Monetary Policy Report to the Congress  

Report submitted to the Congress on February 13, 2001, pursuant
to section 2B of the Federal Reserve Act    


Monetary Policy and the Economic Outlook   

When the Federal Reserve submitted its previous Monetary Policy
Report to the Congress, in July of 2000, tentative signs of a
moderation in the growth of economic activity were emerging
following several quarters of extraordinarily rapid expansion. After
having increased the interest rate on federal funds through the
spring to bring the growth of aggregate demand and potential
supply into better alignment and thus contain inflationary pressures,
the Federal Reserve had stopped tightening as evidence of an easing
of economic growth began to appear.   

Indications that the expansion had moderated from its earlier rapid
pace gradually accumulated during the summer and into the
autumn. For a time, this downshifting of growth seemed likely to
leave the economy expanding at a pace roughly in line with that of
its potential. Over the last few months of the year, however,
elements of economic restraint emerged from several directions to
slow growth even more. Energy prices, rather than turning down as
had been anticipated, kept climbing, raising costs throughout the
economy, squeezing business profits, and eroding the income
available for discretionary expenditures. Equity prices, after coming
off their highs earlier in the year, slumped sharply starting in
September, slicing away a portion of household net worth and
discouraging the initial offering of new shares by firms. Many
businesses encountered tightening credit conditions, including a
widening of risk spreads on corporate debt issuance and bank loans.
Foreign economic activity decelerated noticeably in the latter part
of the year, contributing to a weakening of the demand for U.S.
exports, which also was being restrained by an earlier appreciation
in the exchange value of the U.S. dollar.   

The dimensions of the economic slowdown were obscured for a
time by the usual lags in the receipt of economic data, but the
situation began to come into sharper focus late in the year as the
deceleration steepened. Spending on business capital, which had
been rising rapidly for several years, elevating stocks of these
assets, flattened abruptly in the fourth quarter. Consumers clamped
down on their outlays for motor vehicles and other durables, the
stocks of which also had climbed to high levels. As the demand for
goods softened, manufacturers adjusted production quickly to
counter a buildup in inventories. Rising concern about slower
growth and worker layoffs contributed to a sharp deterioration of
consumer confidence. In response to the accumulating weakness,
the Federal Open Market Committee (FOMC) lowered the intended
interest rate on federal funds 1/2 percentage point on January 3 of
this year. Another rate reduction of that same size was implemented
at the close of the most recent meeting of the FOMC at the end of
last month.   

As weak economic data induced investors to revise down their
expectations of future short-term interest rates in recent months and
as the Federal Reserve eased policy, financial market conditions
became more accommodative. Since the November FOMC
meeting, yields on many long-term corporate bonds have dropped
on the order of a full percentage point, with the largest declines
taking place on riskier bonds as the yield spreads on those securities
narrowed considerably from their elevated levels. In response,
borrowing in long-term credit markets has strengthened appreciably
so far in 2001. The less restrictive conditions in financial markets
should help lay the groundwork for a rebound in economic growth.  

That rebound should also be encouraged by underlying strengths of
the economy that still appear to be present despite the sluggishness
encountered of late. The most notable of these strengths is the
remarkable step-up in structural productivity growth since the
mid-1990s, which seems to be closely related to the spread of new
technologies. Even as the economy slowed in 2000, evidence of
ongoing efficiency gains were apparent in the form of another year
of rapid advance in output per worker hour in the nonfarm business
sector. With households and businesses still in the process of
putting recent innovations in place and with technological
breakthroughs still occurring, an end to profitable investment
opportunities in the technology area does not yet seem to be in
sight. Should investors continue to seek out emerging
opportunities, the ongoing transformation and expansion of the
capital stock will be maintained, thereby laying the groundwork for
further gains in productivity and ongoing advances in real income
and spending. The impressive performance of productivity and the
accompanying environment of low and stable underlying inflation
suggest that the longer-run outlook for the economy is still quite
favorable, even though downside risks may remain prominent in the
period immediately ahead.    


Monetary Policy, Financial Markets, and the Economy over the
Second Half of 2000 and Early 2001   

As described in the preceding Monetary Policy Report to the
Congress, the very rapid pace of economic growth over the first
half of 2000 was threatening to place additional strains on the
economy's resources, which already appeared to be stretched thin.
Private long-term interest rates had risen considerably in response
to the strong economy, and, in an effort to slow the growth of
aggregate demand and thereby prevent a buildup of inflationary
pressures, the Federal Reserve had tightened its policy settings
substantially through its meeting in May 2000. Over subsequent
weeks, preliminary signs began to emerge suggesting that growth in
aggregate demand might be slowing, and at its June meeting the
FOMC left the federal funds rate unchanged.   

Further evidence accumulated over the summer to indicate that
demand growth was moderating. The rise in mortgage interest rates
over the previous year seemed to be damping activity in the housing
sector. Moreover, the growth of consumer spending had slowed
from the exceptional pace of earlier in the year; the impetus to
spending from outsized equity price gains in 1999 and early 2000
appeared to be partly wearing off, and rising energy prices were
continuing to erode the purchasing power of households. By
contrast, business fixed investment still was increasing very rapidly,
and strong growth of foreign economies was fostering greater
demand for U.S. exports. Weighing this evidence and recognizing
that the effects of previous tightenings had not yet been fully felt,
the FOMC decided at its meeting in August to hold the federal
funds rate unchanged. The Committee remained concerned that
demand could continue to grow faster than potential supply at a
time when the labor market was already taut, and it saw the balance
of risks still tilted toward heightened inflation pressures.   

The FOMC faced fairly similar circumstances at its October
meeting. By then, it had become more apparent that the growth in
demand had fallen to a pace around that of potential supply.
Although consumer spending had picked up again for a time, it did
not regain the vigor it had displayed earlier in the year, and capital
spending, while still growing briskly, had decelerated from its
first-half pace. With increases in demand moderating, private
employment gains slowed from the rates seen earlier in the year.
However, labor markets remained exceptionally tight, and the
hourly compensation of workers had accelerated to a point at which
unit labor costs were edging up despite strong gains in productivity.
In addition, sizable increases in energy prices were pushing broad
inflation measures above the levels of recent years. Although core
inflation measures were at most only creeping up, the Committee
felt that there was some risk that the increase in energy prices,
which was lasting longer than had seemed likely earlier in the year,
would start to leave an imprint on business costs and longer-run
inflation expectations, posing the risk that core inflation rates could
rise more substantially. Weighing these considerations, the FOMC
decided to hold the federal funds rate unchanged at its October
meeting. While recognizing that the risks in the outlook were
shifting, the FOMC believed that the tautness of labor markets and
the rise in energy prices meant that the balance of those risks still
was weighted towards heightened inflation pressures, and this
assessment was noted in the balance-of-risks statement.   

By the time of the November FOMC meeting, conditions in the
financial markets were becoming less accommodative in some
ways, even as the Federal Reserve held the federal funds rate
steady. Equity prices had declined considerably over the previous
several months, resulting in an erosion of household wealth that
seemed likely to restrain consumer spending going forward. Those
price declines, along with the elevated volatility of equity prices,
also hampered the ability of firms to raise funds in equity markets
and were likely discouraging business investment. Some firms faced
more restrictive conditions in credit markets as well, as risk spreads
in the corporate bond market widened significantly for firms with
lower credit ratings and as banks tightened the standards and terms
on their business loans. Meanwhile, incoming data indicated that the
pace of economic activity had softened a bit further. Still, the
growth of aggregate demand apparently had moved only modestly
below that of potential supply. Moreover, while crude oil prices
appeared to be topping out, additional inflationary pressures were
arising in the energy sector in the form of surging prices for natural
gas, and there had been no easing of the tightness in the labor
market. In assessing the evidence, the members of the Committee
felt that the risks to the outlook were coming into closer balance
but had not yet shifted decisively. At the close of the meeting, the
FOMC left the funds rate unchanged once again, and it stated that
the balance of risks continued to point toward increased inflation.
However, in the statement released after the meeting, the FOMC
noted the possibility of subpar growth in the economy in the period
ahead.   

Toward the end of the year, the moderation of economic growth
gave way, fairly abruptly, to more sluggish conditions. By the time
of the December FOMC meeting, manufacturing activity had
softened considerably, especially in motor vehicles and related
industries, and a number of industries had accumulated excessive
stocks of inventories. Across a broader set of firms, forecasts for
corporate sales and profits in the fourth quarter and in 2001 were
being slashed, contributing to a continued decline in equity prices
and a further widening of risk spreads on lower-rated corporate
bonds. In this environment, growth in business fixed investment
appeared to be slowing appreciably. Consumer spending showed
signs of decelerating further, as falling stock prices eroded
household wealth and consumer confidence weakened. Moreover,
growth in foreign economies seemed to be slowing, on balance, and
U.S. export performance began to deteriorate. Market interest rates
had declined sharply in response to these developments. Against
this backdrop, the FOMC at its December meeting decided that the
risks to the outlook had swung considerably and now were
weighted toward economic weakness, although it decided to wait
for additional evidence on the extent and persistence of the
slowdown before moving to an easier policy stance. Recognizing
that the current position of the economy was difficult to discern
because of lags in the data and that prospects for the near term
were particularly uncertain, the Committee agreed at the meeting
that it would be especially attentive over coming weeks to signs
that an intermeeting policy action was called for.   

Additional evidence that economic activity was slowing
significantly emerged not long after the December meeting. New
data indicated a marked weakening in business investment, and
retail sales over the holiday season were appreciably lower than
businesses had expected. To contain the resulting buildup in
inventories, activity in the manufacturing sector continued to drop.
In addition, forecasts of near-term corporate profits were being
marked down further, resulting in additional declines in equity
prices and in business confidence. Market interest rates continued
to fall, as investors became more pessimistic about the economic
outlook. Based on these developments, the Committee held a
telephone conference call on January 3, 2001, and decided to cut
the intended federal funds rate 1/2 percentage point. Equity prices
surged on the announcement, and the Treasury yield curve
steepened considerably, apparently because market participants
became more confident that a prolonged downturn in economic
growth would likely be forestalled. Following the policy easing, the
Board of Governors approved a decrease in the discount rate of a
total of 1/2 percentage point.   

