federal
Employees' Retirement System.  Incoming individual nonwithheld tax
receipts later that month allowed the Treasury to reinvest the G-fund
assets with an adjustment for interest.  Late in May, the Treasury
declared a debt ceiling emergency, which allowed it to disinvest a
portion of the Civil Service Retirement and Disability Fund, in
addition to the G-fund, to keep its debt from breaching the statutory
limit.  At the time of the declaration, the Treasury indicated that
disinvestments from these two funds, combined with other stopgap
measures, would be sufficient to keep it from breaching the debt
ceiling only through late June.  The Congress approved legislation
raising the statutory borrowing limit to $6.4 trillion on June 27.

State and Local Governments

Slow growth of revenue resulting from the economic downturn has also
generated a notable deterioration in the fiscal position of many state
and local governments over the past year.  In response, many states
and localities have been trimming spending plans and, in some cases,
raising taxes and fees.  In addition, many states have been dipping
into rainy-day and other reserve funds.  Together, these actions are
helping to move operating budgets toward balance.

Real consumption and investment spending by state and local
governments rose at an annual rate of 4-1/4 percent in the first
quarter, but available data suggest that outlays were little changed
in the second quarter.  Outlays for consumption items seem to have
held to only moderate increases in the first half of this year, a
step-down from last year's more robust gains.  Investment spending
rose briskly in the first quarter and retreated in the second quarter;
this pattern largely reflects the contour of construction
expenditures, which were boosted early in the year by unseasonably
warm and dry weather.

Debt growth in the state and local government sector has slowed so far
in 2002 from last year's very rapid pace.  States and localities have
continued to borrow heavily in bond markets to finance capital
expenditures and to refund existing obligations, including short-term
debt issued last year.  The overall credit quality of the sector has
remained high despite the fiscal stresses associated with the recent
economic slowdown, and yield ratios relative to Treasuries have
changed little this year, on net.


The External Sector

Stronger growth in the United States contributed to a widening of
U.S. external deficits in the first quarter of this year.  The United
States has continued to receive large net private financial inflows in
2002, but both inflows and outflows have been at lower levels than in
recent years.

Trade and the Current Account

The U.S. deficit on trade in goods and services widened about 
$27 billion in the first quarter, to nearly $380 billion at an annual
rate, as a surge in imports overwhelmed a slower expansion of exports.
U.S. net investment income decreased $33 billion to a slight deficit
position after recording modest surpluses in all four quarters last
year.  The U.S. deficit on other income and transfers widened about 
$9 billion, to nearly $70 billion at an annual rate.  The U.S. current
account, which is the sum of the above, recorded a deficit in the
first quarter of $450 billion at an annual rate, 4.3 percent of GDP
and nearly $70 billion larger than the deficit in the fourth quarter
of 2001.

Real exports of goods and services increased 3 percent at an annual
rate in the first quarter, after five quarters of decline.  This
improvement resulted from a very large step-up in service receipts, as
payments by foreign travelers moved back up to near pre-September 11
levels and other private service receipts increased as well.  The real
value of exported goods contracted in the first quarter, but at only a
3-1/2 percent annual rate.  Goods exports had declined much more
steeply in the previous three quarters under the effects of slower
output growth abroad, continued appreciation of the dollar, and
plunging global demand for high-tech products.  The better performance
in the first quarter of 2002 included a markedly slower rate of
decline of machinery exports and a small increase in exported
aircraft.  While exports of computers continued to fall, exports of
semiconductors rose for the first time in nearly two years.  Export
prices continued to edge down in the first quarter.

U.S. real imports of goods and services expanded in the first quarter
at an 8 percent annual rate.  As was the case with exports, a
substantial part of the increase came from larger service payments
related to increased travel abroad by U.S. residents.  Reflecting the
rebound in U.S. economic activity, imports of real goods rose at about
a 4 percent pace in the first quarter of 2002, the first increase in
four quarters, as a decline in oil imports was more than offset by a
substantial increase in imports of other goods.  Growth of non-oil
imports was led by increased imports of computers, autos, and consumer
goods.  The price of imported non-oil goods declined at about a 
2-1/4 percent annual rate, in line with its trend in 2001; prices fell for a
wide range of capital goods and industrial supplies.

