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Board of Governors of the Federal Reserve System




Board of Governors of the Federal Reserve System

This publication is available from the Board of Governors of the Federal Reserve System,
Publications Services, Mail Stop 127, Washington, DC 20551. It is also available at the
Board’s World Wide Web site, at
Letter of Transmittal

Board of Governors of the

Federal Reserve System
Washington, D.C., April 2002

The Speaker of
The House of Representatives

Pursuant to the requirements of section 10 of the Federal Reserve Act,

I am pleased to submit the eighty-eighth annual report of the Board of Governors
of the Federal Reserve System.
This report covers operations of the Board during calendar year 2001.

Monetary Policy and Economic Developments
7 Monetary Policy, Financial Markets, and the Economy over 2001 and Early 2002
9 Economic Projections for 2002


12 The Household Sector
14 The Business Sector
20 The Government Sector
22 The External Sector
25 The Labor Market
27 Prices
29 U.S. Financial Markets
35 International Developments


41 Report of February 13, 2001
71 Report of July 18, 2001


99 Implementation of Monetary Policy in 2001
101 Banks’ Demand for Fed Balances
103 Autonomous Factors Affecting the Supply of Fed Balances
105 Domestic Financial Assets on the Federal Reserve Balance Sheet
and Open Market Operations
111 The Federal Funds Rate and Discount Window Credit
113 The Conduct of Monetary Operations after September 11

Federal Reserve Operations

121 Curbing Abusive Lending
122 Fostering Research
122 Preparing for the Community Reinvestment Act Review
123 Expanding Access to Consumer Information
126 Regulatory Matters
126 CRA Bank Examinations and Activities
128 Community Affairs
129 Consumer Advisory Council
131 HMDA Data and Mortgage Lending Patterns
132 Economic Effects of the Electronic Fund Transfer Act
133 Compliance Activities
134 Agency Reports on Compliance with Consumer Protection Laws and Regulations
137 Consumer Complaints


142 Scope of Responsibilities for Supervision and Regulation
143 Supervision for Safety and Soundness
151 Supervisory Policy
162 Supervisory Information Technology
163 Staff Training
165 Regulation of the U.S. Banking Structure
169 Enforcement of Other Laws and Regulations
172 Federal Reserve Membership


173 Major Initiatives
173 Developments in Federal Reserve Priced Services
179 Developments in Currency and Coin
180 Developments in Fiscal Agency and Government Depository Services
182 Information Technology
182 Examinations of Federal Reserve Banks
183 Income and Expenses
184 Holdings of Securities and Loans
184 Volume of Operations
184 Federal Reserve Bank Premises
186 Pro Forma Financial Statements for Federal Reserve Priced Services


191 Strategic and Performance Plans
191 Mission
191 Goals and Objectives
192 Interagency Coordination
196 Proposed Check Truncation Act

199 Regulation B (Equal Credit Opportunity), Regulation E (Electronic Fund Transfers),
Regulation M (Consumer Leasing), Regulation Z (Truth in Lending), and
Regulation DD (Truth in Savings)
199 Regulation D (Reserve Requirements of Depository Institutions)
200 Regulation E
201 Regulation H (Membership of State Banking Institutions
in the Federal Reserve System)
202 Regulation H and Regulation Y (Bank Holding Companies
and Change in Bank Control)
203 Regulation K (International Banking Operations) and
Rules Regarding Delegation of Authority
204 Regulation Y
205 Regulation Z
205 Miscellanous Interpretations
206 Rules Regarding Equal Opportunity
207 Policy Statements and Other Actions
208 Discount Rates in 2001


215 Authorization for Domestic Open Market Operations
217 Guidelines for the Conduct of System Open Market Operations
in Federal Agency Issues
217 Domestic Policy Directive
217 Authorization for Foreign Currency Operations
219 Foreign Currency Directive
219 Procedural Instructions with Respect to Foreign Currency Operations
220 Meeting Held on January 30–31, 2001
236 Meeting Held on March 20, 2001
246 Meeting Held on May 15, 2001
255 Meeting Held on June 26–27, 2001
264 Meeting Held on August 21, 2001
273 Meeting Held on October 2, 2001
282 Meeting Held on November 6, 2001
290 Meeting Held on December 11, 2001

301 Judicial Review of Board Orders under the Bank Holding Company Act
301 Litigation under the Financial Institutions Supervisory Act
301 Litigation under the Gramm–Leach–Bliley Act
301 Other Actions

Federal Reserve System Organization




308 Federal Advisory Council
309 Consumer Advisory Council
310 Thrift Institutions Advisory Council


311 Officers of Federal Reserve Banks and Branches
313 Conference of Chairmen
313 Conference of Presidents
313 Conference of First Vice Presidents
313 Directors of the Banks and Branches


Statistical Tables
338 1. Statement of Condition of the Federal Reserve Banks, by Bank,
December 31, 2001 and 2000
342 2. Federal Reserve Open Market Transactions, 2001
346 3. Federal Reserve Bank Holdings of U.S. Treasury and Federal Agency Securities,
December 31, 1999–2001
347 4. Number and Annual Salaries of Officers and Employees of the Federal Reserve
Banks, December 31, 2001
348 5. Income and Expenses of the Federal Reserve Banks, by Bank, 2001
352 6. Income and Expenses of the Federal Reserve Banks, 1914–2001
356 7. Acquisition Costs and Net Book Value of Premises of the Federal Reserve
Banks and Branches, December 31, 2001
357 8. Operations in Principal Departments of the Federal Reserve Banks, 1998–2001
358 9. Federal Reserve Bank Interest Rates on Loans to Depository Institutions,
December 31, 2001
359 10. Reserve Requirements of Depository Institutions, December 31, 2001
360 11. Initial Margin Requirements under Regulations T, U, and X
361 12. Principal Assets and Liabilities and Number of Insured Commercial Banks
in the United States, by Class of Bank, June 30, 2001 and 2000
362 13. Reserves of Depository Institutions, Federal Reserve Bank Credit,
and Related Items, Year-End 1918–2001 and Month-End 2001
368 14. Banking Offices and Banks Affiliated with Bank Holding Companies
in the United States, December 31, 2000 and 2001

Financial Statements



Monetary Policy and
Economic Developments

Monetary Policy and the Economic Outlook

Last year was a difficult one for the in that rate to 3 percentage points by
economy of the United States. The August.
slowdown in the growth of economic The devastating events of Septem-
activity that had become apparent in late ber 11 further set back an already fragile
2000 intensified in the first half of the economy. Heightened uncertainty and
year. Businesses slashed investment badly shaken confidence caused a wide-
spending—making especially deep spread pullback from economic activity
cuts in outlays for high-technology and from risk-taking in financial mar-
equipment—in response to weakening kets, where equity prices fell sharply for
final demand, an oversupply of some several weeks and credit risk spreads
types of capital, and declining profits. widened appreciably. The most pressing
As actual and prospective sales deterio- concern of the Federal Reserve in the
rated, many firms in the factory sector first few days following the attacks was
struggled with uncomfortably high lev- to help shore up the infrastructure of
els of inventories, and the accompany- financial markets and to provide mas-
ing declines in manufacturing output sive quantities of liquidity to limit poten-
steepened. At the same time, foreign tial disruptions to the functioning of
economies also slowed, further reducing those markets. The economic fallout of
the demand for U.S. production. The the events of September 11 led the Fed-
aggressive actions by the Federal eral Open Market Committee (FOMC)
Reserve to ease the stance of monetary to cut the target federal funds rate after a
policy in the first half of the year pro- conference call early the following week
vided support to consumer spending and and again at each meeting through the
the housing sector. Nevertheless, the end of the year (see box ‘‘Monetary
weakening in activity became more Policy after the Terrorist Attacks’’).
widespread through the summer, job Displaying the same swift response to
losses mounted further, and the unem- economic developments that appears
ployment rate moved higher. With few to have characterized much business
indications that economic conditions behavior in the current cyclical episode,
were about to improve, with underlying firms moved quickly to reduce payrolls
inflation moderate and edging lower, and cut production after mid-September.
and with inflation expectations well Although these adjustments occurred
contained, the Federal Reserve contin- across a broad swath of the economy,
ued its efforts to counter the ongoing manufacturing and industries related to
weakness by cutting the federal funds travel, hospitality, and entertainment
rate, bringing the cumulative reduction bore the brunt of the downturn. Mea-
sures of consumer confidence fell
sharply in the first few weeks after the
Note. The discussions here and in the next attacks, but the deterioration was not
section (‘‘Economic and Financial Developments especially large by cyclical standards,
in 2001 and Early 2002’’) consist of the text,
tables, and selected charts from Monetary Policy
and improvement in some of these
Report to the Congress (Board of Governors, Feb- indexes was evident in October. Simi-
ruary 2002). larly, equity prices started to rebound in
4 88th Annual Report, 2001

Monetary Policy after the Terrorist Attacks

The terrorist attacks on September 11 Depository institutions took up the offer,
destroyed a portion of the infrastructure of and borrowing surged to a record
U.S. financial markets, disrupted communi- $451⁄2 billion by Wednesday. Discount
cation networks, and forced some market loans outstanding dropped off sharply on
participants to retreat to contingency sites Thursday and returned to very low levels
in varying states of readiness. These devel- by Friday. Separately, overnight overdrafts
opments, along with the tragic loss of life on Tuesday and Wednesday rose to several
among the employees of a few major finan- billion dollars, as a handful of depository
cial firms, greatly complicated trading, and other institutions with accounts at the
clearing, and settlement of many different Federal Reserve were forced into overdraft
classes of financial instruments. Direct dis- on their reserve accounts. Overnight over-
locations elevated uncertainties about pay- drafts returned to negligible levels by the
ment flows, making it difficult for the end of the week.
reserve market to channel funds where they Like their U.S. counterparts, foreign
were needed most. Depositories that held financial institutions operating in the
more reserve balances than they preferred United States faced elevated dollar liquid-
had considerable difficulty unloading the ity needs. In some cases, however, these
excess in the market; by contrast, deposi- institutions encountered difficulties posi-
tories awaiting funds had to scramble to tioning the collateral at their U.S. branches
cover overdraft positions. As a result, the to secure Federal Reserve discount window
effective demand for reserves ballooned. credit. To be in a position to help meet
The Federal Reserve accommodated the those needs, three foreign central banks
increase in the demand for reserves through established new or expanded arrangements
a variety of means, the relative importance with the Federal Reserve to receive dollars
of which shifted through the week. On in exchange for their respective currencies.
Tuesday morning, shortly after the attacks, These swap lines, which lasted for
the Federal Reserve issued a press release thirty days, consisted of $50 billion for the
reassuring financial markets that the Fed- European Central Bank, $30 billion for the
eral Reserve System was functioning nor- Bank of England, and an increase of $8 bil-
mally and stating that ‘‘the discount win- lion (from $2 billion to $10 billion) for
dow is available to meet liquidity needs.’’ the Bank of Canada. The European Central

late September, and risk spreads began ately following September 11. Several
to narrow somewhat by early Novem- factors were at work in support of
ber, when it became apparent that the household spending during this period.
economic effects of the attacks were Low and declining interest rates pro-
proving less severe than many had vided a lift to outlays for durable goods
feared. and to activity in housing markets.
Consumer spending remained sur- Nowhere was the boost from low inter-
prisingly solid over the final three est rates more apparent than in the sales
months of the year in the face of of new motor vehicles, which soared in
enormous economic uncertainty, wide- response to the financing incentives
spread job losses, and further deteriora- offered by manufacturers. Low mort-
tion of household balance sheets from gage interest rates not only sustained
the sharp drop in equity prices immedi- high levels of new home construction
Monetary Policy and the Economic Outlook 5

Bank drew on its line that week to channel level. As anticipated by the FOMC, federal
the funds to institutions with a need for funds traded somewhat below their new
dollars. target level for the rest of the week. By the
By Thursday and Friday, the disruption end of the month, bid–asked spreads and
in air traffic caused the Federal Reserve to trading volumes in the interbank and other
extend record levels of credit to depository markets receded to more normal levels,
institutions in the form of check float. Float and federal funds consistently began to
increased dramatically because the Federal trade around the intended rate.
Reserve continued to credit the accounts of The Federal Reserve took several steps
banks for deposited checks even though the to facilitate market functioning in Septem-
grounding of airplanes meant that checks ber in addition to accommodating the
normally shipped by air could not be pre- heightened demand for reserves. The hours
sented to the checkwriters’ banks on the of funds and securities transfer systems
usual schedule. Float declined to normal operated by the Federal Reserve were
levels the following week once air traffic extended significantly for a week after the
was permitted to recommence. Lastly, over attacks. The Federal Reserve Bank of New
the course of the week that included Sep- York liberalized the terms under which it
tember 11, as the market for reserves began would lend the securities in the System
to function more normally, the Federal portfolio, and the amount of securities lent
Reserve resumed the use of open market rose to record levels in the second half
operations to provide the bulk of reserves. of September. For the ten days following
The open market Desk accommodated the attacks, the Federal Reserve reduced
all propositions down to the target federal or eliminated the penalty charged on over-
funds rate, operating exclusively through night overdrafts, largely because those
overnight transactions for several days. The overdrafts were almost entirely the result
injection of reserves through open market of extraordinary developments beyond the
operations peaked at $81 billion on Friday. control of the account holders. In addition,
The combined infusion of liquidity from the Federal Reserve helped restore commu-
the various sources pushed the level of nication between market participants and
reserve balances at Federal Reserve Banks in some cases processed bilateral loans of
to more than $100 billion on Wednesday, reserves between account holders in lieu
September 12, about ten times the normal of market intermediation.

but also allowed households to refi- of demand, the surprising strength in

nance mortgages and extract equity from household spending late in the year
homes to pay down other debts or to resulted in a dramatic liquidation of
increase spending. Fiscal policy pro- inventories. In the end, real gross
vided additional support to consumer domestic product posted a much better
spending. The cuts in taxes enacted last performance than had been anticipated
year, including the rebates paid out over in the immediate aftermath of the
the summer, cushioned the loss of attacks.
income from the deterioration in labor More recently, there have been
markets. And the purchasing power of encouraging signs that economic activ-
household income was further enhanced ity is beginning to firm. Job losses
by the sharp drop in energy prices dur- diminished considerably in December
ing the autumn. With businesses having and January, and initial claims for unem-
positioned themselves to absorb a falloff ployment insurance and the level of
6 88th Annual Report, 2001

insured unemployment have reversed provide some stimulus to activity this

their earlier sharp increases. Although year. Perhaps the most significant poten-
motor vehicle purchases have declined tial support to the economy could come
appreciably from their blistering fourth- from further gains in private-sector pro-
quarter pace, early readings suggest that ductivity. Despite the pronounced slow-
consumer spending overall has remained down in real GDP growth last year, out-
very strong early this year. In the put per hour in the nonfarm business
business sector, new orders for capital sector increased impressively. Contin-
equipment have provided some tentative ued robust gains in productivity, stem-
indications that the deep retrenchment ming from likely advances in technol-
in investment spending could be abat- ogy, should provide a considerable boost
ing. Meanwhile, purchasing managers to household and business incomes and
in the manufacturing sector report that spending and contribute to a sustained,
orders have strengthened and that they noninflationary recovery.
view the level of their customers’ inven- Still, the economy faces considerable
tories as being in better balance. Indeed, risk of subpar economic performance
the increasingly rapid pace of inventory in the period ahead. Because outlays for
runoff over the course of the last year durable goods and for new homes have
has left the level of production well been relatively well maintained in this
below that of sales, suggesting scope for cycle, the scope for strong upward impe-
a recovery in output given the current tus from household spending seems
sales pace. Against this backdrop, the more limited than has often been the
FOMC left its target for the federal case in past recoveries. Moreover, the
funds rate unchanged in January. How- net decline in household net worth rela-
ever, reflecting a concern that growth tive to income over the past two years is
could be weaker than the economy’s likely to continue to restrain the growth
potential for a time, the FOMC retained of spending in coming quarters. To be
its assessment that the risks were sure, the contraction in business capital
tilted unacceptably toward economic spending appears to be waning. But
weakness. spending on some types of equipment,
The extent and persistence of any most notably communications equip-
recovery in production will, of course, ment, continues to decline, and there are
depend critically on the trajectory of few signs yet of a broad-based upturn in
final demand in the period ahead. Sev- capital outlays. Activity abroad remains
eral factors are providing impetus to subdued, and a rebound of foreign out-
such a recovery in the coming year. put is likely to follow, not lead, a
With the real federal funds rate hovering rebound in the United States. Further-
around zero, monetary policy should be more, lenders and equity investors
positioned to support growth in spend- remain quite cautious. Banks have con-
ing. Money and credit expanded fairly tinued to tighten terms and standards
rapidly through the end of the year, and on loans, and risk spreads have
many households and businesses have increased a little this year. Stock prices
strengthened their finances by locking have retreated from recent highs as earn-
in relatively low-cost long-term credit. ings continue to fall amid concerns
The second installment of personal about the transparency of corporate
income tax cuts and scheduled increases financial reports and uncertainty about
in government spending on homeland the pace at which profitability will
security and national defense also will improve.
Monetary Policy and the Economic Outlook 7

Monetary Policy, Financial 21⁄2 percentage points—in 5 half-point

Markets, and the Economy steps—by the middle of May. Moreover,
over 2001 and Early 2002 the FOMC indicated throughout this
period that it judged the balance of risks
As economic weakness spread and to the outlook as weighted toward eco-
intensified over the first half of 2001, nomic weakness. The Board of Gover-
the FOMC aggressively lowered its tar- nors of the Federal Reserve System
get for the federal funds rate. Because approved reductions in the discount rate
firms reacted unusually swiftly to indi- that matched the Committee’s cuts in
cators that inventories were uncom- the target federal funds rate. As a result,
fortably high and capital was becoming the discount rate declined from 6 per-
underutilized, the drop in production cent to 31⁄2 percent over the period.
and business capital spending was espe- At its June and August meetings,
cially steep. Moreover, sharp downward the FOMC noted information suggest-
revisions in corporate profit expecta- ing continued softening in the economy
tions caused equity prices to plunge, and a lack of convincing evidence that
which, along with a decline in consumer the end of the slide in activity was in
confidence, pointed to vulnerability in sight. Although consumer spending on
household spending. Meanwhile, a sig- both housing and nonhousing items—
nificant deceleration in energy prices, buoyed by the tax cuts and rebates, low
after a surge early in the year, began to mortgage interest rates, declining energy
hold down overall inflation; the restrain- prices, and realized capital gains from
ing effect of energy prices, combined home sales—remained fairly resilient,
with the moderation of resource utiliza- economic conditions in manufacturing
tion, also promised to reduce core infla- deteriorated further. Firms continued to
tion. Responding to the rapid deteriora- reduce payrolls, work off excess inven-
tion in economic conditions, the FOMC tories, and cut back capital equipment
cut its target for the federal funds rate expenditures amid sluggish growth in

Selected Interest Rates


Intended federal funds rate 7

Ten-year Treasury 6

Two-year Treasury 3

Discount rate

2/2 3/21 5/16 6/28 8/22 10/3 11/15 12/19 1/3 1/31 3/20 4/18 5/15 6/27 8/21 9/17 10/2 11/6 12/11 1/30
2000 2001 2002

Note. The data are daily and extend through February 25, 2002. The dates on the horizontal axis
are those of scheduled FOMC meetings and of any intermeeting policy actions.
8 88th Annual Report, 2001

business sales, significantly lower cor- to flock from private to Treasury and
porate profits, and greater uncertainty federal agency debt, boosted risk
about future sales and earnings. With spreads sharply, especially on lower-
energy prices in retreat, price inflation rated corporate debt. Increased demand
remained subdued. In reaching its policy for safe and liquid assets contributed to
decisions at its June and August meet- selling pressure in the stock market. At
ings, the FOMC took into account the its October 2 meeting, the FOMC had
substantial monetary policy stimulus little hard information available on eco-
already implemented since the start of nomic developments since the attacks.
the year—but not yet fully absorbed by However, evidence gleaned from sur-
the economy—and the oncoming effects veys, anecdotes, and market contacts
of stimulative fiscal policy measures indicated that the events of Septem-
recently enacted by the Congress. Con- ber 11 had considerable adverse reper-
sequently, the Committee opted for cussions on an already weak economy:
smaller interest rate cuts of 1⁄4 percent- Survey indicators of consumer confi-
age point at both the June and August dence had fallen, and consumer spend-
meetings, which brought the target fed- ing had apparently declined. At the same
eral funds rate down to 31⁄2 percent; as time, anecdotal information pointed to
earlier in the year, the FOMC continued additional deep cutbacks in capital
to indicate that it judged the balance of spending by many firms after an
risks to the outlook as weighted toward already-significant contraction in busi-
economic weakness. After both meet- ness fixed investment over the summer
ings, the Board of Governors of the months.
Federal Reserve System also approved When the FOMC met on November
similar reductions in the discount rate, 6, scattered early data tended to confirm
which moved down to 3 percent. the information that the decline in pro-
After the terrorist attacks on Septem- duction, employment, and final demand
ber 11, the available Committee mem- had steepened after the terrorist attacks.
bers held a telephone conference on Although an economic turnaround
September 13, during which they agreed beginning in the first half of 2002 was
that the financial markets were too dis- a reasonable expectation according to
rupted to allow for an immediate alter- the Committee, concrete evidence that
ation in the stance of monetary policy. the economy was stabilizing had yet
However, the members were in agree- to emerge. Meanwhile, the marked
ment that the attacks’ potential effects decrease in energy prices since the
on asset prices and on the performance spring had induced a decline in overall
of the economy, and the resulting uncer- price inflation, and inflation expec-
tainty, would likely warrant some policy tations had fallen. Accordingly, the
easing in the very near future. Accord- FOMC voted to lower its target for the
ingly, the FOMC, at a telephone confer- federal funds rate 1⁄2 percentage point
ence on September 17, voted to reduce at both its October and November meet-
its target for the federal funds rate ings and reiterated its view that the risks
1⁄2 percentage point, to 3 percent, and to the outlook were weighted toward
stated that it continued to judge the risks economic weakness. The sizable adjust-
to the outlook to be weighted toward ments in the stance of monetary policy
economic weakness. in part reflected concerns that insuffi-
Over subsequent weeks, heightened cient policy stimulus posed an unaccept-
aversion to risk, which caused investors ably high risk of a more extended cycli-
Monetary Policy and the Economic Outlook 9

cal retrenchment that could prove rate that matched the FOMC’s cuts in
progressively more difficult to counter, the target federal funds rate, bringing
given that the federal funds rate—at the discount rate to 11⁄4 percent, its low-
2 percent—was already at such a low est level since 1948.
level. Subsequent news on economic activ-
By the time of the December FOMC ity bolstered the view that the economy
meeting, the most recent data were sug- was beginning to stabilize. The informa-
gesting that the rate of economic decline tion reviewed at the January 29–30,
might be moderating. After plunging 2002, FOMC meeting indicated that
earlier in the year, orders and shipments consumer spending had held up remark-
of nondefense capital goods had turned ably well, investment orders had firmed
up early in the fourth quarter, and the further, and the rate of decline in manu-
most recent survey evidence for manu- facturing production had lessened
facturing also suggested that some toward the end of 2001. With weakness
expansion in that sector’s activity might in business activity abating, and mone-
be in the offing. In the household sec- tary policy already having been eased
tor, personal consumption expenditures substantially, the FOMC left the federal
appeared to have been quite well main- funds rate unchanged at the close of its
tained, an outcome that reflected the meeting, but it continued to see the risks
continuation of zero-rate financing to the outlook as weighted mainly
packages offered by the automakers, toward economic weakness.
widespread price discounting, and low
interest rates. In an environment of very
low mortgage interest rates, household
Economic Projections for 2002
demand for housing remained at a rela- Federal Reserve policymakers are
tively high level, and financial resources expecting the economy to begin to
freed up by a rapid pace of mortgage recover this year from the mild down-
refinancing activity also supported con- turn experienced in 2001, but the pace
sumer spending. of expansion is not projected to be suffi-
Nonetheless, the evidence of emerg- cient to cut into the margin of underuti-
ing stabilization in the economy was lized resources. The central tendency of
quite tentative and limited, and the the real GDP growth forecasts made by
Committee saw subpar economic perfor- the members of the Board of Governors
mance as likely to persist over the near and the Federal Reserve Bank presi-
term. Moreover, in the probable absence dents is 21⁄2 percent to 3 percent, mea-
of significant inflationary pressures for sured as the change between the final
some time, a modest easing action could quarter of 2001 and the final quarter of
be reversed in a timely manner if it this year. The pace of expansion is likely
turned out not to be needed. In view of to increase only gradually over the
these considerations, the FOMC low- course of the year, and the unemploy-
ered its target for the federal funds rate ment rate is expected to move higher for
1⁄4 percentage point, to 13⁄4 percent, on a time. The FOMC members project the
December 11, 2001, and stated that it civilian unemployment rate to stand at
continued to judge the risks to the out- about 6 percent to 61⁄4 percent at the end
look to be weighted mainly toward eco- of 2002.
nomic weakness. As had been the case A diminution of the rate of inventory
throughout the year, the Board of Gover- liquidation is likely to be an important
nors approved reductions in the discount factor helping to buoy production this
10 88th Annual Report, 2001

Economic Projections for 2002


Federal Reserve Governors

and Reserve Bank presidents
Indicator 2001 actual
Range tendency

Change, fourth quarter to fourth quarter 1

Nominal GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.9 31⁄2–51⁄2 4–41⁄2
Real GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 2–31⁄2 21⁄2–3
PCE chain-type price index . . . . . . . . . . . . . . . . . . 1.3 1–2 About 11⁄2
Average level, fourth quarter
Civilian unemployment rate . . . . . . . . . . . . . . . . . 5.6 53⁄4–61⁄2 6–61⁄4

1. Change from average for fourth quarter of previous

year to average for fourth quarter of year indicated.

year. In 2001, businesses cut inventories through this period of economic weak-
sharply so as to avoid carrying exces- ness suggests a lack of pent-up con-
sive stocks relative to the weaker pace sumer demand going forward. In addi-
of sales, and although this process of tion, consumers likely will not benefit
liquidation probably is not yet complete from declining energy prices to the
in many industries, the overall pace of extent they did last year, and the net
reduction is likely to slow. Then, as decline in equity values since mid-2000
final demand strengthens, liquidation will probably continue to weigh on con-
should give way to some restocking later sumption spending in the period ahead.
in the year. Federal Reserve policymakers believe
As noted above, the forces affecting that consumer prices will increase
demand this year are mixed. On the slightly more rapidly in 2002 than in
positive side are the stimulative effects 2001, as last year’s sharp decline in
of both fiscal policy and the earlier energy prices is unlikely to be repeated.
monetary policy actions. A gradual turn- The central tendency of the FOMC
around in employment and a strengthen- members’ projections for increases in
ing of the economies of our major trad- the chain-type price index for personal
ing partners should provide some lift consumption expenditures (PCE) is
to final demand, and spending by both about 11⁄2 percent; last year’s actual
households and businesses ought to increase was about 11⁄4 percent. Never-
be supported by robust productivity theless, diminished levels of resource
growth. On the other hand, the problems utilization, the indirect effects of previ-
facing the high-tech sector have not yet ous declines in energy prices on firms’
completely receded, and indications are costs, and continued competitive pres-
that spending on other types of capital sures all ought to restrain the pace of
equipment remains lackluster. The sur- price increases outside of the energy
prising strength of household spending sector this year.