The Committee's action improved financial conditions to a degree.
Over the next few weeks, equity prices rose, on net. Investors
seemed to become less wary of credit risk, and yield spreads
narrowed across most corporate bonds even as the issuance of
these securities picked up sharply. But in some other respects,
investors remained cautious, as evidenced by widening spreads in
commercial paper markets. Incoming data pointed to further
weakness in the manufacturing sector and a sharp decline in
consumer confidence. Moreover, slower U.S. growth appeared to
be spilling over to several important trading partners. In late
January, the FOMC cut the intended federal funds rate 1/2
percentage point while the Board of Governors approved a
decrease in the discount rate of an equal amount. Because of the
significant erosion of consumer and business confidence and the
need for additional adjustments to production to work off elevated
inventory levels, the FOMC indicated that the risks to the outlook
continued to be weighted toward economic weakness.   


Economic Projections for 2001   

Although the economy appears likely to be sluggish over the near
term, the members of the Board of Governors and the Reserve
Bank presidents expect stronger conditions to emerge as the year
progresses. For 2001 overall, the central tendency of their forecasts
of real GDP growth is 2 percent to 2-1/2 percent, measured as the
change from the fourth quarter of 2000 to the fourth quarter of
2001. With growth falling short of its potential rate, especially in
the first half of this year, unemployment is expected to move up a
little further. Most of the governors and Reserve Bank presidents
are forecasting that the average unemployment rate in the fourth
quarter of this year will be about 4-1/2 percent, still quite low by
historical standards.   

The rate of economic expansion over the near term will depend
importantly on the speed at which inventory overhangs that
developed over the latter part of 2000 are worked off. Gains in
information technology have no doubt enabled businesses to
respond more quickly to a softening of sales, which has steepened
the recent production cuts but should also damp the buildup in
inventories and facilitate a turnaround. The motor vehicle industry
made some progress toward reducing excess stocks in January
owing to a combination of stronger sales and a further sharp
cutback in assemblies. In other parts of manufacturing, the sizable
reductions in production late last year suggest that producers in
general were moving quickly to get output into better alignment
with sales. Nevertheless, stocks at year-end were above desired
levels in a number of industries.   

Once inventory imbalances are worked off, production should
become more closely linked to the prospects for sales. Household
and business expenditures have decelerated markedly in recent
months, and uncertainties about how events might unfold are
considerable. But, responding in part to the easing of monetary
policy, financial markets are shifting away from restraint, and this
shift should create a more favorable underpinning to the expected
pickup in the economy as the year progresses. The sharp drop in
mortgage interest rates since May of last year appears to have
stemmed the decline in housing activity; it also has enabled many
households to refinance existing mortgages at lower rates, an action
that should free up cash for added spending. Conditions of business
finance also have eased to some degree. Interest rates on
investment-grade corporate bonds have recently fallen to their
lowest levels in about 1-1/2 years. Moreover, the premiums
required of bond issuers that are perceived to be at greater risk
have dropped back in recent weeks from the elevated levels of late
2000. As credit conditions have eased, firms have issued large
amounts of corporate bonds so far in 2001. However, considerable
caution is evident in the commercial paper market and among
banks, whose loan officers have reported a further tightening of
lending conditions since last fall. In equity markets, prices have
recently dropped in response to negative reports on corporate
earnings, reversing the gains that took place in January.
  
The restraint on domestic demand from high energy prices is
expected to ease in coming quarters. Natural gas prices have
dropped back somewhat in recent weeks as the weather has turned
milder, and crude oil prices also are down from their peaks.
Although these prices could run up again in conjunction with either
a renewed surge in demand or disruptions in supply, participants in
futures markets are anticipating that prices will be trending
gradually lower over time. A fall in energy prices would relieve cost
pressures on businesses to some degree and would leave more
discretionary income in the hands of households.  

How quickly investment spending starts to pick up again will
depend not only on the cost of finance but also on the prospective
rates of return to capital. This past year, expectations regarding the
prospects of some high-tech companies clearly declined, and capital
spending seems unlikely to soon regain the exceptional strength that
was evident in the latter part of the 1990s and for a portion of last
year. From all indications, however, technological advance still is
going forward at a rapid pace, and investment will likely pick up
again if, as expected, the expansion of the economy gets back on
more solid footing. Private analysts are still anticipating high rates
of growth in corporate earnings over the long-run, suggesting that
the current sluggishness of the economy has not undermined
perceptions of favorable long-run fundamentals.   

The degree to which increases in exports might help to support the
U.S. economy through a stretch of sluggishness has become subject
to greater uncertainty recently because foreign economies also seem
to have decelerated toward the end of last year. However, the
expansion of imports has slowed sharply, responding in part to the
softening of domestic demand growth. In effect, some of the
slowdown in demand in this country is being shifted to foreign
suppliers, implying that the adjustments required of domestic
producers are not as great as they otherwise would have been.   

In adjusting labor input to the slowing of the economy, businesses
are facing conflicting pressures. Speedy adjustment of production
and ongoing gains in efficiency argue for cutbacks in labor input,
but companies are also reluctant to lay off workers that have been
difficult to attract and retain in the tight labor market conditions of
the past few years. In the aggregate, the balance that has been
struck in recent months has led, on net, to slower growth of
employment, cutbacks in the length of the average workweek, and,
in January of this year, a small increase in the unemployment rate.   

Inflation is not expected to be a pressing concern over the coming
year. Most of the governors and Reserve Bank presidents are
forecasting that the rise in the chain-type price index for personal
consumption expenditures will be smaller than the price rise in
2000. The central tendency of the range of forecasts is 1-3/4
percent to 2-1/4 percent. Inflation should be restrained this coming
year by an expected downturn in energy prices. In addition, the
reduced pressure on resources that is associated with the slowing of
the economy should help damp increases in labor costs and prices.   


Economic and Financial Developments in 2000 and Early 2001   

The combination of exceptionally strong growth in the first half of
2000 and subdued growth in the second half resulted in a rise in real
GDP of about 3-1/2 percent for the year overall. Domestic demand
started out the year with incredible vigor but decelerated thereafter
and was sluggish by year-end. Exports surged for three quarters
and then faltered. In the labor market, growth of employment
slowed over the year but was sufficient to keep the unemployment
rate around the lowest sustained level in more than thirty years.  

Core inflation remained low in 2000 in the face of sharp increases in
energy prices. Although the chain-type price index for personal
consumption expenditures (PCE) moved up faster than in 1999, it
showed only a slight step-up in the rate of increase after excluding
the prices of food and energy. Unit labor costs picked up
moderately, adding to the cost pressures from energy, but the
ability of businesses to raise prices was restrained by the slowing of
the economy and the persistence of competitive pricing conditions.   


The Household Sector  

Personal consumption expenditures increased 4-1/2 percent in real
terms in 2000 after having advanced 5 percent in 1998 and 5-1/2
percent in 1999. A large portion of last year's gain came in the first
quarter, when consumption moved ahead at an unusually rapid
pace. The increase in consumer spending over the remainder of the
year was moderate, averaging about 3-1/2 percent at an annual rate.
Consumer outlays for motor vehicles and parts surged to a record
high early in 2000 but reversed that gain over the remainder of the
year; sales of vehicles tailed off especially sharply as the year drew
to a close. Real consumer purchases of gasoline fell during the year
in response to the steep run-up in gasoline prices. Most other broad
categories of goods and services posted sizable gains over the year
as a whole, but results late in the year were mixed: Real outlays for
goods other than motor vehicles eked out only a small gain in the
fourth quarter, while real outlays for consumer services rose very
rapidly, not only because of higher outlays for home heating fuels
during a spell of colder-than-usual weather but also because of
continued strength in real outlays for other types of services.   

Changes in income and wealth provided less support to
consumption in 2000 than in other recent years. Real disposable
personal income rose about 2-1/4 percent last year after a gain of
slightly more than 3 percent in 1999. Disposable income did not rise
quite as much in nominal terms as it had in 1999, and rising prices
eroded a larger portion of the nominal gain. Meanwhile, the net
worth of households turned down in 2000 after having climbed
rapidly for several years, as the effect of a decline in the stock
market was only partially offset by a sizable increase in the value of
residential real estate. With the peak in stock prices not coming
until the year was well under way, and with valuations having
previously been on a sharp upward course for an extended period,
stock market wealth may well have continued to exert a strong
positive effect on consumer spending for several months after share
values had topped out. As time passed, however, the impetus to
consumption from this source most likely diminished. The personal
saving rate, which had dropped sharply during the stock market
surge of previous years, fell further in 2000, but the rate of decline
slowed, on average, after the first quarter.   

Even with real income growth slowing and the stock market turning
down, consumers maintained a high degree of optimism through
most of 2000 regarding the state of the economy and the economic
outlook. Indexes of sentiment from both the University of Michigan
Survey Research Center and the Conference Board rose to new
peaks in the first quarter of the year, and the indexes remained close
to those levels for several more months. Survey readings on
personal finances, general business conditions, and the state of the
labor market remained generally favorable through most of the
year. As of late autumn, only mild softness could be detected.
Toward year-end, however, confidence in the economy dropped
sharply. Both of the indexes of confidence showed huge declines
over the two months ended in January. The marked shift in attitudes
toward year-end probably was brought on by a combination of
developments, including the weakness in the stock market over the
latter part of the year and more frequent reports of layoffs.   

Real outlays for residential investment declined about 2-1/4
percent, on net, over the course of 2000, as construction of new
housing dropped back from the elevated level of the previous year.
Investment in housing was influenced by a sizable swing in
mortgage interest rates as well as by slower growth of employment
and income and the downturn in the stock market. After having
moved up appreciably in 1999, mortgage rates continued to
advance through the first few months of 2000. By mid-May, the
average commitment rate on conventional fixed-rate mortgages was
above 8-1/2 percent, up roughly 1-1/2 percentage points from the
level of a year earlier. New construction held up even as rates were
rising in 1999 and early 2000, but it softened in the spring of last
year. Starts and permits for single-family houses declined from the
first quarter to the third quarter.   