Declining demand during the second half of last year put the price of
West Texas intermediate (WTI) crude oil in December 2001 at around
$19 per barrel, its lowest level since mid-1999.  Unusually warm
winter weather in the United States--along with low prices--helped
keep the value of oil imports at a very low level in the first
quarter.  But oil prices began to rise in February and March as global
economic activity picked up and as OPEC reduced its production targets
in an agreement with five major non-OPEC producers (Angola, Mexico,
Norway, Oman, and Russia).  Oil prices remained firm in the second
quarter around $26 per barrel amid turmoil in the Middle East, a
one-month suspension of oil exports by Iraq, disruption of supply from
Venezuela, and increasing global demand.  The price of gold also has
reacted to heightened geopolitical tensions and moved up more than 
13 percent over the first half of 2002.

The Financial Account

The shift in the pattern of U.S. international financial flows
observed in the second half of 2001 continued into the first quarter
of this year.  Influenced by increased economic uncertainty, questions
about corporate governance and accounting, and sagging share prices,
foreign demand for U.S. equities remained weak.  Foreign net purchases
of U.S. bonds slowed; although purchases of corporate bonds continued
to be robust, demand for agency and Treasury bonds slackened.
Nonetheless, because U.S. net purchases of foreign securities also
fell off, the contribution of net inflows through private securities
transactions to financing the U.S. current account deficit remained at
a high level.  Preliminary and incomplete data for the second quarter
of 2002 suggest a continuation of this pattern.

Slower economic activity, both in the United States and abroad, and
reduced merger activity caused direct investment inflows and outflows
to drop sharply late last year.  Direct investment inflows, which were
strong through the first half of 2001, plummeted in the second half.
U.S. direct investment abroad stayed at a high level through the third
quarter but then fell sharply.  Both inflows and outflows remained
weak in the first quarter of 2002.  Available data point to a pickup
of capital inflows from official sources during the first half of
2002, as the recent weakening of the foreign exchange value of the
dollar prompted some official purchases.


The Labor Market

Labor markets weakened further in the first few months of the year;
they now appear to have stabilized but have yet to show signs of a
sustained and substantial pickup.  Growth of nominal compensation
slowed further in the first part of the year after having decelerated
in 2001.  With productivity soaring in recent quarters, unit labor
costs have fallen sharply.

Employment and Unemployment

After having fallen an average of nearly 160,000 per month in 2001,
private payroll employment declined at an average monthly rate of
88,000 in the first quarter and was about unchanged in the second
quarter.  Employment losses in the manufacturing sector have moderated
in recent months, and employment in the help supply services
industry--which provides many of its workers to the manufacturing
sector--has increased.  These two categories, which were a major locus
of weakness last year, gained an average of 11,000 jobs per month over
the past three months, compared with an average loss of 76,000 jobs
per month in the first quarter of the year and 163,000 jobs per month
over 2001.

Apart from manufacturing and help supply, private payrolls fell 12,000
per month in the first quarter and declined 8,000 per month in the
second quarter.  In the second quarter, hiring in construction fell by
the same amount as in the first quarter.  Retail employment declined
somewhat after rising a bit in the first quarter, and the employment
gain in services other than help supply was slightly smaller than in
the first quarter.  However, employment losses in several other
categories abated in the second quarter.

The unemployment rate in the second quarter averaged 5.9 percent, up
from a reading of 5.6 percent in both the fourth quarter of last year
and the first quarter of this year.  The higher unemployment rate in
recent months is consistent with weak employment gains, and it
probably was boosted a bit by the federal temporary extended
unemployment compensation program.  Because this program provides
additional benefits to individuals who have exhausted their regular
state benefits, it encourages unemployed individuals to be more
selective about taking a job offer and likely draws some people into
the labor force to become eligible for these benefits.

Productivity and Labor Costs

Labor productivity has increased rapidly in recent quarters.  After
rising at an average annual rate of around 1 percent in the first
three quarters of last year, output per hour in

the nonfarm business sector jumped at an annual rate of 5-1/2 percent
in the fourth quarter of last year and 8-1/2 percent in the first
quarter of this year.  Productivity likely continued to rise in the
second quarter, albeit at a slower pace.  Labor productivity often
rises briskly in the early stages of economic recoveries, but what
makes the recent surge unusual is that it followed a period of modest
increases, rather than declines.  In earlier postwar recessions,
productivity deteriorated as firms retained more workers than may have
been required to meet reduced production needs.  The strength in
productivity growth around the beginning of this year suggests that
employers may have doubted the durability of the pickup in sales and,
therefore, deferred new hiring until they became more convinced of the
vigor of the expansion.  Smoothing through the recent cyclical
fluctuations, productivity advanced at an average annual rate of close
to 3-1/2 percent between the fourth quarter of 2000 and the first
quarter of this year.  Although this pace is unlikely to be sustained,
it further bolsters the view that the underlying trend in productivity
has moved up since the first half of the 1990s.