Economic and Financial Developments

in 2001 and Early 2002
In 2001, the economy turned in its maintained, buoyed by lower interest
weakest performance in a decade. Real rates and cuts in federal taxes. Firms
GDP increased at an annual rate of trimmed payrolls through most of the
3⁄4 percent in the first half of the year year, and the unemployment rate moved
and, according to the advance estimate up nearly 2 percentage points to around
from the Commerce Department, 53⁄4 percent by year-end. Job losses were
declined at a 1⁄2 percent annual rate in especially large following the terrorist
the second half. Although the effects of attacks of September 11, which had
the weakening economy were broadly extremely adverse effects on certain sec-
felt, the factory sector was especially tors of the economy—most notably, air-
hard hit. Faced with slumping demand line transportation and hospitality indus-
both here and abroad, manufacturers tries. Nevertheless, by early this year
cut production aggressively to limit some signs appeared that the economy
excessive buildups of inventories. More- was beginning to mend.
over, businesses sharply reduced their Inflation declined last year, pulled
investment spending, with particularly down by a sharp drop in energy prices.
dramatic cuts in outlays for high- Excluding food and energy items, con-
technology equipment. By contrast, sumer price inflation leveled off and, by
household spending was reasonably well some measures, moved lower last year.
Weakening economic activity, the indi-
Change in Real GDP rect effects of declining energy prices on

Percent, annual rate

Change in PCE Chain-Type Price Index


Excluding food and energy

+ 2

1995 1997 1999 2001

Note. Here and in subsequent charts, except as

noted, annual changes are measured from Q4 to Q4, 1995 1997 1999 2001
and change for a half-year is measured between its
final quarter and the final quarter of the preceding Note. The data are for personal consumption
period. expenditures (PCE).
12 88th Annual Report, 2001

firms’ costs, and continued strong com- wealth position of many households;
petitive pressures helped keep a lid on in the aggregate, however, household
core consumer price inflation. wealth deteriorated further as equity
prices moved lower, on net. The decline
in wealth since mid-2000 likely exerted
a notable restraining influence on house-
The Household Sector hold spending last year.
Both monetary and fiscal policy sup-
Consumer Spending ported consumer spending over the past
Growth in consumer spending slowed year. Low interest rates helped enable
last year but remained sufficiently solid motor vehicle finance companies to
to provide an important source of offer favorable financing on new vehi-
support to overall final demand. Per- cles. In addition, low mortgage rates led
sonal consumption expenditures (PCE) to a spate of mortgage refinancing that
increased 3 percent in real terms in 2001 lasted most of the year, lowering pay-
after having advanced 41⁄4 percent in ments and freeing cash to be used by
2000 and around 5 percent in both 1998 households for other spending needs.
and 1999. The deceleration in consumer Indeed, many households apparently
spending was widespread among dura- used these refinancings as an opportu-
ble goods, nondurable goods, and ser- nity to extract equity from their homes,
vices. However, motor vehicle expen- a move that further accommodated con-
ditures remained strong through most sumer spending. Furthermore, the first
of the year and surged in the fall as wave of tax reductions from the Eco-
consumers responded enthusiastically to nomic Growth and Tax Relief Reconcili-
automakers’ aggressive expansion of ation Act of 2001—including the $300
financing incentives. After Septem- and $600 rebate checks mailed last
ber 11, spending declined in certain summer—likely helped to boost spend-
travel- and tourism-related categories, ing in the latter part of the year. The
including air transportation, hotels and continued phase-in of the tax reductions
motels, and recreation services such as enacted last year should provide further
amusement parks; spending in these
categories has recovered only partially Change in Real Income and Consumption
since then.
Last year’s downshift in consumption Percent, annual rate
growth reflected the weakening labor
Disposable personal income
market and associated deceleration of Personal consumption
income as well as the erosion in house- expenditures 8
hold wealth since the middle of 2000.
With employment declining over much
of last year, real personal income rose
only about 13⁄4 percent after a gain of
41⁄2 percent in 2000. The slowing of 4
income growth was even sharper in
nominal terms, but price declines for
gasoline and other energy items in the
latter half of the year substantially cush-
ioned the blow to real incomes. A con-
1995 1997 1999 2001
tinued rise in house prices supported the
Economic and Financial Developments in 2001 and Early 2002 13

stimulus to income and consumption down sharply to very low levels in the
this year. fourth quarter and into early 2002.
The personal saving rate, which had According to the Michigan SRC survey,
declined through 1999, leveled off in declining mortgage rates have helped
2000 and in the first half of 2001. The elevate consumers’ assessments of
saving rate moved erratically in the sec- homebuying conditions substantially
ond half of the year but rose on average. since mid-2000.
It shot up in the summer as households In the single-family sector, 1.27 mil-
received their tax rebates; it then lion new homes were started last year,
declined later in the year as households 31⁄2 percent more than in 2000, when
spent some of the rebates and as pur- activity had been held down by higher
chases of new motor vehicles soared in mortgage rates. The pace of starts
response to the incentives. moved up further in January 2002, in
Consumer sentiment, as measured by part because of unusually favorable
both the University of Michigan Survey weather. Furthermore, sizable backlogs
Research Center (SRC) and the Con- of building permits early this year
ference Board, had been running at suggest that construction activity will
extremely high levels through most of remain solid. Sales of new homes were
2000 but fell considerably near the elevated throughout 2001—indeed, for
beginning of last year as concerns about the year, they were the highest on
the economy intensified. By the spring, record—and sales of existing homes
measures of sentiment leveled off near remained strong as well. Meanwhile, the
their historical averages and well above increase in home prices moderated last
levels normally associated with reces- year. The constant-quality price index of
sions. Sentiment dropped in September. new homes, which attempts to control
The SRC measure recovered gradually for the mix of homes sold, rose only
thereafter, while the Conference Board 11⁄2 percent last year, down from a 6 per-
index fell further before turning up later cent gain in 2000.
in the year; by early 2002, both senti- In the multifamily sector, starts aver-
ment measures again stood near their aged 328,000 units last year, a rate close
historical averages. to the solid pace of the past several
years. Conditions are still relatively
favorable for the construction of multi-
Residential Investment family units. In particular, vacancy rates
As with consumer spending, real expen- have remained low, although rents and
ditures on housing were well maintained property values increased at a slower
last year, buoyed by favorable mortgage rate last year than in 2000.
interest rates. Interest rates on thirty-
year fixed-rate mortgages, which had
been as high as 81⁄2 percent in the spring
Household Finance
of 2000, hovered around the low level Households continued to borrow at a
of 7 percent in the first half of 2001. brisk pace last year, increasing their debt
They moved down further to 61⁄2 per- outstanding an estimated 83⁄4 percent, a
cent by late October, before backing up rate about 1 percentage point faster than
to 7 percent again by December as pros- the average growth over the previous
pects for the economy improved. As two years. The cumulative declines in
monetary policy eased, contract rates mortgage interest rates encouraged
on adjustable-rate mortgages moved households to take on large amounts of
14 88th Annual Report, 2001

mortgage debt, both by fostering home- credit in that segment of the market
buying and by making it attractive to moved sharply higher.
refinance existing mortgages and extract
some of the accumulated equity; indeed,
the Mortgage Bankers Association
The Business Sector
(MBA) refinancing index in October Much of the weakness in activity last
reached the highest level since its incep- year was concentrated in the business
tion in January 1980. The frenzied pace sector. In late 2000, manufacturers had
of refinancing activity tailed off some begun to cut back production in an effort
later in the fourth quarter, when fixed to reduce an undesired build-up of
mortgage interest rates backed up. All inventories, and sharp inventory liquida-
told, mortgage debt grew an estimated tion continued throughout last year.
9 percent last year. Strength in durable Moreover, the boom in capital outlays
goods outlays supported growth in con- that had helped drive the expansion
sumer credit (debt not secured by real through the late 1990s gave way to a
estate) in the first quarter of 2001, but as softening of spending in late 2000 and
consumption spending decelerated over to sharp declines last year. Spending
the next two quarters, the expansion of dropped for most types of capital equip-
consumer credit slowed sharply. How- ment and structures; cutbacks were
ever, consumer credit growth surged in especially severe for high-tech equip-
the fourth quarter, in large part because ment, some types of which may have
of the jump in motor vehicle sales. For been over-bought. A sharp reduction in
the year as a whole, the rate of expan- corporate profits and cash flow contrib-
sion of consumer credit, at 61⁄4 percent, uted to last year’s downturn in capital
was well below the 101⁄4 percent rate spending, as did general uncertainty
posted in 2000. about the economic outlook. Despite the
Hefty household borrowing out- reduction in interest rates, which helped
stripped the growth of disposable per- restrain businesses’ interest expenses,
sonal income in 2001. As a result, financing conditions worsened some-
despite lower interest rates, the house- what, on balance, given weaker equity
hold debt-service burden—an estimate values, higher borrowing costs for risky
of minimum scheduled payments on firms, and some tightening of banks’
mortgage and consumer debt as a share lending standards.
of disposable income—finished the year
near the peak recorded at the end of
1986. Measures of household credit
Fixed Investment
quality deteriorated noticeably last year. Real spending on equipment and soft-
According to the MBA, delinquency ware (E&S) declined 81⁄2 percent in
rates on home mortgages continued to 2001 after an increase of the same
trend higher from their historic lows of amount in 2000 and double-digit rates
the late 1990s, and auto loan delinquen- of increase for several preceding years.
cies at finance companies edged up, Spending on high-tech equipment,
although they too remained at a rela- which has accounted for about 40 per-
tively subdued level. The economic cent of E&S spending in recent years,
slowdown and the rise in unemployment dropped especially sharply last year.
significantly eroded the quality of loans Outlays for computers and peripheral
to subprime borrowers, and delinquency equipment, which had risen more than
rates for both mortgages and consumer 30 percent in each of the preceding
Economic and Financial Developments in 2001 and Early 2002 15

seven years, fell 9 percent in 2001. ditions and the absence of new appli-
Spending on communications equip- cations requiring the most up-to-date
ment swung even more severely, mov- machines. But in addition, the magni-
ing from increases of more than 20 per- tude by which these categories of expen-
cent on average from 1998 to 2000 to a diture had increased in preceding years,
decline of more than 30 percent last together with the abruptness of their
year. Business spending on software downturn, suggests that firms may have
held up comparatively well, falling only been too optimistic about the immediate
21⁄2 percent in 2001 after having risen profitability of some types of high-tech
around 12 percent in 1999 and 2000. capital; as these expectations were
A number of factors may have revised, businesses viewed their previ-
weighed on outlays for high-tech equip- ous investment as more than sufficient
ment, including businesses’ decisions to to meet anticipated demand. This possi-
lengthen the replacement cycle for com- bility is especially likely in the case of
puters in light of weak economic con- communications equipment, for which
expectations about prospects for growth
Change in Real Business Fixed Investment in demand appear to have been disap-
pointed. Some of the cutbacks may have
Percent, annual rate reflected a general pulling back in an
environment of greater uncertainty. The
Equipment and software 20
sharp rise and subsequent decline of
equity values in the high-tech sector
mirrors the pattern of rising and slowing
investment and provides some support
+ for the notion that earnings expectations
_ may have been overly upbeat in the
Under the influence of ongoing weak-
ness in the market for heavy trucks,
business spending on motor vehicles
declined through most of the year. But
Percent, annual rate
spending stabilized in the fourth quarter,
as the generous incentives on motor
High-tech equipment vehicles may have helped boost spend-
and software 50
ing by small businesses as well as con-
Other equipment sumers. Domestic orders for new air-
craft declined last year, especially after
the terrorist attacks last fall, but these
20 lower orders had not yet affected spend-
ing by year-end because of the very
10 long lags involved in producing planes.
0 Apart from spending on transportation
and high-tech equipment, real outlays
10 declined 71⁄2 percent last year after hav-
ing increased 6 percent in 2000, with the
1995 1997 1999 2001 turnaround driven by a sharp swing in
Note. High-tech equipment includes computers and spending on many types of industrial
peripheral equipment and communications equipment. machinery and on office furniture.
16 88th Annual Report, 2001

Late last year, conditions in some seg- of fiber-optic networks. Investment in

ments of the high-tech sector showed the energy sector was a pocket of
signs of bottoming. Developments in the strength last year. Construction of drill-
semiconductor industry have improved, ing structures surged in 2000 and much
with production increasing during the of 2001, as the industry responded to
fall. Some of the improvement is appar- elevated prices of oil and natural gas.
ently coming from increased demand However, with oil and natural gas prices
for computers. In the advance estimate reversing their earlier increases, drilling
from the Commerce Department for the activity turned down in the latter part of
fourth quarter, real spending on comput- the year.
ers and peripheral equipment was
reported to have surged at an annual rate
of 40 percent. However, spending on
Inventory Investment
communications equipment, for which By late 2000, manufacturers were
evidence of a capital overhang has been already cutting production to slow the
most pronounced, continued to decline pace of inventory accumulation as
sharply in the fourth quarter, and orders inventories moved up relative to sales.
for communications equipment have Production cuts intensified in early
yet to display any convincing signs of 2001, and producers and distributers
turning around. As for other types of liquidated inventories at increasing rates
capital equipment, spending continued throughout the year. The runoff of
to decline in the fourth quarter, but inventories was a major factor holding
a moderate rebound in new orders down GDP growth last year. Indeed, the
for many types of capital goods arithmetic subtraction from real GDP
from their autumn lows hinted that a growth attributable to the decline in non-
broader firming of demand may be farm inventory investment was 11⁄2 per-
under way. centage points over the four quarters
Real business spending for nonresi- of 2001. However, because sales also
dential structures also declined sharply were weakening, inventory-sales ratios
in 2001. Construction of office buildings remained high in much of the manufac-
dropped last year after having increased turing sector, and in some portions of
notably for several years; industrial the wholesale sector as well, throughout
building remained fairly steady through the year.
the first half of last year but plummeted The motor vehicle sector accounted
in the second half. Vacancy rates for for about one-quarter of last year’s over-
these two types of properties rose con- all inventory drawdown. Late in 2000
siderably, and by year-end the indus- and early last year, automakers cut pro-
trial vacancy rate had reached its high- duction in an attempt to clear out excess
est level since mid-1993. Meanwhile, stocks held by dealers. By the spring,
spending on non-office commercial vehicle assemblies had stabilized, and
buildings (a category that includes retail, the automakers instead dealt with heavy
wholesale, and some warehouse space) stocks by further sweetening incentives
decreased moderately last year. Invest- to boost sales. By the end of the year,
ment in public utilities moved down inventories of cars and light trucks stood
as well, a decline reflecting, in part, a at a relatively lean 21⁄4 million units,
cutback in spending for communi- nearly 1 million units fewer than were
cations projects such as the installation held a year earlier.
Economic and Financial Developments in 2001 and Early 2002 17

Corporate Profits and Business Business borrowing slowed markedly

Finance last year because firms slashed invest-
ment in fixed capital and inventories
The profitability of the U.S. nonfinan- even more than the drop in profits and
cial corporate sector suffered a severe other internally generated funds. Busi-
blow in 2001. The profit slump had ness debt expanded at a 61⁄4 percent
begun in the fourth quarter of the previ- annual rate in 2001, well below the
ous year, when the economic profits of double-digit rates of the two previous
nonfinancial corporations—that is, book years, and its composition shifted decid-
profits from current production with edly toward longer-term sources of
inventory and capital consumption funds. Early in the year, favorable condi-
adjustments compiled by the Commerce tions in the corporate bond market, com-
Department—plummeted almost 45 per- bined with firms’ desire to lock in low
cent at an annual rate. The first three interest rates, prompted investment-
quarters of 2001 brought little respite, grade firms to issue a high volume of
and economic profits spiraled down- bonds. They used the proceeds to
ward at an average annual rate of 25 per- strengthen their balance sheets by repay-
cent. The ratio of the profits of nonfi- ing short-term debt obligations, refi-
nancial corporations to the sector’s gross nancing other longer-term debt, and
nominal output fell to 71⁄2 percent last building up liquid assets. Junk bond
year, a level not seen since the early
issuance was also strong early in 2001,
1980s. Earnings reports for the fourth
as speculative-grade yields fell in
quarter indicate that nonfinancial corpo-
response to monetary policy easings,
rate profits continued to fall late in the
although investors shunned the riskiest
issues amid increasing economic uncer-
tainty and rising defaults among below-
Before-Tax Profits of Nonfinancial investment-grade borrowers.
Corporations as a Percent of Sector GDP The heavy pace of bond issuance,
along with a reduced need to finance
capital investments, enabled firms to
decrease their business loans at banks
and their commercial paper outstanding.
12 The move out of commercial paper
also reflected elevated credit spreads
between high- and low-tier issuers
resulting from the defaults of California
utilities and several debt downgrades
among prominent firms early in the year.
Announcements of new equity share
repurchase programs thinned consider-
ably in the first half of the year, as firms
sought to conserve their cash buffers
1981 1986 1991 1996 2001 in response to plummeting profits. A
significant slowdown in cash-financed
Note. The data are quarterly and extend through
2001:Q3. Profits are from domestic operations of
merger activity further damped equity
nonfinancial corporations, with inventory valuation retirements, although these retirements
and capital consumption adjustments. still outpaced gross equity issuance,
18 88th Annual Report, 2001

which was restrained by falling share recovered, because of ongoing concerns

prices. Over the summer, issuance of about credit quality and ratings down-
investment-grade bonds dropped off grades among some high-profile issuers
appreciably. Moreover, market senti- in the fall.
ment toward speculative-grade issues By early October, the investment-
cooled, as further erosion in that sector’s grade corporate bond market had largely
credit quality took its toll. Business recovered from the disruptions associ-
loans and outstanding commercial paper ated with the terrorist attacks, and bond
continued to contract, and with share issuance in that segment of the market
prices in the doldrums, nonfinancial picked up considerably. Firms capital-
firms raised only a small amount of ized on relatively low longer-term
funds in public equity markets in the interest rates to pay down short-term
third quarter. obligations, to refinance existing higher-
The terrorist attacks on September 11 coupon debt, and to boost their holdings
constricted corporate financing flows for of liquid assets. With high-yield bond
a time. The stock market closed for that risk spreads receding moderately, issu-
week, and trading in corporate bonds ance in the speculative-grade segment
came to a virtual halt. After the shut- of the corporate bond market stirred
down of the stock market, the Securities somewhat from its moribund state,
and Exchange Commission, in an effort although investors remained highly
to ensure adequate liquidity, temporarily selective. Public equity issuance, after
lifted some restrictions on firms’ repur- stalling in September, also regained
chases of their own shares. According some ground in the fourth quarter,
to reports from dealers, this change spurred by a rebound in stock prices. As
triggered a spate of repurchases in the was the case for most of the year, initial
first few days after the stock markets
reopened on September 17. When
full-scale trading in corporate bonds Spreads of Corporate Bond Yields over the
resumed on September 17, credit Ten-Year Swap Rate
spreads on corporate bonds widened
Percentage points
sharply: Risk spreads on speculative-
grade private debt soared to levels not 9
seen since late 1991, and spreads on
investment-grade corporate bonds also
moved higher, although by a consider-
ably smaller amount. Against this back- 6
High yield
drop, junk bond issuance nearly dried up 5
for the rest of the month. Commercial 4
paper rates—even for top-tier issuers— 3
jumped immediately after the attacks, BBB 2
as risk of payment delays increased. In 1
AA +
response to elevated rates, some issuers
tapped their backup lines at commercial
banks, and business loans spiked in the 2000 2001 2002
weeks after the attacks. Risk spreads for
low-tier borrowers in the commercial Note. The data are daily and extend through Feb-
ruary 21, 2002. The spreads compare the yields on the
paper market remained elevated, even Merrill Lynch AA, BBB, and 175 indexes with the
after market operations had largely ten-year swap rate.
Economic and Financial Developments in 2001 and Early 2002 19

public offerings and venture capital recent years, and most firms did not
financing remained at depressed levels. experience significant difficulties servic-
Commercial paper issuance recovered ing their debt. However, many firms
somewhat early in the fourth quarter as were downgraded, and evidence of
firms repaid bank loans made in the financial distress mounted over the
immediate aftermath of the terrorist course of the year. The twelve-month
attacks and as credit spreads for lower- trailing average of the default rate on
rated issuers started to narrow. How- corporate bonds nearly tripled last year
ever, the collapse of the Enron Corpora- and by December ran almost 1⁄2 percent-
tion combined with typical year-end age point higher than its peak in 1991.
pressures to widen quality spreads in Delinquency rates on business loans at
early December. All told, the volume of banks also rose, although not nearly as
domestic nonfinancial commercial paper dramatically. The amount of nonfinan-
outstanding shrank by one-third over the cial debt downgraded by Moody’s
year as a whole. Business loans at banks Investors Service last year was more
fell further in the fourth quarter; for the than five times the amount upgraded;
year, business loans contracted 41⁄4 per- downgrades were especially pronounced
cent, their first annual decline since in the fourth quarter, when ratings agen-
1993. cies lowered debt ratings of firms in the
The slowing of sales and the drop in telecommunication, energy, and auto
profits caused corporate credit quality sectors.
to deteriorate noticeably last year. In Commercial mortgage debt, sup-
part because of the decline in market ported by still-strong construction
interest rates, the ratio of net interest spending, expanded at a brisk 10 percent
payments to cash flow in the nonfinan- pace over the first half of 2001. The
cial corporate sector moved only mod- growth of commercial mortgage debt
estly above the relatively low levels of edged down only 1⁄2 percentage point
in the second half, despite a sharp
slowdown in business spending on
nonresidential structures. As a result,
Default Rate on Outstanding Bonds
the issuance of commercial-mortgage-
Percent backed securities (CMBS) maintained a
robust pace throughout the year. Avail-
able data indicate some deterioration
in the quality of commercial real estate
2.5 credit. Delinquency rates on commercial
real estate loans at banks rose steadily
2.0 in 2001 and have started to edge out
of their recent record-low range. In
1.5 addition, CMBS delinquency rates
increased, especially toward the end of
the year, amid the rise in office vacancy
rates. Despite the erosion in credit qual-
ity in commercial real estate and heavy
issuance of CMBS, yield spreads on
1991 1993 1995 1997 1999 2001 investment-grade CMBS over swap
Note. The data are monthly; the series shown is a rates were about unchanged over the
twelve-month moving average. year, suggesting that investors view
20 88th Annual Report, 2001

credit problems in this sector as being decline in net interest payments, outlays
contained. Commercial banks, however, increased nearly 6 percent, a second
stiffened their lending posture in year of increases larger than had pre-
response to eroding prospects for the vailed for some time. Outlays have
commercial real estate sector; signifi- increased across all major categories of
cant net fractions of loan officers expenditure, including defense, Medi-
surveyed over the course of the year care and Medicaid, and social security.
reported that their institutions had As for the part of federal spending that
firmed standards on commercial real is counted in GDP, real federal outlays
estate loans. for consumption and gross investment
increased somewhat more rapidly than
in recent years through the first three
The Government Sector quarters of 2001 as defense expendi-
tures picked up. Spending rose faster
Federal Government still in the fourth quarter because of
Deteriorating economic conditions and increases for homeland security and the
new fiscal initiatives have led to smaller additional costs associated with the war
federal budget surpluses than had been in Afghanistan.
anticipated earlier. The fiscal 2001 sur- The existence of surpluses through
plus on a unified basis was $127 billion, fiscal 2001 meant that the federal gov-
or about 11⁄4 percent of GDP—well ernment continued to contribute to the
below both the record $236 billion sur- pool of national saving. Nevertheless,
plus recorded in fiscal 2000 and the gross saving by households, businesses,
$281 billion surplus that the Congres- and governments has been trending
sional Budget Office had anticipated down over the past few years from the
for fiscal 2001 at this time last year. recent high of around 19 percent of GDP
Receipts, which had increased at least in 1998.
6 percent in each of the preceding seven The Treasury used federal budget
fiscal years, declined around 2 percent surpluses over the first half of the year
in fiscal 2001; the rise in individual tax to pay down its outstanding marketable
receipts slowed dramatically and cor- debt. In the third quarter, however, the
porate receipts plunged 27 percent. The cut in personal income taxes and a
lower receipts reflected both the weak- weakening in receipts as the economy
ening economy—specifically, slow contracted led the Treasury to reenter
growth of personal income, the drop in the credit markets as a significant bor-
corporate profits, and a pattern of rower of new funds. The Treasury’s
declines in equity values that led to budget position swung back into surplus
lower net capital gains realizations— late in the year owing to somewhat
and changes associated with the Eco- stronger-than-expected tax receipts,
nomic Growth and Tax Relief Reconcili- which helped push fourth-quarter net
ation Act of 2001. Some provisions of borrowing below its third-quarter level.
the act went into effect immediately, Despite the increase in the Treasury’s
including the rebate checks that were net borrowing over the second half of
mailed last summer. In addition, the act the year, publicly held debt remained at
shifted some corporate tax payments only about one-third of nominal GDP
into fiscal 2002. last year, its lowest level since the mid-
Meanwhile, outlays were up 4 per- 1980s and well below the 1993 peak of
cent in fiscal 2001; abstracting from a almost 50 percent.
Economic and Financial Developments in 2001 and Early 2002 21

Federal Government Debt debt buybacks scheduled for late Sep-

Held by the Public tember to conserve cash, it later
announced that buyback operations
Percent of nominal GDP
would begin again in October.
With its credit needs still limited, the
Treasury announced on October 31 that
45 it was suspending issuance of nominal
and inflation-indexed thirty-year securi-
ties. Subsequently, the thirty-year Trea-
35 sury bond yield fell sharply, bid-asked
spreads on outstanding bonds widened,
and liquidity in the bond sector deterio-
rated. Although bid-asked spreads nar-
rowed over the balance of the year,
market participants reported that liquid-
ity in the bond sector remained below its
1961 1971 1981 1991 2001 level before the Treasury’s announce-
ment. The announcement on October 31
Note. The data are as of the end of the fiscal year.
Excludes debt held in federal government accounts
also indicated that after the January
and by the Federal Reserve System. 2002 buyback operations, the Treasury
would determine the amount and timing
of buybacks on a quarter-by-quarter
The terrorist attacks on September 11 basis, thereby fueling speculation that
and the associated disruptions to finan- future buybacks might be scaled back in
cial markets had some spillover effects light of the changed budget outlook.
on Treasury financing. On the day of
the attacks, the Treasury cancelled its
scheduled bill auction; over the next State and Local Governments
several days, it drew down nearly all of
its compensating balances with com- Real expenditures for consumption and
mercial banks—about $121⁄2 billion in gross investment by states and localities
total—to meet its obligations. On Thurs- rose 5 percent last year after an increase
day of that week, the settlement of secu- of 21⁄2 percent in 2000. Much of the
rities sold the day before the attacks acceleration reflected a burst of spend-
eased the Treasury’s immediate cash ing on construction of schools and other
squeeze, and the incoming stream of infrastructure needs. In addition, outlays
estimated quarterly personal income tax at the end of last year were boosted
payments provided additional funds. by the cleanup from the September 11
Infrastructure problems involving the attacks in New York. As for employ-
trading and clearing of Treasury securi- ment, state and local governments added
ties were largely resolved over the fol- jobs in 2001 at a more rapid pace than
lowing week, and when the Treasury they did over the previous year and
resumed its regular bill issuance on thereby helped to offset job losses in the
September 17, exceptionally strong private sector.
demand for bills pushed stop-out rates— The fiscal condition of state and local
that is, the highest yield accepted during governments has been strained by the
the auction—to their lowest level since deterioration in economic performance.
1961. Although the Treasury cancelled State governments are considering a
22 88th Annual Report, 2001

variety of actions to achieve budget The External Sector

balance in the current fiscal year. Most
states are intending to cut planned Trade and the Current Account
expenditures, and many are considering
The U.S. current account deficit nar-
drawing down rainy-day funds, which
rowed significantly during 2001, with
governments had built up in earlier
both imports and exports of goods and
years. According to the National Con-
services falling sharply in response to a
ference of State Legislators, these rainy-
global weakening of economic activity.
day funds stood at the relatively high
The deficit in goods and services nar-
level of $23 billion at the end of fiscal
rowed to $333 billion at an annual rate
2001 (June 30). Moreover, some states
in the fourth quarter of 2001 from
that had planned to fund capital expendi-
$401 billion at the end of the previous
tures with current receipts appear to be
year. In addition, the deficit was tempo-
shifting to debt financing. Finally, a few
rarily reduced further in the third quarter
states are considering actions such as
because service import payments were
postponing tax cuts that were enacted
lowered by a large one-time estimated
insurance payment from foreign insur-
Debt of the state and local govern-
ers (reported on an accrual basis)
ment sector expanded rapidly last year
related to the events of September 11.1
after slow growth in 2000. Gross issu-
Excluding the estimated insurance
ance of long-term municipal bonds
figure, the current account deficit was
accelerated over the first half of 2001 as
$434 billion at an annual rate over
state and local governments took advan-
the first three quarters of the year,
tage of lower yields to refund outstand-
or 41⁄4 percent of GDP, compared with
ing debt. Spurred by falling interest rates
$445 billion and 41⁄2 percent for the
and declining tax revenues, these gov-
year 2000. Net investment income
ernments continued to issue long-term
payments were about the same during
bonds to finance new capital projects at
the first three quarters of 2001 as in
a rapid clip over the second half of the
the corresponding period a year ear-
year. Despite a deterioration in tax
lier; higher net payments on our grow-
receipts, credit quality in the municipal
ing net portfolio liability position were
market remained high in 2001. Late in
offset by higher net direct investment
the year, however, signs of weakness
had emerged, as the pace of net credit-
U.S. real exports were hit by slower
ratings upgrades slowed noticeably.
growth abroad, continued appreciation
Especially significant problems continue
of the dollar, and plunging global
to plague California and New York, both
of which saw their debt ratings lowered
in November. In California, the prob-
lems were attributed to declining tax 1. The ‘‘insurance payment’’ component of
revenues and difficulties related to the imported services is calculated as the value of
premiums paid to foreign companies less the
state’s electricity crisis earlier in the amount of losses recovered from foreign compa-
year, while New York’s slip in credit nies. In the third quarter, the estimated size of
quality resulted not only from deteriorat- losses recovered far exceeded the amount paid for
ing tax receipts but also from fears of insurance premiums, resulting in a negative
recorded insurance payment. According to NIPA
higher-than-expected costs related to accounting, the entire amount of a recovery is
clean up and rebuilding after the terror- recorded in the quarter in which the incident
ist attacks. occurred.
Economic and Financial Developments in 2001 and Early 2002 23

demand for high-tech products. Real during the year.2 Imported goods fell
exports of goods and services fell 6 percent last year, with much of the
11 percent over the four quarters of decrease in capital goods (computers,
2001, with double-digit declines begin- semiconductors, and other machinery).
ning in the second quarter. Service In contrast, real imports of automotive
receipts decreased 7 percent; all of the products, consumer goods, oil, and other
decline came after the events of Sep- industrial supplies were little changed,
tember 11. Receipts from travel and and imports of foods rose. The pattern
passenger fares, which plunged fol- of import growth appears to have shifted
lowing the terrorist attacks, were about toward the end of the year. Imports of
one-fourth lower in the fourth quarter real non-oil goods declined at about a
than in the second quarter. Receipts 10 percent annual rate during the first
from foreigners for other services three quarters of the year but fell less
changed little over the year. Exports rapidly in the fourth quarter. The price
declined in almost all major goods of imported non-oil goods, after rising
categories, with the largest drops by in the first quarter, declined at an annual
far in high-tech capital goods and rate of about 6 percent from the second
other machinery. Two exceptions were quarter through the fourth quarter, led
exports of automotive products, which by decreases in the price of imported
rose during the second and third quar- industrial supplies.
ters (largely parts to Canada and Mexico The value of imported oil fell more
destined ultimately for use in U.S. than one-third over the four quarters of
markets, and vehicles to Canada), and 2001, a drop resulting almost entirely
agricultural goods. About 45 percent from a sharp decline in oil prices. The
of U.S. exports of goods were capital spot price of West Texas intermediate
equipment; 20 percent were industrial (WTI) crude decreased about $10 per
supplies; and 5 percent to 10 percent barrel during the year, with much of the
each were agricultural, automotive, con- decline occurring after September 11.
sumer, and other goods. The value of During the first eight months of 2001,
exported goods declined at double-digit the spot price of WTI averaged $28 per
rates for almost all major market desti- barrel as weakened demand for oil
nations. Even exports to Canada and and increased non-OPEC supply were
Mexico declined sharply, despite sup- largely offset by OPEC production
port from two-way trade with the United restraint. In the wake of the terrorist
States in such sectors as automotive attacks, oil prices dropped sharply in
products. response to a decline in jet fuel con-
As growth of the U.S. economy sumption, weaker economic activity,
slowed noticeably, real imports of goods and reassurance from Saudi Arabia that
and services turned down and declined supply would be forthcoming. Oil prices
8 percent for 2001 as a whole. Service continued to drift lower during the
payments dropped 15 percent last year.
The plunge in outlays for travel and
passenger fares after September 11 held 2. According to NIPA accounting, the value of
down total real service payments, bring- the one-time insurance payments by foreign insur-
ing their level in the fourth quarter ers is not reflected in NIPA real imports of
services. The deflator for service imports was
15 percent below that in the second adjusted down for the third quarter to offset the
quarter. Spending on services other than lower value of service imports; the deflator
travel and passenger fares changed little returned to its usual value in the fourth quarter.
24 88th Annual Report, 2001

fourth quarter, reflecting OPEC’s appar- eigners, who had sold a significant
ent unwillingness to continue to sacri- quantity of Treasury securities during
fice market share in order to defend 2000, roughly halted their sales in the
higher oil prices. In late December, how- first half of 2001. The increased capi-
ever, OPEC worked out an arrangement tal inflows arising from larger foreign
in which it agreed to reduce its produc- purchases of U.S. securities in the
tion targets an additional 1.5 million first half was only partly offset by an
barrels per day, contingent on the increase in the pace at which U.S. resi-
pledges from several non-OPEC produc- dents acquired foreign securities, espe-
ers (Angola, Mexico, Norway, Oman, cially equities.
and Russia) to reduce oil exports a total The pattern of private securities trans-
of 462,500 barrels per day. Given the actions changed significantly in the third
uncertainty over the extent to which quarter: Foreign purchases of U.S. equi-
these reductions will actually be imple- ties slowed markedly, and U.S. investors
mented and the comfortable level of oil shifted from net purchases of foreign
inventories, the spot price of WTI securities to net sales. However, the
remained near $20 per barrel in early reduced flows in the third quarter
2002. seem to have reflected short-lived
reactions to events in the quarter. Pre-
liminary data for the fourth quarter show
a significant bounceback in foreign pur-
Financial Account chases of U.S. securities and a return to
The slowing of U.S. and foreign eco- purchases of foreign securities by U.S.
nomic growth over the course of last residents.
year had noticeable effects on the com- The changing economic climate also
position of U.S. capital flows, especially affected direct investment capital flows.
when the slowing became more pro- During 2000, foreign direct invest-
nounced in the second half. On bal- ment in the United States averaged
ance, net private capital flowed in at more than $70 billion per quarter.
a pace only slightly below the record These flows slowed to less than
set in 2000, including unprecedented $60 billion per quarter in the first
net inflows through private securities half and then dropped to only $26 bil-
transactions. lion in the third quarter (the last avail-
During the first half of 2001, sagging able data). The drop resulted in part
stock prices and signs of slower growth from a decline in the outlook for cor-
brought a shift in the types of U.S. secu- porate profits and a significant reduc-
rities demanded by private foreigners tion in general merger and acquisition
but did not reduce the overall demand activity. By contrast, U.S. direct invest-
for them. Indeed, during the first half, ment abroad picked up over the course
foreign private purchases of U.S. securi- of 2001. The third quarter outflow of
ties averaged $137 billion per quarter, a $52 billion—a record—reflected both a
rate well above the record $109 billion large merger and robust retained earn-
pace set in 2000. A slowing of foreign ings by the foreign affiliates of U.S.
purchases of U.S. equities, relative to firms. Capital inflows from official
2000, was more than offset by a pickup sources were relatively modest in 2001,
in foreign purchases of corporate and totaling only $15 billion, compared with
agency bonds. In addition, private for- $36 billion in 2000.
Economic and Financial Developments in 2001 and Early 2002 25