But even as homebuilding activity was turning down, conditions in
mortgage markets were moving back in a direction more favorable
to housing. From the peak in May, mortgage interest rates fell
substantially over the remainder of the year and into the early part
of 2001, reversing the earlier increases. Sales of new homes firmed
as rates turned down, and prices of new houses continued to trend
up faster than the general rate of inflation. Inventories of unsold
new homes held fairly steady over the year and were up only
moderately from the lows of 1997 and 1998. With demand
well-maintained and inventories under control, activity stabilized.
Starts and permits for single-family houses in the fourth quarter of
2000 were up from the average for the third quarter.   

Households continued to borrow at a brisk pace last year, with
household debt expanding an estimated 8-3/4 percent, well above
the growth rate of disposable personal income. Consumer credit
increased rapidly early in the year, boosted by strong outlays on
durable goods; but as consumer spending cooled later in the year,
the expansion of consumer credit slowed. For the year as a whole,
consumer credit is estimated to have advanced more than 8-1/2
percent, up from the 7 percent pace of 1999. Households also took
on large amounts of mortgage debt, which grew an estimated 9
percent last year, reflecting the solid pace of home sales.   

With the rapid expansion of household debt in recent years, the
household debt service burden has increased to levels not seen since
the late 1980s. Even so, with unemployment low and household net
worth high, the credit quality of the household sector appears to
have deteriorated little last year. Personal bankruptcy filings held
relatively steady and remain well below their peak from several
years ago. Delinquency rates on home mortgages, credit cards, and
auto loans have edged up in recent quarters but are at most only
slightly above their levels of the fourth quarter of 1999. Lenders did
not appear to be significantly concerned about the credit quality of
the household sector for most of last year, although some lenders
have become more cautious of late. According to surveys of banks
conducted by the Federal Reserve, few commercial banks tightened
lending conditions on consumer installment loans and mortgage
loans to households over the first three quarters of 2000. However,
the most recent survey indicates that a number of banks tightened
standards and terms on consumer loans, particularly non-credit-card
loans, over the past several months, perhaps because of some
uneasiness about how the financial position of households will hold
up as the pace of economic activity slows.   


The Business Sector   

Real business fixed investment rose 10 percent in 2000 according to
the advance estimate from the Commerce Department. Investment
spending shot ahead at an annual rate of 21 percent in the first
quarter of the year; its strength in that period came, in part, from
high-tech purchases that had been delayed from 1999 by companies
that did not want their operating systems to be in a state of change
at the onset of the new millennium. Expansion of investment was
slower but still relatively brisk in the second and third quarters, at
annual rates of about 15 percent and 8 percent respectively. In the
fourth quarter, however, capital spending downshifted abruptly in
response to the slowing economy, tightening financial conditions,
and rising concern about the prospects for profits; the current
estimate shows real investment outlays having fallen at an annual
rate of 1-1/2 percent in that period.   

Fixed investment in equipment and software was up 9-1/2 percent
in 2000, with the bulk of the gain coming in the first half of the
year. Spending slowed to a rate of growth of about 5-1/2 percent in
the third quarter and then declined in the fourth quarter. Business
investment in motor vehicles fell roughly 15 percent, on net, during
2000, with the largest portion of the drop coming in the fourth
quarter; the declines in real outlays on larger types of trucks were
particularly sizable. Investment in industrial equipment, tracking the
changing conditions in manufacturing, also fell in the fourth quarter
but was up appreciably for the year overall. Investment in high-tech
equipment decelerated over the year but was still expanding in the
fourth quarter: Real outlays for telecommunications equipment
posted exceptionally large gains in the first half of the year,
flattened out temporarily in the third quarter, and expanded again in
the fourth. Spending on computers and peripherals increased, in
real terms, at an average rate of about 45 percent over the first
three quarters of the year but slowed abruptly to a 6 percent rate of
expansion in the year's final quarter, the smallest quarterly advance
in several years.   

Investment in nonresidential structures rose substantially in 2000,
about 12-1/2 percent in all, after having declined 1-3/4 percent in
1999. Investment in factory buildings, which had fallen more than
20 percent in 1999 in an apparent reaction to the economic
disruptions abroad and the associated softness in demand for U.S.
exports, more than recouped that decline over the course of 2000.
Real outlays for office construction, which had edged down in 1999
after several years of strong advance, got back on track in 2000,
posting a gain of about 13-1/2 percent. Real investment in
commercial buildings other than offices was little changed after
moderate gains in the two previous years. Spending on structures
used in drilling for energy strengthened in response to the surge in
energy prices.   

Business inventory investment was subdued early in the year when
final sales were surging; aggregate inventory-sales ratios, which
have trended lower in recent years as companies became more
efficient at managing stocks, edged down further. As sales
moderated in subsequent months, production growth did not
decelerate quite as quickly, and inventories began to rise more
rapidly. Incoming information through the summer suggested that
some firms might be encountering a bit of backup in stocks but that
the problems were not severe overall. In the latter part of the year,
however, inventory-sales ratios turned up, indicating that more
serious overhangs were developing. Responding to the slowing of
demand and the increases in stocks, manufacturers reduced output
in each of the last three months of the year by successively larger
amounts. Businesses also began to clamp down on the flow of
imports. Despite those adjustments, stocks in a number of domestic
industries were likely well above desired levels as the year drew to
a close.   

The Commerce Department's compilation of business profits
currently extends only through the third quarter of 2000, but these
data show an evolving pattern much like that of other economic
data. After having risen at an annual rate of more than 16 percent in
the first half of the year, U.S. corporations' economic profits--that
is, book profits with inventory and capital consumption
adjustments--slowed to less than a 3 percent rate of growth in the
third quarter. Profits from operations outside the United States
continued to increase rapidly in the third quarter. However,
economic profits from domestic operations edged down in that
period, as solid gains for financial corporations were more than
offset by a 4 percent rate of decline in the profits of nonfinancial
corporations. Profits of nonfinancial corporations as a share of their
gross nominal output rose about 1/2 percentage point in the first
half of 2000 but reversed part of that gain in the third quarter.
Earnings reports for the fourth quarter indicate that corporate
profits fell sharply in that period.  

Business debt expanded strongly over the first half of 2000,
propelled by robust capital spending as well as by share repurchases
and cash-financed merger activity. The high level of capital
expenditures outstripped internally generated funds by a
considerable margin despite continued impressive profits. To meet
their borrowing needs, firms tapped commercial paper, bank loans,
and corporate bonds in volume in the first quarter. The rapid pace
of borrowing continued in the second quarter, although borrowers
relied more heavily on bank loans and commercial paper to meet
their financing needs in response to a rise in longer-term interest
rates.   

Business borrowing slowed appreciably in the second half of the
year. As economic growth moderated and profits weakened, capital
spending decelerated sharply. In addition, firms held down their
borrowing needs by curbing their buildup of liquid assets, which
had been accumulating quite rapidly in previous quarters.
Borrowing may have been deterred by a tightening of financial
conditions for firms with lower credit ratings, as investors and
lenders apparently became more concerned about credit risk. Those
concerns likely were exacerbated by indications that credit quality
had deteriorated at some businesses. The default rate on high-yield
bonds continued to climb last year, reaching its highest level since
1991. Some broader measures of credit quality also slipped. The
amount of nonfinancial debt downgraded by Moody's Investor
Services in 2000 was more than twice as large as the amount
upgraded, and the delinquency rate on business loans at commercial
banks continued to rise over the year. But while some firms were
clearly having financial difficulties, many other firms remained
soundly positioned to service their debt. Indeed, the ratio of net
interest payments to cash flow for all nonfinancial firms moved only
modestly above the relatively low levels of recent years.   

As concerns about risk mounted, lenders became more cautious
about extending credit to some borrowers. An increasingly large
proportion of banks reported firming terms and standards on
business loans over the course of the year. In the corporate bond
market, yield spreads on high-yield and lower-rated
investment-grade bonds, measured relative to the ten-year swap
rate, began climbing sharply in September and by year-end were at
levels well above those seen in the fall of 1998. Lower-rated
commercial paper issuers also had to pay unusually large premiums
late in the year, particularly on paper spanning the year-end. As
financial conditions became more stingent, issuance of high-yield
debt was cut back sharply in the fourth quarter, although
investment-grade bond issuance remained strong. Bank lending to
businesses was also light at that time, and net issuance of
commercial paper came to a standstill. In total, the debt of
nonfinancial businesses expanded at an estimated 5-1/2 percent rate
in the fourth quarter, less than half the pace of the first half of the
year. The slowdown in borrowing in the latter part of the year
damped the growth of nonfinancial business debt over 2000,
although it still expanded an estimated 8-3/4 percent.   

In early 2001, borrowing appears to have picked up from its
sluggish fourth-quarter pace. Following the easing of monetary
policy in early January, yield spreads on corporate bonds reversed a
considerable portion of their rise over the latter part of 2000, with
spreads on high-yield bonds narrowing more than a percentage
point. As yields declined, corporate bond issuance picked up, and
even some below-investment grade issues were brought to the
market. In contrast, investors in the commercial paper market
apparently became more concerned about credit risk, partly in
response to the defaults of two California utilities on some bonds
and commercial paper in mid-January related to the difficulties in
the electricity market in that state. After those defaults, spreads
between top-tier and second-tier commercial paper widened
further, and investors became more discriminating even within the
top rating tier. Some businesses facing resistance in the commercial
paper market reportedly met their financing needs by tapping
backup credit lines at banks.   

Growth in commercial mortgage debt slowed last year to an
estimated rate of 9-1/4 percent, and issuance of
commercial-mortgage-backed securities in 2000 fell back from its
1999 pace. Spreads on lower-rated commercial-mortgage-backed
securities over swap rates widened by a small amount late in the
year, and banks on net reported tightening their standards on
commercial real estate credit over the year. Nevertheless,
fundamentals in the commercial real estate market remain solid, and
delinquency rates on commercial mortgages stayed around their
historic lows.   


