This essay has a total of 10721 words and 40 pages.


The expansion of U.S. economic activity maintained considerable momentum through the early
months of 2000 despite the firming in credit markets that has occurred over the past year.
Only recently has the pace of real activity shown signs of having moderated from the
extremely rapid rate of increase that prevailed during the second half of 1999 and the
first quarter of 2000. Real GDP increased at an annual rate of 5-1/2 percent in the first
quarter of 2000. Private domestic final sales, which had accelerated in the second half of
1999, were particularly robust, rising at an annual rate of almost 10 percent in the first
quarter. Underlying that surge in domestic spending were many of the same factors that had
contributed to the con-siderable strength of outlays in the second half of 1999. The
ongoing influence of substantial increases in real income and wealth continued to fuel
consumer spend-ing, and business investment, which continues to be undergirded by the
desire to take advantage of new, cost-saving technologies, was further buoyed by an
accel-eration in sales and profits late last year. Export demand posted a solid gain
during the first quarter while imports rose even more rapidly to meet booming domestic
demand. The available data, on balance, point to another solid increase in real GDP in the
second quarter, although they suggest that private household and business fixed investment
spending likely slowed noticeably from the extraordinary first-quarter pace. Through June,
the expansion remained brisk enough to keep labor utilization near the very high levels
reached at the end of 1999 and to raise the factory utilization rate to close to its
long-run average by early spring.

Inflation rates over the first half of 2000 were elevated by an additional increase in the
price of imported crude oil, which led to sharp hikes in retail energy prices early in the
year and again around midyear. Apart from energy, consumer price inflation so far this
year has been somewhat higher than during 1999, and some of that acceleration may be
attributable to the indirect effects of higher en-ergy costs on the prices of core goods
and services. Sustained strong gains in worker productivity have kept increases in unit
labor costs minimal despite the per-sistence of a historically low rate of unemployment.

Consumer spending was exceptionally vigorous during the first quarter of 2000. Real
personal consumption expenditures rose at an annual rate of 7-3/4 percent, the sharpest
increase since early 1983. At that time, the economy was rebounding from a deep recession
during which households had deferred discretionary pur-chases. In contrast, the
first-quarter surge in consumption came on the heels of two years of very robust spending
during which real outlays increased at an annual rate of more than 5 percent, and the
personal saving rate dropped sharply.

Outlays for durable goods, which rose at a very fast pace in 1998 and 1999, accelerated
during the first quarter to an annual rate of more than 24 percent. Most notably, spending
on motor vehicles, which had climbed to a new high in 1999, jumped even further in the
first quarter of 2000 as unit sales of light motor vehi-cles soared to a record rate of
18.1 million units. In addition, households' spending on computing equipment and software
rebounded after the turn of the year; some consumers apparently had postponed their
purchases of these goods in late 1999 before the century date change. Outlays for
nondurable goods posted a solid in-crease of 5-3/4 percent in the first quarter, marked by
a sharp upturn in spending on clothing and shoes. Spending for consumer services also
picked up in the first quarter, rising at an annual rate of 5-1/2 percent. Spending was
quite brisk for a number of non-energy consumer services, ranging from recreation and
telephone use to brokerage fees. Also contributing to the acceleration was a rebound in
out-lays for energy services, which had declined in late 1999, when weather was
unsea-sonably warm.

In recent months, the rise in consumer spending has moderated considerably from the
phenomenal pace of the first quarter, with much of the slowdown in out-lays for goods. At
an annual rate of 17-1/4 million units in the second quarter, light motor vehicles sold at
a rate well below their first-quarter pace. Nonetheless, that level of sales is still
historically high, and with prices remaining damped and auto-makers continuing to use
incentives, consumers' assessments of the motor vehicle market continue to be positive.
The information on retail sales for the April-to-June period indicate that consumer
expenditures for other goods rose markedly slower in the second quarter than in the first
quarter, at a pace well below the av-erage rate of increase during the preceding two
years. In contrast, personal con-sumption expenditures for consumer services continued to
rise relatively briskly in April and May.