The Labor Market Early last year, employment in

manufacturing, which had been trend-
Employment and Unemployment ing down for several years, began to
decline more rapidly. Job losses were
Last year’s weakening in economic widespread within the manufacturing
activity took its toll on the labor market. sector but were most pronounced in
Payroll employment edged up early last durable-goods industries, such as those
year and then dropped nearly 11⁄2 mil- producing electrical and industrial
lion by January 2002. Declines were machinery and metals. Employment at
particularly large in manufacturing,
help supply firms and in wholesale
which has shed one in twelve jobs since trade—industries that are directly
mid-2000. Job cuts accelerated in the
related to manufacturing—also began to
months following the terrorist attacks of decline. Outside of manufacturing and
September 11, with declines occurring its related industries, private payrolls
in a wide variety of industries. The continued to increase robustly in the first
unemployment rate moved up from quarter of last year, but hiring then
4 percent in late 2000 to 5.8 percent by slowed, although it remained positive,
December 2001. In January 2002, the on net, in the second and third quarters.
unemployment rate edged down to Construction payrolls increased into
5.6 percent. the spring but flattened out thereafter.
Employment at retail trade establish-
ments also continued to increase moder-
Measures of Labor Utilization
ately through the spring but began to
Percent decline in the late summer. In services
industries other than help supply
firms—a broad group that accounted for
15 nearly half of the private payroll
unemployment increases over the preceding several
rate 12 years—job gains slowed but remained
positive in the second and third quarters
9 of last year. In all, private payroll
employment declined about 115,000 per
6 month in the second and third quarters,
and the unemployment rate moved up
unemployment 3 steadily to 41⁄2 percent by the spring and
rate to nearly 5 percent by August.
The labor market was especially hard
1972 1982 1992 2002 hit by the terrorist attacks. Although
Note. The data extend through January 2002. The labor demand was weak prior to the
augmented umemployment rate is the number of attacks, the situation turned far worse
unemployed plus those who are not in the labor force following the events of September 11,
and want a job, divided by the civilian labor force
plus those who are not in the labor force and want a and private payrolls plunged more than
job. In January 1994, a redesigned survey was intro- 400,000 per month on average in Octo-
duced; data for the augmented rate from that point ber and November. Employment fell
on are not directly comparable with those of earlier
periods. For the augmented rate, the data are quarterly
substantially not only in manufacturing
through December 1993 and monthly thereafter; for and in industries directly affected by
the civilian labor force rate, the data are monthly. the attacks, such as air transportation,
26 88th Annual Report, 2001

hotels, and restaurants, but also in a magnitude of that deceleration. The

wide variety of other industries such as slowing likely reflected the influence of
construction and much of the retail the soft labor market, energy-driven
sector. declines in price inflation toward the
Employment continued to decline in latter part of the year, and subdued infla-
December and January but much less tion expectations. Compensation prob-
than in the preceding two months. ably was also held down by a reduction
Manufacturing and its related industries in variable pay, such as bonuses that are
lost jobs at a slower pace, and employ- tied to company performance and stock-
ment leveled off in other private indus- option activity.
tries. The unemployment rate moved up According to the employment cost
to 5.8 percent in December but then index, hourly compensation costs
ticked down to 5.6 percent in January. increased 41⁄4 percent during 2001,
The recent reversal of the October and down from a 41⁄2 percent increase in
November spikes in new claims for 2000; both the wages and salaries and
unemployment insurance and in the benefits components recorded slightly
level of insured unemployment also smaller increases. The deceleration in
point to some improvement in labor the index for wages and salaries was
market conditions early this year. concentrated among sales workers,
whose wages often include a substantial
commission component and so are espe-
Productivity and Labor Costs cially sensitive to cyclical develop-
Given economic conditions, growth of ments. Although the increase in employ-
labor productivity was impressive in ers’ cost of benefits slowed overall,
2001. Productivity growth typically the cost of providing health insurance
drops when the economy softens, partly increased more than 9 percent last year;
because businesses tend not to shed the rise continued this component’s
workers in proportion to reduced accelerating contribution to labor costs
demand. Last year, however, output per over the past few years after a period
hour in the nonfarm business sector
increased a relatively solid 11⁄2 percent, Change in Output per Hour
according to the advance estimate, after
having risen 21⁄2 percent in 2000—a Percent, annual rate

mild deceleration by past cyclical stan-

dards. Indeed, productivity is estimated
to have increased at an annual rate of
more than 2 percent in the second half
of the year, an impressive performance
during a period when real GDP was, on
net, contracting. The buoyancy of pro-
ductivity during 2001 provides further
support to the view that the underlying 1
trend of productivity growth has stepped +
up notably in recent years. 0
Hourly labor compensation costs
increased more slowly last year than in 1991 1993 1995 1997 1999 2001
2000, although different compensation
measures paint different pictures of the Note. Nonfarm business sector.
Economic and Financial Developments in 2001 and Early 2002 27

of restrained cost increases in the mid- The chain-type price index for personal
1990s. consumption expenditures (PCE)
An alternative measure of hourly increased 1.3 percent last year after hav-
compensation is the BLS’s measure of ing increased 2.6 percent in 2000; the
compensation per hour in the non- turnaround in consumer energy prices
farm business sector, which is derived accounted for almost all of that decelera-
from compensation information in tion. Increases in PCE prices excluding
the national accounts; this measure food and energy items also slowed a
increased 4 percent last year, a very little last year after having moved up in
large drop from the 73⁄4 percent increase 2000. The chain-type price index for
registered in 2000. One reason that gross domestic purchases—the broadest
these two compensation measures may price measure for domestically pur-
diverge is that only nonfarm compensa- chased goods and services—decelerated
tion per hour captures the cost of stock considerably last year. The small
options. Although the two compensa- increase in this index reflected both the
tion measures differ in numerous other drop in energy prices and a resumption
respects as well, the much sharper decel- of rapid declines for prices of invest-
eration in nonfarm compensation per ment goods, especially computers, fol-
hour may indicate that stock option lowing a period of unusual firmness in
exercises leveled off or declined in 2001 2000. The price index for GDP—the
in response to the fall in equity values. broadest price measure for domestically
However, because nonfarm compensa- produced goods and services—posted a
tion per hour can be revised substan- smaller deceleration of about 1⁄2 percent-
tially, one must be cautious in interpret- age point between 2000 and 2001
ing the most recent quarterly figures because lower oil prices have a smaller
from this series. weight in U.S. production than in U.S.
Unit labor costs, the ratio of hourly purchases.
compensation to output per hour in the Consumer energy prices continued to
nonfarm business sector, increased about move higher through the early months
2 percent last year. Although down from of 2001 before turning down sharply in
a huge 5 percent increase in 2000 that the second half of the year. Despite the
reflected that year’s surge in nonfarm fact that crude oil prices were declining
compensation per hour, the figure for
2001 is still a little higher than the mod-
erate increases seen over the preceding Alternative Measures of Price Change
several years. Last year’s increase in Percent
unit labor costs was held up by the Price measure 2000 2001
smaller productivity increases that
accompanied weak economic activity; Chain-type
accordingly, subsequent increases in unit Gross domestic product . . . . . . . . 2.4 1.8
Gross domestic purchases . . . . . . 2.5 1.1
labor costs would be held down if out- Personal consumption
put per hour begins to increase more expenditures . . . . . . . . . . . . . . 2.6 1.3
Excluding food and energy . . . 1.9 1.6
rapidly as the economy strengthens.
Consumer price index . . . . . . . . . . 3.4 1.9
Excluding food and energy . . . 2.5 2.7
Note. Changes are based on quarterly averages and
Inflation declined in 2001 largely are measured to the fourth quarter of the year indicated
because of a steep drop in energy prices. from the fourth quarter of the preceding year.
28 88th Annual Report, 2001

over the first half of the year, retail large increases in livestock prices—
gasoline prices increased at an annual especially beef. But these prices soft-
rate of 8 percent during that period. The ened later in the year under the influ-
sizable increase in margins on gasoline ence of higher supplies, lower domestic
reflected both refinery disruptions and demand, and foreign outbreaks of mad
low inventory levels going into the sum- cow disease, which apparently damped
mer driving season. But gasoline prices demand for beef no matter where
fell sharply thereafter as refineries came produced.
back on line, imports of gasoline picked Excluding food and energy items,
up, and crude oil prices moved consider- PCE prices rose 1.6 percent last year, a
ably lower over the latter half of the small deceleration from its 1.9 percent
year. In all, gasoline prices were down increase over 2000. That deceleration
19 percent over the year as a whole. was concentrated in prices of goods,
Heating oil prices reflected crude oil with prices especially soft for motor
developments more directly and vehicles and apparel. By contrast, prices
declined sharply through most of the of many services continued to accelerate
year. Meanwhile, spot prices of natural last year. In particular, shelter costs—
gas peaked in January 2001 at the which include residential rent, the
extraordinarily high level of nearly $10 imputed rent of owner-occupied hous-
per million BTUs, and prices at the con- ing, and hotel and motel prices—
sumer level continued to surge in the increased 41⁄4 percent last year after hav-
first few months of the year. These ing risen 31⁄2 percent in 2000.
increases reflected the pressure from Standing somewhat in contrast to the
ongoing strength in demand coupled small deceleration in core PCE prices,
with unusually cold weather early last the core consumer price index (CPI)
winter that left stocks at very low levels. increased 23⁄4 percent last year, about
But the situation improved as expanded the same rate as in 2000. Although com-
supply allowed stocks to be replenished: ponents of the CPI are key inputs of the
Spot prices reversed those earlier PCE price index, the two price measures
increases, and prices of consumer natu- differ in a variety of ways. One impor-
ral gas declined substantially through tant difference is that the PCE measure
the rest of the year. is broader in scope; it includes expendi-
In contrast, electricity prices rose tures made by nonprofit institutions and
through most of last year. The increases consumption of items such as checking
reflected the effects of the earlier rises in services that banks provide without
the prices of natural gas and coal on fuel explicit charge. Prices for the PCE cate-
costs of utilities as well as problems gories that are outside the scope of the
with electricity generation in California. CPI decelerated notably in 2001 and
California was able to avoid serious accounted for much of the differential
power disruptions last summer because movements of inflation measured by the
high electricity prices, weak economic two price indexes. Another difference is
activity, and moderate weather all that the CPI places a larger weight on
helped keep demand in check. housing than does the PCE price index,
Consumer food prices increased more and last year’s acceleration of housing
rapidly last year, rising about 3 percent prices therefore boosted the CPI relative
after having risen only 21⁄2 percent in to the PCE measure.
2000. Early in the year, strong demand, The leveling off or decline in core
both domestic and foreign, led to consumer price inflation reflects a vari-
Economic and Financial Developments in 2001 and Early 2002 29

ety of factors, including the weakening increased likelihood of federal budget

of economic activity and the accompa- deficits and, except in the immediate
nying slackening of resource utilization; aftermath of the terrorist attacks, by
the decline in energy prices that reduced investors’ optimism about future eco-
firms’ costs; and continuing intense nomic prospects. Despite this opti-
competitive pressures in product mar- mism, the slowdown in final demand, a
kets. These factors also likely helped slump in corporate earnings, and a
to reduce inflation expectations late last marked deterioration in credit quality
year, and this reduction itself may be of businesses in a number of sectors
contributing to lower inflation. Accord- made investors more wary about risk.
ing to the Michigan SRC, median one- Although interest rates on higher-rated
year inflation expectations, which had investment- grade corporate bonds gen-
held near 3 percent through 2000 and erally moved in line with those on
into last summer, moved down to comparably dated government securi-
23⁄4 percent in the third quarter and ties, lower-rated firms found credit to
plummeted to 1 percent or lower in be considerably more expensive, as
October and November. Falling energy risk spreads on speculative-grade debt
prices and widespread reports of dis- soared for most of the year before nar-
counting following the September 11 rowing somewhat over the last few
attacks likely played a role in causing months. Interest rates on commercial
this sharp break in expectations. Part of paper and business loans fell last year
this drop was reversed in December, and by about as much as the federal funds
since then, inflation expectations have rate, but risk spreads generally remained
remained around 2 percent—a rate still in the elevated range. In addition, com-
well below the levels that had prevailed mercial banks tightened standards and
earlier. Meanwhile, the Michigan SRC’s terms for business borrowers throughout
measure of longer-term inflation expec- the year. Equity prices were exception-
tations, which had also remained close ally volatile and fell further, on balance,
to 3 percent through 2000 and the first in 2001.
half of 2001, ticked down to 23⁄4 percent Increased caution on the part of lend-
in October and stood at that level early ers did not appear to materially damp
this year. aggregate credit flows. Private borrow-
ing was robust last year, especially when
compared with the marked slowing in
U.S. Financial Markets nominal spending. Relatively low long-
term interest rates encouraged both busi-
As a consequence of the Federal nesses and households to concentrate
Reserve’s aggressive easing of the borrowing in longer-term instruments,
stance of monetary policy in 2001, inter- thereby locking in lower debt-service
est rates on short- and intermediate-term obligations. The proceeds of long-term
Treasury securities fell substantially borrowing were also used to strengthen
over the course of the year. Longer-term balance sheets by building stocks of liq-
Treasury bond yields, however, ended uid assets. A shift toward safer and more
the year about unchanged, on balance. liquid asset holdings showed through in
These rates had already fallen appre- rapid growth of M2, which was spurred
ciably in late 2000 in anticipation of further by reduced short-term market
monetary policy easing. They may also interest rates and elevated stock market
have been held up last year by an volatility.
30 88th Annual Report, 2001

Interest Rates and longer-term interest rates turned

down again.
Short-term market interest rates moved The terrorist attacks of September 11
down with the FOMC’s cumulative cut dramatically redrew the picture of the
in the target federal funds rate of nation’s near-term economic prospects.
43⁄4 percentage points, and yields on Market participants lowered markedly
intermediate-term Treasury securities
their expected trajectory for the path of
declined almost 2 percentage points.
the federal funds rate in the immediate
Longer-term interest rates had already
aftermath of the attacks, and revisions to
fallen in the latter part of 2000, when
policy expectations, combined with con-
investors began to anticipate significant
siderable flight-to-safety demands, cut
policy easing in response to weakening
short- and intermediate-term Treasury
economic growth. As the FOMC aggres-
yields substantially over subsequent
sively eased the stance of monetary pol-
days. The FOMC, confronted with evi-
icy during the winter and spring, inves-
dence of additional weakness in final
tors’ expectations of a prompt revival in
demand and prices, eased policy further
economic activity took hold and were
over the balance of the year, and short-
manifested in a sharp upward tilt of
term market interest rates continued to
money market futures rates and an
decline. In early November, however,
appreciable rise in longer-term interest
intermediate- and long-term interest
rates over the second quarter. How-
rates turned up, as it became apparent
ever, signs of the anticipated economic
that the economic fallout from the
turnaround failed to materialize as
attacks would be more limited than
the summer progressed. Indeed, the
some had originally feared, and as mili-
weakening in economic activity was
tary success in Afghanistan bolstered
becoming more widespread, which
investors’ confidence and moderated
prompted expectations of further mone-
safe-haven demands. By the end of the
tary policy easing over the near term,
year, yields on intermediate-term Trea-
sury securities had reversed about half
of their post–September 11 decline,
Rates on Selected Treasury Securities
while yields on longer-term Treasury
Percent securities had risen enough to top their
pre-attack levels. In early 2002, how-
7 ever, yields on intermediate- and longer-
term Treasuries edged down again, as
6 market participants trimmed their expec-
5 tations for the strength of the economic
rebound, and the Congress failed to
4 move forward with additional fiscal
Yields on higher quality investment-
Three-month 2 grade corporate bonds generally fol-
lowed those on comparably dated Trea-
sury securities last year, although risk
spreads widened moderately before
2000 2001 2002 narrowing over the last few months. In
Note. The data are daily and extend through Feb- contrast, interest rates on speculative-
ruary 21, 2002. grade corporate debt increased steadily
Economic and Financial Developments in 2001 and Early 2002 31

in 2001, as risk spreads ballooned came to a halt at the end of the first
in response to mounting signs of finan- quarter, with the Wilshire 5000—a very
cial distress among weaker firms. Even broad index of stock prices—down
with a considerable narrowing over about 13 percent, while the tech-heavy
the final two months of the year, risk Nasdaq ended the first quarter at its
spreads on below-investment-grade lowest level since 1998 and more than
bonds remained quite wide. Spreads for 60 percent below its record high reached
high-yield bonds edged down further in in March of 2000.
2002 after rising sharply in early Janu- Companies, especially in the technol-
ary, when several important technology ogy sector, reported weak profits for the
and telecommunications companies first quarter, but their announcements
revised down their earnings forecasts or generally surpassed analysts’ sharply
released corrections to past earnings lowered expectations. With the 1 per-
statements. Interest rates on commercial centage point reduction in the federal
and industrial (C&I) loans at banks fell funds rate over March and April, inves-
last year by about as much as the federal tors became more confident that an
funds rate. According to the Federal improvement in economic conditions
Reserve’s quarterly Survey of Terms of was in train, and equity prices rallied;
Business Lending, the spread over the the rebound was particularly strong for
target federal funds rate of the average technology companies—the Nasdaq
interest rate on C&I loans varied some- rose almost 40 percent between April
what over the year, falling for a while and the end of May. The forward
then rising sharply between August and momentum in equity markets was
November; nonetheless, it has generally checked in June, however, in part
remained in the elevated range that has because analysts slashed their estimates
persisted since late 1998. The same sur- for near-term corporate earnings growth.
vey also indicated that over the course Although the stock market initially
of last year commercial banks, like other proved resilient in the face of the bleak
lenders, have become especially cau-
tious about lending to marginal credits,
Major Stock Price Indexes
as indicated by the average spread on
riskier C&I loans not made under a pre- January 3, 2000 = 100
vious commitment, which soared in
Equity Markets
The exceptional volatility of equity S&P 500
prices in 2001 likely reflected the dra- 75
matic fluctuations in investors’ assess- 5000
ment of the outlook for the economy
and corporate earnings. Share prices 50
tumbled early last year, as pessimism
and uncertainty about the direction of
the economy were intensified by a spate
of negative earnings announcements and 2000 2001 2002

profit warnings in February and March. Note. The data are daily and extend through Feb-
The pronounced sell-off of equities ruary 21, 2002.
32 88th Annual Report, 2001

profit news, suggesting that weak earn- 10 percent, while the Nasdaq fell 20 per-
ings had been largely anticipated by cent. The widespread decline in equity
investors, the steady barrage of dismal prices through the first three quarters of
economic news—particularly in the 2001 is estimated to have wiped out
technology and telecommunications nearly $31⁄2 trillion in household wealth,
sectors—started to exert downward translating into 81⁄4 percent of total
pressure on share prices by early household net worth. Of this total, how-
August. The slide in stock prices intensi- ever, about $11⁄4 trillion was restored by
fied in early September, with technology the stock market rally in the fourth quar-
stocks taking an exceptional drubbing. ter. Moreover, the level of household net
By September 10, the Wilshire 5000 worth at the end of last year was still
was down almost 10 percent from the almost 50 percent higher than it was at
end of July, while the Nasdaq had lost the end of 1995, when stepped-up pro-
more than 16 percent. ductivity gains had begun to induce
The attacks on September 11, a Tues- investors to boost significantly their
day, caused stock markets to shut down expectations of long-term earnings
and to remain closed for the rest of that growth. In January and early February
week. Trading resumed in an orderly of 2002, investors reacted to generally
fashion on Monday, September 17, but disappointing news about expected earn-
the day ended with the market as a ings, especially in the telecommunica-
whole down about 5 percent—with air- tions sector, and to concerns about cor-
line and hotel stocks pounded most— porate accounting practices by erasing
and trading volume on the New York some of the fourth-quarter gain in equity
Stock Exchange hitting a record high. prices. Despite this decline, the price-
Major stock price indexes, which sagged earnings ratio for the S&P 500 index
further in subsequent days and weeks, (calculated using operating earnings
were weighed down by investors’ more expected over the next year) remained
pessimistic evaluation of the near-term close to its level at the beginning of
economic outlook and by sizable down- 2001. The relatively elevated ratio
ward revisions to analysts’ earnings reflected lower market interest rates as
projections for the rest of 2001. By the well as investor anticipation of a return
third week of the month, broad stock to robust earnings growth.
price indexes had fallen a total of
12 percent from their levels on Septem-
ber 10.
Debt and Depository Intermediation
In late September, stock prices staged The growth of the debt of nonfederal
a comeback that lasted through the sectors was strong over the first half of
fourth quarter, as incoming information the year, as the decline in longer-term
suggested that the economy had proven interest rates during the final months of
remarkably resilient and economic pros- 2000 prompted some opportunistic tap-
pects were improving. On the percep- ping of bond markets by businesses and
tion that the worst for the technology helped keep the expansion of household
sector would soon pass, share prices of credit brisk. However, the combination
firms in technology industries jumped of a stepdown in the growth of con-
sharply, lifting the Nasdaq more than sumer durables purchases, a further drop
35 percent from its September nadir. On in capital expenditures, and a substantial
balance, last year’s gyrations in stock inventory liquidation over the second
prices left the Wilshire 5000 down about half of the year resulted in a signifi-
Economic and Financial Developments in 2001 and Early 2002 33

cantly slower pace of private borrowing. October, however, the disruptions to

On balance, growth of nonfederal debt business financing patterns and payment
retreated about 1 percentage point in systems that bloated bank balance sheets
2001, to 71⁄2 percent. Federal debt con- had largely dissipated, and loans con-
tinued to contract early last year; it then tracted sharply.
turned up as the budget fell into a deficit Commercial banks reported a marked
reflecting the implementation of the tax deterioration in loan performance last
cut, the effect of the weaker economy year. Delinquency and charge-off rates
on tax receipts, and emergency spending on C&I loans trended up appreciably,
in the wake of the terrorist attacks. As although they remained well below rates
a result, the federal government paid recorded during the 1990-91 recession.
down only 11⁄4 percent of its debt, on Delinquency rates on credit card
net, over 2001, compared with 63⁄4 per- accounts increased for the second year
cent in the previous year. With nominal in a row, reaching 5 percent for the first
GDP decelerating sharply, the ratio of time since early 1992. Banks responded
nonfinancial debt to GDP moved up to the deteriorating business and house-
notably in 2001, more than reversing its hold balance sheets by tightening credit
decrease in the previous year. standards and terms for both types of
The economic slowdown and the loan, according to the Federal Reserve’s
decline in market interest rates last year Senior Loan Officer Opinion Survey on
left a noticeable imprint on the composi- Bank Lending Practices. Banks indi-
tion of financial flows, with borrowing cated that they had tightened business
by businesses and households migrating lending policies in response to greater
toward longer-term bond and mortgage uncertainty about the economic outlook
markets. As a consequence, credit at and their reduced tolerance for risk.
depository institutions expanded slug- Similarly, the net fractions of banks
gishly over the year. Growth of loans at reporting that they had tightened stan-
commercial banks dropped off sharply, dards for both credit card and other con-
from 12 percent in 2000 to 21⁄4 per- sumer loans rose markedly over the first
cent in 2001. The slowdown in total half of last year. As household financial
bank credit—after adjustments for conditions continued to slip, the net pro-
mark-to-market accounting rules—was portion of banks that tightened stan-
less severe, because banks acquired dards on consumer loans remained at an
securities, largely mortgage-backed elevated level in the second half of the
securities, at a brisk pace throughout the year.
year. A healthy banking sector served as In response to rising levels of delin-
an important safety valve for several quent and charged-off loans, commer-
weeks after September 11, as businesses cial banks significantly boosted the rate
tapped backup lines of credit to over- of provisioning for loan losses last year,
come problems associated with the which, along with reduced income from
repayment of maturing commercial capital market activities, cut into the
paper and issuance of new paper. More- banking sector’s profits. Nonetheless,
over, with payment flows temporarily through the third quarter of 2001—
interrupted by the terrorist attacks, a the latest period for which Call Report
substantial volume of overdrafts was data are available—measures of indus-
created, causing a spike in the ‘‘other’’ try profitability remained near the
loan category that includes loans to elevated range recorded for the past sev-
depository institutions. By the end of eral years, and banks continued to hold
34 88th Annual Report, 2001

substantial capital to absorb losses. assets, especially for its liquid deposits
Indeed, virtually all assets were at well- (the sum of checking and savings
capitalized banks at the end of the third accounts) and retail money funds com-
quarter, and the substitution of securities ponents. Moreover, negative returns and
for loans on banks’ balance sheets also elevated volatility in equity markets
helped edge up risk-based capital ratios. likely raised household demand for M2
In the fourth quarter, a number of large assets through the fall. An unprec-
banks saw their profits decline further edented level of mortgage refinancing
because of their exposure to Enron and, activity (which results in prepayments
to a lesser extent, Argentina. On the that temporarily accumulate in deposit
positive side, wider net interest margins accounts before being distributed to
helped support profits throughout 2001. investors in mortgage-backed securi-
ties), as well as increased foreign
demand for U.S. currency, also bolstered
The Monetary Aggregates the growth of M2 over the course of the
The broad monetary aggregates grew year.
very rapidly in 2001. Over the four quar- Involuntary accumulation of liquid
ters of the year, M2 increased 101⁄4 per- deposits resulting from payment system
cent, a rate significantly above the pace disruptions after the terrorist attacks,
of the past several years. Because the combined with elevated safe-haven
rates of return provided by many com- demands, caused M2 to surge tempo-
ponents of M2 move sluggishly, the rarily in the weeks following Septem-
swift decline in short-term market inter- ber 11. At the same time, plunging
est rates last year significantly lowered equity prices led to a sharp step-up
the opportunity cost of holding M2 in the growth of retail money mar-
ket mutual funds. After a substantial
M2 Growth Rate unwinding of distortions to money flows
in October, M2 growth over the balance
Percent of the year was spurred by further
declines in its opportunity cost resulting
from additional monetary policy easings
and by heightened volatility in equity
markets. The hefty advance in M2 last
8 year outpaced the anemic expansion of
nominal income, and M2 velocity—the
6 ratio of nominal GDP to M2—posted a
record decline.
4 M3—the broadest monetary
aggregate—grew 13 percent over 2001.
2 In addition to the surge in its M2 com-
ponent, huge inflows into institutional
money funds boosted M3 growth. Inves-
1991 1993 1995 1997 1999 2001
tors’ appetite for these instruments was
Note. M2 consists of currency, travelers checks, enormous last year because their returns
demand deposits, other checkable deposits, savings were unusually attractive as they lagged
deposits (including money market deposit accounts), the steep decline in market interest rates.
small-denomination time deposits, and balances in
retail money market funds. Annual growth rates are The slow-down in the growth of bank
computed from fourth-quarter averages. credit over the summer, which resulted
Economic and Financial Developments in 2001 and Early 2002 35

in a contraction in managed liabilities, expect economic recovery, thereby sup-

damped the rise in M3 somewhat. The porting long-term interest rates. Follow-
velocity of M3 dropped for the seventh ing the terrorist attacks in September,
year in the row, to a record low. interest rates declined around the globe
as expected economic activity weak-
ened and demand shifted away from
International Developments equities and toward the relative safety of
Economic activity in foreign economies bonds. However, toward year-end, as the
weakened substantially in 2001. Early in period of crisis passed, long-term inter-
the year, activity abroad was depressed est rates rebounded strongly.
by high oil prices, the global slump in Overall stock indexes in foreign
the high-tech sector, and spillover from industrial economies declined for the
the U.S. economic slowdown. The Sep- second consecutive year as activity fal-
tember terrorist attacks further height- tered and actual and projected corporate
ened economic uncertainty. On average, earnings fell sharply. Technology-
foreign economic activity was about flat oriented stock indexes again fell more
over the year. The weakest performer than the overall indexes. Among emerg-
among industrial economies was Japan, ing market economies, the performance
where output declined. The euro area of stocks was mixed; stock indexes in
eked out a slight increase in its real several Asian emerging market econo-
GDP. Activity in most emerging market mies rebounded strongly late in the year,
economies in both Asia and Latin a move possibly reflecting market par-
America declined. Asian developing ticipants’ hopes for a revival in global
economies were particularly hard hit by demand for the high technology prod-
the falloff in demand for their high-tech ucts that feature prominently in these
exports. In Latin America, the output countries’ exports. Argentine financial
decline in Mexico largely reflected markets came under increasing pressure
sharply reduced export demand from the
United States; Argentina’s financial
crisis precipitated a further sharp drop Foreign Equity Indexes
in output in that country. An easing of January 1999 = 100
average foreign inflation reflected the
weakness of activity as well as a net Latin America
decline in global oil prices over the 200

course of the year.