The Government Sector   

Real consumption and investment expenditures of federal, state,
and local governments, the part of government spending that is
included in GDP, rose only 1-1/4 percent in the aggregate during
2000. The increase was small partly because the consumption and
investment expenditures of the federal government had closed out
1999 with a large increase in advance of the century date change.
Federal purchases in the fourth quarter of 2000 were about 1
percent below the elevated level at year-end 1999. Abstracting from
the bumps in the spending data, the underlying trend in real federal
consumption and investment outlays appears to have been mildly
positive over the past couple of years. The consumption and
investment expenditures of state and local governments rose about
2-1/2 percent in 2000 after an unusually large increase of 4-1/4
percent in 1999. The slowdown in spending was mainly a reflection
of a downshift in government investment in structures, which can
be volatile from year to year and had posted a large gain in 1999.  

Total federal spending, as reported in the unified budget, rose 5
percent in fiscal year 2000, the largest increase in several years. A
portion of the rise stemmed from shifts in the timing of some
outlays in a way that tended to boost the tally for fiscal 2000. But
even allowing for those shifts, the rise in spending would have
exceeded the increases of other recent years. Outlays accelerated
for most major functions, including defense, health, social security,
and income security. Of these, spending on health--about
three-fourths of which consists of outlays for Medicaid--recorded
the biggest increase. Medicaid grants to the states were affected last
fiscal year by increased funding for the child health insurance
initiative that was passed in 1997 and by a rise in the portion of
Medicaid expenses picked up by the federal government. Spending
on agriculture rose very sharply for a third year but not as rapidly as
in fiscal 1999. The ongoing paydown of debt by the federal
government led to a decline of nearly 3 percent in net interest
payments in fiscal 2000 after a somewhat larger drop in these
payments in fiscal 1999.   

Federal receipts increased 10-3/4 percent in fiscal year 2000, the
largest advance in more than a decade. The increase in receipts
from taxes on the income of individuals amounted to more than 14
percent. In most recent years, these receipts have grown much
faster than nominal personal income as measured in the national
income and product accounts. One important factor in the
difference is that rising levels of income and a changing distribution
have shifted more taxpayers into higher tax brackets; another is an
increase in revenues from taxes on capital gains and other items that
are not included in personal income. Receipts from the taxation of
corporate profits also moved up sharply in fiscal 2000, rebounding
from a small decline the previous fiscal year. With federal receipts
rising much faster than spending, the surplus in the unified budget
rose to $236 billion in fiscal 2000, nearly double that of fiscal 1999.
The on-budget surplus, which excludes surpluses accumulating in
the social security trust fund, rose from essentially zero in fiscal
1999 to $86 billion in fiscal 2000. Excluding net interest payments,
a charge resulting from past deficits, the surplus in fiscal 2000 was
about $460 billion.   

Federal saving, which is basically the federal budget surplus
adjusted to conform to the accounting practices followed in the
national income and product accounts, amounted to about 3-1/2
percent of nominal GDP over the first three quarters of 2000. This
figure has been rising roughly 1 percentage point a year over the
past several years. Mainly because of that rise in federal saving, the
national saving rate has been running at a higher level in recent
years than was observed through most of the 1980s and first half of
the 1990s, even as the personal saving rate has plunged. The rise in
federal saving has kept interest rates lower than they otherwise
would have been and has contributed, in turn, to the rapid growth
of capital investment and the faster growth of the economy's
productive potential.   

The burgeoning federal budget surplus allowed the Treasury to pay
down its debt last year at an even faster pace than in recent years.
As of the end of fiscal 2000, the stock of marketable Treasury debt
outstanding had fallen about $500 billion from its peak in 1997. The
existing fiscal situation and the anticipation that budget surpluses
would continue led the Treasury to implement a number of debt
management changes during 2000, many designed to preserve the
liquidity of its securities. In particular, the Treasury sought to
maintain large and regular offerings of new securities at some key
maturities, because such attributes are thought to importantly
contribute to market liquidity. In part to make room for continued
sizable auctions of new securities, the Treasury initiated a debt
buyback program through which it can purchase debt that it
previously issued. In total, the Treasury conducted twenty buyback
operations in 2000, repurchasing a total of $30 billion par value of
securities with maturities ranging from twelve to twenty-seven
years. Those operations were generally well received and caused
little disruption to the market. Going forward, the Treasury intends
to conduct two buyback operations per month and expects to
repurchase about $9 billion par value of outstanding securities in
each of the first two quarters of 2001.   

Despite conducting buybacks on that scale, the Treasury had to cut
back considerably its issuance of new securities. To still achieve
large sizes of individual issues at some maturities, the Treasury
implemented a schedule of regular reopenings--in which it auctions
additional amounts of a previously issued security instead of issuing
a new one--for its five-, ten-, and thirty-year instruments. Under
that schedule, every other auction of each of those securities is a
smaller reopening of the previously auctioned security. At other
maturities, the Treasury reduced the sizes of its two-year notes and
inflation-indexed securities and eliminated the April auction of the
thirty-year inflation-indexed bond. In addition, the Treasury
recently announced that it would stop issuing one-year bills
following the February auction, after having cut back the frequency
of new offerings of that security last year.   

These reductions in the issuance of Treasury securities have caused
the Federal Reserve to modify some of its procedures for obtaining
securities at Treasury auctions, as described in detail below. In
addition, the Treasury made changes in the rules for auction
participation by foreign and international monetary authority
(FIMA) accounts, which primarily include foreign central banks and
governmental monetary entities. The new rules, which went into
effect on February 1, 2001, impose limits on the size of
non-competitive bids from individual FIMA accounts and on the
total amount of such bids that will be awarded at each auction.
These limits will leave a larger pool of securities available for
competitive bidding at the auctions, helping to maintain the liquidity
and efficiency of the market. Moreover, FIMA purchases will be
subtracted from the total amount of securities offered, rather than
being added on as they were in some previous instances, making the
amount of funds raised at the auction more predictable.   

State and local government debt increased little in 2000. Gross
issuance of long-term municipal bonds was well below the robust
pace of the past two years. Refunding offerings were held down by
higher interest rates through much of the year, and the need to raise
new capital was diminished by strong tax revenues. Net issuance
was also damped by an increase in the retirement of bonds from
previous refunding activity. Credit quality in the municipal market
improved considerably last year, with credit upgrades outnumbering
downgrades by a substantial margin. The only notable exception
was in the not-for-profit health care sector, where downgrades
predominated.   


The External Sector   


Trade and Current Account   

The current account deficit reached $452 billion (annual rate) in the
third quarter of 2000, or 4.5 percent of GDP, compared with $331
billion and 3.6 percent for 1999. Most of the expansion in the
current account deficit occurred in the balance of trade in goods
and services. The deficit on trade in goods and services widened to
$383 billion (annual rate) in the third quarter from $347 billion in
the first half of the year. Data for trade in October and November
suggest that the deficit may have increased further in the fourth
quarter. Net payments on investments were a bit less during the
first three quarters of 2000 than in the second half of 1999 owing to
a sizable increase in income receipts from direct investment abroad.  

U.S. exports of goods and services rose an estimated 7 percent in
real terms during 2000. Exports surged during the first three
quarters, supported by a pickup in economic activity abroad that
began in 1999. By market destination, U.S. exports were strongest
to Mexico and countries in Asia. About 45 percent of U.S. goods
exports were capital equipment, 20 percent were industrial supplies,
and roughly 10 percent each were agricultural, automotive,
consumer, and other goods. Based on data for October and
November, real exports are estimated to have declined in the fourth
quarter, reflecting in part a slowing of economic growth abroad.
This decrease was particularly evident in exports of capital goods,
automotive products, consumer goods, and agricultural products.   

The quantity of imported goods and services expanded rapidly
during the first three quarters of 2000, reflecting the continuing
strength of U.S. domestic demand and the effects of past dollar
appreciation on price competitiveness. Increases were widespread
among trade categories. Based on data for October and November,
real imports of goods and services are estimated to have risen only
slightly in the fourth quarter. Moderate increases in imported
consumer and capital goods were partly offset by declines in other
categories of imports, particularly industrial supplies and
automotive products, for which domestic demand had softened.
The price of non-oil imports is estimated to have increased by less
than 1 percent during 2000.   

The price of imported oil rose nearly $7 per barrel over the four
quarters of 2000. During the year, oil prices generally remained
high and volatile, with the spot price of West Texas intermediate
(WTI) crude fluctuating between a low of $24 per barrel in April
and a high above $37 per barrel in September. Strong
demand--driven by robust world economic growth--kept upward
pressure on oil prices even as world supply increased considerably.
Over the course of 2000, OPEC raised its official production
targets by 3.7 million barrels per day, reversing the production cuts
made in the previous two years. Oil production from non-OPEC
sources rebounded as well. During the last several weeks of 2000,
oil prices fell sharply as market participants became convinced that
the U.S. economy was slowing. In early 2001, however, oil prices
moved back up when OPEC announced a planned production cut
of 1.5 million barrels per day.   


Financial Account   

The counterpart to the increased U.S. current account deficit in
2000 was an increase in net capital inflows. As in 1999, U.S. capital
flows in 2000 reflected the relatively strong cyclical position of the
U.S. economy for most of the year and the global wave of
corporate mergers. Foreign private purchases of U.S. securities
were exceptionally robust--well in excess of the record set in 1999.
The composition of U.S. securities purchased by foreigners
continued the shift away from Treasuries as the U.S. budget
surplus, and the attendant decline in the supply of Treasuries,
lowered their yield relative to other debt. Last year private
foreigners sold, on net, about $50 billion in Treasury securities,
compared with net sales of $20 billion in 1999. Although sizable,
these sales were slightly less than what would have occurred had
foreigners reduced their holdings in proportion to the reduction in
Treasuries outstanding. The increased sale of Treasuries was fully
offset by larger foreign purchases of U.S. securities issued by
government-sponsored agencies. Net purchases of agency securities
topped $110 billion, compared with the previous record of $72
billion set in 1999. In contrast to the shrinking supply of Treasury
securities, U.S. government-sponsored agencies accelerated the
pace of their debt issuance. Private foreign purchases of U.S.
corporate debt grew to $180 billion, while net purchases of U.S.
equities ballooned to $170 billion compared with $108 billion in
1999.   