Real disposable personal income increased at an annual rate of about 3 per-cent between
December and May--slightly below the 1999 pace of 3-3/4 percent. However, the impetus to
spending from the rapid rise in household net worth was still considerable, labor markets
remained tight, and confidence was still high. As a result, households continued to allow
their spending to outpace their flow of cur-rent income, and the personal saving rate, as
measured in the national income and product accounts, dropped further, averaging less than
1 percent during the first five months of the year.

After having boosted the ratio of household net worth to disposable income to a record
high in the first quarter, stock prices have fallen back, suggesting less impetus to
consumer spending going forward. In addition, smaller employment gains and the pickup in
energy prices have moderated the rise in real income of late. Al-though these developments
left some imprint on consumer attitudes in June, house-holds remained relatively upbeat
about their prospective financial situation, accord-ing to the results of the University
of Michigan Survey Research Center (SRC) sur-vey. However, they became a bit less positive
about the outlook for business condi-tions and saw a somewhat greater likelihood of a rise
in unemployment over the coming year.

Housing activity stayed at a high level during the first half of this year. Homebuild-ers
began the year with a considerable backlog of projects that had developed as the
exceptionally strong demand of the previous year strained capacity. As a result, they
maintained starts of new single-family homes at an annual rate of 1.33 million units, on
average, through April--matching 1999's robust pace. Households' demand for single-family
homes was supported early in the year by ongoing gains in jobs and income and the earlier
run-up in wealth; those forces apparently were sufficient to offset the effects that
higher mortgage interest rates had on the affordability of new homes. Sales of new homes
were particularly robust, setting a new record by March; but sales of existing units
slipped below their 1999 high. As a result of the continued strength in sales, the
homeownership rate reached a new high in the first quarter.

By the spring, higher mortgage interest rates were leaving a clearer mark on the attitudes
of both consumers and builders. The Michigan SRC survey reported that households'
assessments of home buying conditions dropped between April and June to the lowest level
in more than nine years. Survey respondents noted that, besides higher financing costs,
higher prices of homes were becoming a factor in their less positive assessment of market
conditions. Purchases of existing homes were little changed, on balance, in April and May
from the first-quarter average; however, because these sales are recorded at the time of
closing, they tend to be a lagging indicator of demand. Sales of new homes--a more current
indicator--fell back in April and May, and homebuilders reported that sales dropped
further in June. Perhaps a sign that softer demand has begun to affect construction,
starts of new single-family homes slipped to a rate of 1-1/4 million units in May. That
level of new homebuilding, although noticeably slower than the robust pace that
charac-terized the fall and winter period, is only a bit below the elevated level that
pre-vailed throughout much of 1998, when single-family starts reached their highest level
in twenty years. Starts of multifamily housing units, which also had stepped up sharply in
the first quarter of the year, to an annual rate of 390,000 units, settled back to a
340,000 unit rate in April and May.

Fueled by robust spending, especially early in the year, the expansion of household debt
remained brisk during the first half of 2000, although below the very strong 1999 growth
rate. Apparently, a favorable outlook for income and employment, along with rising wealth,
made households feel confident enough to continue to spend and take on debt. Despite
rising mortgage and consumer loan rates, household debt increased at an annual rate of
nearly 8 percent in the first quarter, and pre-liminary data point to a similar increase
in the second quarter.

Mortgage debt expanded at an annual rate of 7 percent in the first quarter, boosted by the
high level of housing activity. Household debt not secured by real estate--including
credit card balances and auto loans--posted an impressive 10 per-cent gain in the first
quarter to help finance a large expansion in outlays for con-sumer durables, especially
motor vehicles. The moderation in the growth of house-hold debt this year has been driven
primarily by its mortgage component: Prelimi-nary data for the second quarter suggest
that, although consumer credit likely de-celerated from the first quarter, it still grew
faster than in 1999.

Debt in margin accounts, which is largely a household liability and is not in-cluded in
reported measures of credit market debt, has declined, on net, in recent months, following
a surge from late in the third quarter of 1999 through the end of March 2000. There has
been no evidence that recent downdrafts in share prices this year caused serious repayment
problems at the aggregate level that might pose broader systemic concerns.