In response to the pronounced weak-
ness in economic activity, monetary 150
authorities in the major industrial coun- Europe
tries eased policy throughout the year. 125
Nevertheless, interest rates on long-term
government securities showed little net 100
change from the beginning to the end of Developing Asia
the year in most major industrial coun- Japan
tries. Weak economic conditions tended
to put downward pressure on long-term 1999 2000 2001 2002
rates, but moves toward more stimula-
Note. The data are monthly. The last observations
tive macroeconomic policies appeared are the average of trading days through February 21,
to encourage market participants to 2002.
36 88th Annual Report, 2001

throughout the year because of growing ing U.S. economic performance in the
fears of a debt default and the end of the near term. The dollar’s average foreign
peso’s peg to the dollar. Near year-end, exchange value against the currencies of
Argentine authorities in fact suspended other major industrial countries recorded
debt payments to the private sector and, a net increase of 8 percent over 2001 as
early in 2002, ended the one-to-one peg a whole. The dollar also strengthened,
to the dollar. There was limited negative but by a lesser amount, against the cur-
spillover to other emerging financial rencies of our most important develop-
markets from the sharp deterioration in ing country trading partners. So far this
Argentina’s economic and financial con- year, the dollar’s average value has risen
dition, in contrast to the situation that further on balance.
prevailed during other emerging market
financial crises of recent years.
The dollar’s average foreign ex-
Industrial Economies
change value remained strong through The dollar showed particular strength
most of 2001. The dollar continued to against the Japanese yen last year,
rise despite mounting evidence of weak- appreciating nearly 15 percent. The
ening U.S. economic activity and the weakness of the yen reflected serious
significant easing of monetary policy ongoing structural problems and the
by the FOMC. Market participants may relapse of the Japanese economy back
have felt that the falloff in economic into recession. Early in the year, in
growth in foreign economies and expec- response to signs of renewed weakening
tations that the United States offered of the economy, the Bank of Japan
stronger prospects for economic growth announced that it was easing policy by
in the future outweighed disappoint- shifting its operating target from the
overnight rate—already not far above
Nominal U.S. Dollar Exchange Rate Indexes zero—to balances held by financial
institutions at the Bank of Japan. Policy
January 1999 = 100 was eased further and more liquidity
was injected into the banking system
Major currencies when the balances target was raised
115 three times later in the year. The yen
received a temporary boost when
Junichiro Koizumi, widely seen as more
likely to introduce economic reforms,
became prime minister in April. The yen
105 again strengthened in the immediate
wake of the September terrorist attacks,
prompting the Bank of Japan to make
Broad 100
substantial intervention sales of yen.
However, later in the year, amid signs of
a renewed deterioration of economic
1999 2000 2001 2002
conditions, the yen again started to
Note. The data are monthly. Indexes are trade- weaken significantly.
weighted averages of the exchange value of the dollar For the year as a whole, Japanese real
against major currencies and against the currencies of GDP is estimated to have declined more
a broader group of important U.S. trading partners.
Last observations are the average of trading days than 1 percent, a reversal of the rebound
through February 21, 2002. recorded the previous year. Private
Economic and Financial Developments in 2001 and Early 2002 37

investment declined and private con- pants appeared to revise downward their
sumption moved lower, as households expectation of an early U.S. recovery.
curtailed spending in the face of rising Then, later in the year, with more signs
unemployment and falling real income. of a further weakening of activity in
The winding-down of the large-scale Europe, the euro again declined. On bal-
public works programs of recent years ance, the dollar appreciated more than
more than offset the effect on growth 5 percent relative to the euro over the
from the additional spending contained course of the year. Real GDP in the euro
in several supplemental budgets. Last area is estimated to have increased at
year marked the third consecutive year less than a 1 percent rate in 2001, a
of deflation, with the prices of both con- sharp slowing from the nearly 3 percent
sumer goods and real estate continuing growth rate of the previous year. Fixed
to move lower. investment and inventory investment
The dollar’s movements against the both are estimated to have made nega-
euro in 2001 appear to have been mainly tive contributions to the growth of real
influenced by market perceptions of the GDP, whereas consumption growth
strength of economic activity in the remained near the rate of the previous
United States relative to that in the euro year. The slowing of growth in the euro
area. In the early part of the year, the area was not uniform across countries,
euro weakened as evidence mounted with weakness being more pronounced
that the economic slowdown that was in Germany and less so in France.
already apparent in the United States as The European Central Bank (ECB)
the year began was also taking hold in held off easing monetary policy in the
Europe. During the summer, the euro early months of the year, restrained by
rose against the dollar as market partici- the euro’s weakness, growth of M3 that
remained in excess of the ECB’s refer-
ence value, and a euro-area inflation rate
U.S. Dollar Exchange Rate against the Euro above its 2 percent target ceiling. In
and the Japanese Yen May, evidence of slowing activity
prompted the ECB to reduce its key
January 1999 = 100
policy rate 25 basis points. Three addi-
tional reductions followed later in the
130 year, as activity weakened further and
the inflation rate receded toward its tar-
Euro 120 get ceiling. The total reduction in the
ECB’s key policy rate over the course of
the year was 150 basis points. The
beginning of 2002 saw the introduction
of euro notes and coins, a process that
proceeded smoothly.
Japanese yen
The dollar appreciated 6 percent
against the Canadian dollar in 2001 as
the Canadian economy slowed abruptly.
1999 2000 2001 2002 Real GDP in Canada is estimated to
have been about flat last year after
Note. The data are monthly. Exchange rates are in growing more than 3 percent in 2000. A
foreign currency units per dollar. Last observations
are the average of trading days through February 21, key factor in this slowing was the sharp
2002. drop-off in Canadian exports to the
38 88th Annual Report, 2001

United States. An inventory correction in the year; financial asset prices fell
also depressed output. Earlier in the sharply, and funds moved out of the
year, consumption was buoyed by con- banking system as the government
tinued employment growth, tax cuts, and moved to restructure its debt and the
a housing boom. However, later in the one-to-one peg to the dollar looked
year, growth of consumption faltered as increasingly precarious. In early Decem-
employment prospects worsened and ber, the government imposed capital
asset prices weakened. The Bank of controls, including limits on bank
Canada has moved aggressively to account withdrawals. These restrictions
counter the slowing of economic activ- led to widespread protests, which trig-
ity by lowering its key policy interest gered the resignation of President de la
rate nine times in 2001 and once in Rua and an interval of political turmoil.
January 2002 for a cumulative total of After the resignation of President de la
375 basis points.3 When the Bank of Rua, the government announced it
Canada initiated easing moves early in would suspend debt payments to the pri-
2001, inflation was slightly above the vate sector. The government of the new
Bank’s target range of 1 percent to president, Eduardo Duhalde, suspended
3 percent; but by the end of the year, Argentina’s currency board arrangement
slack activity and falling energy prices and established a temporary dual
had pushed the inflation rate down to exchange rate system. In early February,
near the bottom of the range. the dual exchange rate system was aban-
doned, and the peso’s floating rate
moved to about 2 pesos per dollar amid
Emerging Market Economies continuing economic uncertainty. For
2001 as a whole, Argentine real GDP is
Argentina was a main focus of attention
estimated to have fallen at well over a
among emerging market economies in
5 percent rate, and prices declined
2001. In the first part of the year,
worse-than-expected data on the fiscal
To date, the negative spillover from
situation and concerns that the govern-
events in Argentina to other emerging
ment would be unable to implement
financial markets has been limited, pos-
announced fiscal measures heightened
sibly because market participants had
doubts about whether Argentina would
been well aware of Argentina’s prob-
be able to avoid a default on its debt.
lems for some time and viewed them as
Argentine financial markets received
largely confined to that country. Brazil
only temporary support from a large-
was probably most heavily affected by
scale debt exchange completed in June
events in Argentina, and the bond spread
and an enhancement of IMF support
on Brazilian debt showed a net increase
approved in September. With financial
of about 110 basis points over the course
market confidence eroding, conditions
of last year while the spread on Argen-
took a dramatic turn for the worse late
tina debt exploded upward. Other
important factors weighing on Brazilian
economic activity last year likely were
3. Among these reductions was one on Septem- weak growth in the United States—
ber 17, when the Bank of Canada (along with the Brazil’s most important export market—
ECB) announced a reduction of its policy rate by
50 basis points, following the 50 basis point reduc-
and the emergence of an energy short-
tion in the federal funds rate announced by the age as drought limited hydroelectric
FOMC earlier in the day. output. For the year as a whole, Brazil-
Economic and Financial Developments in 2001 and Early 2002 39

ian real GDP is estimated to have risen had fueled rapid export growth in the
at less than a 1 percent rate after grow- region in recent years.
ing at a 4 percent rate the previous two The economies of Taiwan, Singapore,
years. The Brazilian currency registered and Malaysia are highly dependent on
a net depreciation against the dollar of exports of semiconductors and other
about 16 percent over the course of last high-tech products, and as global
year, while stock prices declined more demand for these goods was cut back
than 10 percent. The Brazilian central sharply, real GDP in these countries
bank tightened policy last year in an declined by an estimated 5 percent on
effort to hold down the inflationary average last year. Indonesia and Thai-
impact of currency depreciation. land, both relatively less dependent on
Real GDP in Mexico declined about high-tech exports and experiencing
1 percent in 2001, a sharp reversal from some reduction in political tension over
the 5 percent growth rates recorded in the course of the year, managed to
the previous two years. The falloff in record small positive real GDP growth
activity was mainly a reflection of the rates last year, albeit well below rates of
negative effects on direct trade and con- the previous year.
fidence in Mexico arising from the slow- Korean real GDP is estimated to have
down of the U.S. economy. In light of increased about 2 percent in 2001.
the marked weakening of activity, While in an absolute sense Korea is an
declining inflation, and a strong peso, important exporter of high-tech prod-
the Bank of Mexico started to loosen the ucts such as semiconductors, it has a
stance of monetary policy in May, and relatively more diversified economy
short-term interest rates continued to than most of its Asian neighbors, and
decline over the rest of the year. In thus the magnitude of its slowdown last
February 2002, the Bank of Mexico year was somewhat muted. Government
moved to tighten monetary conditions, moves toward monetary and fiscal pol-
citing concerns that an increase in icy stimulus over the course of the year
administered prices would raise infla- helped support domestic demand in
tion. Mexican financial markets fared Korea.
quite well last year, with the peso appre- In China, recorded growth of real
ciating 5 percent against the dollar and GDP remained robust last year. China’s
stock prices rising nearly 15 percent. lesser dependency on exports in general,
The effect on Mexican financial markets and high-tech exports in particular,
from Argentina’s difficulties appeared cushioned it from last year’s global
to have been quite limited, as indicated slowdown, and the government stepped
by the net decline of the Mexican debt up the pace of fiscal stimulus to offset
spread by 80 basis points over the weakening private demand. Hong Kong,
course of the year. with exports not heavily concentrated
Economic growth in the Asian emerg- in high-tech goods and an economy
ing market economies turned negative closely integrated with a rapidly grow-
last year. On average, real GDP in ing Chinese economy, is nevertheless
developing Asia is estimated to have estimated to have experienced a decline
declined about 1 percent in 2001, com- in real GDP last year. The peg of Hong
pared with average growth of 6 percent Kong’s currency to a strengthening U.S.
in the previous year. A key factor in this dollar put pressure on its competitive
slowing was the sharp falloff in global position, and domestic price deflation
demand for the high-tech products that continued.
40 88th Annual Report, 2001

Conditions in financial markets in for the region as a whole, exchange rates

emerging Asia were, for the most part, against the dollar generally moved
not particularly volatile last year. Debt lower, and stock indexes declined some-
spreads were little changed on average what on average.

Monetary Policy Reports to the Congress

Report submitted to the Congress on their highs earlier in the year, slumped
February 13, 2001, pursuant to sec- sharply starting in September, slicing
tion 2B of the Federal Reserve Act away a portion of household net worth
and discouraging the initial offering
of new shares by firms. Many busi-
nesses encountered tightening credit
Report of February 13, 2001 conditions, including a widening of risk
spreads on corporate debt issuance and
Monetary Policy and the bank loans. Foreign economic activity
Economic Outlook decelerated noticeably in the latter part
of the year, contributing to a weakening
When the Federal Reserve submitted its of the demand for U.S. exports, which
previous Monetary Policy Report to the also was being restrained by an earlier
Congress, in July of 2000, tentative appreciation in the exchange value of
signs of a moderation in the growth the U.S. dollar.
of economic activity were emerging The dimensions of the economic
following several quarters of extraor- slowdown were obscured for a time by
dinarily rapid expansion. After having the usual lags in the receipt of economic
increased the interest rate on federal data, but the situation began to come
funds through the spring to bring the into sharper focus late in the year as
growth of aggregate demand and poten- the deceleration steepened. Spending on
tial supply into better alignment and business capital, which had been ris-
thus contain inflationary pressures, the ing rapidly for several years, elevating
Federal Reserve had stopped tightening stocks of these assets, flattened abruptly
as evidence of an easing of economic in the fourth quarter. Consumers
growth began to appear. clamped down on their outlays for motor
Indications that the expansion had vehicles and other durables, the stocks
moderated from its earlier rapid pace of which also had climbed to high
gradually accumulated during the sum- levels. As the demand for goods soft-
mer and into the autumn. For a time, this ened, manufacturers adjusted produc-
downshifting of growth seemed likely to tion quickly to counter a buildup
leave the economy expanding at a pace in inventories. Rising concern about
roughly in line with that of its potential. slower growth and worker layoffs con-
Over the last few months of the year, tributed to a sharp deterioration of con-
however, elements of economic restraint sumer confidence. In response to the
emerged from several directions to slow accumulating weakness, the Federal
growth even more. Energy prices, rather Open Market Committee (FOMC) low-
than turning down as had been antici- ered the intended interest rate on federal
pated, kept climbing, raising costs funds 1⁄2 percentage point on January 3
throughout the economy, squeezing of this year. Another rate reduction of
business profits, and eroding the income that same size was implemented at the
available for discretionary expendi- close of the most recent meeting of the
tures. Equity prices, after coming off FOMC at the end of last month.
42 88th Annual Report, 2001

As weak economic data induced ment of low and stable underlying infla-
investors to revise down their expecta- tion suggest that the longer-run outlook
tions of future short-term interest rates for the economy is still quite favorable,
in recent months and as the Federal even though downside risks may remain
Reserve eased policy, financial market prominent in the period immediately
conditions became more accommoda- ahead.
tive. Since the November FOMC meet-
ing, yields on many long-term corporate
bonds have dropped on the order of a
Monetary Policy, Financial
full percentage point, with the largest
Markets, and the Economy
declines taking place on riskier bonds as
over the Second Half of 2000
the yield spreads on those securities nar-
and Early 2001
rowed considerably from their elevated
levels. In response, borrowing in long- As described in the preceding Monetary
term credit markets has strengthened Policy Report to the Congress, the very
appreciably so far in 2001. The less rapid pace of economic growth over
restrictive conditions in financial mar- the first half of 2000 was threatening
kets should help lay the groundwork for to place additional strains on the econo-
a rebound in economic growth. my’s resources, which already appeared
That rebound should also be encour- to be stretched thin. Private long-term
aged by underlying strengths of the interest rates had risen considerably in
economy that still appear to be present response to the strong economy, and, in
despite the sluggishness encountered of an effort to slow the growth of aggregate
late. The most notable of these strengths demand and thereby prevent a buildup
is the remarkable step-up in structural of inflationary pressures, the Federal
productivity growth since the mid- Reserve had tightened its policy settings
1990s, which seems to be closely related substantially through its meeting in
to the spread of new technologies. Even May 2000. Over subsequent weeks, pre-
as the economy slowed in 2000, evi- liminary signs began to emerge suggest-
dence of ongoing efficiency gains were ing that growth in aggregate demand
apparent in the form of another year of might be slowing, and at its June meet-
rapid advance in output per worker hour ing the FOMC left the federal funds rate
in the nonfarm business sector. With unchanged.
households and businesses still in the Further evidence accumulated over
process of putting recent innovations the summer to indicate that demand
in place and with technological break- growth was moderating. The rise in
throughs still occurring, an end to profit- mortgage interest rates over the pre-
able investment opportunities in the vious year seemed to be damping activ-
technology area does not yet seem to ity in the housing sector. Moreover,
be in sight. Should investors continue the growth of consumer spending had
to seek out emerging opportunities, the slowed from the exceptional pace of ear-
ongoing transformation and expansion lier in the year; the impetus to spending
of the capital stock will be maintained, from outsized equity price gains in 1999
thereby laying the groundwork for fur- and early 2000 appeared to be partly
ther gains in productivity and ongoing wearing off, and rising energy prices
advances in real income and spending. were continuing to erode the purchasing
The impressive performance of produc- power of households. By contrast, busi-
tivity and the accompanying environ- ness fixed investment still was increas-
Monetary Policy Reports, February 43

ing very rapidly, and strong growth of meeting. While recognizing that the
foreign economies was fostering greater risks in the outlook were shifting, the
demand for U.S. exports. Weighing this FOMC believed that the tautness of
evidence and recognizing that the effects labor markets and the rise in energy
of previous tightenings had not yet been prices meant that the balance of those
fully felt, the FOMC decided at its risks still was weighted toward height-
meeting in August to hold the federal ened inflation pressures, and this assess-
funds rate unchanged. The Committee ment was noted in the balance-of-risks
remained concerned that demand could statement.
continue to grow faster than potential By the time of the November FOMC
supply at a time when the labor market meeting, conditions in the financial mar-
was already taut, and it saw the balance kets were becoming less accommoda-
of risks still tilted toward heightened tive in some ways, even as the Federal
inflation pressures. Reserve held the federal funds rate
The FOMC faced fairly similar cir- steady. Equity prices had declined
cumstances at its October meeting. By considerably over the previous several
then, it had become more apparent months, resulting in an erosion of
that the growth in demand had fallen household wealth that seemed likely to
to a pace around that of potential sup- restrain consumer spending going for-
ply. Although consumer spending had ward. Those price declines, along with
picked up again for a time, it did not the elevated volatility of equity prices,
regain the vigor it had displayed earlier also hampered the ability of firms to
in the year, and capital spending, while raise funds in equity markets and were
still growing briskly, had decelerated likely discouraging business investment.
from its first-half pace. With increases Some firms faced more restrictive con-
in demand moderating, private employ- ditions in credit markets as well, as risk
ment gains slowed from the rates seen spreads in the corporate bond market
earlier in the year. However, labor mar- widened significantly for firms with
kets remained exceptionally tight, and lower credit ratings and as banks tight-
the hourly compensation of workers had ened the standards and terms on their
accelerated to a point at which unit labor business loans. Meanwhile, incoming
costs were edging up despite strong data indicated that the pace of economic
gains in productivity. In addition, siz- activity had softened a bit further. Still,
able increases in energy prices were the growth of aggregate demand appar-
pushing broad inflation measures above ently had moved only modestly below
the levels of recent years. Although core that of potential supply. Moreover, while
inflation measures were at most only crude oil prices appeared to be topping
creeping up, the Committee felt that out, additional inflationary pressures
there was some risk that the increase in were arising in the energy sector in the
energy prices, which was lasting longer form of surging prices for natural gas,
than had seemed likely earlier in the and there had been no easing of the
year, would start to leave an imprint on tightness in the labor market. In assess-
business costs and longer-run inflation ing the evidence, the members of the
expectations, posing the risk that core Committee felt that the risks to the out-
inflation rates could rise more substan- look were coming into closer balance
tially. Weighing these considerations, but had not yet shifted decisively. At the
the FOMC decided to hold the federal close of the meeting, the FOMC left the
funds rate unchanged at its October funds rate unchanged once again, and it
44 88th Annual Report, 2001

stated that the balance of risks continued that an intermeeting policy action was
to point toward increased inflation. called for.
However, in the statement released after Additional evidence that economic
the meeting, the FOMC noted the possi- activity was slowing significantly
bility of subpar growth in the economy emerged not long after the December
in the period ahead. meeting. New data indicated a marked
Toward the end of the year, the mod- weakening in business investment, and
eration of economic growth gave way, retail sales over the holiday season
fairly abruptly, to more sluggish con- were appreciably lower than businesses
ditions. By the time of the December had expected. To contain the resulting
FOMC meeting, manufacturing activity buildup in inventories, activity in the
had softened considerably, especially in manufacturing sector continued to drop.
motor vehicles and related industries, In addition, forecasts of near-term cor-
and a number of industries had accu- porate profits were being marked down
mulated excessive stocks of inventories. further, resulting in additional declines
Across a broader set of firms, forecasts in equity prices and in business confi-
for corporate sales and profits in the dence. Market interest rates continued to
fourth quarter and in 2001 were being fall, as investors became more pessimis-
slashed, contributing to a continued tic about the economic outlook. Based
decline in equity prices and a further on these developments, the Committee
widening of risk spreads on lower-rated held a telephone conference call on
corporate bonds. In this environment, January 3, 2001, and decided to cut
growth in business fixed investment the intended federal funds rate 1⁄2 per-
appeared to be slowing appreciably. centage point. Equity prices surged on
Consumer spending showed signs of the announcement, and the Treasury
decelerating further, as falling stock yield curve steepened considerably,
prices eroded household wealth and con- apparently because market participants
sumer confidence weakened. Moreover, became more confident that a prolonged
growth in foreign economies seemed to downturn in economic growth would
be slowing, on balance, and U.S. export likely be forestalled. Following the pol-
performance began to deteriorate. Mar- icy easing, the Board of Governors
ket interest rates had declined sharply in approved a decrease in the discount rate
response to these developments. Against of a total of 1⁄2 percentage point.
this backdrop, the FOMC at its Decem- The Committee’s action improved
ber meeting decided that the risks to the financial conditions to a degree. Over
outlook had swung considerably and the next few weeks, equity prices rose,
now were weighted toward economic on net. Investors seemed to become less
weakness, although it decided to wait wary of credit risk, and yield spreads
for additional evidence on the extent narrowed across most corporate bonds
and persistence of the slowdown before even as the issuance of these securities
moving to an easier policy stance. Rec- picked up sharply. But in some other
ognizing that the current position of respects, investors remained cautious, as
the economy was difficult to discern evidenced by widening spreads in com-
because of lags in the data and that mercial paper markets. Incoming data
prospects for the near term were particu- pointed to further weakness in the manu-
larly uncertain, the Committee agreed at facturing sector and a sharp decline in
the meeting that it would be especially consumer confidence. Moreover, slower
attentive over coming weeks to signs U.S. growth appeared to be spilling over
Monetary Policy Reports, February 45

to several important trading partners. In ployment rate in the fourth quarter of

late January, the FOMC cut the intended this year will be about 41⁄2 percent, still
federal funds rate 1⁄2 percentage point quite low by historical standards.
while the Board of Governors approved The rate of economic expansion over
a decrease in the discount rate of an the near term will depend importantly
equal amount. Because of the significant on the speed at which inventory over-
erosion of consumer and business con- hangs that developed over the latter
fidence and the need for additional part of 2000 are worked off. Gains in
adjustments to production to work off information technology have no doubt
elevated inventory levels, the FOMC enabled businesses to respond more
indicated that the risks to the outlook quickly to a softening of sales, which
continued to be weighted toward eco- has steepened the recent production cuts
nomic weakness. but should also damp the buildup in
inventories and facilitate a turnaround.
The motor vehicle industry made some
Economic Projections for 2001 progress toward reducing excess stocks
Although the economy appears likely to in January owing to a combination of
be sluggish over the near term, the mem- stronger sales and a further sharp cut-
bers of the Board of Governors and the back in assemblies. In other parts of
Reserve Bank presidents expect stronger manufacturing, the sizable reductions
conditions to emerge as the year in production late last year suggest that
progresses. For 2001 overall, the central producers in general were moving
tendency of their forecasts of real GDP quickly to get output into better align-
growth is 2 percent to 21⁄2 percent, mea- ment with sales. Nevertheless, stocks at
sured as the change from the fourth year-end were above desired levels in a
quarter of 2000 to the fourth quarter of number of industries.
2001. With growth falling short of its Once inventory imbalances are
potential rate, especially in the first half worked off, production should become
of this year, unemployment is expected more closely linked to the prospects for
to move up a little further. Most of the sales. Household and business expendi-
governors and Reserve Bank presidents tures have decelerated markedly in
are forecasting that the average unem- recent months, and uncertainties about

Economic Projections for 2001


Federal Reserve governors

and Reserve Bank presidents
Indicator 2000 actual
Range tendency

Change, fourth quarter to fourth quarter 1

Nominal GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.9 33⁄4–51⁄4 4–5
Real GDP 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.5 2–23⁄4 2–21⁄2
PCE chain-type price index . . . . . . . . . . . . . . . . . . 2.4 13⁄4–21⁄2 13⁄4–21⁄4
Average level, fourth quarter
Civilian unemployment rate . . . . . . . . . . . . . . . . . 4.0 41⁄2–5 About 41⁄2