The pace of foreign direct investment inflows in the first three
quarters of 2000 also accelerated from the record pace of 1999. As
in the previous two years, direct investment inflows were driven by
foreign acquisition of U.S. firms, reflecting the global strength in
merger and acquisition activity. Of the roughly $200 billion in direct
investment inflows in the first three quarters, about $100 billion was
directly attributable to merger activity. Many of these mergers were
financed, at least in part, by an exchange of equity, in which shares
in the U.S. firm were swapped for equity in the acquiring firm.
Although U.S. residents generally appear to have sold a portion of
the equity acquired through these swaps, the swaps likely
contributed significantly to the $97 billion capital outflow attributed
to U.S. acquisition of foreign securities. U.S. direct investment
abroad was also boosted by merger activity and totaled $117 billion
in the first three quarters of 2000, a slightly faster pace than that of
1999.   

Capital inflows from foreign official sources totaled $38 billion in
2000--a slight increase from 1999. Nearly all of the official inflows
were attributable to reinvested interest earnings. Modest official
sales of dollar assets associated with foreign exchange intervention
were offset by larger inflows from some non-OPEC oil exporting
countries, which benefited from the elevated price of oil.   


The Labor Market   

Nonfarm payroll employment increased about 1-1/2 percent in
2000, measured on a December-to-December basis. The job count
had risen slightly more than 2 percent in 1999 and roughly 2-1/2
percent a year over the 1996-98 period. Over the first few months
of 2000, the expansion of jobs proceeded at a faster pace than in
1999, boosted both by the federal government's hiring for the
decennial Census and by a somewhat faster rate of job creation in
the private sector. Indications of a moderation in private hiring
started to emerge toward mid-year, but because of volatility of the
incoming data a slowdown could not be identified with some
confidence until late summer. Over the remainder of the year
monthly increases in private employment stepped down further. Job
growth came almost to a stop in December, when severe weather
added to the restraint from a slowing economy. In January of this
year, employment picked up, but the return of milder weather
apparently accounted for a sizable portion of the gain.   

Employment rose moderately in the private service-producing
sector of the economy in 2000, about 2 percent overall after an
increase of about 3 percent in 1999. In the fourth quarter, however,
hiring in the services-producing sector was relatively slow, in large
part because of a sizable decline in the number of jobs in personnel
supply--a category that includes temporary help agencies.
Employment in construction increased about 2-1/2 percent in 2000
after several years of gains that were considerably larger. The
number of jobs in manufacturing was down for a third year, owing
to reductions in factory employment in the second half of the year,
when manufacturers were adjusting to the slowing of demand.
Those adjustments in manufacturing may also have involved some
cutbacks in the employment of temporary hires, which would help
to account for the sharp job losses in personnel supply. The average
length of the workweek in manufacturing was scaled back as well
over the second half of the year.   

The slowing of the economy did not lead to any meaningful easing
in the tightness of the labor market in 2000. The household survey's
measure of the number of persons employed rose 1 percent, about
in line with the expansion of labor supply. On net, the
unemployment rate changed little; its fourth-quarter average of 4.0
percent was down just a tenth of a percentage point from the
average unemployment rate in the fourth quarter of 1999. The
flatness of the rate through the latter half of 2000, when the
economy was slowing, may have partly reflected a desire of
companies to hold on to labor resources that had been difficult to
attract and retain in the tight labor market of recent years. January
of this year brought a small increase in the rate, to 4.2 percent.   

Productivity continued to rise rapidly in 2000. Output per hour in
the nonfarm business sector was up about 3-1/2 percent over the
year as a whole. Sizable gains in efficiency continued to be evident
even as the economy was slowing in the second half of the year.
Except for 1999, when output per hour rose about 3-3/4 percent,
the past year's increase was the largest since 1992, a year in which
the economy was in cyclical recovery from the 1990-91 recession.
Cutting through the year-to-year variations in measured
productivity, the underlying trend still appears to have traced out a
pattern of strong acceleration since the middle part of the 1990s.
Support for a step-up in the trend has come from increases in the
amount of capital per worker--especially high-tech capital--and
from organizational efficiencies that have resulted in output rising
faster than the combined inputs of labor and capital.   

Alternative measures of the hourly compensation of workers, while
differing in their coverage and methods of construction, were
consistent in showing some acceleration this past year. The
employment cost index for private industry (ECI), which attempts
to measure changes in the labor costs of nonfarm businesses in a
way that is free from the effects of employment shifts among
occupations and industries, rose nearly 4-1/2 percent during 2000
after having increased about 3-1/2 percent in 1999. Compensation
per hour in the nonfarm business sector, a measure that picks up
some forms of employee compensation that the ECI omits but that
also is more subject to eventual revision than the ECI, showed
hourly compensation advancing 5-3/4 percent this past year, up
from a 1999 increase of about 4-1/2 percent. Tightness of the labor
market was likely one factor underlying the acceleration of hourly
compensation in 2000, with employers relying both on larger wage
increases and more attractive benefit packages to attract and retain
workers. Compensation gains may also have been influenced to
some degree by the pickup of consumer price inflation since 1998.
Rapid increases in the cost of health insurance contributed
importantly to a sharp step-up in benefit costs.   

Unit labor costs, the ratio of hourly compensation to output per
hour, increased about 2-1/4 percent in the nonfarm business sector
in 2000 after having risen slightly more than 1/2 percent in 1999.
Roughly three-fourths of the acceleration was attributable to the
faster rate of increase in compensation per hour noted above. The
remainder stemmed from the small deceleration of measured
productivity. The labor cost rise for the latest year was toward the
high end of the range of the small to moderate increases that have
prevailed over the past decade.   


Prices   

Led by the surge in energy prices, the aggregate price indexes
showed some acceleration in 2000. The chain-type price index for
real GDP, the broadest measure of goods and services produced
domestically, rose 2-1/4 percent in 2000, roughly 3/4 percentage
point more than in 1999. The price index for gross domestic
purchases, the broadest measure of prices for goods and services
purchased by domestic buyers, posted a rise of almost 2-1/2 percent
in 2000 after having increased slightly less than 2 percent the
previous year. Prices paid by consumers, as measured by the
chain-type price index for personal consumption expenditures,
picked up as well, about as much as the gross purchases index. The
consumer price index (CPI) continued to move up at a faster pace
than the PCE index this past year, and it exhibited slightly more
acceleration--an increase of nearly 3-1/2 percent in 2000 was 3/4
percentage point larger than the 1999 rise. Price indexes for fixed
investment and government purchases also accelerated this past
year.   

The prices of energy products purchased directly by consumers
increased about 15 percent in 2000, a few percentage points more
than in 1999. In response to the rise in world oil prices, consumer
prices of motor fuels rose nearly 20 percent in 2000, bringing the
cumulative price hike for those products over the past two years to
roughly 45 percent. Prices also rose rapidly for home heating oil.
Natural gas prices increased 30 percent, as demand for that fuel
outpaced the growth of supply, pulling stocks down to low levels.
Prices of natural gas this winter have been exceptionally high
because of the added demand for heating that resulted from
unusually cold weather in November and December. Electricity
costs jumped for some users, and prices nationally rose faster than
in other recent years, about 2-1/4 percent at the consumer level.   

Businesses had to cope with rising costs of energy in production,
transportation, and temperature control. In some industries that
depend particularly heavily on energy inputs, the rise in costs had a
large effect on product prices. Producer prices of goods such as
industrial chemicals posted increases that were well above the
average rates of inflation last year, and rising prices for natural gas
sparked especially steep price advances for nitrogen fertilizers used
in farming. Prices of some services also exhibited apparent energy
impacts: Producers paid sharply higher prices for transportation
services via air and water, and consumer airfares moved up rapidly
for a second year, although not nearly as much as in 1999. Late in
2000 and early this year, high prices for energy inputs prompted
shutdowns in production at some companies, including those
producing fertilizers and aluminum.   

Despite the spillover of energy effects into other markets, inflation
outside the energy sector remained moderate overall. The ongoing
rise in labor productivity helped to contain the step-up in labor
costs, and the slow rate of rise in the prices of non-oil imports
meant that domestic businesses had to remain cautious about
raising their prices because of the potential loss of market share.
Rapid expansion of capacity in manufacturing prevented
bottlenecks from developing in the goods-producing sector of the
economy when domestic demand was surging early in the year;
later on, an easing of capacity utilization was accompanied by a
softening of prices in a number of industries. Inflation expectations,
which at times in the past have added to the momentum of rising
inflation, remained fairly quiescent in 2000.   

Against this backdrop, core inflation remained low in 2000.
Producer prices of intermediate materials excluding food and
energy, after having accelerated through the first few months of
2000, slowed thereafter, and their four-quarter rise of 1-3/4 percent
was only a bit larger than the increase during 1999. Prices of crude
materials excluding food and energy fell moderately this past year
after having risen about 10 percent a year earlier. At the consumer
level, the CPI excluding food and energy moved up 2-1/2 percent in
2000, an acceleration of slightly less than 1/2 percentage point from
1999 when put on a basis that maintains consistency of
measurement. The rise in the chain-type price index for personal
consumption expenditures excluding food and energy was 1-3/4
percent, just a bit above the increases recorded in each of the two
previous years.   

Consumer food prices rose 2-1/2 percent in 2000 after an increase
of about 2 percent in 1999. In large part, the moderate step-up in
these prices probably reflected cost and price considerations similar
to those at work elsewhere in the economy. Also, farm commodity
prices moved up, on net, during 2000, after three years of sharp
declines, and this turnabout likely showed through to the retail level
to some extent. Meat prices, which are linked more closely to farm
prices than is the case with many other foods, recorded increases
that were appreciably larger than the increases for food prices
overall.   

The chain-type price index for private fixed investment rose about
1-3/4 percent in 2000, but that small increase amounted to a fairly
sharp acceleration from the pace of the preceding few years, several
of which had brought small declines in investment prices. Although
the price index for investment in residential structures slowed a
little, to about a 3-1/2 percent rise, the index for nonresidential
structures sped up from a 2-3/4 percent increase in 1999 to one of
4-1/2 percent in 2000. Moreover, the price index for equipment and
software ticked up slightly, after having declined 2 percent or more
in each of the four preceding years. To a large extent, that
turnabout was a reflection of a smaller rate of price decline for
computers; they had dropped at an average rate of more than 20
percent through the second half of the 1990s but fell at roughly half
that rate in 2000. Excluding computers, equipment prices increased
slightly in 2000 after having declined a touch in 1999.   