The combination of rapid debt growth and rising interest rates has pushed the household
debt-service burden to levels not reached since the late 1980s. Nonetheless, with
household income and net worth both having grown rapidly, and employment prospects
favorable, very few signs of worsening credit problems in the household sector have
emerged, and commercial banks have reported in recent Federal Reserve surveys that they
remain favorably disposed to make consumer in-stallment and mortgage loans. Indeed,
financial indicators of the household sector have remained mostly positive: The rate of
personal bankruptcy filings fell in the first quarter to its lowest level since 1996;
delinquency rates on home mortgages and auto loans remained low; and the delinquency rate
on credit cards edged down further, although it remained in the higher range that has
prevailed since the mid-1990s. However, delinquency rates may be held down, to some
extent, by the surge in new loan originations in recent quarters because newly originated
loans are less likely to be delinquent than seasoned ones.

The boom in capital spending extended into the first half of 2000 with few indica-tions
that businesses' desire to take advantage of more-efficient technologies is diminishing.
Real business fixed investment surged at an annual rate of almost 24 percent in the first
quarter of the year, rebounding sharply from its lull at the end of 1999, when firms
apparently postponed some projects because of the century date change. In recent months,
the trends in new orders and shipments of nonde-fense capital goods suggest that demand
has remained solid.

Sustained high rates of investment spending have been a key feature shaping the current
economic expansion. Business spending on new equipment and software has been propelled
importantly by ongoing advances in computer and information technologies that can be
applied to a widening range of business processes. The ability of firms to take advantage
of these emerging developments has been sup-ported by the strength of domestic demand and
by generally favorable conditions in credit and equity markets. In addition, because these
high-technology goods can be produced increasingly efficiently, their prices have
continued to decline steeply, providing additional incentive for rapid investment. The
result has been a signifi-cant rise in the stock of capital in use by businesses and an
acceleration in the flow of services from that capital as more-advanced vintages of
equipment replace older ones. The payoff from the prolonged period during which firms have
upgraded their plant and equipment has increasingly shown through in the economy's
improved pro-ductivity performance.

Real outlays for business equipment and software shot up at an annual rate of nearly 25
percent in the first quarter of this year. That jump followed a modest increase in the
final quarter of 1999 and put spending for business equipment and software back on the
double-digit uptrend that has prevailed throughout the cur-rent economic recovery.
Concerns about potential problems with the century date change had the most noticeable
effect on the patterns of spending for computers and peripherals and for communications
equipment in the fourth and first quarters; expenditures for software were also affected,
although less so. For these catego-ries of goods overall, the impressive resurgence in
business purchases early this year left little doubt that the underlying strength in
demand for high-tech capital goods had been only temporarily interrupted by the century
date change. Indeed, nominal shipments of office and computing equipment and of
communication devices registered sizable increases over the April-May period.

In the first quarter, business spending on computers and peripheral equip-ment was up
almost 40 percent from a year earlier--a pace in line with the trend of the current
expansion. Outlays for communications equipment, however, acceler-ated; the first-quarter
surge brought the year-over-year increase in spending to 35 percent, twice the pace that
prevailed a year earlier. Expanding Internet usage has been driving the need for new
network architectures. In addition, cable companies have been investing heavily in
preparation for their planned entry into the markets for residential and commercial
telephony and broad-band Internet services.

Demand for business equipment outside of the high-tech area was also strong at the
beginning of the year. In the first quarter, outlays for industrial equipment rose at a
brisk pace for a third consecutive quarter as the recovery of the manu-facturing sector
from the effects of the Asian crisis gained momentum. In addi-tion, investment in farm and
construction machinery, which had fallen steadily dur-ing most of 1999, turned up, and
shipments of civilian aircraft to domestic custom-ers increased. More recent data show a
further rise in the backlog of unfilled or-ders placed with domestic firms for equipment
and machinery (other than high-tech items and transportation equipment), suggesting that
demand for these items has been well maintained. However, business purchases of motor
vehicles are likely to drop back in the second quarter from the very high level recorded
at the beginning of the year. In particular, demand for heavy trucks appears to have been
adversely affected by higher costs of fuel and shortages of drivers.