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

average for fourth quarter of 2001.
46 88th Annual Report, 2001

how events might unfold are consider- some degree and would leave more
able. But, responding in part to the eas- discretionary income in the hands of
ing of monetary policy, financial mar- households.
kets are shifting away from restraint, How quickly investment spending
and this shift should create a more starts to pick up again will depend not
favorable underpinning to the expected only on the cost of finance but also on
pickup in the economy as the year the prospective rates of return to capital.
progresses. The sharp drop in mortgage This past year, expectations regarding
interest rates since May of last year the prospects of some high-tech compa-
appears to have stemmed the decline nies clearly declined, and capital spend-
in housing activity; it also has enabled ing seems unlikely to soon regain the
many households to refinance existing exceptional strength that was evident
mortgages at lower rates, an action that in the latter part of the 1990s and for
should free up cash for added spending. a portion of last year. From all indica-
Conditions of business finance also have tions, however, technological advance
eased to some degree. Interest rates on still is going forward at a rapid pace,
investment-grade corporate bonds have and investment will likely pick up again
recently fallen to their lowest levels in if, as expected, the expansion of the
about 11⁄2 years. Moreover, the premi- economy gets back on more solid foot-
ums required of bond issuers that are ing. Private analysts are still anticipating
perceived to be at greater risk have high rates of growth in corporate earn-
dropped back in recent weeks from the ings over the long-run, suggesting that
elevated levels of late 2000. As credit the current sluggishness of the economy
conditions have eased, firms have issued has not undermined perceptions of
large amounts of corporate bonds so far favorable long-run fundamentals.
in 2001. However, considerable caution The degree to which increases in
is evident in the commercial paper mar- exports might help to support the U.S.
ket and among banks, whose loan offi- economy through a stretch of sluggish-
cers have reported a further tightening ness has become subject to greater
of lending conditions since last fall. In uncertainty recently because foreign
equity markets, prices have recently economies also seem to have deceler-
dropped in response to negative reports ated toward the end of last year. How-
on corporate earnings, reversing the ever, the expansion of imports has
gains that took place in January. slowed sharply, responding in part to the
The restraint on domestic demand softening of domestic demand growth.
from high energy prices is expected to In effect, some of the slowdown in
ease in coming quarters. Natural gas demand in this country is being shifted
prices have dropped back somewhat in to foreign suppliers, implying that the
recent weeks as the weather has turned adjustments required of domestic pro-
milder, and crude oil prices also are ducers are not as great as they otherwise
down from their peaks. Although these would have been.
prices could run up again in conjunction In adjusting labor input to the slowing
with either a renewed surge in demand of the economy, businesses are facing
or disruptions in supply, participants in conflicting pressures. Speedy adjust-
futures markets are anticipating that ment of production and ongoing gains
prices will be trending gradually lower in efficiency argue for cutbacks in labor
over time. A fall in energy prices would input, but companies are also reluctant
relieve cost pressures on businesses to to lay off workers that have been diffi-
Monetary Policy Reports, February 47

cult to attract and retain in the tight 1999, it showed only a slight step-up in
labor market conditions of the past few the rate of increase after excluding the
years. In the aggregate, the balance that prices of food and energy. Unit labor
has been struck in recent months has costs picked up moderately, adding to
led, on net, to slower growth of employ- the cost pressures from energy, but the
ment, cutbacks in the length of the aver- ability of businesses to raise prices was
age workweek, and, in January of this restrained by the slowing of the econ-
year, a small increase in the unemploy- omy and the persistence of competitive
ment rate. pricing conditions.
Inflation is not expected to be a press-
ing concern over the coming year. Most
of the governors and Reserve Bank
The Household Sector
presidents are forecasting that the rise Personal consumption expenditures
in the chain-type price index for per- increased 41⁄2 percent in real terms in
sonal consumption expenditures will be 2000 after having advanced 5 percent in
smaller than the price rise in 2000. The 1998 and 51⁄2 percent in 1999. A large
central tendency of the range of fore- portion of last year’s gain came in the
casts is 13⁄4 percent to 21⁄4 percent. Infla- first quarter, when consumption moved
tion should be restrained this coming ahead at an unusually rapid pace. The
year by an expected downturn in energy increase in consumer spending over the
prices. In addition, the reduced pressure remainder of the year was moderate,
on resources that is associated with the averaging about 31⁄2 percent at an annual
slowing of the economy should help rate. Consumer outlays for motor vehi-
damp increases in labor costs and prices. cles and parts surged to a record high
early in 2000 but reversed that gain
over the remainder of the year; sales of
Economic and Financial vehicles tailed off especially sharply as
Developments in 2000 the year drew to a close. Real consumer
and Early 2001 purchases of gasoline fell during the
The combination of exceptionally strong year in response to the steep run-up in
growth in the first half of 2000 and gasoline prices. Most other broad cate-
subdued growth in the second half gories of goods and services posted siz-
resulted in a rise in real GDP of about able gains over the year as a whole, but
31⁄2 percent for the year overall. Domes- results late in the year were mixed: Real
tic demand started out the year with outlays for goods other than motor
incredible vigor but decelerated there- vehicles eked out only a small gain in
after and was sluggish by year-end. the fourth quarter, while real outlays for
Exports surged for three quarters and consumer services rose very rapidly, not
then faltered. In the labor market, only because of higher outlays for home
growth of employment slowed over the heating fuels during a spell of colder-
year but was sufficient to keep the than-usual weather but also because of
unemployment rate around the lowest continued strength in real outlays for
sustained level in more than thirty years. other types of services.
Core inflation remained low in 2000 Changes in income and wealth pro-
in the face of sharp increases in energy vided less support to consumption in
prices. Although the chain-type price 2000 than in other recent years. Real
index for personal consumption expen- disposable personal income rose about
ditures (PCE) moved up faster than in 21⁄4 percent last year after a gain of
48 88th Annual Report, 2001

slightly more than 3 percent in 1999. two months ended in January. The
Disposable income did not rise quite as marked shift in attitudes toward year-
much in nominal terms as it had in 1999, end probably was brought on by a com-
and rising prices eroded a larger portion bination of developments, including the
of the nominal gain. Meanwhile, the net weakness in the stock market over the
worth of households turned down in latter part of the year and more frequent
2000 after having climbed rapidly for reports of layoffs.
several years, as the effect of a decline Real outlays for residential invest-
in the stock market was only partially ment declined about 21⁄4 percent, on net,
offset by a sizable increase in the value over the course of 2000, as construction
of residential real estate. With the peak of new housing dropped back from the
in stock prices not coming until the year elevated level of the previous year.
was well under way, and with valuations Investment in housing was influenced
having previously been on a sharp by a sizable swing in mortgage interest
upward course for an extended period, rates as well as by slower growth of
stock market wealth may well have employment and income and the down-
continued to exert a strong positive turn in the stock market. After having
effect on consumer spending for several moved up appreciably in 1999, mort-
months after share values had topped gage rates continued to advance through
out. As time passed, however, the impe- the first few months of 2000. By mid-
tus to consumption from this source May, the average commitment rate on
most likely diminished. The personal conventional fixed-rate mortgages was
saving rate, which had dropped sharply above 81⁄2 percent, up roughly 11⁄2 per-
during the stock market surge of pre- centage points from the level of a year
vious years, fell further in 2000, but the earlier. New construction held up even
rate of decline slowed, on average, after as rates were rising in 1999 and early
the first quarter. 2000, but it softened in the spring of last
Even with real income growth slow- year. Starts and permits for single-
ing and the stock market turning down, family houses declined from the first
consumers maintained a high degree quarter to the third quarter.
of optimism through most of 2000 But even as homebuilding activity
regarding the state of the economy and was turning down, conditions in mort-
the economic outlook. Indexes of senti- gage markets were moving back in a
ment from both the University of Michi- direction more favorable to housing.
gan Survey Research Center and the From the peak in May, mortgage interest
Conference Board rose to new peaks rates fell substantially over the remain-
in the first quarter of the year, and the der of the year and into the early part of
indexes remained close to those levels 2001, reversing the earlier increases.
for several more months. Survey read- Sales of new homes firmed as rates
ings on personal finances, general busi- turned down, and prices of new houses
ness conditions, and the state of the continued to trend up faster than the
labor market remained generally favor- general rate of inflation. Inventories of
able through most of the year. As of unsold new homes held fairly steady
late autumn, only mild softness could over the year and were up only moder-
be detected. Toward year-end, however, ately from the lows of 1997 and 1998.
confidence in the economy dropped With demand well-maintained and
sharply. Both of the indexes of confi- inventories under control, activity stabi-
dence showed huge declines over the lized. Starts and permits for single-
Monetary Policy Reports, February 49

family houses in the fourth quarter of and terms on consumer loans, particu-
2000 were up from the average for the larly non-credit-card loans, over the
third quarter. past several months, perhaps because
Households continued to borrow at a of some uneasiness about how the finan-
brisk pace last year, with household debt cial position of households will hold up
expanding an estimated 83⁄4 percent, as the pace of economic activity slows.
well above the growth rate of dispos-
able personal income. Consumer credit
increased rapidly early in the year,
The Business Sector
boosted by strong outlays on durable Real business fixed investment rose
goods; but as consumer spending cooled 10 percent in 2000 according to the
later in the year, the expansion of con- advance estimate from the Commerce
sumer credit slowed. For the year as a Department. Investment spending shot
whole, consumer credit is estimated to ahead at an annual rate of 21 percent in
have advanced more than 81⁄2 percent, the first quarter of the year; its strength
up from the 7 percent pace of 1999. in that period came, in part, from high-
Households also took on large amounts tech purchases that had been delayed
of mortgage debt, which grew an esti- from 1999 by companies that did not
mated 9 percent last year, reflecting the want their operating systems to be in a
solid pace of home sales. state of change at the onset of the new
With the rapid expansion of house- millennium. Expansion of investment
hold debt in recent years, the household was slower but still relatively brisk in
debt service burden has increased to lev- the second and third quarters, at annual
els not seen since the late 1980s. Even rates of about 15 percent and 8 per-
so, with unemployment low and house- cent respectively. In the fourth quarter,
hold net worth high, the credit quality of however, capital spending downshifted
the household sector appears to have abruptly in response to the slowing
deteriorated little last year. Personal economy, tightening financial condi-
bankruptcy filings held relatively steady tions, and rising concern about the pros-
and remain well below their peak from pects for profits; the current estimate
several years ago. Delinquency rates on shows real investment outlays having
home mortgages, credit cards, and auto fallen at an annual rate of 11⁄2 percent in
loans have edged up in recent quarters that period.
but are at most only slightly above their Fixed investment in equipment and
levels of the fourth quarter of 1999. software was up 91⁄2 percent in 2000,
Lenders did not appear to be signifi- with the bulk of the gain coming in the
cantly concerned about the credit qual- first half of the year. Spending slowed to
ity of the household sector for most of a rate of growth of about 51⁄2 percent in
last year, although some lenders have the third quarter and then declined in the
become more cautious of late. Accord- fourth quarter. Business investment in
ing to surveys of banks conducted by motor vehicles fell roughly 15 percent,
the Federal Reserve, few commercial on net, during 2000, with the largest
banks tightened lending conditions on portion of the drop coming in the fourth
consumer installment loans and mort- quarter; the declines in real outlays on
gage loans to households over the first larger types of trucks were particularly
three quarters of 2000. However, the sizable. Investment in industrial equip-
most recent survey indicates that a ment, tracking the changing conditions
number of banks tightened standards in manufacturing, also fell in the fourth
50 88th Annual Report, 2001

quarter but was up appreciably for the mer suggested that some firms might be
year overall. Investment in high-tech encountering a bit of backup in stocks
equipment decelerated over the year but but that the problems were not severe
was still expanding in the fourth quarter: overall. In the latter part of the year,
Real outlays for telecommunications however, inventory–sales ratios turned
equipment posted exceptionally large up, indicating that more serious over-
gains in the first half of the year, flat- hangs were developing. Responding to
tened out temporarily in the third quar- the slowing of demand and the increases
ter, and expanded again in the fourth. in stocks, manufacturers reduced output
Spending on computers and peripherals in each of the last three months of the
increased, in real terms, at an average year by successively larger amounts.
rate of about 45 percent over the first Businesses also began to clamp down
three quarters of the year but slowed on the flow of imports. Despite those
abruptly to a 6 percent rate of expansion adjustments, stocks in a number of
in the year’s final quarter, the smallest domestic industries were likely well
quarterly advance in several years. above desired levels as the year drew to
Investment in nonresidential struc- a close.
tures rose substantially in 2000, about The Commerce Department’s com-
121⁄2 percent in all, after having declined pilation of business profits currently
13⁄4 percent in 1999. Investment in fac- extends only through the third quarter
tory buildings, which had fallen more of 2000, but these data show an evolv-
than 20 percent in 1999 in an apparent ing pattern much like that of other eco-
reaction to the economic disruptions nomic data. After having risen at an
abroad and the associated softness in annual rate of more than 16 percent in
demand for U.S. exports, more than the first half of the year, U.S. corpora-
recouped that decline over the course of tions’ economic profits—that is, book
2000. Real outlays for office construc- profits with inventory and capital con-
tion, which had edged down in 1999 sumption adjustments—slowed to less
after several years of strong advance, than a 3 percent rate of growth in the
got back on track in 2000, posting a gain third quarter. Profits from operations
of about 131⁄2 percent. Real investment outside the United States continued to
in commercial buildings other than increase rapidly in the third quarter.
offices was little changed after moderate However, economic profits from domes-
gains in the two previous years. Spend- tic operations edged down in that period,
ing on structures used in drilling for as solid gains for financial corporations
energy strengthened in response to the were more than offset by a 4 percent rate
surge in energy prices. of decline in the profits of nonfinancial
Business inventory investment was corporations. Profits of nonfinancial
subdued early in the year when final corporations as a share of their gross
sales were surging; aggregate inventory– nominal output rose about 1⁄2 percent-
sales ratios, which have trended lower in age point in the first half of 2000 but
recent years as companies became more reversed part of that gain in the third
efficient at managing stocks, edged quarter. Earnings reports for the fourth
down further. As sales moderated in quarter indicate that corporate profits
subsequent months, production growth fell sharply in that period.
did not decelerate quite as quickly, and Business debt expanded strongly over
inventories began to rise more rapidly. the first half of 2000, propelled by
Incoming information through the sum- robust capital spending as well as by
Monetary Policy Reports, February 51

share repurchases and cash-financed As concerns about risk mounted,

merger activity. The high level of capital lenders became more cautious about
expenditures outstripped internally gen- extending credit to some borrowers. An
erated funds by a considerable margin increasingly large proportion of banks
despite continued impressive profits. reported firming terms and standards
To meet their borrowing needs, firms on business loans over the course of the
tapped commercial paper, bank loans, year. In the corporate bond market, yield
and corporate bonds in volume in the spreads on high-yield and lower-rated
first quarter. The rapid pace of borrow- investment-grade bonds, measured rela-
ing continued in the second quarter, tive to the ten-year swap rate, began
although borrowers relied more heavily climbing sharply in September and by
on bank loans and commercial paper to year-end were at levels well above those
meet their financing needs in response seen in the fall of 1998. Lower-rated
to a rise in longer-term interest rates. commercial paper issuers also had to
Business borrowing slowed apprecia- pay unusually large premiums late in
bly in the second half of the year. As the year, particularly on paper spanning
economic growth moderated and profits the year-end. As financial conditions
weakened, capital spending decelerated became more stringent, issuance of
sharply. In addition, firms held down high-yield debt was cut back sharply in
their borrowing needs by curbing their the fourth quarter, although investment-
buildup of liquid assets, which had been grade bond issuance remained strong.
accumulating quite rapidly in previous Bank lending to businesses was also
quarters. Borrowing may have been light at that time, and net issuance of
deterred by a tightening of financial con- commercial paper came to a standstill.
ditions for firms with lower credit rat- In total, the debt of nonfinancial busi-
ings, as investors and lenders apparently nesses expanded at an estimated 51⁄2 per-
became more concerned about credit cent rate in the fourth quarter, less than
risk. Those concerns likely were exacer- half the pace of the first half of the year.
bated by indications that credit quality The slowdown in borrowing in the latter
had deteriorated at some businesses. The part of the year damped the growth of
default rate on high-yield bonds contin- nonfinancial business debt over 2000,
ued to climb last year, reaching its high- although it still expanded an estimated
est level since 1991. Some broader mea- 83⁄4 percent.
sures of credit quality also slipped. The In early 2001, borrowing appears to
amount of nonfinancial debt down- have picked up from its sluggish fourth-
graded by Moody’s Investor Services quarter pace. Following the easing of
in 2000 was more than twice as large monetary policy in early January, yield
as the amount upgraded, and the delin- spreads on corporate bonds reversed a
quency rate on business loans at com- considerable portion of their rise over
mercial banks continued to rise over the the latter part of 2000, with spreads on
year. But while some firms were clearly high-yield bonds narrowing more than a
having financial difficulties, many other percentage point. As yields declined,
firms remained soundly positioned to corporate bond issuance picked up, and
service their debt. Indeed, the ratio of even some below-investment grade
net interest payments to cash flow for all issues were brought to the market. In
nonfinancial firms moved only mod- contrast, investors in the commercial
estly above the relatively low levels of paper market apparently became more
recent years. concerned about credit risk, partly in
52 88th Annual Report, 2001

response to the defaults of two Cali- mildly positive over the past couple of
fornia utilities on some bonds and com- years. The consumption and investment
mercial paper in mid-January related expenditures of state and local govern-
to the difficulties in the electricity mar- ments rose about 21⁄2 percent in 2000
ket in that state. After those defaults, after an unusually large increase of
spreads between top-tier and second-tier 41⁄4 percent in 1999. The slowdown in
commercial paper widened further, and spending was mainly a reflection of a
investors became more discriminating downshift in government investment in
even within the top rating tier. Some structures, which can be volatile from
businesses facing resistance in the com- year to year and had posted a large gain
mercial paper market reportedly met in 1999.
their financing needs by tapping backup Total federal spending, as reported in
credit lines at banks. the unified budget, rose 5 percent in
Growth in commercial mortgage fiscal year 2000, the largest increase
debt slowed last year to an estimated in several years. A portion of the rise
rate of 91⁄4 percent, and issuance of stemmed from shifts in the timing of
commercial-mortgage-backed securities some outlays in a way that tended to
in 2000 fell back from its 1999 pace. boost the tally for fiscal 2000. But even
Spreads on lower-rated commercial- allowing for those shifts, the rise in
mortgage-backed securities over swap spending would have exceeded the
rates widened by a small amount late in increases of other recent years. Outlays
the year, and banks on net reported tight- accelerated for most major functions,
ening their standards on commercial real including defense, health, social secu-
estate credit over the year. Nevertheless, rity, and income security. Of these,
fundamentals in the commercial real spending on health—about three-
estate market remain solid, and delin- fourths of which consists of outlays
quency rates on commercial mortgages for Medicaid—recorded the biggest
stayed around their historic lows. increase. Medicaid grants to the states
were affected last fiscal year by
increased funding for the child health
The Government Sector insurance initiative that was passed in
Real consumption and investment ex- 1997 and by a rise in the portion of
penditures of federal, state, and local Medicaid expenses picked up by the fed-
governments, the part of government eral government. Spending on agricul-
spending that is included in GDP, rose ture rose very sharply for a third year
only 11⁄4 percent in the aggregate during but not as rapidly as in fiscal 1999. The
2000. The increase was small partly ongoing paydown of debt by the federal
because the consumption and invest- government led to a decline of nearly
ment expenditures of the federal gov- 3 percent in net interest payments in
ernment had closed out 1999 with a fiscal 2000 after a somewhat larger drop
large increase in advance of the century in these payments in fiscal 1999.
date change. Federal purchases in the Federal receipts increased 103⁄4 per-
fourth quarter of 2000 were about 1 per- cent in fiscal year 2000, the largest
cent below the elevated level at year- advance in more than a decade. The
end 1999. Abstracting from the bumps increase in receipts from taxes on the
in the spending data, the underlying income of individuals amounted to more
trend in real federal consumption and than 14 percent. In most recent years,
investment outlays appears to have been these receipts have grown much faster
Monetary Policy Reports, February 53

than nominal personal income as mea- its debt last year at an even faster pace
sured in the national income and prod- than in recent years. As of the end of
uct accounts. One important factor in fiscal 2000, the stock of marketable
the difference is that rising levels of Treasury debt outstanding had fallen
income and a changing distribution have about $500 billion from its peak in 1997.
shifted more taxpayers into higher tax The existing fiscal situation and the
brackets; another is an increase in reve- anticipation that budget surpluses would
nues from taxes on capital gains and continue led the Treasury to implement
other items that are not included in per- a number of debt management changes
sonal income. Receipts from the taxa- during 2000, many designed to preserve
tion of corporate profits also moved up the liquidity of its securities. In particu-
sharply in fiscal 2000, rebounding from lar, the Treasury sought to maintain
a small decline the previous fiscal year. large and regular offerings of new secu-
With federal receipts rising much faster rities at some key maturities, because
than spending, the surplus in the unified such attributes are thought to impor-
budget rose to $236 billion in fiscal tantly contribute to market liquidity.
2000, nearly double that of fiscal 1999. In part to make room for continued
The on-budget surplus, which excludes sizable auctions of new securities, the
surpluses accumulating in the social Treasury initiated a debt buyback pro-
security trust fund, rose from essentially gram through which it can purchase
zero in fiscal 1999 to $86 billion in debt that it previously issued. In total,
fiscal 2000. Excluding net interest pay- the Treasury conducted twenty buyback
ments, a charge resulting from past defi- operations in 2000, repurchasing a total
cits, the surplus in fiscal 2000 was about of $30 billion par value of securities
$460 billion. with maturities ranging from twelve to
Federal saving, which is basically twenty-seven years. Those operations
the federal budget surplus adjusted to were generally well received and caused
conform to the accounting practices fol- little disruption to the market. Going
lowed in the national income and prod- forward, the Treasury intends to conduct
uct accounts, amounted to about 31⁄2 per- two buyback operations per month and
cent of nominal GDP over the first three expects to repurchase about $9 billion
quarters of 2000. This figure has been par value of outstanding securities in
rising roughly 1 percentage point a year each of the first two quarters of 2001.
over the past several years. Mainly Despite conducting buybacks on that
because of that rise in federal saving, scale, the Treasury had to cut back con-
the national saving rate has been run- siderably its issuance of new securities.
ning at a higher level in recent years To still achieve large sizes of individual
than was observed through most of the issues at some maturities, the Treasury
1980s and the first half of the 1990s, implemented a schedule of regular
even as the personal saving rate has reopenings—in which it auctions addi-
plunged. The rise in federal saving has tional amounts of a previously issued
kept interest rates lower than they other- security instead of issuing a new one—
wise would have been and has contrib- for its five-, ten-, and thirty-year instru-
uted, in turn, to the rapid growth of ments. Under that schedule, every other
capital investment and the faster growth auction of each of those securities is a
of the economy’s productive potential. smaller reopening of the previously auc-
The burgeoning federal budget sur- tioned security. At other maturities, the
plus allowed the Treasury to pay down Treasury reduced the sizes of its two-
54 88th Annual Report, 2001

year notes and inflation-indexed securi- pal market improved considerably last
ties and eliminated the April auction year, with credit upgrades outnumbering
of the thirty-year inflation-indexed downgrades by a substantial margin.
bond. In addition, the Treasury recently The only notable exception was in the
announced that it would stop issuing not-for-profit health care sector, where
one-year bills following the February downgrades predominated.
auction, after having cut back the fre-
quency of new offerings of that security
last year. The External Sector
These reductions in the issuance of Trade and Current Account
Treasury securities have caused the
Federal Reserve to modify some of The current account deficit reached
its procedures for obtaining securities at $452 billion (annual rate) in the third
Treasury auctions, as described in detail quarter of 2000, or 4.5 percent of GDP,
below. In addition, the Treasury made compared with $331 billion and 3.6 per-
changes in the rules for auction par- cent for 1999. Most of the expansion
ticipation by foreign and international in the current account deficit occurred
monetary authority (FIMA) accounts, in the balance of trade in goods and
which primarily include foreign central services. The deficit on trade in goods
banks and governmental monetary enti- and services widened to $383 billion
ties. The new rules, which went into (annual rate) in the third quarter from
effect on February 1, 2001, impose lim- $347 billion in the first half of the year.
its on the size of non-competitive bids Data for trade in October and Novem-
from individual FIMA accounts and on ber suggest that the deficit may have
the total amount of such bids that will increased further in the fourth quarter.
be awarded at each auction. These lim- Net payments on investments were a bit
its will leave a larger pool of securities less during the first three quarters of
available for competitive bidding at the 2000 than in the second half of 1999
auctions, helping to maintain the liquid- owing to a sizable increase in income
ity and efficiency of the market. More- receipts from direct investment abroad.
over, FIMA purchases will be subtracted U.S. exports of goods and services
from the total amount of securities rose an estimated 7 percent in real terms
offered, rather than being added on as during 2000. Exports surged during the
they were in some previous instances, first three quarters, supported by a
making the amount of funds raised at pickup in economic activity abroad that
the auction more predictable. began in 1999. By market destination,
State and local government debt U.S. exports were strongest to Mexico
increased little in 2000. Gross issuance and countries in Asia. About 45 percent
of long-term municipal bonds was well of U.S. goods exports were capital
below the robust pace of the past two equipment, 20 percent were industrial
years. Refunding offerings were held supplies, and roughly 10 percent each
down by higher interest rates through were agricultural, automotive, con-
much of the year, and the need to raise sumer, and other goods. Based on data
new capital was diminished by strong for October and November, real exports
tax revenues. Net issuance was also are estimated to have declined in the
damped by an increase in the retire- fourth quarter, reflecting in part a slow-
ment of bonds from previous refunding ing of economic growth abroad. This
activity. Credit quality in the munici- decrease was particularly evident in
Monetary Policy Reports, February 55

exports of capital goods, automotive Financial Account

products, consumer goods, and agricul-
tural products. The counterpart to the increased U.S.
The quantity of imported goods and current account deficit in 2000 was
services expanded rapidly during the an increase in net capital inflows. As
first three quarters of 2000, reflecting in 1999, U.S. capital flows in 2000
the continuing strength of U.S. domestic reflected the relatively strong cyclical
demand and the effects of past dollar position of the U.S. economy for most of
appreciation on price competitiveness. the year and the global wave of corpo-
Increases were widespread among trade rate mergers. Foreign private purchases
categories. Based on data for October of U.S. securities were exceptionally
and November, real imports of goods robust—well in excess of the record set
and services are estimated to have risen in 1999. The composition of U.S. securi-
only slightly in the fourth quarter. Mod- ties purchased by foreigners continued
erate increases in imported consumer the shift away from Treasuries as the
and capital goods were partly offset by U.S. budget surplus, and the attendant
declines in other categories of imports, decline in the supply of Treasuries, low-
particularly industrial supplies and auto- ered their yield relative to other debt.
motive products, for which domestic Last year private foreigners sold, on net,
demand had softened. The price of about $50 billion in Treasury securities,
non-oil imports is estimated to have compared with net sales of $20 billion
increased by less than 1 percent during in 1999. Although sizable, these sales
2000. were slightly less than what would have
The price of imported oil rose nearly occurred had foreigners reduced their
$7 per barrel over the four quarters of holdings in proportion to the reduction
2000. During the year, oil prices gener- in Treasuries outstanding. The increased
ally remained high and volatile, with the sale of Treasuries was fully offset by
spot price of West Texas intermediate larger foreign purchases of U.S. securi-
(WTI) crude fluctuating between a low ties issued by government-sponsored
of $24 per barrel in April and a high agencies. Net purchases of agency secu-
above $37 per barrel in September. rities topped $110 billion, compared
Strong demand—driven by robust world with the previous record of $72 billion
economic growth—kept upward pres- set in 1999. In contrast to the shrink-
sure on oil prices even as world supply ing supply of Treasury securities, U.S.
increased considerably. Over the course government-sponsored agencies accel-
of 2000, OPEC raised its official pro- erated the pace of their debt issuance.
duction targets by 3.7 million barrels per Private foreign purchases of U.S. corpo-
day, reversing the production cuts made rate debt grew to $180 billion, while net
in the previous two years. Oil produc- purchases of U.S. equities ballooned to
tion from non-OPEC sources rebounded $170 billion compared with $108 billion
as well. During the last several weeks of in 1999.
2000, oil prices fell sharply as market The pace of foreign direct investment
participants became convinced that the inflows in the first three quarters of 2000
U.S. economy was slowing. In early also accelerated from the record pace
2001, however, oil prices moved back of 1999. As in the previous two years,
up when OPEC announced a planned direct investment inflows were driven
production cut of 1.5 million barrels per by foreign acquisition of U.S. firms,
day. reflecting the global strength in merger
56 88th Annual Report, 2001

and acquisition activity. Of the roughly confidence until late summer. Over the
$200 billion in direct investment remainder of the year monthly increases
inflows in the first three quarters, about in private employment stepped down
$100 billion was directly attributable to further. Job growth came almost to a
merger activity. Many of these mergers stop in December, when severe weather
were financed, at least in part, by an added to the restraint from a slow-
exchange of equity, in which shares in ing economy. In January of this year,
the U.S. firm were swapped for equity employment picked up, but the return of
in the acquiring firm. Although U.S. milder weather apparently accounted for
residents generally appear to have sold a a sizable portion of the gain.
portion of the equity acquired through Employment rose moderately in the
these swaps, the swaps likely contrib- private service-producing sector of the
uted significantly to the $97 billion capi- economy in 2000, about 2 percent over-
tal outflow attributed to U.S. acquisition all after an increase of about 3 percent
of foreign securities. U.S. direct invest- in 1999. In the fourth quarter, however,
ment abroad was also boosted by merger hiring in the services-producing sec-
activity and totaled $117 billion in the tor was relatively slow, in large part
first three quarters of 2000, a slightly because of a sizable decline in the num-
faster pace than that of 1999. ber of jobs in personnel supply—a
Capital inflows from foreign official category that includes temporary help
sources totaled $38 billion in 2000—a agencies. Employment in construction
slight increase from 1999. Nearly all increased about 21⁄2 percent in 2000
of the official inflows were attributable after several years of gains that were
to reinvested interest earnings. Modest considerably larger. The number of jobs
official sales of dollar assets associated in manufacturing was down for a third
with foreign exchange intervention were year, owing to reductions in factory
offset by larger inflows from some non- employment in the second half of the
OPEC oil exporting countries, which year, when manufacturers were adjust-
benefited from the elevated price of oil. ing to the slowing of demand. Those
adjustments in manufacturing may also
have involved some cutbacks in the
The Labor Market employment of temporary hires, which
Nonfarm payroll employment increased would help to account for the sharp job
about 11⁄2 percent in 2000, measured on losses in personnel supply. The average
a December-to-December basis. The job length of the workweek in manufactur-
count had risen slightly more than 2 per- ing was scaled back as well over the
cent in 1999 and roughly 21⁄2 percent a second half of the year.
year over the 1996–98 period. Over the The slowing of the economy did not
first few months of 2000, the expansion lead to any meaningful easing in the
of jobs proceeded at a faster pace than in tightness of the labor market in 2000.
1999, boosted both by the federal gov- The household survey’s measure of the
ernment’s hiring for the decennial Cen- number of persons employed rose 1 per-
sus and by a somewhat faster rate of job cent, about in line with the expansion of
creation in the private sector. Indications labor supply. On net, the unemployment
of a moderation in private hiring started rate changed little; its fourth-quarter
to emerge toward mid-year, but because average of 4.0 percent was down just
of volatility of the incoming data a slow- a tenth of a percentage point from the
down could not be identified with some average unemployment rate in the fourth
Monetary Policy Reports, February 57