The employment cost index (ECI) for private nonfarm businesses
increased just under 4 percent during the twelve months ended in March
of this year, after rising about 4-1/4 percent in the preceding
twelve-month period.  The recent small step-down likely reflects the
lagged effects of the greater slack in labor markets and lower
consumer price inflation.  The wages and salaries component and the
benefits component of the ECI both decelerated by 1/4 percentage point
relative to the preceding year.  The slowing in benefits costs
occurred despite a 2-1/2 percentage point pickup in health insurance
cost inflation, to a 10-1/2 percent rate of increase.

Nominal compensation per hour in the nonfarm business sector--an
alternative measure of compensation based on the national income and
product accounts--rose 3-1/2 percent during the year ending in the
first quarter.  This rate represented a sharp slowing from the 
7-1/4 percent pace recorded four quarters earlier, which likely had been
boosted significantly by stock options; stock options are included in
this measure at their value when exercised.  The deceleration in this
measure of compensation is much more dramatic than in the ECI because
the ECI does not include stock options.  The moderate increase in
nominal compensation combined with the spike in productivity growth
led unit labor costs to drop at an annual rate in excess of 5 percent
in the first quarter, after a decline of 3 percent in the fourth
quarter.

Information about the behavior of compensation in more recent months
is limited.  Readings on average hourly earnings of production or
nonsupervisory workers suggest a further deceleration in wages: The
twelve-month change in this series was 3-1/4 percent in June, 
3/4 percentage point below the change for the preceding twelve months.


Prices

A jump in energy prices in the spring pushed up overall inflation in
the first part of 2002, but core inflation remained subdued.  The
chain-type price index for personal consumption expenditures (PCE)
increased at an annual rate of 2-1/4 percent over the first five
months of the year, compared with a rise of just over 1 percent for
the twelve months of 2001.  Core PCE prices rose at an annual rate of
just over 1-1/2 percent during the first five months of this year,
which was the pace recorded for 2001.

Energy prices rose sharply in March and April but have turned down
more recently.  Gasoline prices spiked in those two months, as crude
oil costs moved higher and retail gasoline margins surged.  Since
April, gasoline prices have, on balance, reversed a small part of this
rise.  Natural gas prices stayed low in early 2002 against a backdrop
of very high inventories; however, these prices have, on average,
moved higher in more recent months.  Electricity prices have dropped
this year, a move reflecting deregulation of residential prices in
Texas as well as lower prices for coal and natural gas, which are used
as inputs in electricity generation.  All told, energy prices
increased at an annual rate of 20 percent over the first five months
of the year, reversing a little more than half of last year's decline.

Consumer food prices increased at an annual rate of 1-1/2 percent
between December and May.  A poor winter crop of vegetables pushed up
prices early this year, but supplies subsequently increased and prices
came down.  In addition, consumer prices for meats and poultry, which
began to weaken late last year, remained subdued this spring.

Core inflation was held down over the first five months of the year by
continued softness in goods prices, including a significant decline in
motor vehicle prices.  Non-energy services prices continued to move up
at a faster pace than core goods prices, although the very sizable
increases in residential rent and the imputed rent of owner-occupied
housing have eased off in recent months.  The rate of increase in core
consumer prices has been damped by several forces.  One is the lower
level of resource utilization that has prevailed over the past year.
Core price increases were also held down by declines in non-oil import
prices and the lagged effects of last year's decline in energy prices
on firms' costs.  In addition, inflation expectations have stayed in
check: The Michigan Survey Research Center index of median expected
inflation over the subsequent year has rebounded from last fall's
highly unusual tumble, but its average in recent months of 
2-3/4 percent is below the average reading of 3 percent in 2000.

Like core PCE inflation, inflation measured by the core consumer price
index (CPI) has remained subdued.  However, the levels of inflation
corresponding to these two alternative measures of consumer prices are
markedly different: Core PCE inflation was about 1-1/2 percent over
the twelve months ended in May, while core CPI inflation was about
2-1/2 percent.  This gap is more than 1/2 percentage point larger than
the average difference between these inflation measures during the
1990s (based on the current methods used to construct the CPI instead
of the official published CPI).  The larger differential arises from
several factors.  First, the PCE price index (unlike the CPI) includes
several components for which market-based prices are not available,
such as checking services provided by banks without explicit charges;
the imputed prices for these components have increased considerably
less rapidly in the past couple of years than previously.  Second, the
substantial acceleration in shelter costs since the late 1990s has
provided a larger boost to the CPI than to the PCE price index because
housing services have a much larger weight in the CPI.  Third, PCE
medical services prices--which are largely based on producer price
indexes rather than information from the CPI--have increased more
slowly than CPI medical services prices over the past couple of years.