U.S. Financial Markets   

Financial markets in 2000 were influenced by the changing outlook
for the U.S. economy and monetary policy and by shifts in
investors' perceptions of and attitudes toward risk. Private
longer-term interest rates generally firmed in the early part of the
year as growth remained unsustainably strong and as market
participants anticipated a further tightening of monetary policy by
the Federal Reserve. Later in the year, as it became apparent that
the pace of economic growth was slowing, market participants
began to incorporate expectations of significant policy easing into
asset prices, and most longer-term interest rates fell sharply over
the last several months of 2000 and into 2001. Over the course of
the year, investors became more concerned about credit risk and
demanded larger yield spreads to hold lower-rated corporate bonds,
especially once the growth of the economy slowed in the second
half. Banks, apparently having similar concerns, reported widening
credit spreads on business loans and tightening standards for
lending to businesses. Weakening economic growth and tighter
financial conditions in some sectors led to a slowing in the pace of
debt growth over the course of the year.   

Stock markets had another volatile year in 2000. After touching
record highs in March, stock prices turned lower, declining
considerably over the last four months of the year. Valuations in
some sectors fell precipitously from high levels, and near-term
earnings forecasts were revised down sharply late in the year. On
balance, the broadest stock indexes fell more than 10 percent last
year, and the tech-heavy Nasdaq was down nearly 40 percent.   


Interest Rates   

The economy continued to expand at an exceptionally strong and
unsustainable pace in the early part of 2000, prompting the Federal
Reserve to tighten its policy stance in several steps ending at its
May meeting. Private interest rates and shorter-term Treasury
yields rose considerably over that period, reaching a peak just after
the May FOMC meeting. Investors apparently became more
concerned about credit risk as well; spreads between rates on
lower-rated corporate bonds and swaps widened in the spring,
adding to the upward pressure on private interest rates. Long-term
Treasury yields, in contrast, remained below their levels from earlier
in the year, as market participants became increasingly convinced
that the supply of those securities would shrink considerably in
coming years and incorporated a "scarcity premium" into their
prices. By mid-May, with the rapid expansion of economic activity
showing few signs of letting up, rates on federal funds and
eurodollar futures, which can be used as a rough gauge of policy
expectations, were indicating that market participants expected
additional policy tightening going forward.   

Signs of a slowdown in the growth of aggregate demand began to
appear in the incoming data soon after the May FOMC meeting and
continued to gradually accumulate over subsequent months. In
response, market participants became increasingly convinced that
the FOMC would not have to tighten its policy stance further,
which was reflected in a flattening of the term structure of rates on
federal funds and eurodollar futures. Interest rates on most
corporate bonds declined gradually on the shifting outlook for the
economy, and by the end of August had fallen more than 1/2
percentage point from their peaks in May.   

Most market interest rates continued to edge lower into the fall, as
the growth of the economy seemed to moderate further. Over the
last couple months of 2000 and into early 2001, as it became
apparent that economic growth was slowing more abruptly, market
participants sharply revised down their expectations for future
short-term interest rates. Treasury yields plummeted over that
period, particularly at shorter maturities: The two-year Treasury
yield dropped more than a full percentage point from
mid-November to early January, moving below the thirty-year yield
for the first time since early 2000. Yields on inflation-indexed
securities also fell considerably, but by less than their nominal
counterparts, suggesting that the weakening of economic growth
lowered expectations of both real interest rates and inflation.   

Although market participants had come to expect considerable
policy easing over the first part of this year, the timing and
magnitude of the intermeeting cut in the federal funds rate in early
January was a surprise. In response, investors built into asset prices
anticipations of a more rapid policy easing over the near-term.
Indeed, the further substantial reduction in the federal funds rate
implemented at the FOMC meeting later that month was largely
expected and elicited little response in financial markets. Even with
a full percentage point reduction in the federal funds rate in place,
futures rates have recently pointed to expectations of additional
policy easing over coming months. Investors appear to be uncertain
about this outlook, however, judging from the recent rise in the
implied volatilities of interest rates derived from option prices. On
balance since the beginning of 2000, the progressive easing in the
economic outlook, in combination with the effects of actual and
prospective reductions in the supply of Treasury securities, has
resulted in a sizable downward shift in the Treasury yield curve.   

The prospect of a weakening in economic growth, along with
sizable declines in equity prices and downward revisions to profit
forecasts, apparently caused investors to reassess credit risks in the
latter part of last year. Spreads between rates on high-yield
corporate bonds and swaps soared beginning in September, pushing
the yields on those bonds substantially higher. Concerns about
credit risk also spilled over into the investment-grade sector, where
yield spreads widened considerably for lower-rated securities. For
most investment-grade issuers, though, the effects of the revised
policy outlook more than offset any widening in risk spreads,
resulting in a decline in private interest rates in the fourth quarter.
Since the first policy easing in early January, yield spreads on
corporate bonds have narrowed considerably, including a
particularly large drop in the spread on high-yield bonds. Overall,
yields on most investment-grade corporate bonds have reached
their lowest levels since the first half of 1999, while rates on most
high-yield bonds have fallen about 2 percentage points from their
peaks and have reached levels similar to those of mid-2000.   

Although investors at times in recent months appeared more
concerned about credit risk than they were in the fall of 1998, the
recent financial environment, by most accounts, did not resemble
the market turbulence and disruption of that time. The Treasury and
investment-grade corporate bond markets remained relatively
liquid, and the investment-grade market easily absorbed the high
volume of bond issuance over 2000. Investors continued to show a
heightened preference for larger, more liquid corporate issues, but
they did not exhibit the extreme desire for liquidity that was
apparent in the fall of 1998. For example, the liquidity premium for
the on-the-run ten-year Treasury note this year remained well
below the level of that fall.   

Nonetheless, the Treasury market has become somewhat less liquid
than it was several years ago. Moreover, in 2000, particular
segments of the Treasury market occasionally experienced bouts of
unusually low liquidity that appeared related to actual or potential
reductions in the supply of individual securities. Given the
possibility that liquidity could deteriorate further as the Treasury
continues to pay down its debt, market participants reportedly
increased their reliance on alternative instruments--including
interest rate swaps and debt securities issued by
government-sponsored housing agencies and other
corporations--for some of the hedging and pricing functions
historically provided by Treasury securities. Fannie Mae and
Freddie Mac continued to issue large amounts of debt under their
Benchmark and Reference debt programs, which are designed to
mimic characteristics of Treasury securities--such as large issue
sizes and a regular calendar of issuance--that are believed to
contribute to their liquidity. By the end of 2000, the two firms
together had more than $300 billion of notes and bonds and more
than $200 billion of bills outstanding under those programs.
Trading volume and dealer positions in agency securities have risen
considerably since 1998, and the market for repurchase agreements
in those securities has reportedly become more active. Also, several
exchanges listed options and futures on agency debt securities.
Open interest on some of those futures contracts has picked up
significantly, although it remains small compared to that on futures
contracts on Treasury securities.   

The shrinking supply of Treasury securities and the possibility of a
consequent decline in market liquidity also pose challenges for the
Federal Reserve. For many years, Treasury securities have provided
the Federal Reserve with an effective asset for System portfolio
holdings and the conduct of monetary policy. The remarkable
liquidity of Treasury securities has allowed the System to conduct
sizable policy operations quickly and with little disruption to
markets, while the safety of Treasury securities has allowed the
System to avoid credit risk in its portfolio. However, if Treasury
debt continues to be paid down, at some point the amount
outstanding will be insufficient to meet the Federal Reserve's
portfolio needs. Well before that time, the proportion of Treasury
securities held by the System could reach levels that would
significantly disrupt the Treasury market and make monetary policy
operations increasingly difficult or costly. Recognizing this
possibility, last year the FOMC initiated a study to consider
alternative approaches to managing the Federal Reserve's portfolio,
including expanding the use of the discount window and broadening
the types of assets acquired in the open market. As it continues to
study various alternatives, the FOMC will take into consideration
the effect that such approaches might have on the liquidity and
safety of its portfolio and the potential for distorting the allocation
of credit to private entities.   

Meanwhile, some measures have been taken to prevent the System's
holdings of individual Treasury securities from reaching possibly
disruptive levels and to help curtail any further lengthening of the
average maturity of the System's holdings. On July 5, 2000, the
Federal Reserve Bank of New York announced guidelines limiting
the System's holdings of individual Treasury securities to specified
percentages of their outstanding amounts, depending on the
remaining maturity of the issue. Those limits range from 35 percent
for Treasury bills to 15 percent for longer-term bonds. As a result,
the System has redeemed some of its holdings of Treasury
securities on occasions when the amount of maturing holdings has
exceeded the amount that could be rolled over into newly issued
Treasury securities under these limits. Redemptions of Treasury
holdings in 2000 exceeded $28 billion, with more than $24 billion
of the redemptions in Treasury bills. In addition, the Federal
Reserve accommodated a portion of the demand for reserves last
year by increasing its use of longer-term repurchase agreements
rather than by purchasing Treasury securities outright. The System
maintained an average of more than $15 billion of longer-term
repurchase agreements over 2000, typically with maturities of
twenty-eight days.   


Equity Prices   

After having moved higher in the first quarter of 2000, equity prices
reversed course and finished the year with considerable declines.
Early in the year, the rapid pace of economic activity lifted
corporate profits, and stock analysts became even more optimistic
about future earnings growth. In response, most major equity
indexes reached record highs in March, with the Wilshire 5000
rising 6-3/4 percent above its 1999 year-end level and the Nasdaq
soaring 24 percent, continuing its rapid run-up from the second half
of 1999. Equity prices fell from these highs during the spring, with
a particularly steep drop in the Nasdaq, as investors grew more
concerned about the lofty valuations of some sectors and the
prospect of higher interest rates.   