quarter of 1999. The flatness of the rate picks up some forms of employee com-
through the latter half of 2000, when the pensation that the ECI omits but that
economy was slowing, may have partly also is more subject to eventual revision
reflected a desire of companies to hold than the ECI, showed hourly compensa-
on to labor resources that had been diffi- tion advancing 53⁄4 percent this past
cult to attract and retain in the tight year, up from a 1999 increase of about
labor market of recent years. January of 41⁄2 percent. Tightness of the labor mar-
this year brought a small increase in the ket was likely one factor underlying
rate, to 4.2 percent. the acceleration of hourly compensation
Productivity continued to rise rapidly in 2000, with employers relying both
in 2000. Output per hour in the nonfarm on larger wage increases and more
business sector was up about 31⁄2 per- attractive benefit packages to attract
cent over the year as a whole. Sizable and retain workers. Compensation gains
gains in efficiency continued to be evi- may also have been influenced to some
dent even as the economy was slowing degree by the pickup of consumer price
in the second half of the year. Except for inflation since 1998. Rapid increases in
1999, when output per hour rose about the cost of health insurance contributed
33⁄4 percent, the past year’s increase was importantly to a sharp step-up in benefit
the largest since 1992, a year in which costs.
the economy was in cyclical recovery Unit labor costs, the ratio of hourly
from the 1990–91 recession. Cutting compensation to output per hour,
through the year-to-year variations in increased about 21⁄4 percent in the non-
measured productivity, the underlying farm business sector in 2000 after hav-
trend still appears to have traced out a ing risen slightly more than 1⁄2 percent
pattern of strong acceleration since the in 1999. Roughly three-fourths of the
middle part of the 1990s. Support for acceleration was attributable to the
a step-up in the trend has come from faster rate of increase in compensation
increases in the amount of capital per per hour noted above. The remainder
worker—especially high-tech capital— stemmed from the small deceleration
and from organizational efficiencies that of measured productivity. The labor cost
have resulted in output rising faster rise for the latest year was toward the
than the combined inputs of labor and high end of the range of the small to
capital. moderate increases that have prevailed
Alternative measures of the hourly over the past decade.
compensation of workers, while differ-
ing in their coverage and methods of
construction, were consistent in show-
ing some acceleration this past year. The Led by the surge in energy prices, the
employment cost index for private aggregate price indexes showed some
industry (ECI), which attempts to mea- acceleration in 2000. The chain-type
sure changes in the labor costs of non- price index for real GDP, the broadest
farm businesses in a way that is free measure of goods and services produced
from the effects of employment shifts domestically, rose 21⁄4 percent in 2000,
among occupations and industries, rose roughly 3⁄4 percentage point more than
nearly 41⁄2 percent during 2000 after in 1999. The price index for gross
having increased about 31⁄2 percent in domestic purchases, the broadest mea-
1999. Compensation per hour in the sure of prices for goods and services
nonfarm business sector, a measure that purchased by domestic buyers, posted a
58 88th Annual Report, 2001

rise of almost 21⁄2 percent in 2000 after demand for heating that resulted from
having increased slightly less than 2 per- unusually cold weather in November
cent the previous year. Prices paid by and December. Electricity costs jumped
consumers, as measured by the chain- for some users, and prices nationally
type price index for personal consump- rose faster than in other recent years,
tion expenditures, picked up as well, about 21⁄4 percent at the consumer level.
about as much as the gross purchases Businesses had to cope with rising
index. The consumer price index (CPI) costs of energy in production, trans-
continued to move up at a faster pace portation, and temperature control. In
than the PCE index this past year, and it some industries that depend particu-
exhibited slightly more acceleration—an larly heavily on energy inputs, the rise
increase of nearly 31⁄2 percent in 2000 in costs had a large effect on product
was 3⁄4 percentage point larger than the prices. Producer prices of goods such
1999 rise. Price indexes for fixed invest- as industrial chemicals posted increases
ment and government purchases also that were well above the average rates
accelerated this past year. of inflation last year, and rising prices
The prices of energy products pur- for natural gas sparked especially steep
chased directly by consumers increased price advances for nitrogen fertilizers
about 15 percent in 2000, a few per- used in farming. Prices of some services
centage points more than in 1999. In also exhibited apparent energy impacts:
response to the rise in world oil prices, Producers paid sharply higher prices for
consumer prices of motor fuels rose transportation services via air and water,
nearly 20 percent in 2000, bringing the and consumer airfares moved up rapidly
cumulative price hike for those products for a second year, although not nearly
over the past two years to roughly as much as in 1999. Late in 2000 and
45 percent. Prices also rose rapidly for early this year, high prices for energy
home heating oil. Natural gas prices inputs prompted shutdowns in produc-
increased 30 percent, as demand for that tion at some companies, including those
fuel outpaced the growth of supply, pull- producing fertilizers and aluminum.
ing stocks down to low levels. Prices of Despite the spillover of energy effects
natural gas this winter have been excep- into other markets, inflation outside the
tionally high because of the added energy sector remained moderate over-
all. The ongoing rise in labor productiv-
ity helped to contain the step-up in labor
Alternative Measures of Price Change costs, and the slow rate of rise in the
Percent prices of non-oil imports meant that
Price measure 1999 2000
domestic businesses had to remain cau-
tious about raising their prices because
Chain-type of the potential loss of market share.
Gross domestic product . . . . . . . . 1.6 2.3 Rapid expansion of capacity in manu-
Gross domestic purchases . . . . . . 1.9 2.4
Personal consumption facturing prevented bottlenecks from
expenditures . . . . . . . . . . . . . . 2.0 2.4 developing in the goods-producing
Excluding food and energy . . . 1.5 1.7
sector of the economy when domestic
Consumer price index . . . . . . . . . . 2.6 3.4 demand was surging early in the year;
Excluding food and energy . . . 2.1 2.6 later on, an easing of capacity utilization
was accompanied by a softening of
Note. Changes are based on quarterly averages and
are measured to the fourth quarter of the year indicated prices in a number of industries. Infla-
from the fourth quarter of the preceding year. tion expectations, which at times in the
Monetary Policy Reports, February 59

past have added to the momentum of years, several of which had brought
rising inflation, remained fairly quies- small declines in investment prices.
cent in 2000. Although the price index for investment
Against this backdrop, core inflation in residential structures slowed a little,
remained low in 2000. Producer prices to about a 31⁄2 percent rise, the index for
of intermediate materials excluding food nonresidential structures sped up from a
and energy, after having accelerated 23⁄4 percent increase in 1999 to one of
through the first few months of 2000, 41⁄2 percent in 2000. Moreover, the price
slowed thereafter, and their four-quarter index for equipment and software ticked
rise of 13⁄4 percent was only a bit larger up slightly, after having declined 2 per-
than the increase during 1999. Prices cent or more in each of the four pre-
of crude materials excluding food and ceding years. To a large extent, that
energy fell moderately this past year turnabout was a reflection of a smaller
after having risen about 10 percent a rate of price decline for computers; they
year earlier. At the consumer level, the had dropped at an average rate of more
CPI excluding food and energy moved than 20 percent through the second
up 21⁄2 percent in 2000, an acceleration half of the 1990s but fell at roughly half
of slightly less than 1⁄2 percentage point that rate in 2000. Excluding computers,
from 1999 when put on a basis that equipment prices increased slightly in
maintains consistency of measurement. 2000 after having declined a touch in
The rise in the chain-type price index 1999.
for personal consumption expenditures
excluding food and energy was 13⁄4 per-
cent, just a bit above the increases
U.S. Financial Markets
recorded in each of the two previous Financial markets in 2000 were influ-
years. enced by the changing outlook for the
Consumer food prices rose 21⁄2 per- U.S. economy and monetary policy and
cent in 2000 after an increase of about by shifts in investors’ perceptions of and
2 percent in 1999. In large part, the attitudes toward risk. Private longer-
moderate step-up in these prices prob- term interest rates generally firmed in
ably reflected cost and price consid- the early part of the year as growth
erations similar to those at work else- remained unsustainably strong and as
where in the economy. Also, farm market participants anticipated a further
commodity prices moved up, on net, tightening of monetary policy by the
during 2000, after three years of sharp Federal Reserve. Later in the year, as it
declines, and this turnabout likely became apparent that the pace of eco-
showed through to the retail level to nomic growth was slowing, market par-
some extent. Meat prices, which are ticipants began to incorporate expecta-
linked more closely to farm prices than tions of significant policy easing into
is the case with many other foods, asset prices, and most longer-term inter-
recorded increases that were apprecia- est rates fell sharply over the last several
bly larger than the increases for food months of 2000 and into 2001. Over the
prices overall. course of the year, investors became
The chain-type price index for private more concerned about credit risk and
fixed investment rose about 13⁄4 per- demanded larger yield spreads to hold
cent in 2000, but that small increase lower-rated corporate bonds, especially
amounted to a fairly sharp acceleration once the growth of the economy slowed
from the pace of the preceding few in the second half. Banks, apparently
60 88th Annual Report, 2001

having similar concerns, reported wid- eurodollar futures, which can be used as
ening credit spreads on business loans a rough gauge of policy expectations,
and tightening standards for lending were indicating that market participants
to businesses. Weakening economic expected additional policy tightening
growth and tighter financial conditions going forward.
in some sectors led to a slowing in the Signs of a slowdown in the growth
pace of debt growth over the course of of aggregate demand began to appear
the year. in the incoming data soon after the
Stock markets had another volatile May FOMC meeting and continued to
year in 2000. After touching record gradually accumulate over subsequent
highs in March, stock prices turned months. In response, market participants
lower, declining considerably over the became increasingly convinced that
last four months of the year. Valuations the FOMC would not have to tighten
in some sectors fell precipitously from its policy stance further, which was
high levels, and near-term earnings fore- reflected in a flattening of the term
casts were revised down sharply late in structure of rates on federal funds and
the year. On balance, the broadest stock eurodollar futures. Interest rates on most
indexes fell more than 10 percent last corporate bonds declined gradually on
year, and the tech-heavy Nasdaq was the shifting outlook for the economy,
down nearly 40 percent. and by the end of August had fallen
more than 1⁄2 percentage point from their
peaks in May.
Interest Rates
Most market interest rates continued
The economy continued to expand at an to edge lower into the fall, as the growth
exceptionally strong and unsustainable of the economy seemed to moderate
pace in the early part of 2000, prompt- further. Over the last couple months of
ing the Federal Reserve to tighten its 2000 and into early 2001, as it became
policy stance in several steps ending at apparent that economic growth was
its May meeting. Private interest rates slowing more abruptly, market partici-
and shorter-term Treasury yields rose pants sharply revised down their expec-
considerably over that period, reaching tations for future short-term interest
a peak just after the May FOMC meet- rates. Treasury yields plummeted over
ing. Investors apparently became more that period, particularly at shorter matu-
concerned about credit risk as well; rities: The two-year Treasury yield
spreads between rates on lower-rated dropped more than a full percentage
corporate bonds and swaps widened in point from mid-November to early Janu-
the spring, adding to the upward pres- ary, moving below the thirty-year yield
sure on private interest rates. Long-term for the first time since early 2000.
Treasury yields, in contrast, remained Yields on inflation-indexed securities
below their levels from earlier in the also fell considerably, but by less than
year, as market participants became their nominal counterparts, suggesting
increasingly convinced that the supply that the weakening of economic growth
of those securities would shrink consid- lowered expectations of both real inter-
erably in coming years and incorporated est rates and inflation.
a ‘‘scarcity premium’’ into their prices. Although market participants had
By mid-May, with the rapid expansion come to expect considerable policy eas-
of economic activity showing few signs ing over the first part of this year, the
of letting up, rates on federal funds and timing and magnitude of the intermeet-
Monetary Policy Reports, February 61

ing cut in the federal funds rate in early Overall, yields on most investment-
January was a surprise. In response, grade corporate bonds have reached
investors built into asset prices anticipa- their lowest levels since the first half of
tions of a more rapid policy easing over 1999, while rates on most high-yield
the near-term. Indeed, the further sub- bonds have fallen about 2 percentage
stantial reduction in the federal funds points from their peaks and have
rate implemented at the FOMC meeting reached levels similar to those of mid-
later that month was largely expected 2000.
and elicited little response in financial Although investors at times in recent
markets. Even with a full percentage months appeared more concerned about
point reduction in the federal funds rate credit risk than they were in the fall of
in place, futures rates have recently 1998, the recent financial environment,
pointed to expectations of additional by most accounts, did not resemble
policy easing over coming months. the market turbulence and disruption of
Investors appear to be uncertain about that time. The Treasury and investment-
this outlook, however, judging from the grade corporate bond markets remained
recent rise in the implied volatilities of relatively liquid, and the investment-
interest rates derived from option prices. grade market easily absorbed the high
On balance since the beginning of 2000, volume of bond issuance over 2000.
the progressive easing in the economic Investors continued to show a height-
outlook, in combination with the effects ened preference for larger, more liquid
of actual and prospective reductions in corporate issues, but they did not exhibit
the supply of Treasury securities, has the extreme desire for liquidity that was
resulted in a sizable downward shift in apparent in the fall of 1998. For exam-
the Treasury yield curve. ple, the liquidity premium for the on-
The prospect of a weakening in eco- the-run ten-year Treasury note this year
nomic growth, along with sizable remained well below the level of that
declines in equity prices and downward fall.
revisions to profit forecasts, apparently Nonetheless, the Treasury market has
caused investors to reassess credit risks become somewhat less liquid than it was
in the latter part of last year. Spreads several years ago. Moreover, in 2000,
between rates on high-yield corporate particular segments of the Treasury mar-
bonds and swaps soared beginning in ket occasionally experienced bouts of
September, pushing the yields on those unusually low liquidity that appeared
bonds substantially higher. Concerns related to actual or potential reductions
about credit risk also spilled over into in the supply of individual securities.
the investment-grade sector, where yield Given the possibility that liquidity could
spreads widened considerably for lower- deteriorate further as the Treasury
rated securities. For most investment- continues to pay down its debt, market
grade issuers, though, the effects of the participants reportedly increased their
revised policy outlook more than offset reliance on alternative instruments—
any widening in risk spreads, resulting including interest rate swaps and
in a decline in private interest rates in debt securities issued by government-
the fourth quarter. Since the first policy sponsored housing agencies and other
easing in early January, yield spreads on corporations—for some of the hedging
corporate bonds have narrowed consid- and pricing functions historically pro-
erably, including a particularly large vided by Treasury securities. Fannie
drop in the spread on high-yield bonds. Mae and Freddie Mac continued to issue
62 88th Annual Report, 2001

large amounts of debt under their ognizing this possibility, last year the
Benchmark and Reference debt pro- FOMC initiated a study to consider
grams, which are designed to mimic alternative approaches to managing the
characteristics of Treasury securities— Federal Reserve’s portfolio, including
such as large issue sizes and a regular expanding the use of the discount
calendar of issuance—that are believed window and broadening the types of
to contribute to their liquidity. By the assets acquired in the open market. As it
end of 2000, the two firms together had continues to study various alternatives,
more than $300 billion of notes and the FOMC will take into considera-
bonds and more than $200 billion of tion the effect that such approaches
bills outstanding under those programs. might have on the liquidity and safety of
Trading volume and dealer positions its portfolio and the potential for distort-
in agency securities have risen consid- ing the allocation of credit to private
erably since 1998, and the market for entities.
repurchase agreements in those securi- Meanwhile, some measures have
ties has reportedly become more active. been taken to prevent the System’s hold-
Also, several exchanges listed options ings of individual Treasury securities
and futures on agency debt securities. from reaching possibly disruptive levels
Open interest on some of those futures and to help curtail any further lengthen-
contracts has picked up significantly, ing of the average maturity of the Sys-
although it remains small compared to tem’s holdings. On July 5, 2000, the
that on futures contracts on Treasury Federal Reserve Bank of New York
securities. announced guidelines limiting the Sys-
The shrinking supply of Treasury tem’s holdings of individual Treasury
securities and the possibility of a con- securities to specified percentages of
sequent decline in market liquidity also their outstanding amounts, depending
pose challenges for the Federal Reserve. on the remaining maturity of the issue.
For many years, Treasury securities Those limits range from 35 percent for
have provided the Federal Reserve with Treasury bills to 15 percent for longer-
an effective asset for System portfolio term bonds. As a result, the System
holdings and the conduct of monetary has redeemed some of its holdings of
policy. The remarkable liquidity of Treasury securities on occasions when
Treasury securities has allowed the Sys- the amount of maturing holdings has
tem to conduct sizable policy operations exceeded the amount that could be
quickly and with little disruption to mar- rolled over into newly issued Treasury
kets, while the safety of Treasury securi- securities under these limits. Redemp-
ties has allowed the System to avoid tions of Treasury holdings in 2000
credit risk in its portfolio. However, exceeded $28 billion, with more than
if Treasury debt continues to be paid $24 billion of the redemptions in
down, at some point the amount out- Treasury bills. In addition, the Federal
standing will be insufficient to meet Reserve accommodated a portion of
the Federal Reserve’s portfolio needs. the demand for reserves last year by
Well before that time, the proportion increasing its use of longer-term repur-
of Treasury securities held by the Sys- chase agreements rather than by pur-
tem could reach levels that would sig- chasing Treasury securities outright.
nificantly disrupt the Treasury market The System maintained an average of
and make monetary policy operations more than $15 billion of longer-term
increasingly difficult or costly. Rec- repurchase agreements over 2000, typi-
Monetary Policy Reports, February 63

cally with maturities of twenty-eight composite plunged 39 percent, leaving it

days. at year-end more than 50 percent below
its record high and erasing nearly all of
its gains since the beginning of 1999.
Equity Prices
The broad decline in equity prices last
After having moved higher in the first year is estimated to have lopped more
quarter of 2000, equity prices reversed than $13⁄4 trillion from household
course and finished the year with con- wealth, or more than 4 percent of the
siderable declines. Early in the year, total net worth of households. Neverthe-
the rapid pace of economic activity less, the level of household net worth is
lifted corporate profits, and stock ana- still quite high—about 50 percent above
lysts became even more optimistic about its level at the end of 1995. Investors
future earnings growth. In response, continued to accumulate considerable
most major equity indexes reached amounts of equity mutual funds over
record highs in March, with the Wil- 2000, although they may have become
shire 5000 rising 63⁄4 percent above its increasingly discouraged by losses on
1999 year-end level and the Nasdaq their equity holdings toward the end
soaring 24 percent, continuing its rapid of the year, when flows into equity
run-up from the second half of 1999. funds slumped. At that time, money
Equity prices fell from these highs dur- market mutual funds expanded sharply,
ing the spring, with a particularly steep as investors apparently sought a refuge
drop in the Nasdaq, as investors grew for financial assets amid the height-
more concerned about the lofty valua- ened volatility and significant drops
tions of some sectors and the prospect of in equity prices. So far in 2001, major
higher interest rates. equity indexes are little changed, on
Broader equity indexes recovered balance, as the boost from lower inter-
much of those losses through August, est rates has been countered by con-
supported by the decline in market inter- tinued disappointments over corporate
est rates and the continued strength of earnings.
earnings growth in the second quarter. Some of the most dramatic plunges in
But from early September through the share prices in 2000 took place among
end of the year, stock prices fell con- technology, telecommunications, and
siderably in response to the downshift in Internet shares. While these declines
economic growth, a reassessment of the partly stemmed from downward revi-
prospects for some high-tech industries, sions to near-term earnings estimates,
and disappointments in corporate earn- which were particularly severe in some
ings. In December and January, equity cases, they were also driven by a reas-
analysts significantly reduced their fore- sessment of the elevated valuations of
casts for year-ahead earnings for the many companies in these sectors. The
S&P 500. However, analysts apparently price–earnings ratio (calculated using
view the slowdown in earnings as short- operating earnings expected over the
lived, as long-run earnings forecasts did next year) for the technology compo-
not fall much and remain at very high nent of the S&P 500 index fell substan-
levels, particularly for the technology tially from its peak in early 2000,
sector. although it remains well above the ratio
On balance, the Wilshire 5000 index for the S&P 500 index as a whole. For
fell 12 percent over 2000—its first the entire S&P 500 index, share prices
annual decline since 1994. The Nasdaq fell a bit more in percentage terms than
64 88th Annual Report, 2001

the downward revisions to year-ahead and has remained subdued so far in

earnings forecasts, leaving the price– 2001.
earnings ratio modestly below its his-
torical high.
The volatility of equity price move-
Debt and the Monetary Aggregates
ments during 2000 was at the high end Debt and Depository Intermediation
of the elevated levels observed in recent
years. In the technology sector, the Aggregate debt of domestic nonfinan-
magnitudes of daily share price changes cial sectors increased an estimated
were at times remarkable. There were 51⁄4 percent over 2000, a considerable
twenty-seven days during 2000 in which slowdown from the gains of almost
the Nasdaq composite index moved up 7 percent posted in 1998 and 1999. The
or down by at least 5 percent; by com- expansion of nonfederal debt moderated
parison, such outsized movements were to 81⁄2 percent in 2000 from 91⁄2 percent
observed on a total of only seven days in 1999; the slowing owed primarily to a
from 1990 to 1999. weakening of consumer and business
Despite the volatility of share price borrowing in the second half of the year,
movements and the large declines on as the growth of durables consumption
balance over 2000, equity market con- and capital expenditures fell off and
ditions were fairly orderly, with few financial conditions tightened for some
reports of difficulties meeting margin firms. Some of the slowdown in total
requirements or of large losses creating nonfinancial debt was also attributable
problems that might pose broader sys- to the federal government, which paid
temic concerns. The fall in share prices down 63⁄4 percent of its debt last year,
reined in some of the margin debt of compared with 21⁄2 percent in 1999. In
equity investors. After having run up 1998 and 1999, domestic nonfinancial
sharply through March, the amount of debt increased faster than nominal GDP,
outstanding margin debt fell by about despite the reduction in federal debt over
30 percent over the remainder of the those years. The ratio of nonfinancial
year. At year-end, the ratio of margin debt to GDP edged down in 2000,
debt to total equity market capitaliza- however, as the federal debt paydown
tion was slightly below its level a year accelerated and nonfederal borrowing
earlier. slowed.
The considerable drop in valuations Depository institutions continued to
in some sectors and the elevated volatil- play an important role in meeting the
ity of equity price movements caused demand for credit by businesses and
the pace of initial public offerings to households. Credit extended by
slow markedly over the year, despite a commercial banks, after adjustment
large number of companies waiting to for mark-to-market accounting rules,
go public. The slowdown was particu- increased 10 percent over 2000, well
larly pronounced for technology com- above the pace for total nonfinancial
panies, which had been issuing new debt. Bank credit expanded at a particu-
shares at a frantic pace early in the larly brisk rate through late summer,
year. In total, the dollar amount of initial when banks, given their ample capital
public offerings by domestic nonfinan- base and solid profits, were willing to
cial companies tapered off in the fourth meet strong loan demand by households
quarter to its lowest level in two years and businesses. Over the remainder of
Monetary Policy Reports, February 65

the year, the growth of bank credit vious years. With delinquency rates for
declined appreciably, as banks became consumer and real estate loans having
more cautious lenders and as several changed little, on net, last year, banks
banks shed large amounts of govern- did not tighten credit conditions signifi-
ment securities. cantly for loans to households over the
Banks reported a deterioration of the first three quarters of 2000. More
quality of their business loan portfolios recently, however, an increasing portion
last year. Delinquency and charge-off of banks increased standards and terms
rates on C&I loans, while low by his- for consumer loans other than credit
torical standards, rose steadily, partly cards, and some of the banks surveyed
reflecting some repayment difficulties anticipated a further tightening of condi-
in banks’ syndicated loan portfolios. tions on consumer loans during 2001.
Several large banks have stated that the
uptrend in delinquencies is expected to
The Monetary Aggregates
continue in 2001. Higher levels of provi-
sioning for loan losses and some nar- The monetary aggregates grew rather
rowing of net interest margins contrib- briskly last year. The expansion of the
uted to a fallback of bank profits from broadest monetary aggregate, M3, was
the record levels of 1999. In addition, particularly strong over the first three
capitalization measures slipped a bit last quarters of 2000, as the robust growth
year. Nevertheless, by historical stan- in depository credit was partly funded
dards banks remained quite profitable through issuance of the managed liabili-
overall and appeared to have ample ties included in this aggregate, such as
capital. In the aggregate, total capital large time deposits. M3 growth eased
(the sum of tier 1 and tier 2 capital) somewhat in the fourth quarter because
remained above 12 percent of risk- the slowing of bank credit led deposi-
weighted assets over the first three quar- tory institutions to reduce their reli-
ters of last year, more than two per- ance on managed liabilities. Institutional
centage points above the minimum money funds increased rapidly through-
level required to be considered well- out 2000, despite the tightening of pol-
capitalized. icy early in the year, in part owing
In response to greater uncertainty to continued growth in their provision
about the economic outlook and a of cash management services for busi-
reduced tolerance for risk, increasing nesses. For the year as a whole, M3
proportions of banks reported tightening expanded 91⁄4 percent, well above the
standards and terms on business loans 73⁄4 percent pace in 1999. This advance
during 2000 and into 2001, with the again outpaced that of nominal income,
share recently reaching the highest level and M3 velocity—the ratio of nominal
since 1990. The tightening became income to M3—declined for the sixth
widespread for loans to large and year in a row.
middle-market firms. A considerable M2 increased 61⁄4 percent in 2000,
portion of banks reported firming stan- about unchanged from its pace in 1999.
dards and terms on loans to small busi- Some slowing in M2 growth would have
nesses as well, consistent with surveys been expected based on the rise in short-
of small businesses indicating that a term interest rates over the early part of
larger share of those firms had difficulty the year, which pushed up the ‘‘opportu-
obtaining credit in 2000 than in pre- nity cost’’ of holding M2, given that the
66 88th Annual Report, 2001

Growth of Money and Debt M2 slightly exceeded that of nominal

Percent income, and M2 velocity edged down.
The behavior of the components of
non- M2 was influenced importantly by inter-
Period M1 M2 M3 financial est rate spreads. The depressing effect of
higher short-term market interest rates
Annual 1 was most apparent in the liquid deposit
1990 . . . . . . . . . . . . 4.2 4.2 1.9 6.7 components, including checkable depos-
1991 . . . . . . . . . . . . 7.9 3.1 1.2 4.5
1992 . . . . . . . . . . . . 14.4 1.8 .6 4.5 its and savings accounts, whose rates
1993 . . . . . . . . . . . . 10.6 1.3 1.0 4.9 respond very sluggishly to movements
1994 . . . . . . . . . . . . 2.5 .6 1.7 4.8
in market rates. Small time deposits and
1995 . . . . . . . . . . . . −1.5 3.8 6.1 5.4
1996 . . . . . . . . . . . . −4.5 4.5 6.8 5.3 retail money market mutual funds,
1997 . . . . . . . . . . . . −1.2 5.6 8.9 5.4 whose rates do not lag market rates as
1998 . . . . . . . . . . . . 2.2 8.4 10.9 6.9
1999 . . . . . . . . . . . . 1.8 6.2 7.7 6.8 much, expanded considerably faster than
2000 . . . . . . . . . . . . −1.5 6.3 9.2 5.3
liquid deposits. Currency growth was
held down early in the year by a runoff
Quarterly of the stockpile accumulated in advance
(annual rate) 2
2000:Q1 . . . . . . . . 2.0 5.8 10.6 5.6 of the century date change. In addition,
Q2 . . . . . . . . −1.8 6.4 9.0 6.2
Q3 . . . . . . . . −3.7 5.8 8.9 4.7 it was surprisingly sluggish over the bal-
Q4 . . . . . . . . −2.7 6.6 7.1 4.1 ance of the year given the rapid pace
of income growth, with weakness appar-
Note. M1 consists of currency, travelers checks,
demand deposits, and other checkable deposits. M2 con- ently in both domestic and foreign
sists of M1 plus savings deposits (including money mar- demands.
ket deposit accounts), small-denomination time deposits,
and balances in retail money market funds. M3 consists
of M2 plus large-denomination time deposits, balances in
institutional money market funds, RP liabilities (over-
International Developments
night and term), and eurodollars (overnight and term).
Debt consists of the outstanding credit market debt of the
In 2000, overall economic activity in
U.S. government, state and local governments, house- foreign economies continued its strong
holds and nonprofit organizations, nonfinancial busi- performance of the previous year. How-
nesses, and farms.
1. From average for fourth quarter of preceding year to ever, in both industrial and developing
average for fourth quarter of year indicated. countries, growth was strongest early,
2. From average for preceding quarter to average for and clear signs of a general slowing
quarter indicated.
emerged later in the year. Among indus-
trial countries, growth in Japan last year
moved up to an estimated 2 percent, and
interest rates on many components of growth in the euro area slowed slightly
M2 do not increase by the same amount to 3 percent. Emerging market econo-
or as quickly as market rates. However, mies in both Asia and Latin America
with the level of long-term rates close to grew about 6 percent on average in
that of short-term rates, investors had 2000. For Asian developing economies,
much less incentive to shift funds out of this represented a slowing from the
M2 assets and into assets with longer torrid pace of the previous year, while
maturities, which helped support M2 growth in Latin America, especially
growth. M2 was also boosted at times Mexico, picked up from 1999. Average
by households’ increased preference for foreign inflation edged up slightly to
safe and liquid assets during periods of 3 percent, mainly reflecting higher oil
heightened volatility in equity markets. prices. Over the first part of the year,
On balance over the year, the growth of monetary authorities moved to tighten
Monetary Policy Reports, February 67