The chain-type price index for gross domestic purchases--which
captures prices paid for consumption, investment, and government
purchases--rose at an annual rate of roughly 1 percent in the first
quarter of 2002, putting the four-quarter change at 3/4 percent.  This
pace represents a marked slowing relative to the 2-1/4 percent rise in
the year-earlier period, owing to both a drop in energy prices (as the
decline in the second half of 2001 was only partly offset by the
increase this spring) and more rapid declines in the prices of
investment goods such as computers.  The GDP price index rose at an
annual rate of 1-1/4 percent in the first quarter and was up almost
1-1/2 percent relative to the first quarter of last year.  The GDP
price index decelerated somewhat less than the index for gross
domestic purchases, in part because declining oil prices receive a
smaller weight in U.S. production than in U.S. purchases.


U.S. Financial Markets

Market interest rates have moved lower, on net, since the end of 2001,
as market participants apparently viewed the ongoing recovery as
likely to be less robust than they had been expecting late last year.
Such a reassessment of the strength of economic activity and
associated business earnings, along with worries about the accuracy of
published corporate financial statements, weighed heavily on major
equity indexes, which dropped 12 to 31 percent.  The debt of the
nonfinancial sectors expanded at a moderate pace, but lenders have
imposed somewhat firmer financing terms, especially on marginal
borrowers.

Households' preferences for safer assets, which had intensified
following last year's terrorist attacks, diminished early in 2002, as
evidenced by strong flows into both equity and bond mutual funds.
Equity fund inflows lessened in May and turned into outflows in June,
however, as concerns about the strength and accuracy of corporate
earnings reports mounted.  But the net shift toward longer-term assets
this year appears to have contributed to a significant deceleration in
M2, which has also been slowed by reduced mortgage refinancing
activity and a leveling out of the opportunity cost of holding M2
assets.

Interest Rates

Uncertain about the robustness of the economic recovery, the FOMC
opted to retain its accommodative policy stance over the first half of
2002, leaving its target for the federal funds rate at 1-3/4 percent.
Market participants, too, have apparently been unsure about the
strength of the recovery, and shifts in their views of the economic
outlook have played a significant role in movements in market interest
rates so far this year.  During the first quarter of the year, news on
aggregate spending and output came in well above expectations, and
Treasury coupon yields rose between 35 and 65 basis points.  The
second quarter, however, brought renewed concerns about the economic
outlook, compounded by sharp declines in equity prices.  In recent
months, Treasury coupon yields have more than reversed their earlier
increases and are now 40 to 50 basis points below their levels at the
end of 2001.

Survey measures of long-term inflation expectations have been quite
stable this year, implying that real rates changed about as much as
nominal rates.  The spread between nominal and inflation-indexed
Treasury yields, another gauge of investors' expectations about
inflation, has moved over a relatively wide range since the end of
2001, but, on net, it has edged up only slightly.  Even the small
widening of this spread likely overstates a shift in sentiment
regarding future price pressures in the economy.  In mid-February, the
Treasury reassured investors that it would continue to issue indexed
debt, an announcement that was reinforced in May when the Treasury
made public its decision to add one more auction of ten-year indexed
notes to its annual schedule of offerings.  This reaffirmation of the
Treasury's commitment to issue indexed securities may have pulled
indexed yields down by bolstering the actual and expected liquidity of
the market.

Yields on longer-maturity bonds issued by investment-grade
corporations have stayed close to their lows of the past ten years,
but speculative-grade yields remained near the high end of their range
since the mid-1990s.  Spreads relative to Treasury yields have widened
most recently for both investment- and speculative-grade bonds as
concerns about corporate earnings reporting intensified.  Such
concerns have also played a prominent role in the commercial paper
market, especially early this year, when investors, who had become
increasingly worried about accounting scandals, imposed high premiums
on lower quality borrowers.  Subsequently, however, many such
borrowers either left the commercial paper market or reduced their
reliance on commercial paper financing, and the average yield spread
on second-tier commercial paper over top-tier paper has narrowed
considerably.