Broader equity indexes recovered much of those losses through
August, supported by the decline in market interest rates and the
continued strength of earnings growth in the second quarter. But
from early September through the end of the year, stock prices fell
considerably in response to the downshift in economic growth, a
reassessment of the prospects for some high-tech industries, and
disappointments in corporate earnings. In December and January,
equity analysts significantly reduced their forecasts for year-ahead
earnings for the S&P 500. However, analysts apparently view the
slowdown in earnings as short-lived, as long-run earnings forecasts
did not fall much and remain at very high levels, particularly for the
technology sector.   

On balance, the Wilshire 5000 index fell 12 percent over 2000--its
first annual decline since 1994. The Nasdaq composite plunged 39
percent, leaving it at year-end more than 50 percent below its
record high and erasing nearly all of its gains since the beginning of
1999. The broad decline in equity prices last year is estimated to
have lopped more than $1-3/4 trillion from household wealth, or
more than 4 percent of the total net worth of households.
Nevertheless, the level of household net worth is still quite
high--about 50 percent above its level at the end of 1995. Investors
continued to accumulate considerable amounts of equity mutual
funds over 2000, although they may have become increasingly
discouraged by losses on their equity holdings toward the end of
the year, when flows into equity funds slumped. At that time,
money market mutual funds expanded sharply, as investors
apparently sought a refuge for financial assets amid the heightened
volatility and significant drops in equity prices. So far in 2001,
major equity indexes are little changed, on balance, as the boost
from lower interest rates has been countered by continued
disappointments over corporate earnings.   

Some of the most dramatic plunges in share prices in 2000 took
place among technology, telecommunications, and Internet shares.
While these declines partly stemmed from downward revisions to
near-term earnings estimates, which were particularly severe in
some cases, they were also driven by a reassessment of the elevated
valuations of many companies in these sectors. The price-earnings
ratio (calculated using operating earnings expected over the next
year) for the technology component of the S&P 500 index fell
substantially from its peak in early 2000, although it remains well
above the ratio for the S&P 500 index as a whole. For the entire
S&P 500 index, share prices fell a bit more in percentage terms than
the downward revisions to year-ahead earnings forecasts, leaving
the price-earnings ratio modestly below its historical high.   

The volatility of equity price movements during 2000 was at the
high end of the elevated levels observed in recent years. In the
technology sector, the magnitudes of daily share price changes were
at times remarkable. There were twenty-seven days during 2000 in
which the Nasdaq composite index moved up or down by at least 5
percent; by comparison, such outsized movements were observed
on a total of only seven days from 1990 to 1999.   

Despite the volatility of share price movements and the large
declines on balance over 2000, equity market conditions were fairly
orderly, with few reports of difficulties meeting margin
requirements or of large losses creating problems that might pose
broader systemic concerns. The fall in share prices reined in some
of the margin debt of equity investors. After having run up sharply
through March, the amount of outstanding margin debt fell by
about 30 percent over the remainder of the year. At year-end, the
ratio of margin debt to total equity market capitalization was
slightly below its level a year earlier.  

The considerable drop in valuations in some sectors and the
elevated volatility of equity price movements caused the pace of
initial public offerings to slow markedly over the year, despite a
large number of companies waiting to go public. The slowdown
was particularly pronounced for technology companies, which had
been issuing new shares at a frantic pace early in the year. In total,
the dollar amount of initial public offerings by domestic nonfinancial
companies tapered off in the fourth quarter to its lowest level in
two years and has remained subdued so far in 2001.   


Debt and the Monetary Aggregates   


Debt and Depository Intermediation   

Aggregate debt of domestic nonfinancial sectors increased an
estimated 5-1/4 percent over 2000, a considerable slowdown from
the gains of almost 7 percent posted in 1998 and 1999. The
expansion of nonfederal debt moderated to 8-1/2 percent in 2000
from 9-1/2 percent in 1999; the slowing owed primarily to a
weakening of consumer and business borrowing in the second half
of the year, as the growth of durables consumption and capital
expenditures fell off and financial conditions tightened for some
firms. Some of the slowdown in total nonfinancial debt was also
attributable to the federal government, which paid down 6-3/4
percent of its debt last year, compared with 2-1/2 percent in 1999.
In 1998 and 1999, domestic nonfinancial debt increased faster than
nominal GDP, despite the reduction in federal debt over those
years. The ratio of nonfinancial debt to GDP edged down in 2000,
however, as the federal debt paydown accelerated and nonfederal
borrowing slowed.   

Depository institutions continued to play an important role in
meeting the demand for credit by businesses and households. Credit
extended by commercial banks, after adjustment for
mark-to-market accounting rules, increased 10 percent over 2000,
well above the pace for total nonfinancial debt. Bank credit
expanded at a particularly brisk rate through late summer, when
banks, given their ample capital base and solid profits, were willing
to meet strong loan demand by households and businesses. Over the
remainder of the year, the growth of bank credit declined
appreciably, as banks became more cautious lenders and as several
banks shed large amounts of government securities.   

Banks reported a deterioration of the quality of their business loan
portfolios last year. Delinquency and charge-off rates on C&I loans,
while low by historical standards, rose steadily, partly reflecting
some repayment difficulties in banks' syndicated loan portfolios.
Several large banks have stated that the uptrend in delinquencies is
expected to continue in 2001. Higher levels of provisioning for loan
losses and some narrowing of net interest margins contributed to a
fallback of bank profits from the record levels of 1999. In addition,
capitalization measures slipped a bit last year. Nevertheless, by
historical standards banks remained quite profitable overall and
appeared to have ample capital. In the aggregate, total capital (the
sum of tier 1 and tier 2 capital) remained above 12 percent of
risk-weighted assets over the first three quarters of last year, more
than two percentage points above the minimum level required to be
considered well-capitalized.  

In response to greater uncertainty about the economic outlook and
a reduced tolerance for risk, increasing proportions of banks
reported tightening standards and terms on business loans during
2000 and into 2001, with the share recently reaching the highest
level since 1990. The tightening became widespread for loans to
large and middle-market firms. A considerable portion of banks
reported firming standards and terms on loans to small businesses
as well, consistent with surveys of small businesses indicating that a
larger share of those firms had difficulty obtaining credit in 2000
than in previous years. With delinquency rates for consumer and
real estate loans having changed little, on net, last year, banks did
not tighten credit conditions significantly for loans to households
over the first three quarters of 2000. More recently, however, an
increasing portion of banks increased standards and terms for
consumer loans other than credit cards, and some of the banks
surveyed anticipated a further tightening of conditions on consumer
loans during 2001.   


The Monetary Aggregates   

The monetary aggregates grew rather briskly last year. The
expansion of the broadest monetary aggregate, M3, was
particularly strong over the first three quarters of 2000, as the
robust growth in depository credit was partly funded through
issuance of the managed liabilities included in this aggregate, such
as large time deposits. M3 growth eased somewhat in the fourth
quarter because the slowing of bank credit led depository
institutions to reduce their reliance on managed liabilities.
Institutional money funds increased rapidly throughout 2000,
despite the tightening of policy early in the year, in part owing to
continued growth in their provision of cash management services
for businesses. For the year as a whole, M3 expanded 9-1/4
percent, well above the 7-3/4 percent pace in 1999. This advance
again outpaced that of nominal income, and M3 velocity--the ratio
of nominal income to M3--declined for the sixth year in a row.   

M2 increased 6-1/4 percent in 2000, about unchanged from its pace
in 1999. Some slowing in M2 growth would have been expected
based on the rise in short-term interest rates over the early part of
the year, which pushed up the "opportunity cost" of holding M2,
given that the interest rates on many components of M2 do not
increase by the same amount or as quickly as market rates.
However, with the level of long-term rates close to that of
short-term rates, investors had much less incentive to shift funds
out of M2 assets and into assets with longer maturities, which
helped support M2 growth. M2 was also boosted at times by
households' increased preference for safe and liquid assets during
periods of heightened volatility in equity markets. On balance over
the year, the growth of M2 slightly exceeded that of nominal
income, and M2 velocity edged down.   

The behavior of the components of M2 was influenced importantly
by interest rate spreads. The depressing effect of higher short-term
market interest rates was most apparent in the liquid deposit
components, including checkable deposits and savings accounts,
whose rates respond very sluggishly to movements in market rates.
Small time deposits and retail money market mutual funds, whose
rates do not lag market rates as much, expanded considerably faster
than liquid deposits. Currency growth was held down early in the
year by a runoff of the stockpile accumulated in advance of the
century date change. In addition, it was surprisingly sluggish over
the balance of the year given the rapid pace of income growth, with
weakness apparently in both domestic and foreign demands.  


International Developments   

In 2000, overall economic activity in foreign economies continued
its strong performance of the previous year. However, in both
industrial and developing countries, growth was strongest early,
and clear signs of a general slowing emerged later in the year.
Among industrial countries, growth in Japan last year moved up to
an estimated 2 percent, and growth in the euro area slowed slightly
to 3 percent. Emerging market economies in both Asia and Latin
America grew about 6 percent on average in 2000. For Asian
developing economies, this represented a slowing from the torrid
pace of the previous year, while growth in Latin America, especially
Mexico, picked up from 1999. Average foreign inflation edged up
slightly to 3 percent, mainly reflecting higher oil prices. Over the
first part of the year, monetary authorities moved to tighten
conditions in many industrial countries, in reaction to continued
strong growth in economic activity that was starting to impinge on
capacity constraints, as well as some upward pressures on prices.
Interest rates on long-term government securities declined on
balance in most industrial countries, especially toward year-end
when evidence of a slowdown in global economic growth started to
emerge.   

Conditions in foreign financial markets were somewhat more
unsettled than in the previous year. Overall stock indexes in the
foreign industrial countries generally declined, most notably in
Japan. As in the United States, technology-oriented stock indexes
were extremely volatile during the year. After reaching peaks in the
first quarter, they started down while experiencing great swings
toward mid-year, then fell sharply in the final quarter, resulting in
net declines for the year of one-third or more. Stock prices in
emerging market economies were generally quite weak, especially
in developing Asia, where growth in recent years has depended
heavily on exports of high-tech goods. Although there was no
major default or devaluation among emerging market economies,
average risk spreads on developing country debt still moved higher
on balance over the course of the year, as the threat of potential
crises in several countries, most notably Argentina and Turkey,
heightened investor concerns.   