Real investment in private nonresidential structures jumped at an annual rate of more than
20 percent in the first quarter of the year after having declined in 1999. Both last
year's weakness and this year's sudden and widespread revival are difficult to explain
fully. Nonetheless, the higher levels of spending on office build-ings, other commercial
facilities, and industrial buildings recorded early this year would seem to accord well
with the overall strength in aggregate demand. However, the fundamentals in this sector of
the economy are mixed. Available information suggests that property values for offices,
retail space, and warehouses have been rising more slowly than they were several years
ago. However, office vacancy rates have come down, which suggests that, at least at an
aggregate level, the office sec-tor is not overbuilt. The vacancy rate for industrial
buildings has also fallen, but in only a few industries, such as semiconductors and other
electronic components, are capacity pressures sufficiently intense to induce significant
expansion of produc-tion facilities.

The ratio of inventories to sales in many nonfarm industries moved lower early this year.
Those firms that had accumulated some additional stocks toward the end of 1999 as a
precaution against disruptions related to the century date change seemed to have little
difficulty working off those inventories after the smooth transition to the new year.
Moreover, the first-quarter surge in final demand may have, to some extent, exceeded
businesses' expectations. In current-cost terms, non-auto manufacturing and trade
establishments built inventories in April and May at a somewhat faster rate than in the
first quarter but still roughly in line with the rise in their sales. As a result, the
ratio of inventories to sales, at current cost, for these businesses was roughly unchanged
from the first quarter. Overall, the ongo-ing downtrend in the ratios of inventories to
sales during the past several years suggests that businesses increasingly are taking
advantage of new technologies and software to implement better inventory management.

The swing in inventory investment in the motor vehicle industry has been more pronounced
recently. Dealer stocks of new cars and light trucks were drawn down during the first
quarter as sales climbed to record levels. Accordingly, auto and truck makers kept
assemblies at a high level through June in order to maintain ready supplies of popular
models. Even though demand appears to have softened and inventories of a few models have
backed up, scheduled assemblies for the third quarter are above the elevated level of the
first half.

The economic profits of nonfinancial U.S. corporations posted another solid in-crease in
the first quarter. The profits that nonfinancial corporations earned on their domestic
operations were 10 percent above the level of a year earlier; the rise lifted the share of
profits in this sector's nominal output close to its 1997 peak. Nonetheless, with
investment expanding rapidly, businesses' external financ-ing requirements, measured as
the difference between capital expenditures and in-ternally generated funds, stayed at a
high level in the first half of this year. Busi-nesses' credit demands were also supported
by cash-financed merger and acquisi-tion activity. Total debt of nonfinancial businesses
increased at a 10-1/2 percent clip in the first quarter, close to the brisk pace of 1999,
and available information suggests that borrowing remained strong into the second quarter.

On balance, businesses have altered the composition of their funding this year to rely
more on shorter-term sources of credit and less on the bond market, although the funding
mix has fluctuated widely in response to changing market con-ditions. After the passing of
year-end, corporate borrowers returned to the bond market in volume in February and March,
but subsequent volatility in the capital market in April and May prompted a pullback. In
addition, corporate bond investors have been less receptive to smaller, less liquid
offerings, as has been true for some time.

In the investment-grade market, bond issuers have responded to investors' concerns about
the interest rate and credit outlook by shortening the maturities of their offerings and
by issuing more floating-rate securities. In the below-investment-grade market, many of
the borrowers who did tap the bond market in February and March did so by issuing
convertible bonds and other equity-related debt instruments. Subsequently, amid increased
equity market volatility and grow-ing investor uncertainty about the outlook for
prospective borrowers, credit spreads in the corporate bond market widened, and issuance
in the below-investment-grade market dropped sharply in April and May. Conditions in the
corpo-rate bond market calmed in late May and June, and issuance recovered to close to its
first-quarter pace.

As the bond market became less hospitable in the spring, many businesses evidently turned
to banks and to the commercial paper market for financing. Partly as a result, commercial
and industrial loans at banks have expanded briskly, even as a larger percentage of banks
have reported in Federal Reserve surveys that they have been tightening standards and
terms on such loans.

Underscoring lenders' concerns about the creditworthiness of borrowers, the ratio of
liabilities of failed businesses to total liabilities has increased further so far this
year, and the default rate on outstanding junk bonds has risen further from the relatively
elevated level reached in 1999. Through midyear, Moody's In-vestors Service has
downgraded, on net, more debt in the nonfinancial business sector than it has upgraded,
although it has placed more debt on watch for future upgrades than downgrades.