Interest rates on car loans have changed little, on net, this year,
and mortgage rates have moved lower.  However, according to the
Federal Reserve's Survey of Terms of Business Lending, interest rates
on C&I loans at domestic banks have moved a bit higher this year, as
banks have raised the spread of the average interest rate on business
loans over the target federal funds rate.  The wider spread reflects
higher risk premiums on C&I loans to lower-quality borrowers; spreads
for higher-quality borrowers have changed little on net.

Equity Markets

After falling in January in reaction to pessimistic assessments of
expected business conditions over the coming year--especially in the
tech sector--stock prices rebounded smartly toward the end of the
first quarter on stronger-than-expected macroeconomic data.  Most
first-quarter corporate earnings releases met or even exceeded market
participants' expectations, but many firms included sobering guidance
on sales and earnings prospects in those announcements.  These
warnings, combined with mounting questions about corporate accounting
practices, worries about threats of domestic terrorism, and escalating
geopolitical tensions, have taken a considerable toll on equity prices
since the end of March.  On net, all major equity indexes are down
substantially so far this year.  Share prices in the telecom and
technology sectors have performed particularly poorly, and, on July
10, the Nasdaq was 31 percent lower than at the end of 2001.  The
Wilshire 5000, a broad measure of equity prices, fell 18-1/2 percent
over the same period, returning to a level 40 percent below its
historical peak reached in March 2000.

Declining share prices pulled down the price-earnings ratio for the
S&P 500 index (calculated using operating profits expected over the
coming year).  Nonetheless, the ratio remained elevated relative to
its typical values before the mid-1990s, suggesting that investors
continued to anticipate rapid long-term growth in corporate profits.

Monetary Policy Instruments 

At its March 19 meeting, the FOMC assessed the priorities, given
limited resources, it should attach to further studies of the
feasibility of outright purchases for the System Open Market Account
(SOMA) of mortgage-backed securities guaranteed by the Government
National Mortgage Association (GNMA-MBS) and the addition of foreign
sovereign debt securities to the list of collateral eligible for
U.S. dollar repurchase agreements by the System.  As noted in the
February and July 2001 Monetary Policy Reports to the Congress, such
alternatives could prove useful if outstanding Treasury debt
obligations were to become increasingly scarce relative to the
necessary growth in the System's portfolio, and the FOMC had requested
that the staff explore these options.  Noting that many of the staff
engaged in these studies were also involved in contingency planning,
which had been intensified after the September 11 attacks, the FOMC
decided to give the highest priority to such planning.  Federal
budgetary developments over the past year meant that constraints on
Treasury debt supply would not become as pressing an issue as soon as
the FOMC had previously thought.  Still, given the inherent
uncertainty of budget forecasts, the likely significant needs for
large SOMA operations in coming years, and the lead times required to
implement new procedures, the FOMC decided that the exploratory work
on the possible addition of outright purchases of GNMA-MBS should go
forward once it was possible to do so without impeding contingency
planning efforts.

The Federal Reserve also addressed possible changes to the structure
of its discount window facility.  On May 17, 2002, the Federal Reserve
Board released for public comment a proposed amendment to the Board's
Regulation A that would substantially revise its discount window
lending procedures.  Regulation A currently authorizes the Federal
Reserve Banks to operate three main discount window programs:
adjustment credit, extended credit, and seasonal credit.  The proposed
amendment would establish two new discount window programs called
primary credit and secondary credit as replacements for adjustment and
extended credit.  The Board also requested comment on the continued
need for the seasonal program but did not propose any substantive
changes to the program.  The proposal envisions that primary credit
would be available for very short terms, ordinarily overnight, to
depository institutions that are in generally sound financial
condition at an interest rate that would usually be above short-term
market interest rates, including the federal funds rate; currently,
the discount rate is typically below money market interest rates.  The
requirement that only financially sound institutions should have
access to primary credit should help reduce the stigma currently
associated with discount window borrowings.  In addition, because the
proposed discount rate structure will eliminate the incentive that
currently exists for depository institutions to borrow to exploit a
positive spread between short-term money market rates and the discount
rate, the Federal Reserve will be able to reduce the administrative
burden on borrowing banks.  As a result, depository institutions
should be more likely to turn to the discount window when money
markets tighten significantly, enhancing the window's ability to serve
as a marginal source of reserves for the overall banking system and as
a backup source of liquidity for individual depository institutions.
Secondary credit would be available, subject to Reserve Bank approval
and monitoring, for depository institutions that do not qualify for
primary credit.  The proposed amendment is intended to improve the
functioning of the discount window and the money market more
generally.  Adoption of the proposal would not entail a change in the
stance of monetary policy.  It would not require a change in the
FOMC's target for the federal funds rate and would not affect the
overall level of market interest rates.  The comment period on the
proposal ends August 22, 2002.  If the Board then votes to revise its
lending programs, the changes likely would take place several months
later.