conditions in many industrial countries, year when evidence emerged that the
in reaction to continued strong growth pace of U.S. activity was slowing much
in economic activity that was starting to more sharply than had been expected.
impinge on capacity constraints, as well Despite this decline, the dollar’s average
as some upward pressures on prices. foreign exchange value against the cur-
Interest rates on long-term government rencies of other major foreign industrial
securities declined on balance in most countries recorded a net increase of over
industrial countries, especially toward 7 percent for the year as a whole. The
year-end when evidence of a slowdown dollar also strengthened nearly as much
in global economic growth started to on balance against the currencies of the
emerge. most important developing country trad-
Conditions in foreign financial mar- ing partners of the United States. So far
kets were somewhat more unsettled than this year, the dollar’s average value has
in the previous year. Overall stock remained fairly stable.
indexes in the foreign industrial coun-
tries generally declined, most notably
Industrial Economies
in Japan. As in the United States,
technology-oriented stock indexes were The dollar showed particular strength
extremely volatile during the year. After last year against the euro, the common
reaching peaks in the first quarter, they currency of much of Europe. During the
started down while experiencing great first three quarters of the year, the euro
swings toward mid-year, then fell continued to weaken, and by late Octo-
sharply in the final quarter, resulting in ber had fallen to a low of just above
net declines for the year of one-third or 82 cents, nearly one-third below its
more. Stock prices in emerging market value when it was introduced in January
economies were generally quite weak, 1999. The euro’s decline against the dol-
especially in developing Asia, where lar through most of last year appeared to
growth in recent years has depended be due mainly to the vigorous growth of
heavily on exports of high-tech goods. real GDP and productivity in the United
Although there was no major default or States contrasted with steady but less
devaluation among emerging market impressive improvements in Europe. In
economies, average risk spreads on addition, investors may have perceived
developing country debt still moved that Europe was slower to adopt ‘‘new
higher on balance over the course of the economy’’ technologies, making it a
year, as the threat of potential crises in relatively less attractive investment cli-
several countries, most notably Argen- mate. In September, a concerted inter-
tina and Turkey, heightened investor vention operation by the monetary
concerns. authorities of the G-7 countries, includ-
The dollar’s average foreign ex- ing the United States, was undertaken at
change value increased over most of the request of European authorities to
the year, supported by continued robust provide support for the euro. The Euro-
growth of U.S. activity, rising interest pean Central Bank also made interven-
rates on dollar assets, and market per- tion purchases of euros on several occa-
ceptions that longer-term prospects for sions acting on its own. Late in the year,
U.S. growth and rates of return were the euro abruptly changed course and
more favorable than in other industrial started to move up strongly, reversing
countries. Part of the rise in the dollar’s over half of its decline of earlier in the
average value was reversed late in the year. This recovery of the euro against
68 88th Annual Report, 2001

the dollar appeared to reflect mainly a had maintained for nearly a year and a
market perception that, while growth half, and its target for the overnight rate
was slowing in both Europe and the was raised to 25 basis points. Later in
United States, the slowdown was much the year, evidence emerged suggesting
sharper for the United States. For the that the nascent recovery in economic
year as a whole, the dollar appreciated, activity was losing steam, and in
on net, about 7 percent against the response the yen started to depreciate
euro. sharply against the dollar.
The European Central Bank raised its For the year as a whole, Japanese real
policy interest rate target six times by a GDP is estimated to have increased
total of 175 basis points over the first about 2 percent, a substantial improve-
ten months of the year. These increases ment from the very small increase of the
reflected concerns that the euro’s previous year and the decline recorded
depreciation, tightening capacity con- in 1998. Growth, which was concen-
straints and higher oil prices would put trated in the first part of the year, was
upward pressure on inflation. While led by private nonresidential invest-
core inflation—inflation excluding food ment. In contrast, residential investment
and energy—remained well below the slackened as the effect of tax incentives
2 percent inflation target ceiling, higher waned. Consumption rebounded early in
oil prices pushed the headline rate above the year from a sharp decline at the end
the ceiling for most of the year. Real of 1999 but then stagnated, depressed in
GDP in the euro area is estimated to part by record-high unemployment and
have increased about 3 percent for 2000 concerns that ongoing corporate restruc-
as a whole, only slightly below the rate turing could lead to further job losses.
of the previous year, although activity Public investment, which gave a major
slowed toward the end of the year. boost to the economy in 1999, remained
Growth was supported by continued strong through the first half of last year
strong increases in investment spending. but then fell off sharply, and for the year
Net exports made only a modest contri- as a whole the fiscal stance is estimated
bution to growth, as rapid increases in to have been somewhat contractionary.
exports were nearly matched by robust Inflation was negative for the second
imports. Overall activity was sufficiently consecutive year, with the prices of both
strong to lead to a further decline in the consumer goods and real estate continu-
average euro-area unemployment rate to ing to move lower.
below 9 percent, a nearly 1 percentage The dollar appreciated 4 percent rela-
point reduction for the year. tive to the Canadian dollar last year.
The dollar rose about 12 percent Among the factors that apparently
against the Japanese yen over the course contributed to the Canadian currency’s
of 2000, roughly reversing the decline weakness were declines in the prices of
of the previous year. Early in the year, commodities that Canada exports, such
the yen experienced periods of upward as metals and lumber, and a perception
pressure on evidence of a revival of by market participants of unfavorable
activity in Japan. On several of these differentials in rates of return and eco-
occasions, the Bank of Japan made nomic growth prospects in Canada rela-
substantial intervention sales of yen. By tive to the United States. For the year as
August, signs of recovery were strong a whole, real GDP growth in Canada
enough to convince the Bank of Japan to is estimated to have been only slightly
end the zero interest rate policy that it below the strong 5 percent rate of 1999,
Monetary Policy Reports, February 69

although, as in most industrial countries, time of a general heightening of finan-

there were signs that the pace of growth cial market volatility and rising interest
was tailing off toward the end of the rates in industrial countries, as well as
year. Domestic demand continued to be increased political uncertainty in several
robust, led by surging business invest- developing countries. After narrowing
ment and solid personal consumption at mid-year, risk spreads on emerging
increases. In the first part of the year, the market economy debt again widened
sustained rapid growth of the economy later in the year, reflecting a general
led Canadian monetary authorities to movement on financial markets away
become increasingly concerned with a from riskier assets, as well as concerns
buildup of inflationary pressures, and that Argentina and Turkey might be fac-
the Bank of Canada matched all of the ing financial crises that could spread to
Federal Reserve’s interest rate increases other emerging market economies. Risk
in 2000, raising its policy rate by a total spreads generally narrowed in the early
of 100 basis points. By the end of the part of 2001.
year, the core inflation rate had risen to Among Latin American countries,
near the middle of the Bank of Canada’s Mexico’s performance was noteworthy.
1 percent to 3 percent target range, Real GDP rose an estimated 7 percent,
while higher oil prices pushed the an acceleration from the already strong
overall rate above the top of the range. result of the previous year. Growth was
So far this year, the Bank of Canada boosted by booming exports, especially
has only partially followed the Federal to the United States, favorable world
Reserve in lowering interest rates, and oil prices, and a rebound in domestic
the Canadian dollar has remained little demand. In order to keep inflation on a
changed. downward path in the face of surging
domestic demand, the Bank of Mexico
Emerging Market Economies tightened monetary conditions six times
last year, pushing up short-term interest
In emerging market economies, the rates, and by the end of the year the rate
average growth rate of economic activ- of consumer price inflation had moved
ity in 2000 remained near the very below the 10 percent inflation target.
strong 6 percent rate of the previous The run-up to the July presidential elec-
year. However, there was a notable and tion generated some sporadic financial
widespread slowing near the end of the market pressures, but these subsided
year, and results in a few individual in reaction to the smooth transition to
countries were much less favorable. the new administration. Over the course
Growth in developing Asian economies of the year, the risk spread on Mexi-
slowed on average from the torrid pace can debt declined on balance, probably
of the previous year, while average reflecting a favorable assessment by
growth in Latin America picked up market participants of macroeconomic
somewhat. No major developing coun- developments and government policies,
try experienced default or devaluation in reinforced by rating upgrades of Mexi-
2000, but nonetheless, financial markets can debt. During 2000, the peso depre-
did undergo several periods of height- ciated slightly against the dollar, but by
ened unrest during the year. In the less than the excess of Mexican over
spring, exchange rates and equity prices U.S. inflation.
weakened and risk spreads widened in Argentina encountered considerable
many emerging market economies at a financial distress last year. Low tax
70 88th Annual Report, 2001

revenues due to continued weak activity developing economies following their

along with elevated political uncertainty financial crises. In addition, a sharp fall
greatly heightened market concerns in Korean equity prices over the course
about the ability of the country to fund of the year, as well as continued diffi-
its debt. Starting in October, domestic culties with the process of financial and
interest rates and debt risk spreads corporate sector restructuring, tended
soared amid market speculation that to depress consumer and business confi-
the government might lose access to dence. These developments contributed
credit markets and be forced to abandon to the downward pressure on the won
the exchange rate peg to the dollar. seen near the end of the year. Elsewhere
Financial markets began to recover after in Asia, market concerns over height-
an announcement in mid-November ened political instability were a major
that an IMF-led international finan- factor behind financial pressures last
cial support package was to be put year in Indonesia, Thailand, and the
in place. Further improvement came Philippines. In China, output continued
in the wake of an official announcement to expand rapidly in 2000, driven by a
in December of a $40 billion support combination of surging exports early in
package. The fall in U.S. short-term the year, sustained fiscal stimulus, and
interest rates in January eased pressure some recovery in private consumption.
on Argentina’s dollar-linked economy In contrast, growth in both Hong Kong
as well. and Taiwan slowed, especially in the
Late in the year, Brazilian financial latter part of the year. In Taiwan, the
markets received some negative spill- exchange rate and stock prices both
over from the financial unrest in Argen- came under downward pressure as a
tina, but conditions did not approach result of the slowdown in global elec-
those prevailing during Brazil’s finan- tronics demand and apparent market
cial crisis of early 1999. For 2000 as a concerns over revelations of possible
whole, the Brazilian economy showed weaknesses in the banking and corpo-
several favorable economic trends. Real rate sectors.
GDP growth increased to an estimated Turkey’s financial markets came
4 percent after being less than 1 percent under severe strain in late November as
the previous two years, inflation contin- international investors withdrew capital
ued to move lower, and short-term inter- amid market worries about the health of
est rates declined. Turkey’s banks, the viability of the gov-
Growth in Asian developing coun- ernment’s reform program and its crawl-
tries in 2000 slowed from the previous ing peg exchange rate regime, and the
year, when they had still been experienc- widening current account deficit. The
ing an exceptionally rapid bounceback resulting liquidity shortage caused short-
from the 1997–1998 financial crises term interest rates to spike up and led to
experienced by several countries in the a substantial decline in foreign exchange
region. In Korea, real GDP growth last reserves held by the central bank. Mar-
year is estimated to have been less than kets stabilized somewhat after it was
half of the blistering 14 percent rate announced in December that Turkey had
of 1999. Korean exports, especially been able to reach loan agreements with
of high-tech products, started to fade the IMF, major international banks, and
toward the end of 2000. Rapid export the World Bank in an effort to provide
growth had been a prominent feature of liquidity and restore confidence in the
the recovery of Korea and other Asian banking system.
Monetary Policy Reports, July 71

Report submitted to the Congress on confidence, raised the possibility of

July 18, 2001, pursuant to section 2B of becoming increasingly self-reinforcing
the Federal Reserve Act were households and businesses to post-
pone spending while reassessing their
Report of July 18, 2001 situations. In addition, other financial
developments, including a higher for-
eign exchange value of the dollar, lower
Monetary Policy and the
equity prices, and tighter lending terms
Economic Outlook
and standards at banks, were tending
When the Federal Reserve submitted to restrain aggregate demand and thus
its report on monetary policy in mid- were offsetting some of the influence
February, the Federal Open Market of the lower federal funds rate. Finally,
Committee (FOMC) had already re- despite some worrisome readings early
duced its target for the federal funds rate in the year, price increases remained
twice to counter emerging weakness in fairly well contained, and prospects
the economy. As the year has unfolded, for inflation have become less of a con-
the weakness has become more persis- cern as rates of resource utilization have
tent and widespread than had seemed declined and energy prices have shown
likely last autumn. The shakeout in the signs of turning down.
high-technology sector has been espe- The information available at midyear
cially severe, and with overall sales and for the recent performance of both the
profits continuing to disappoint, busi- U.S. economy and some of our key trad-
nesses are curtailing purchases of other ing partners remains somewhat down-
types of capital equipment as well. The beat, on balance. Moreover, with inven-
slump in demand for capital goods has tories still excessive in some sectors,
also worked against businesses’ efforts orders for capital goods very soft, and
to correct the inventory imbalances that the effects of lower stock prices and
emerged in the second half of last year the weaker job market weighing on
and has contributed to sizable declines consumers, the economy may expand
in manufacturing output this year. At only slowly, if at all, for a while longer.
the same time, foreign economies have Nonetheless, a number of factors are
slowed, limiting the demand for U.S. in place that should set the stage for
exports. stronger growth later this year and in
To foster financial conditions that will 2002. In particular, interest rates have
support strengthening economic growth, declined since last fall; the lower rates
the FOMC has lowered its target for the have helped businesses and house-
federal funds rate four times since Feb- holds strengthen their financial posi-
ruary, bringing the cumulative decline tions and should show through to aggre-
this year to 23⁄4 percentage points. A gate demand in coming quarters. The
number of factors spurred this unusually recently enacted tax cuts and the appar-
steep reduction in the federal funds rate. ent cresting of energy prices should also
In particular, the slowdown in growth bolster aggregate demand fairly soon. In
was rapid and substantial and carried addition, as firms at some point become
considerable risks that the sluggish per- more satisfied with their inventory hold-
formance of the economy in the first ings, the cessation of liquidation will
half of this year would persist. Among boost production and, in turn, provide
other things, the abruptness of the slow- a lift to employment and incomes; a
ing, by jarring consumer and business subsequent shift to inventory accumula-
72 88th Annual Report, 2001

tion in association with the projected that slowing was only beginning to
strengthening in demand should pro- come into focus. At that meeting, the
vide additional impetus to production. FOMC concluded that the risks to the
Moreover, with no apparent sign of economy in the foreseeable future had
abatement in the rapid pace of tech- shifted to being weighted mainly toward
nological innovation, the outlook for conditions that may generate economic
productivity growth over the longer weakness and that economic and finan-
run remains favorable. The efficiency cial developments could warrant further
gains made possible by these innova- close review of the stance of policy well
tions should spur demand for the capi- before the next scheduled meeting. Sub-
tal equipment that embodies the new sequent data indicated that holiday retail
technologies once the overall economic sales had come in below expectations
situation starts to improve and should and that conditions in the manufacturing
support consumption by leading to solid sector had deteriorated. Corporate profit
increases in real incomes over time. forecasts had also been marked down,
Even though an appreciable recovery and it seemed possible that the resulting
in the growth of economic activity by decline in equity values, along with the
early next year seems the most likely expense of higher energy costs, could
outcome, there is as yet no hard evi- damp future business investment and
dence that this improvement is in train, household spending. In response, the
and the situation remains very uncer- FOMC held a telephone conference on
tain. In these circumstances, the FOMC January 3, 2001, and decided to reduce
continues to believe that the risks are the target federal funds rate 1⁄2 percent-
weighted toward conditions that may age point, to 6 percent, and indicated
generate economic weakness in the that the risks to the outlook remained
foreseeable future. At the same time, weighted toward economic weakness.
the FOMC recognizes the importance The timing and size of the cut in the
of sustaining the environment of low target rate seemed to ease somewhat the
inflation and well-anchored inflation concerns of financial market participants
expectations that enabled the Federal about the longer-term outlook for the
Reserve to react rapidly and forcefully economy. Equity prices generally rose
to the slowing in real GDP growth over in January, risk spreads on lower-rated
the past several quarters. When, as the corporate bonds narrowed significantly,
FOMC expects, activity begins to firm, and the yield curve steepened. However,
the Committee will continue to ensure incoming data over the month revealed
that financial conditions remain consis- that the slowing in consumer and busi-
tent with holding inflation in check, a ness spending late last year had been
key requirement for maximum sustain- sizable. Furthermore, a sharp erosion
able growth. in survey measures of consumer con-
fidence, a backup of inventories, and
a steep decline in capacity utilization
Monetary Policy, Financial posed the risk that spending could
Markets, and the Economy remain depressed for some time. In light
over the First Half of 2001 of these developments, the FOMC at its
By the time of the FOMC meeting on scheduled meeting on January 30 and 31
December 19, 2000, it had become evi- cut its target for the federal funds rate
dent that economic growth had down- another 1⁄2 percentage point, to 51⁄2 per-
shifted considerably, but the extent of cent, and stated that it continued to
Monetary Policy Reports, July 73

judge the risks to be weighted mainly rise in mid-April as financial market

toward economic weakness. investors became more confident that a
The information reviewed by the cumulative downward spiral in activity
FOMC at its meeting on March 20 sug- could be avoided, reports continued to
gested that economic activity continued suggest flagging economic performance
to expand, but slowly. Although con- and risks of extended weakness ahead.
sumer spending seemed to be rising In particular, spending by consumers
moderately and housing had remained had leveled out and their confidence had
relatively firm, stock prices had declined fallen further. The FOMC discussed
substantially in February and early economic developments in conference
March, and reduced equity wealth and calls on April 11 and April 18, deciding
lower consumer confidence had the on the latter occasion to reduce its target
potential to damp household spending for the federal funds rate another 1⁄2 per-
going forward. Moreover, manufac- centage point, to 41⁄2 percent. The Com-
turing output had contracted further, mittee again indicated that it judged
as businesses continued to work down the balance of risks to the outlook as
their excess inventories and cut back on weighted toward economic weakness.
capital equipment expenditures. In addi- When the FOMC met on May 15,
tion, economic softness abroad raised economic conditions remained quite
the likelihood of a weakening in U.S. sluggish, especially in manufacturing,
exports. Core inflation had picked up a where production and employment had
bit in January, but some of the increase declined further. Although members
reflected the pass-through of a rise in were concerned that some indicators of
energy prices that was unlikely to con- core inflation had moved up in the early
tinue, and the FOMC judged that the months of the year and that part of the
slowdown in the growth of aggregate recent backup in longer-term interest
demand would ease inflationary pres- rates may have owed to increased infla-
sures on labor and other resources. tion expectations, most saw underly-
Accordingly, the FOMC on March 20 ing price increases as likely to remain
lowered its target for the federal funds damped as continued subpar growth
rate another 1⁄2 percentage point, to relieved pressures on resources. In light
5 percent. The members also continued of the prospect of continued weakness
to see the risks to the outlook as remain- in the economy and the significant risks
ing weighted mainly toward economic to the economic expansion, the FOMC
weakness. Furthermore, the FOMC reduced its target for the federal funds
recognized that in a rapidly evolving rate an additional 1⁄2 percentage point, to
economic situation, it would need to 4 percent. With the softening in aggre-
be alert to the possibility that a con- gate demand still of unknown persis-
ference call would be desirable dur- tence and dimension, the FOMC con-
ing the relatively long interval before tinued to view the risks to the outlook
the next scheduled meeting to discuss as weighted toward economic weakness.
the possible need for a further policy Still, the FOMC recognized that it had
adjustment. eased policy substantially this year and
Capital markets continued to soften that, in the absence of further sizable
in late March and early April, in part adverse shocks to the economy, at future
because corporate profits and economic meetings it might need to consider
activity remained quite weak. Although adopting a more cautious approach to
equity prices and bond yields began to further policy actions.
74 88th Annual Report, 2001

Subsequent news on economic activ- tendency of the forecasts for real GDP
ity and corporate profits failed to point growth in 2002 is 3 percent to 31⁄4 per-
to a rebound. In June, interest rates on cent. The civilian unemployment rate,
longer-term Treasuries and on higher- which averaged 41⁄2 percent in the sec-
quality private securities declined, some ond quarter of 2001, is expected to move
risk spreads widened, and stock prices up to the area of 43⁄4 percent to 5 percent
fell as financial market participants by the end of this year. In 2002, with the
trimmed their expectations for eco- economy projected to expand at closer
nomic activity and profits. When the to its trend rate, the unemployment rate
FOMC met on June 26 and 27, con- is expected to hold steady or perhaps to
ditions in manufacturing appeared to edge higher. With pressures in labor and
have worsened still more. It also seemed product markets abating and with energy
likely that slower growth abroad would prices no longer soaring, inflation is
restrain demand for exports and that expected to be well contained over the
weakening labor markets would hold next year and a half.
down growth in consumer spending. In Despite the projected increase in real
light of these developments, but also GDP growth, the uncertainty about the
taking into account the cumulative near-term outlook remains considerable.
250 basis points of easing already under-
taken and the other forces likely to be Economic Projections for 2001 and 2002
stimulating spending in the future, the
FOMC lowered its target for the fed-
eral funds rate 1⁄4 percentage point, to Board of Governors
33⁄4 percent, and continued to view the and
Reserve Bank presidents
risks to the outlook as weighted toward Indicator
economic weakness. Range Central
The Board of Governors of the Fed-
eral Reserve System approved cuts in 2001
the discount rate in the first half of the
year that matched the FOMC’s cuts in Change, fourth quarter
the target federal funds rate. As a result, to fourth quarter 1
Nominal GDP . . . . . . . . . . . . 31⁄4–5 31⁄2–41⁄4
the discount rate declined from 6 per- Real GDP 2 . . . . . . . . . . . . . . . 1–2 11⁄4–2
PCE prices . . . . . . . . . . . . . . . 2–23⁄4 2–21⁄2
cent to 31⁄4 percent over the period.
Average level,
fourth quarter
Civilian unemployment
Economic Projections rate . . . . . . . . . . . . . . . . . . 43⁄4–5 43⁄4–5
for 2001 and 2002
The members of the Board of Governors
and the Federal Reserve Bank presi- Change, fourth quarter
dents, all of whom participate in the to fourth quarter 1
Nominal GDP . . . . . . . . . . . . 43⁄4–6 5–51⁄2
deliberations of the FOMC, expect eco- Real GDP 2 . . . . . . . . . . . . . . . 3–31⁄2 3–31⁄4
nomic growth to remain slow in the near PCE prices . . . . . . . . . . . . . . . 11⁄2–3 1 ⁄ –21⁄2

term, though most anticipate that it will Average level,

pick up later this year at least a little. fourth quarter
Civilian unemployment
The central tendency of the forecasts rate . . . . . . . . . . . . . . . . . . 43⁄4–51⁄2 43⁄4–51⁄4
for the increase in real GDP over the
1. Change from average for fourth quarter of previous
four quarters of 2001 spans a range of year to average for fourth quarter of year indicated.
11⁄4 percent to 2 percent, and the central 2. Chain-weighted.
Monetary Policy Reports, July 75

This uncertainty arises not only from the lative macroeconomic policies in some
difficulty of assessing when businesses countries.
will feel that conditions are sufficiently The chain-type price index for per-
favorable to warrant a pickup in capi- sonal consumption expenditures rose
tal spending but also from the difficulty 21⁄4 percent over the four quarters of
of gauging where businesses stand in 2000, and most FOMC participants
the inventory cycle. Nonetheless, all the expect inflation to remain around that
FOMC participants foresee a return to rate through next year; indeed, the cen-
solid growth by 2002. By then, the tral tendency of their forecasts for the
inventory correction should have run its increase in this price measure is 2 per-
course, and the monetary policy actions cent to 21⁄2 percent in 2001 and 13⁄4 per-
taken this year, as well as the recently cent to 21⁄2 percent in 2002. One favor-
enacted tax reductions, should be pro- able factor in the inflation outlook is the
viding appreciable support to final behavior of energy prices. Those prices
demand. have declined recently after having
In part because of lower interest rates, increased rapidly in the past couple of
many firms have been able to shore up years, and prospects are good that they
their balance sheets. And although some could stabilize or even fall further
lower-rated firms, especially in tele- in coming quarters. In addition to their
communications and other sectors with direct effects, lower energy prices
gloomy near-term prospects, may con- should tend to limit increases in other
tinue to find it difficult to obtain financ- prices by reducing input costs for a wide
ing, businesses generally are fairly well range of energy-intensive goods and ser-
positioned to step up their capital spend- vices and by helping damp inflation
ing once the outlook for sales and prof- expectations. More broadly, the com-
its improves. By all accounts, techno- petitive conditions that have restricted
logical innovation is still proceeding businesses’ ability to raise prices in
rapidly, and these advances should even- recent years are likely to persist. And
tually revive high-tech investment, espe- although labor costs could come under
cially with the price of computing power upward pressure as wages tend to catch
continuing to drop sharply. up to previous increases in productiv-
In addition, consumer spending is ity, the slackening in resource utiliza-
expected to get a boost from the tax tion this year is expected to contribute
cuts and from falling energy prices, to reduced inflation pressures going
which should help offset the effects of forward.
the weaker job market and the decline
over the past year in stock market
wealth. Housing activity, which has
Economic and Financial
been buoyed in recent quarters by low
Developments in 2001
mortgage interest rates, is likely to Economic growth remained very slow
remain firm into 2002. Significant in the first half of 2001 after having
concerns remain about the foreign eco- downshifted in the second half of 2000.
nomic outlook and the prospects for U.S. Real gross domestic product rose at an
exports. Nevertheless, economic activity annual rate of just 11⁄4 percent in the
abroad is expected to benefit from a first quarter, about the same as in the
strengthening of the U.S. economy, a fourth quarter, and appears to have
stabilization of the global high-tech posted at best a meager gain in the
sector, an easing of oil prices, and stimu- second quarter. Businesses have been
76 88th Annual Report, 2001

working to correct the inventory imbal- stantial expansion of incentives and rose
ances that emerged in the second half to just a tad below the record pace of
of last year, which has led to sizable 2000 as a whole. In addition, outlays
declines in manufacturing output, and for non-auto goods posted a solid gain,
capital spending has weakened apprecia- and spending on services rose modestly
bly. In contrast, household spending— despite a weather-related drop in outlays
especially for motor vehicles and for energy services. In the second quar-
houses—has held up well. Employment ter, however, the rise in consumer spend-
increased only modestly over the first ing seems to have lessened as sales of
three months of the year and turned light motor vehicles dropped a bit, on
down in the spring; the unemployment average, and purchases of other goods
rate in June stood at 41⁄2 percent, 1⁄2 per- apparently did not grow as fast in real
centage point higher than in the fourth terms as they had in the first quarter.
quarter of last year. The rise in real consumption so far
The inflation news early this year was this year has been considerably smaller
not very favorable, as energy prices than the outsized gains in the second
continued to soar and as measures of half of the 1990s and into 2000. But the
core inflation—which exclude food and increase in spending still outstripped
energy—registered some pickup. More the growth in real disposable personal
recently, however, energy prices have income (DPI), which has been restrained
moved lower, and the monthly readings this year by further big increases in con-
on core inflation have returned to more sumer energy prices and by the dete-
moderate rates. Moreover, apart from rioration in the job market; between the
energy, prices at earlier stages of pro- fourth quarter of 2000 and May, real
cessing have been quiescent this year. DPI increased just about 2 percent at an
annual rate, well below the average pace
of the preceding few years. In addition,
The Household Sector the net worth of households fell again
Growth in household spending has in the first quarter, to a level 8 percent
slowed noticeably from the rapid pace below the high reached in the first quar-
of the past few years. Still, it was fairly ter of 2000. On net, the ratio of house-
well maintained in the first half of 2001 hold net worth to DPI has returned to
despite the weaker tenor of income, about the level reached in 1997, signifi-
wealth, and consumer confidence, and cantly below the recent peak but still
the personal saving rate declined a bit high by historical standards. In addition,
further. A greater number of households consumer sentiment indexes, which had
encountered problems servicing debt, risen to extraordinary levels in the late
but widespread difficulties or restric- 1990s and remained there through last
tions on the availability of credit did not fall, fell sharply around the turn of the
emerge. year. However, these indexes have not
deteriorated further, on net, since the
winter and are still at reasonably favor-
Consumer Spending
able levels when compared with the
Real consumer spending grew at an readings for the pre-1997 period.
annual rate of 31⁄2 percent in the first Rising household wealth almost cer-
quarter. Some of the increase reflected tainly was a key factor behind the surge
a rebound in purchases of light motor in consumer spending between the mid-
vehicles, which were boosted by a sub- 1990s and last year, and thus helps to
Monetary Policy Reports, July 77

explain the sharp fall in the personal able, mainly because of perceptions that
saving rate over that period. The saving mortgage rates are low.
rate has continued to fall this year— Likely because of the sustained
from −0.7 percent in the fourth quarter strength of housing demand, home
of 2000 to −1.1 percent in May—even prices have continued to rise faster than
though the boost to spending growth overall inflation, although the various
from the earlier run-up in stock prices measures that attempt to control for
has likely run its course and the effects shifts in the regional composition of
of lower wealth should be starting to sales and in the characteristics of houses
feed through to spending. The apparent sold provide differing signals on the
decline in the saving rate may simply magnitude of the price increases. Nota-
reflect noisiness in the data or a slower bly, over the year ending in the first
response of spending to wealth than quarter, the constant-quality price index
average historical experience might sug- for new homes rose 4 percent, while
gest. In addition, consumers probably the repeat-sales price index for existing
base their spending decisions on income homes was up nearly 9 percent. Despite
prospects over a longer time span than the higher prices, the share of income
just a few quarters. Thus, to the extent required to finance a home purchase—
that consumers do not expect the current one measure of affordability—has fallen
sluggishness in real income growth to in recent quarters as mortgage rates have
persist, the tendency to maintain spend- dropped back after last year’s bulge, and
ing for a time by dipping into savings or that share currently is about as low as it
by borrowing may have offset the effect has been at any time in the past decade.
of the decline in wealth on the saving Rates on thirty-year conventional fixed-
rate. rate loans now stand around 71⁄4 percent,
and ARM rates are at their lowest levels
in a couple of years.
Residential Investment
In the multifamily sector, housing
Housing activity remained buoyant in starts averaged 343,000 units at an
the first half of this year as lower mort- annual rate over the first five months of
gage interest rates appear to have offset the year, matching the robust pace that
the restraint from smaller gains in has been evident since 1997. Moreover,
employment and income and from lower conditions in the market for multifamily
levels of wealth. In the single-family housing continue to be conducive to
sector, starts averaged an annual rate new construction. The vacancy rate for
of 1.28 million units over the first five multifamily rental units in the first quar-
months of the year—4 percent greater ter held near its low year-earlier level,
than the hefty pace for 2000 as a whole. and rents and property values continued
Sales of new and existing homes to rise rapidly.
strengthened noticeably around the turn
of the year and were near record levels Household Finance
in March; they fell back in April but
reversed some of that drop in May. The growth of household debt is esti-
Inventories of new homes for sale are mated to have slowed somewhat in the
exceptionally low; builders’ backlogs first half of this year to a still fairly hefty
are sizable; and, according to the Michi- 71⁄2 percent annual rate—about a per-
gan survey, consumers’ assessments of centage point below its average pace
homebuying conditions remain favor- over the previous two years. Households
78 88th Annual Report, 2001

have increased both their home mort- loans they are willing to make, substan-
gage debt and their consumer credit tial increases from the November sur-
(debt not secured by real estate) substan- vey. Of those that had tightened, most
tially this year, although in both cases cited actual or anticipated increases in
the growth has moderated a bit recently. delinquency rates as a reason.
The relatively low mortgage interest
rates have boosted mortgage borrowing
both by stimulating home purchases The Business Sector
and by making it attractive to refinance The boom in capital spending that has
existing mortgages and extract some of helped fuel the economic expansion
the buildup in home equity. The rapid came to a halt late last year. After hav-
growth in consumer credit has been con- ing risen at double-digit rates over the
centrated in credit card debt, perhaps preceding five years, real business fixed
reflecting households’ efforts to sustain investment flattened out in the fourth
their consumption in the face of weaker quarter of 2000 and rose only a little in
income growth. the first quarter of 2001. Demand for
The household debt service burden— capital equipment has slackened appre-
the ratio of minimum scheduled pay- ciably, reflecting the sluggish economy,
ments on mortgage and consumer debt sharply lower corporate profits and cash
to disposable personal income—rose flow, earlier overinvestment in some
to more than 14 percent at the end of sectors, and tight financing conditions
the first quarter, a twenty-year high, and facing some firms. In addition, inven-
available data suggest a similar reading tory investment fell substantially in the
for the second quarter. In part because first quarter as businesses moved to
of the elevated debt burden, some mea- address the overhangs that began to
sures of household loan performance develop late last year. With investment
have deteriorated a bit in recent quar- spending weakening, businesses have
ters. The delinquency rate on home cut back on new borrowing. Following
mortgage loans has edged up but the drop in longer-term interest rates
remains low, while the delinquency rate in the last few months of 2000, credit
on credit card loans has risen noticeably demands have been concentrated in
and is in the middle part of its range longer-term markets, though cautious
over the past decade. Personal bankrupt- investors have required high spreads
cies jumped to record levels in the from marginal borrowers.
spring, but some of the spurt was prob-
ably the result of a rush to file before Fixed Investment
Congress passed bankruptcy reform
legislation. Real spending on equipment and soft-
Lenders have tightened up somewhat ware (E&S) began to soften in the sec-
in response to the deterioration of house- ond half of last year, and it posted small
hold financial conditions. In the May declines in both the fourth quarter of
Senior Loan Officer Opinion Survey on 2000 and the first quarter of 2001. Much
Bank Lending Practices, about a fifth of of the weakness in the first quarter was
the banks indicated that they had tight- in spending on high-tech equipment and
ened the standards for approving appli- software; such spending, which now
cations for consumer loans over the pre- accounts for about half of E&S out-
ceding three months, and about a fourth lays when measured in nominal terms,
said that they had tightened the terms on declined at an annual rate of about
Monetary Policy Reports, July 79