Commercial mortgage borrowing has also expanded at a robust pace over the first half of
2000, as investment in office and other commercial building strength-ened. Extending last
year's trend, borrowers have tapped banks and life insurance companies as the financing
sources of choice. Banks, in particular, have reported stronger demand for commercial real
estate loans this year even as they have tightened standards a bit for approving such
loans. In the market for commercial mortgage-backed securities, yields have edged higher
since the beginning of the year.

The incoming information regarding the federal budget suggests that the surplus in the
current fiscal year will surpass last year's by a considerable amount. Over the first
eight months of fiscal year 2000--the period from October to May--the uni-fied budget
recorded a surplus of about $120 billion, compared with $41 billion dur-ing the comparable
period of fiscal 1999. The Office of Management and Budget and the Congressional Budget
Office are now forecasting that, when the fiscal year closes, the unified surplus will be
around $225 billion to $230 billion, $100 billion higher than in the preceding year. That
outcome would likely place the surplus at more than 2-1/4 percent of GDP, which would
exceed the most recent high of 1.9 percent, which occurred in 1951.

The swing in the federal budget from deficit to surplus has been an important factor in
maintaining national saving. The rise in federal saving as a percentage of gross national
product from -3.5 percent in 1992 to 3.1 percent in the first quarter of this year has
been sufficient to offset the drop in personal saving that occurred over the same period.
As a result, gross saving by households, businesses, and gov-ernments has stayed above 18
percent of GNP since 1997, compared with 16-1/2 percent over the preceding seven years.
The deeper pool of national saving, along with the continued willingness of foreign
investors to finance our current account deficit, remains an important factor in
containing increases in the cost of capital and sustaining the rapid expansion of domestic
investment. With longer-run projec-tions showing a rising federal government surplus over
the next decade, this source of national saving could continue to expand.

The recent good news on the federal budget has been primarily on the re-ceipts side of the
ledger. Nonwithheld tax receipts were very robust this spring. Both final payments on
personal income tax liabilities for 1999 and final corporate tax payments for 1999 were up
substantially. So far this year, the withheld tax and social insurance contributions on
this year's earnings of individuals have also been strong. As a result, federal receipts
during the first eight months of the fiscal year were almost 12 percent higher than they
were during the year-earlier period.

While receipts have accelerated, federal expenditures have been rising only a little
faster than during fiscal 1999 and continue to decline as a share of nominal GDP. Nominal
outlays for the first eight months of the current fiscal year were 5-1/4 percent above the
year-earlier period. Increases in discretionary spending have picked up a bit so far this
year. In particular, defense spending has been running higher in the wake of the increase
in budget authority enacted last year. The Con-gress has also boosted agricultural
subsidies in response to the weakness in farm income. While nondiscretionary spending
continues to be held down by declines in net interest payments, categories such as
Medicaid and other health programs have been rising more rapidly of late.

As measured by the national income and product accounts, real federal ex-penditures for
consumption and gross investment dropped sharply early this year after having surged in
the fourth quarter of 1999. These wide quarter-to-quarter swings in federal spending
appear to have occurred because the Department of De-fense speeded up its payments to
vendors before the century date change; actual deliveries of defense goods and services
were likely smoother. On average, real de-fense spending in the fourth and first quarters
was up moderately from the aver-age level in fiscal 1999. Real nondefense outlays
continued to rise slowly.

With current budget surpluses coming in above expectations and large sur-pluses projected
to continue for the foreseeable future, the federal government has taken additional steps
aimed at preserving a high level of liquidity in the market for its securities. Expanding
on efforts to concentrate its declining debt issuance in fewer highly liquid securities,
the Treasury announced in February its intention to issue only two new five- and ten-year
notes and only one new thirty-year bond each year. The auctions of five- and ten-year
notes will remain quarterly, alternat-ing between new issues and smaller reopenings, and
the bond auctions will be semi-annual, also alternating between new and smaller reopened
offerings. The Treasury also announced that it was reducing the frequency of its one-year
bill auctions from monthly to quarterly and cutting the size of the monthly two-year note
auctions. In addition, the Treasury eliminated the April auction of the thirty-year
inflation-indexed bond and indicated that the size of the ten-year inflation-indexed note
of-ferings would be modestly reduced. Meanwhile, anticipation of even larger surpluses in
the wake of the surprising strength of incoming tax receipts so far in 2000 led the
Treasury to announce, in May, that it was again cutting the size of the monthly two-year
note auctions. The Treasury also noted that it is considering additional changes in its
auction schedule, including the possible elimination of the one-year bill auctions and a
reduction in the frequency of its two-year note auctions.