Debt and Financial Intermediation

Growth of the debt of domestic nonfinancial sectors other than the
federal government is estimated to have slowed during the first half
of 2002, as businesses' needs for external funds declined further
owing to weak capital spending, continuing inventory liquidation, and
rising profits.  In addition, growth in consumer credit moderated
following a surge in auto financing late last year.  On balance,
nonfederal debt expanded at a 5-1/2 percent annual rate in the first
quarter of the year after growing 7-1/2 percent in 2001.  In contrast,
the stock of federal debt held by the public, which had contracted
slightly in 2001, grew 3-1/4 percent at an annual rate in the first
quarter and expanded further in the second quarter, as federal tax
revenues fell short of expectations and government spending increased
substantially.  The sharp rise in federal debt outstanding followed a
few years of declines.

The proportion of total credit supplied by depository institutions
over the first half of the year is estimated to have been near its
lowest value since 1993.  Although banks have continued to acquire
securities at about the same rapid pace observed in 2001, the shift in
household and business preferences toward longer-term sources of
credit greatly reduced the demand for bank loans.  As noted, banks'
loans to businesses ran off considerably, as corporate borrowers
turned to the bond market in volume to take advantage of favorable
long-term interest rates.  Growth of real estate loans slowed markedly
this year, partly as outlays for nonresidential structures declined,
but growth of consumer loans was fairly well maintained.  With some
measures of credit quality in the business and household sectors still
pointing to pockets of potential strain, loan-loss provisions remained
high at banks and weighed on profits.  Nonetheless, bank profits in
the first quarter stayed in the elevated range observed over the past
several years, and virtually all banks--98 percent by assets--remained
well capitalized.

Among nondepository financial intermediaries, government-sponsored
enterprises (GSEs) curtailed their net lending (net acquisition of
credit market instruments) during the first quarter of the year, but
available data suggest that insurance companies more than made up for
the shortfall.  The GSEs appeared to continue to restrain their net
lending in the second quarter, in part as yields on mortgage-backed
securities, which are a major component of their holdings of financial
assets, compared less favorably to yields on the debt they issue.  Net
lending by insurance providers in the first quarter was especially
strong among life insurance companies, which experienced a surge in
sales late last year in the aftermath of the September 11 terrorist
attacks.  Net lending by the GSEs amounted to 14 percent of the net
funds raised by both the financial and nonfinancial sectors in the
credit markets in the first quarter of 2002, and the figure for
insurance companies was 10 percent; depository credit accounted for 
13 percent of all net borrowing over the same period.

Monetary Aggregates

The broad monetary aggregates decelerated considerably during the
first half of this year.  M2 rose 4-1/2 percent at an annual rate
after having grown 10-1/4 percent in 2001.  Several factors
contributed to the slowing in M2.  Mortgage refinancing activity,
which results in prepayments that temporarily accumulate in deposit
accounts before being distributed to investors in mortgage-backed
securities, moderated over the first half of this year.  In addition,
the opportunity cost of holding M2 assets has leveled out in recent
months, so the increase in this aggregate has been more in line with
income.  Because the rates of return provided by many components of M2
move sluggishly, the rapid declines in short-term market interest
rates last year temporarily boosted the attractiveness of M2 assets.
In recent months, however, yields on M2 components have fallen to more
typical levels relative to short-term market interest rates.  Lastly,
precautionary demand for M2, which was high in the aftermath of last
year's terrorist attacks, seems to have unwound in 2002, with
investors shifting their portfolios back toward longer-term assets
such as equity and bond mutual funds.  With growth in nominal GDP
picking up significantly this year, M2 velocity--the ratio of nominal
GDP to M2--rose about 1-1/2 percent at an annual rate in the first
quarter of 2002, in sharp contrast to the large declines registered
throughout 2001.

M3--the broadest monetary aggregate--grew 3-1/2 percent at an annual
rate through the first six months of the year after rising 
12-3/4 percent in 2001.  Most of this deceleration, apart from that accounted
for by M2, resulted from the weakness of institutional money market
funds, which declined slightly, after having surged about 50 percent
last year.  Yields on these funds tend to lag market yields somewhat,
and so the returns on the funds, like those on many M2 assets, became
less attractive as their yields caught up with market rates.