The dollar's average foreign exchange value increased over most of
the year, supported by continued robust growth of U.S. activity,
rising interest rates on dollar assets, and market perceptions that
longer-term prospects for U.S. growth and rates of return were
more favorable than in other industrial countries. Part of the rise in
the dollar's average value was reversed late in the year when
evidence emerged that the pace of U.S. activity was slowing much
more sharply than had been expected. Despite this decline, the
dollar's average foreign exchange value against the currencies of
other major foreign industrial countries recorded a net increase of
over 7 percent for the year as a whole. The dollar also
strengthened nearly as much on balance against the currencies of
the most important developing country trading partners of the
United States. So far this year, the dollar's average value has
remained fairly stable.  


Industrial Economies   

The dollar showed particular strength last year against the euro, the
common currency of much of Europe. During the first three
quarters of the year, the euro continued to weaken, and by late
October had fallen to a low of just above 82 cents, nearly one-third
below its value when it was introduced in January 1999. The euro's
decline against the dollar through most of last year appeared to be
due mainly to the vigorous growth of real GDP and productivity in
the United States contrasted with steady but less impressive
improvements in Europe. In addition, investors may have perceived
that Europe was slower to adopt "new economy" technologies,
making it a relatively less attractive investment climate. In
September, a concerted intervention operation by the monetary
authorities of G-7 countries, including the United States, was
undertaken at the request of European authorities to provide
support for the euro. The European Central Bank also made
intervention purchases of euros on several occasions acting on its
own. Late in the year, the euro abruptly changed course and started
to move up strongly, reversing over half of its decline of earlier in
the year. This recovery of the euro against the dollar appeared to
reflect mainly a market perception that, while growth was slowing
in both Europe and the United States, the slowdown was much
sharper for the United States. For the year as a whole, the dollar
appreciated, on net, about 7 percent against the euro.   

The European Central Bank raised its policy interest rate target six
times by a total of 175 basis points over the first ten months of the
year. These increases reflected concerns that the euro's
depreciation, tightening capacity constraints and higher oil prices
would put upward pressure on inflation. While core
inflation--inflation excluding food and energy--remained well below
the 2 percent inflation target ceiling, higher oil prices pushed the
headline rate above the ceiling for most of the year. Real GDP in
the euro area is estimated to have increased about 3 percent for
2000 as a whole, only slightly below the rate of the previous year,
although activity slowed toward the end of the year. Growth was
supported by continued strong increases in investment spending.
Net exports made only a modest contribution to growth, as rapid
increases in exports were nearly matched by robust imports. Overall
activity was sufficiently strong to lead to a further decline in the
average euro-area unemployment rate to below 9 percent, a nearly
1 percentage point reduction for the year.   

The dollar rose about 12 percent against the Japanese yen over the
course of 2000, roughly reversing the decline of the previous year.
Early in the year, the yen experienced periods of upward pressure
on evidence of a revival of activity in Japan. On several of these
occasions, the Bank of Japan made substantial intervention sales of
yen. By August, signs of recovery were strong enough to convince
the Bank of Japan to end the zero interest rate policy that it had
maintained for nearly a year and a half, and its target for the
overnight rate was raised to 25 basis points. Later in the year,
evidence emerged suggesting that the nascent recovery in economic
activity was losing steam, and in response the yen started to
depreciate sharply against the dollar.   

For the year as a whole, Japanese real GDP is estimated to have
increased about 2 percent, a substantial improvement from the very
small increase of the previous year and the decline recorded in
1998. Growth, which was concentrated in the first part of the year,
was led by private nonresidential investment. In contrast, residential
investment slackened as the effect of tax incentives waned.
Consumption rebounded early in the year from a sharp decline at
the end of 1999 but then stagnated, depressed in part by
record-high unemployment and concerns that ongoing corporate
restructuring could lead to further job losses. Public investment,
which gave a major boost to the economy in 1999, remained strong
through the first half of last year but then fell off sharply, and for
the year as a whole the fiscal stance is estimated to have been
somewhat contractionary. Inflation was negative for the second
consecutive year, with the prices of both consumer goods and real
estate continuing to move lower.   

The dollar appreciated 4 percent relative to the Canadian dollar last
year. Among the factors that apparently contributed to the
Canadian currency's weakness were declines in the prices of
commodities that Canada exports, such as metals and lumber, and a
perception by market participants of unfavorable differentials in
rates of return and economic growth prospects in Canada relative
to the United States. For the year as a whole, real GDP growth in
Canada is estimated to have been only slightly below the strong 5
percent rate of 1999, although, as in most industrial countries, there
were signs that the pace of growth was tailing off toward the end of
the year. Domestic demand continued to be robust, led by surging
business investment and solid personal consumption increases. In
the first part of the year, the sustained rapid growth of the economy
led Canadian monetary authorities to become increasingly
concerned with a buildup of inflationary pressures, and the Bank of
Canada matched all of the Federal Reserve's interest rate increases
in 2000, raising its policy rate by a total of 100 basis points. By the
end of the year, the core inflation rate had risen to near the middle
of the Bank of Canada's 1 percent to 3 percent target range, while
higher oil prices pushed the overall rate above the top of the range.
So far this year, the Bank of Canada has only partially followed the
Federal Reserve in lowering interest rates, and the Canadian dollar
has remained little changed.  


Emerging Market Economies   

In emerging market economies, the average growth rate of
economic activity in 2000 remained near the very strong 6 percent
rate of the previous year. However, there was a notable and
widespread slowing near the end of the year, and results in a few
individual countries were much less favorable. Growth in
developing Asian economies slowed on average from the torrid
pace of the previous year, while average growth in Latin America
picked up somewhat. No major developing country experienced
default or devaluation in 2000, but nonetheless, financial markets
did undergo several periods of heightened unrest during the year. In
the spring, exchange rates and equity prices weakened and risk
spreads widened in many emerging market economies at a time of a
general heightening of financial market volatility and rising interest
rates in industrial countries, as well as increased political
uncertainty in several developing countries. After narrowing at
mid-year, risk spreads on emerging market economy debt again
widened later in the year, reflecting a general movement on
financial markets away from riskier assets, as well as concerns that
Argentina and Turkey might be facing financial crises that could
spread to other emerging market economies. Risk spreads generally
narrowed in the early part of 2001.   

Among Latin American countries, Mexico's performance was
noteworthy. Real GDP rose an estimated 7 percent, an acceleration
from the already strong result of the previous year. Growth was
boosted by booming exports, especially to the United States,
favorable world oil prices, and a rebound in domestic demand. In
order to keep inflation on a downward path in the face of surging
domestic demand, the Bank of Mexico tightened monetary
conditions six times last year, pushing up short-term interest rates,
and by the end of the year the rate of consumer price inflation had
moved below the 10 percent inflation target. The run-up to the July
presidential election generated some sporadic financial market
pressures, but these subsided in reaction to the smooth transition to
the new administration. Over the course of the year, the risk spread
on Mexican debt declined on balance, probably reflecting a
favorable assessment by market participants of macroeconomic
developments and government policies, reinforced by rating
upgrades of Mexican debt. During 2000, the peso depreciated
slightly against the dollar, but by less than the excess of Mexican
over U.S. inflation.   

Argentina encountered considerable financial distress last year. Low
tax revenues due to continued weak activity along with elevated
political uncertainty greatly heightened market concerns about the
ability of the country to fund its debt. Starting in October, domestic
interest rates and debt risk spreads soared amid market speculation
that the government might lose access to credit markets and be
forced to abandon the exchange rate peg to the dollar. Financial
markets began to recover after an announcement in mid-November
that an IMF-led international financial support package was to be
put in place. Further improvement came in the wake of an official
announcement in December of a $40 billion support package. The
fall in U.S. short-term interest rates in January eased pressure on
Argentina's dollar-linked economy as well.   

Late in the year, Brazilian financial markets received some negative
spillover from the financial unrest in Argentina, but conditions did
not approach those prevailing during Brazil's financial crisis of early
1999. For 2000 as a whole, the Brazilian economy showed several
favorable economic trends. Real GDP growth increased to an
estimated 4 percent after being less than 1 percent the previous two
years, inflation continued to move lower, and short-term interest
rates declined.   

Growth in Asian developing countries in 2000 slowed from the
previous year, when they had still been experiencing an
exceptionally rapid bounceback from the 1997-1998 financial crises
experienced by several countries in the region. In Korea, real GDP
growth last year is estimated to have been less than half of the
blistering 14 percent rate of 1999. Korean exports, especially of
high-tech products, started to fade toward the end of 2000. Rapid
export growth had been a prominent feature of the recovery of
Korea and other Asian developing economies following their
financial crises. In addition, a sharp fall in Korean equity prices over
the course of the year, as well as continued difficulties with the
process of financial and corporate sector restructuring, tended to
depress consumer and business confidence. These developments
contributed to the downward pressure on the won seen near the end
of the year. Elsewhere in Asia, market concerns over heightened
political instability were a major factor behind financial pressures
last year in Indonesia, Thailand, and the Philippines. In China,
output continued to expand rapidly in 2000, driven by a
combination of surging exports early in the year, sustained fiscal
stimulus, and some recovery in private consumption. In contrast,
growth in both Hong Kong and Taiwan slowed, especially in the
latter part of the year. In Taiwan, the exchange rate and stock
prices both came under downward pressure as a result of the
slowdown in global electronics demand and apparent market
concerns over revelations of possible weaknesses in the banking
and corporate sectors.   

Turkey's financial markets came under severe strain in late
November as international investors withdrew capital amid market
worries about the health of Turkey's banks, the viability of the
government's reform program and its crawling peg exchange rate
regime, and the widening current account deficit. The resulting
liquidity shortage caused short-term interest rates to spike up and
led to a substantial decline in foreign exchange reserves held by the
central bank. Markets stabilized somewhat after it was announced
in December that Turkey had been able to reach loan agreements
with the IMF, major international banks, and the World Bank in an
effort to provide liquidity and restore confidence in the banking
system.