Early in the year, the Treasury unveiled the details of its previously an-nounced
reverse-auction, or debt buyback, program, whereby it intends to retire seasoned, less
liquid, debt securities with surplus cash, enabling it to issue more "on-the-run"
securities. The Treasury noted that it would buy back as much as $30 billion this year.
The first operation took place in March, and in May the Treasury announced a schedule of
two operations per month through the end of July of this year. Through midyear, the
Treasury has conducted eight buyback operations, re-deeming a total of $15 billion.
Because an important goal of the buyback program is to help forestall further increases in
the average maturity of the Treasury's pub-licly held debt, the entire amount redeemed so
far has corresponded to securities with remaining maturities at the long end of the yield
curve (at least fifteen years).

In the state and local sector, real consumption and investment expenditures regis-tered
another strong quarter at the beginning of this year. In part, the unseasona-bly good
weather appears to have accommodated more construction spending than usually occurs over
the winter. However, some of the recent rise is an extension of the step-up in spending
that emerged last year, when real outlays rose 5 percent after having averaged around 3
percent for the preceding three years. Higher fed-eral grants for highway construction
have contributed to the pickup in spending. In addition, many of these jurisdictions have
experienced solid improvements in their fiscal conditions, which may be allowing them to
undertake new spending initiatives.

The improving fiscal outlook for state and local governments has affected both the
issuance and the quality of state and local debt. Borrowing by states and municipalities
expanded sluggishly in the first half of this year. In addition to the favorable budgetary
picture, rising interest rates have reduced the demand for new capital financing and
substantially limited refunding issuance. Credit upgrades have outnumbered downgrades by a
substantial margin in the state and local sector.

The deficits in U.S. external balances have continued to get even larger this year. The
current account deficit reached an annual rate of $409 billion in the first quarter of
2000, or 4-1/4 percent of GDP, compared with $372 billion and 4 per-cent in the second
half of 1999. Net payments of investment income were a bit less in the first quarter than
in the second half of last year owing to a sizable increase in income receipts from direct
investment abroad. Most of the expansion in the current account deficit occurred in trade
in goods and services. In the first quar-ter, the deficit in trade in goods and services
widened to an annual rate of $345 billion, a considerable expansion from the deficit of
$298 billion recorded in the second half of 1999. Trade data for April suggest that the
deficit may have in-creased further in the second quarter.

U.S. exports of real goods and services rose at an annual rate of 6-1/4 per-cent in the
first quarter, following a strong increase in exports in the second half of last year. The
pickup in economic activity abroad that began in 1999 continued to support export demand
and partly offset negative effects on price competitiveness of U.S. products from the
dollar's past appreciation. By market destination, U.S. exports to Canada, Mexico, and
Europe increased the most. By product group, ex-port expansion was concentrated in capital
equipment, industrial supplies, and con-sumer goods. Preliminary data for April suggest
that growth of real exports re-mained strong.

The quantity of imported goods and services continued to expand rapidly in the first
quarter. The increase in imports, at an annual rate of 11-3/4 percent, was the same in the
first quarter as in the second half of 1999 and reflected both the continuing strength of
U.S. domestic demand and the effects of past dollar appre-ciation on price
competitiveness. Imports of consumer goods, automotive products, semiconductors,
telecommunications equipment, and other machinery were particu-larly robust. Data for
April suggest that the second quarter got off to a strong start. The price of non-oil
goods imports rose at an annual rate of 1-3/4 percent in the first quarter, the second
consecutive quarter of sizable price increases follow-ing four years of price declines;
non-oil import prices in the second quarter posted only moderate increases.

A number of developments affecting world oil demand and supply led to a fur-ther step-up
in the spot price of West Texas intermediate (WTI) crude this year, along with
considerable volatility. In the wake of the plunge of world oil prices dur-ing 1998, the
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