International Developments

Signs that economic activity abroad had reached a turning point became
clearer during the first half of 2002, but recovery has been uneven
and somewhat tepid on average in the major foreign industrial
countries.  Improving conditions in the high-tech sector have given a
boost to some emerging-market economies, especially in Asia, but
several Latin American economies have been troubled by a variety of
adverse domestic developments.  Foreign financial markets became
increasingly skittish during the first half of the year amid worries
about global political and economic developments, including concerns
about corporate governance and accounting triggered by U.S. events.
Oil prices reversed a large part of their 2001 decline.

During the first half, monetary authorities in some foreign countries
where signs of recovery were most evident and possible future
inflation pressures were becoming a concern--Canada, Australia, New
Zealand, and Sweden, among others--began to roll back a portion of
last year's easing, raising expectations that policy tightening might
become more widespread.  However, policy was held steady at the
European Central Bank (ECB) and the Bank of England.  The Bank of
Japan (BOJ) maintained short-term interest rates near zero and kept
balances of bank deposits at the BOJ at elevated levels.  Yield curves
in most foreign industrial countries became a bit steeper during the
first quarter as long-term rates rose in reaction to news suggesting
stronger U.S. growth and improving prospects for global recovery.
Since then, long-term rates have edged lower, on balance, in part as
investors shifted out of equity investments.  Foreign equities
performed well in most countries early in the year, but share prices
in many countries have fallen since early in the second quarter--in
some cases more steeply than in the United States.  The broad stock
indexes for the major industrial countries are down since the
beginning of the year, except in Japan, where stock prices, on
balance, are about unchanged.  High-tech stocks have been hit
especially hard.

During the first quarter of 2002, the foreign exchange value of the
dollar (measured by a trade-weighted index against the currencies of
major industrial countries) appeared to react primarily to shifting
market views about the relative strength of the U.S. recovery and its
implications for the timing and extent of future monetary tightening.
Despite some fluctuations in this period, the dollar stayed fairly
close to the more than sixteen-year high reached in January.  In the
second quarter, however, the dollar trended downward as earlier market
enthusiasm about U.S. recovery dimmed.  Concerns about profitability,
corporate governance, and disclosure at U.S. corporations appeared to
dampen the attraction of U.S. securities to investors, as did worries
that the United States was particularly vulnerable to the consequences
of global geopolitical developments.  With U.S. investments perceived
as becoming less attractive, the financing requirements of a large and
growing U.S. current account deficit also seemed to emerge as a more
prominent negative factor.  The dollar has lost more than 9 percent
against the major currencies since the end of March and is down, on
balance, more than 8 percent so far in 2002.  In contrast, the dollar
has gained about 2 percent this year, on a weighted-average basis,
against the currencies of our other important trading partners.

The dollar's exchange rate against the Japanese yen was quite volatile
in the first half and, on balance, the dollar has fallen more than 10
percent since the beginning of the year.  Although Japan's domestic
economy continued to struggle with deflation and severe structural
problems, including mounting bad loans in the financial sector and
growing bankruptcies, some indicators (including strong reported
first-quarter GDP, a firming of industrial production, and a somewhat
better reading on business sentiment in the BOJ's second-quarter
Tankan survey) suggested that a cyclical recovery has begun.  The
yen's rise occurred despite downgradings of Japan's government debt by
leading rating services in April and May and several episodes of
intervention sales of yen in foreign exchange markets by Japanese
authorities in May and June.  Japanese stock prices, which had fallen
to eighteen-year lows in early February, turned up later as economic
prospects became less gloomy.  At midyear, the TOPIX index was about
where it was at the start of the calendar year.

After declining in the final quarter of 2001, euro-area GDP appears to
have increased in the first half, though at only a modest rate.
Exports firmed and inventory destocking appeared to be winding down,
but consumption remained weak.  The pace of activity varied across
countries, with growth in Germany--the euro area's largest
economy--lagging behind.  Despite lackluster area-wide growth,
concerns about inflation became increasingly prominent.  For most of
the first half, euro-area headline inflation persisted at or above the
ECB's 2 percent target limit, partly on higher energy and food price
inflation; even excluding the effects of those two components,
inflation picked up somewhat during the period.  Inflation concerns
also were fanned by difficult labor market negotiations this spring,
but the strength of the euro may blunt inflationary pressures to some
extent.  The new euro notes and coins were introduced with no
noticeable difficulties at the beginning of the year, but the euro
drifted down against the dollar for several weeks thereafter.  Since
then, however, the euro has reversed direction and moved steadily
higher.  On balance, the dollar has lost nearly 11 percent against the
euro so far in 2002.

The United Kingdom seemed to weather last year's slump better than
most industrial countries, as strength in consumption counteracted
weakness in investment and net exports, though growth did weaken in
the last quarter of 2001 and into the first quarter of 2002.  Notable
increases in industrial production and continued strength in the
service sector indicate that growth picked up in the second quarter.
Household borrowing has increased briskly, supported by rapid
increases in housing prices, and unemployment rates remain near record
lows.  At the same time, retail price inflation has remained below the
Bank of England's 2-1/2 percent target.  Sterling has fallen nearly 
5 percent against the euro since the beginning of the year, while it has
gained more than 6 percent against the dollar.  Elsewhere in Europe,
the exchange value of the Swiss franc has been driven up by flows into
Swiss assets prompted in part by uncertainties about global political
developments.  The Swiss National Bank eased its official rates in May
to counteract this pressure and provide support for the Swiss economy.

Economic recovery appears to be well under way in Canada.  Real GDP
increased 6 percent at an annual rate in the first quarter, and other
indicators point to continued strong performance in the second
quarter.  Canadian exports--particularly automotive
exports--benefitted early in the year from the firming of U.S. demand,
but the expansion has become more widespread, and employment growth
has been strong.  Although headline consumer price inflation has
remained in the bottom half of the Bank of Canada's target range of 
1 percent to 3 percent, core inflation has crept up this year.  In
April, the Bank of Canada increased its overnight rate 25 basis
points, citing stronger-than-expected growth in both the United States
and Canada, and it increased that rate again by the same amount in
June.  The Canadian dollar, which had been at a historically low level
against the U.S. dollar in January, moved up quite steeply in the
second quarter and has gained about 5 percent for the year so far.

The Mexican economy was hit hard by the global slump in 2001 and
especially by the weaker performance of the U.S. economy.  Mexican
exports stabilized early this year as U.S. activity picked up, and
other indicators also now suggest that the Mexican economy is
beginning to recover.  In February, despite the weak level of activity
at the time, the Bank of Mexico tightened monetary policy to keep
inflation on track to meet its 4-1/2 percent target for 2002, and the
Mexican peso moved up a bit against the dollar during February and
March.  In April, with inflation apparently under control, the central
bank eased policy, and since then the peso has moved down
substantially.  Against the dollar, the decline since the beginning of
the year has amounted to almost 7 percent.  After rising through
April, Mexican share prices also fell sharply, leaving them at midyear
about unchanged from their end-2001 levels.

Financial and economic conditions deteriorated significantly in
Argentina this year.  The Argentine peso was devalued in January and
then allowed to float in early February; since then, it has lost more
than 70 percent of its value versus the dollar.  The peso's fall
severely strained balance sheets of Argentine issuers of dollar-based
obligations.  Various stop-gap measures intended to restrict
withdrawals from bank accounts and to force conversion of
dollar-denominated loans and deposits into peso-denominated form put
banks and depositors under further stress.  Meanwhile, economic
activity has continued to plummet, and the government has struggled to
gain support for reforms that would address chronic fiscal imbalances.
Since late 2001, the government has been servicing its obligations
only to its multilateral creditors, and spreads on Argentina's
international debt have soared to more than 65 percentage points.

In recent months financial markets elsewhere in the region have become
more volatile.  Brazilian markets have been roiled by political
uncertainties related to national elections coming in the fall.
Attention has focused on vulnerabilities associated with Brazil's
large outstanding stock of debt, much of which is short-term.  Since
April, the value of the real against the dollar has fallen nearly 20
percent, and Brazilian spreads have widened substantially.  Several
other South American countries, including Uruguay and Venezuela, also
have been beset by growing financial and economic problems.

Asian economies that rely importantly on exports of computers and
semiconductors (Korea, Singapore, Malaysia, and Taiwan) have grown
quite vigorously so far this year, a buoyancy reflecting in part the
recent turnaround of conditions in the technology sector and stronger
U.S. growth.  The currencies of several countries of this group have
moved up against the dollar.  In Korea, the expansion has been more
broad-based, as domestic demand was fairly resilient during the recent
global downturn and has remained firm.  China, which is less dependent
on technology exports, has continued to record strong growth as well.
Other countries in the region also have started to recover from steep
slowdowns or contractions in 2001, although Hong Kong has continued to
be troubled by the collapse of property prices.  Most stock markets in
the region have recorded gains so far this year.