12 percent in real terms—the first real surprisingly, one bright spot is the
quarterly drop since the 1990 recession. energy sector, where expenditures for
An especially sharp decrease in outlays drilling and mining have been on a
for communications equipment reflected steep uptrend since early 1999 (mainly
the excess capacity that had emerged as because of increased exploration for
a result of the earlier surge in spending, natural gas) and the construction of
the subsequent re-evaluation of profit- facilities for electric power generation
ability, and the accompanying financing remains very strong.
difficulties faced by some firms. In addi-
tion, real spending on computers and
Inventory Investment
peripheral equipment, which rose more
than 40 percent per year in the second A sharp reduction in the pace of inven-
half of the 1990s, showed little growth, tory investment was a major damping
on net, between the third quarter of 2000 influence on real GDP growth in the
and the first quarter of 2001. The level- first quarter of 2001. The swing in real
ing in real computer spending report- nonfarm inventory investment from an
edly reflects some stretching out of busi- accumulation of $51 billion at an annual
nesses’ replacement cycles for personal rate in the fourth quarter of 2000 to a
computers as well as a reduced demand liquidation of $25 billion in the first
for servers. Outside the high-tech area, quarter of 2001 subtracted 3 percentage
spending rose in the first quarter as pur- points from the growth in real GDP in
chases of motor vehicles reversed some the first quarter. Nearly half of the nega-
of the decline recorded over the second tive contribution to GDP growth came
half of 2000 and as outlays for industrial from the motor vehicle sector, where a
equipment picked up after having been sizable cut in assemblies (added to the
flat in the fourth quarter. reduction already in place in the fourth
Real E&S spending likely dropped quarter) brought the overall days’ sup-
further in the second quarter. In addition ply down to comfortable levels by the
to the ongoing contraction in outlays end of the first quarter. A rise in truck
on high-tech equipment, the incoming assemblies early in the second quarter
data for orders and shipments point to a led to some backup of inventories in
decline in investment in non-high-tech that segment of the market, but truck
equipment, largely reflecting the weak- stocks were back in an acceptable range
ness in the manufacturing sector this by June; automobile assemblies were up
year. only a little in the second quarter, and
Outlays on nonresidential construc- stocks remained lean.
tion posted another sizable advance in Firms outside the motor vehicles
early 2001 after having expanded nearly industry also moved aggressively to
13 percent in real terms in 2000, but address inventory imbalances in the first
the incoming monthly construction data half of the year, and this showed through
imply a sharp retrenchment in the sec- to manufacturing output, which, exclud-
ond quarter. The downturn in spending ing motor vehicles, fell at an annual rate
comes on the heels of an increase in of 71⁄2 percent over this period. These
vacancy rates for office and industrial production adjustments—along with a
space in many cities. Moreover, while sharp reduction in the flow of imports—
financing generally remains available contributed to a small decline in real
for projects with viable tenants, lenders non-auto stocks in the first quarter, and
are now showing greater caution. Not book-value data for the manufactur-
80 88th Annual Report, 2001

ing and trade sector point to a further The decline in C&I loans and com-
decrease, on net, in April and May. As mercial paper owes, in part, to less
of May, stocks generally seemed in line hospitable conditions in shorter-term
with sales at retail trade establishments, funding markets. The commercial paper
but there were still some notable over- market was rattled in mid-January by
hangs in wholesale trade and especially the defaults of two large California utili-
in manufacturing, where inventory– ties. Commercial paper is issued only by
shipments ratios for producers of com- highly rated corporations, and default is
puters and electronic products, primary extremely rare. The defaults, along with
and fabricated metals, and chemicals some downgrades, led investors in com-
remained very high. mercial paper to pull back and reevalu-
ate the riskiness of issuers. For a while,
issuance by all but top-rated names
Business Finance
became very difficult and quality
The economic profits of U.S. corpora- spreads widened significantly, pushing
tions fell at a 19 percent annual rate in some issuers into the shortest maturities
the first quarter after a similar decline and inducing others to exit the market
in the fourth quarter of 2000. As a result, entirely. As a consequence, the amount
the ratio of profits to GDP declined of commercial paper outstanding plum-
1 percentage point over the two quar- meted. In the second quarter, risk
ters, to 8.5 percent; the ratio of the prof- spreads returned to more typical levels
its of nonfinancial corporations to sector and the runoff moderated. By the end
output fell 2 percentage points over of June, the amount of nonfinancial
the interval, to 10 percent. Investment commercial paper outstanding was
spending has declined by more than nearly 30 percent below its level at the
profits, however, reducing somewhat the end of 2000, with many firms still not
still-elevated need of nonfinancial cor- having returned to the market.
porations for external funds to finance Even though banks’ C&I loans were
capital expenditures. Corporations have boosted in January and February by bor-
husbanded their increasingly scarce rowers substituting away from the com-
internal funds by cutting back on cash- mercial paper market, loans declined, on
financed mergers and equity repur- net, over the first half of the year, in part
chases. While equity retirements have because borrowers paid down their bank
therefore fallen, so has gross equity issu- loans with proceeds from bond issues.
ance, though by less. Inflows of venture Many banks reported on the Federal
equity capital, in particular, have been Reserve’s Bank Lending Practices sur-
reduced substantially. Businesses have veys this year that they had tightened
met their financing needs by borrowing standards and terms—including the pre-
heavily in the bond market while paying miums charged on riskier loans, the cost
down both commercial and industrial of credit lines, and loan covenants—
(C&I) loans at banks and commercial on C&I loans. Loan officers cited a
paper. In total, after having increased worsened economic outlook, industry-
91⁄2 percent last year, the debt of non- specific problems, and a reduced toler-
financial businesses rose at a 5 percent ance for risk as the reasons for having
annual rate in the first quarter of this tightened. Despite these adjustments to
year and is estimated to have risen at banks’ lending stance, credit appears to
about the same pace in the second remain amply available for sound bor-
quarter. rowers, and recent surveys of small
Monetary Policy Reports, July 81

businesses indicate that they have not other measures of credit performance
found credit significantly more difficult have shown a more moderate worsen-
to obtain. ing. The ratio of the liabilities of failed
Meanwhile, the issuance of corporate businesses to those of all nonfinancial
bonds this year has proceeded at about businesses and the delinquency rate on
double the pace of the preceding two C&I loans at banks have risen notice-
years. With the yields on high-grade ably from their lows in 1998, but both
bonds back down to their levels in the remain well below levels posted in the
first half of 1999 and with futures early 1990s.
quotes suggesting interest rates will be Commercial mortgage debt increased
rising next year, corporations apparently at about an 83⁄4 percent annual rate in
judged it to be a relatively opportune the first half of this year, and the issu-
time to issue. Although investors remain ance of commercial-mortgage-backed
somewhat selective, they have been securities (CMBS) maintained its robust
willing to absorb the large volume of pace of the past several years. While
issuance as they have become more con- spreads of the yields on investment- and
fident that the economy would recover speculative-grade CMBS over swap
and a prolonged disruption to earnings rates have changed little this year, sig-
would be avoided. The heavy pace of nificant fractions of banks reported
issuance has been supported, in part, by on the Bank Lending Practices survey
inflows into bond mutual funds, which that they have tightened terms and
may have come at the expense of equity standards on commercial real estate
funds. loans. Although the delinquency rates
The flows are forthcoming at rela- on CMBS and commercial real estate
tively high risk spreads, however. loans at banks edged up in the first
Spreads of most grades of corporate debt quarter, they remained near record lows.
relative to rates on swaps have fallen Nevertheless, those commercial banks
a little this year, but spreads remain that reported taking a more cautious
unusually high for lower investment- approach toward commercial real estate
grade and speculative-grade credits. The lending stated that they are doing so, in
elevated spreads reflect the deteriora- part, because of a less favorable eco-
tion in business credit quality that has nomic outlook in general and a worsen-
occurred as the economy has slowed. ing of the outlook for commercial real
While declines in interest rates have estate.
held aggregate interest expense at a
relatively low percentage of cash flow,
many individual firms are feeling the
The Government Sector
pinch of decreases in earnings. Over the The fiscal 2001 surplus in the federal
twelve months ending in May, 11 per- unified budget is likely to be smaller
cent of speculative-grade bonds, by dol- than the surplus in fiscal 2000 because
lar volume, have defaulted—the highest of the slower growth in the economy
percentage since 1991 and a substan- and the recently enacted tax legislation.
tial jump from 1998, when less than Nonetheless, the unified surplus will
2 percent defaulted. This deterioration remain large, and the paydown of the
reflects not only the unusually large federal debt is continuing at a rapid
defaults by the California utilities, but clip. As a consequence, the Treasury has
also stress in the telecommunications taken a number of steps to preserve
sector and elsewhere. However, some liquidity in a shrinking market. The
82 88th Annual Report, 2001

weaker economy is also reducing reve- technology-driven boom in domestic

nues at the state and local level, but investment in recent years.
these governments remain in reasonably Federal receipts in the first eight
good fiscal shape overall and are taking months of the current fiscal year were
advantage of historically low interest just 41⁄2 percent higher than during the
rates to refund existing debt and to issue first eight months of fiscal 2000—a
new debt. much smaller gain than those posted,
on average, over the preceding several
years. Much of the slowing was in cor-
Federal Government
porate receipts, which dropped below
The fiscal 2001 surplus in the federal year-earlier levels, reflecting the recent
government’s unified budget is likely to deterioration in profits. In addition, indi-
come in below the fiscal 2000 surplus of vidual income tax payments rose less
$236 billion. Over the first eight months rapidly than over the preceding few
of the fiscal year—October to May—the years, mainly because of slower growth
unified budget recorded a surplus of in withheld tax payments. This spring’s
$137 billion, $16 billion higher than nonwithheld payments of individual
during the comparable period last year. taxes, which are largely payments on the
But over the balance of the fiscal year, previous year’s liability, were relatively
receipts will continue to be restrained strong. Indeed, although there was no
by this year’s slow pace of economic appreciable ‘‘April surprise’’ this year—
growth and the associated decline in that is, these payments were about in
corporate profits. Receipts will also be line with expectations—liabilities again
reduced significantly over the next few appear to have risen faster than the
months by the payout of tax rebates and NIPA tax base in 2000. One factor that
the shift of some corporate payments has lifted liabilities relative to income
into fiscal 2002, provisions included in in recent years is that rising levels of
the Economic Growth and Tax Relief income and a changing distribution have
Reconciliation Act of 2001. shifted more taxpayers into higher tax
Federal saving, which is basically brackets. Higher capital gains realiza-
the unified budget surplus adjusted to tions also have helped raise liabilities
conform to the accounting practices fol- relative to the NIPA tax base over this
lowed in the national income and prod- period. (Capital gains are not included
uct accounts (NIPA), has risen dramati- in the NIPA income measure, which, by
cally since hitting a low of −31⁄2 percent design, includes only income from cur-
of GDP in 1992 and stood at 33⁄4 percent rent production.)
of GDP in the first quarter—a swing of The faster growth in outlays that
more than 7 percentage points. Reflect- emerged in fiscal 2000 has extended
ing the high level of federal saving, into fiscal 2001. Smoothing through
national saving, which comprises saving some timing anomalies at the start of the
by households, businesses, and govern- fiscal year, nominal spending during the
ments, has been running at a higher rate first eight months of fiscal 2001 was
since the late 1990s than it did over more than 4 percent higher than during
most of the preceding decade, even as the same period last year; excluding the
the personal saving rate has plummeted. sizable drop in net interest outlays that
The deeper pool of national saving, has accompanied the paydown of the
along with large inflows of foreign federal debt, the increase in spending
capital, has provided resources for the so far this year was nearly 6 percent.
Monetary Policy Reports, July 83

Spending in the past couple of years following the market turmoil in the fall
has been boosted by sizable increases of 1998.
in discretionary appropriations as well The Treasury has taken a number of
as by faster growth in outlays for the steps to limit the deterioration in the
major health programs. The especially liquidity of its securities. In recent years,
rapid increase in Medicaid outlays it has concentrated its issuance into
reflects the higher cost and utilization fewer securities, so that the auction sizes
of medical care (including prescription of the remaining securities are larger.
drugs), growing enrollments, and a rise Last year, in order to enable issuance of
in the share of expenses picked up a larger volume of new securities, the
by the federal government. Outlays for Treasury began buying back less-liquid
Medicare have been lifted, in part, by older securities, and it also made every
the higher reimbursements to providers second auction of its 5- and 10-year
that were enacted last year. notes and 30-year bond a reopening of
Real federal expenditures for con- the previously issued security. In Febru-
sumption and gross investment, the part ary, the Treasury put limits on the non-
of government spending that is included competitive bids that foreign central
in GDP, rose at a 5 percent annual rate banks and governmental monetary enti-
in the first quarter. Over the past couple ties may make, so as to leave a larger
of years, real nondefense purchases have and more predictable pool of securities
remained on the moderate uptrend that available for competitive bidding, help-
has been evident since the mid-1990s, ing to maintain the liquidity and effi-
while real defense purchases have ciency of the market. In May, the Trea-
started to rise slowly after having bot- sury announced that it would begin
tomed out in the late 1990s. issuing Treasury bills with a four-week
The Treasury has used the substantial maturity to provide it with greater flex-
federal budget surpluses to pay down ibility and cost efficiency in manag-
its debt further. At the end of June, the ing its cash balances, which, in part
outstanding Treasury debt held by the because new securities are now issued
public had fallen nearly $600 billion, or less frequently, have become more vola-
15 percent, from its peak in 1997. Rela- tile. Finally, also in May, the Treasury
tive to nominal GDP, publicly held debt announced it would in the next few
has dropped from nearly 50 percent in months seek public comment on a plan
the mid-1990s to below 33 percent in to ease the ‘‘35 percent rule,’’ which
the first quarter, the lowest it has been limits the bidding at auctions by those
since 1984. holding claims on large amounts of an
Declines in outstanding federal debt issue. With reopenings increasingly
and the associated reductions in the sizes being used to maintain liquidity in indi-
and frequency of auctions of new issues vidual issues, this rule was constraining
have diminished the liquidity of the many potential bidders. As discussed
Treasury market over the past few years. below, the reduced issuance of Trea-
Bid–asked spreads are somewhat wider, sury securities has also led the Federal
quote sizes are smaller, and the differ- Reserve to modify its procedures for
ence between yields on seasoned versus acquiring such securities and to study
most-recently issued securities has possible future steps for its portfolio.
increased. In part, however, these devel- In early 2000, as investors focused
opments may also reflect a more cau- on the possibility that Treasury securi-
tious attitude among securities dealers ties were going to become increasingly
84 88th Annual Report, 2001

scarce, they became willing to pay a managed to adopt balanced budgets for
premium for longer-dated securities, fiscal 2002 with only minor adjustments
pushing down their yields. However, to taxes and spending.
these premiums appear to have largely Real consumption and investment
unwound later in the year as market spending by state and local governments
participants made adjustments to the rose at nearly a 5 percent annual rate
new environment. These adjustments in the first quarter and apparently posted
include the substitution of alternative a sizable increase in the second quarter
instruments for hedging and pricing, as well. Much of the strength this year
such as interest rate swaps, prominent has been in construction spending,
high-grade corporate bonds, and securi- which has rebounded sharply after a
ties issued by government-sponsored reported decline in 2000 that was hard
enterprises (GSEs). To benefit from to reconcile with the sector’s ongoing
adjustments by market participants, in infrastructure needs and the good finan-
1998, Fannie Mae and Freddie Mac ini- cial condition of most governments.
tiated programs to issue securities that Hiring also remained fairly brisk during
share some characteristics with Trea- the first half of the year; on average,
sury securities, such as regular issuance employment rose 30,000 per month,
calendars and large issue sizes; in the about the same as the average monthly
first half of this year they issued $88 bil- increase over the preceding three
lion of coupon securities and $502 bil- years.
lion of bills under these programs. The Although interest rates on munici-
GSEs have also this year begun buy- pal debt have edged up this year, they
ing back older securities to boost the remain low by historical standards.
size of their new issues. Nevertheless, State and local governments have taken
the market for Treasury securities advantage of the low interest rates to
remains considerably more liquid than refund existing debt and to raise new
markets for GSE and other fixed-income capital. Credit quality has remained
securities. quite high in the municipal sector
even as tax receipts have softened, with
State and Local Governments credit upgrades outpacing downgrades
in the first half of this year. Most
State and local governments saw an notable among the downgrades was that
enormous improvement in their budget of California’s general obligation bonds.
positions between the mid-1990s and Standard and Poor’s lowered Califor-
last year as revenues soared and spend- nia’s debt two notches from AA to A+,
ing generally was held in check; accord- citing the financial pressures from the
ingly, these governments were able both electricity crisis and the likely adverse
to lower taxes and to make substan- effects of the crisis on the state’s
tial allocations to reserve funds. More economy.
recently, however, revenue growth has
slowed in many states, and reports of
fiscal strains have increased. Nonethe-
The External Sector
less, the sector remains in relatively The deficits in U.S. external balances
good fiscal shape overall, and most gov- narrowed sharply in the first quarter of
ernments facing revenue shortfalls have this year, largely because of a smaller
Monetary Policy Reports, July 85

deficit in trade in goods and services. quarter, slightly higher than the rate of
Most of the financial flows into the increase recorded in 2000.
United States continued to come from U.S. real exports were hit by slower
private foreign sources. growth abroad, the strength of the
dollar, and plunging global demand
Trade and Current Account for high-tech products. Real exports of
goods and services, which had grown
After widening continuously during the strongly in the first three quarters of
past four years, the deficits in U.S. exter- 2000, fell 61⁄2 percent at an annual rate
nal balances narrowed in the first quar- in the fourth quarter of last year and
ter of 2001. The current account deficit declined another 1 percent in the first
in the first quarter was $438 billion at an quarter of this year. The largest declines
annual rate, or 4.3 percent of GDP, com- in both quarters were in high-tech capi-
pared with $465 billion in the fourth tal goods and automotive products (pri-
quarter of 2000. Most of the reduction marily in intrafirm trade with Canada).
of the current account deficit can be By market destination, the largest
traced to changes in U.S. trade in goods increases in U.S. goods exports during
and services; the trade deficit narrowed the first three quarters of 2000 had been
from an annual rate of $401 billion in to Mexico and countries in Asia; the
the fourth quarter of 2000 to $380 bil- recent declines were mainly in exports
lion in the first quarter of this year. The to Asia and Latin America. In contrast,
trade deficit in April continued at about goods exports to Western Europe
the same pace. Net investment income increased steadily throughout the entire
payments were a bit less in the first period. About 45 percent of U.S. goods
quarter than the average for last year exports in the first quarter of 2001 were
primarily because of a sizable decrease capital equipment; 20 percent were
in earnings by U.S. affiliates of foreign industrial supplies; and 5 to 10 percent
firms. each were agricultural, automotive, con-
As U.S. economic growth slowed in sumer, and other goods.
the second half of last year and early After increasing through much of
this year, real imports of goods and 2000, the spot price of West Texas inter-
services, which had grown very rapidly mediate (WTI) crude oil reached a peak
in the first three quarters of 2000, above $37 per barrel in September, the
expanded more slowly in the fourth highest level since the Gulf War. As
quarter and then contracted 5 percent world economic growth slowed in the
at an annual rate in the first quarter. latter part of 2000, oil price declines
The largest declines were in high-tech reversed much of the year’s price gain.
products (computers, semiconductors, In response, OPEC reduced its official
and telecommunications equipment) production targets in January of this year
and automotive products. In contrast, and again in March. As a result, oil
imports of petroleum and petroleum prices have remained relatively high in
products increased moderately. A tem- 2001 despite weaker global economic
porary surge in the price of imported growth and a substantial increase in
natural gas pushed the increase of the U.S. oil inventories. Oil prices have also
average price of non-oil imports above been elevated by the volatility of Iraqi
an annual rate of 1 percent in the first oil exports arising from tense relations
86 88th Annual Report, 2001

between Iraq and the United Nations. ing, and the unemployment rate rose.
During the first six months of this year, Increases in hourly compensation have
the spot price of WTI has fluctuated, continued to trend up in recent quarters,
with only brief exceptions, between $27 while measured labor productivity has
and $30 per barrel. been depressed by the slower growth of
Financial Account
In the first quarter of 2001, as was the Employment and Unemployment
case in 2000 as a whole, nearly all of the After having risen an average of
net financial flows into the United States 149,000 per month in 2000, private pay-
came from private foreign sources. For- roll employment increased an average
eign official inflows were less than of only 63,000 per month in the first
$5 billion and were composed primar- quarter of 2001, and it declined an aver-
ily of the reinvestment of accumulated age of 117,000 per month in the second
interest earnings. Reported foreign quarter. The unemployment rate moved
exchange intervention purchases of dol- up over the first half of the year and in
lars were modest. June stood at 41⁄2 percent, 1⁄2 percentage
Inflows arising from private foreign point higher than in the fourth quarter of
purchases of U.S. securities accelerated last year.
further in the first quarter and are on a Much of the weakness in employment
pace to exceed last year’s record. All of in the first half of the year was in the
the pickup is attributable to larger net manufacturing sector, where job losses
foreign purchases of U.S. bonds, as for- averaged 78,000 per month in the first
eign purchases of both corporate and quarter and 116,000 per month in the
agency bonds accelerated and private second quarter. Since last July, manufac-
foreign sales of Treasuries paused. For- turing employment has fallen nearly
eign purchases of U.S. equities are only 800,000. Factory job losses were wide-
slightly below their 2000 pace despite spread in the first half of the year, with
the apparent decline in expected returns some of the biggest cutbacks at indus-
to holding U.S. equities. tries struggling with sizable inventory
The pace at which U.S. residents overhangs, including metals and indus-
acquired foreign securities changed little trial and electronic equipment. The
between the second half of last year and weakness in manufacturing also cut into
the first quarter of this year. As in previ- employment at help-supply firms and at
ous years, most of the foreign securities wholesale trade establishments.
acquired were equities. Apart from manufacturing and the
Net financial inflows associated with closely related help-supply and whole-
direct investment slowed a good bit in sale trade industries, employment
the first quarter, as there were signifi- growth held up fairly well in the first
cantly fewer large foreign takeovers of quarter but began to slip noticeably in
U.S. firms and U.S. direct investment the second quarter. Some of the slowing
abroad remained robust. in the second quarter reflected a drop in
construction employment after a strong
The Labor Market first quarter that likely absorbed a por-
tion of the hiring that normally takes
Labor demand weakened in the first place in the spring; on average, con-
half of 2001, especially in manufactur- struction employment rose a fairly brisk
Monetary Policy Reports, July 87

15,000 per month over the first half, through the annual revision process—
about the same as in 2000. Hiring in the shows a steady uptrend over the past
services industry (other than help-supply couple of years; it rose 6 percent over
firms) also slowed markedly in the sec- the year ending in the first quarter after
ond quarter. Employment in retail trade having risen 41⁄2 percent over the pre-
remained on a moderate uptrend over ceding year.
the first half of the year, and employ- According to the ECI, wages and
ment in finance, insurance, and real salaries rose at an annual rate of about
estate increased modestly after having 41⁄2 percent in the first quarter. Exclud-
been unchanged, on net, last year. ing sales workers, wages rose 5 percent
(annual rate) in the first quarter and
41⁄4 percent over the year ending in
Labor Costs and Productivity
March; this compares with an increase
Through the first quarter, compensation of 33⁄4 percent over the year ending in
growth remained quite strong—indeed, March 2000. Separate data on average
trending higher by some measures. hourly earnings of production or non-
These gains likely reflected the influ- supervisory workers also show a dis-
ence of earlier tight labor markets, cernible acceleration of wages: The
higher consumer price inflation— twelve-month change in this series was
largely due to soaring energy prices— 41⁄4 percent in June, 1⁄2 percentage point
and the greater real wage gains made above the reading for the preceding
possible by faster structural productivity twelve months.
growth. The upward pressures on labor Benefit costs as measured in the ECI
costs could abate in coming quarters if have risen faster than wages over the
pressures in labor markets ease and past year, with the increase over the
energy prices fall back. twelve months ending in March totaling
Hourly compensation, as measured by 5 percent. Much of the pressure on bene-
the employment cost index (ECI) for fits is coming from health insurance,
private nonfarm businesses, moved up where employer payments have acceler-
in the first quarter to a level about ated steadily since bottoming out in the
41⁄4 percent above its level of a year mid-1990s and are now going up about
earlier; this compares with increases of 8 percent per year. The surge in spend-
about 41⁄2 percent over the preceding ing on prescription drugs accounts for
year and 3 percent over the year before some of the rise in health insurance
that. The slight deceleration in the most costs, but demand for other types of
recent twelve-month change in the ECI medical care is increasing rapidly as
is accounted for by a slowdown in the well. Moreover, although there has
growth of compensation for sales work- been some revamping of drug coverage
ers relative to the elevated rates that had to counter the pressures of soaring
prevailed in early 2000; these workers’ demand, many employers have been
pay includes a substantial commission reluctant to adjust other features of the
component and thus is especially sensi- health benefits package in view of the
tive to cyclical developments. Compen- need to retain workers in a labor market
sation per hour in the nonfarm business that has been very tight in recent years.
sector—a measure that picks up some Measured labor productivity in the
forms of compensation that the ECI nonfarm business sector has been
omits but that sometimes has been bounced around in recent quarters by
revised substantially once the data go erratic swings in hours worked by self-
88 88th Annual Report, 2001

employed individuals, but on balance, it May but eased in June and early July. In
has barely risen since the third quarter addition, core PCE price inflation has
of last year after having increased about dropped back after the first-quarter
3 percent per year, on average, over the spurt, and the twelve-month change in
preceding three years. This deceleration this series, which is a useful indicator of
coincides with a marked slowing in out- the underlying inflation trend, stood at
put growth and seems broadly in line 11⁄2 percent in May, about the same as
with the experience of past business the change over the preceding twelve
cycles; these readings remain consistent months. The core consumer price index
with a noticeable acceleration in struc- (CPI) continued to move up at a faster
tural productivity having occurred in the pace than the core PCE measure over
second half of the 1990s. Reflecting the the past year, rising 21⁄2 percent over the
movements in hourly compensation and twelve months ending in May, also the
in actual productivity, unit labor costs in same rate as over the preceding year.
the nonfarm business sector jumped in PCE energy prices rose at an annual
the first quarter and have risen 31⁄2 per- rate of about 11 percent in the first quar-
cent over the past year. ter and, given the big increases in April
Looking ahead, prospects for favor- and May, apparently posted another
able productivity performance will sizable advance in the second quarter.
hinge on a continuation of the rapid Unlike the surges in energy prices in
technological advances of recent years 1999 and 2000, the increases in the first
and on the willingness of businesses to half of 2001 were not driven by devel-
expand and update their capital stocks opments in crude oil markets. Indeed,
to take advantage of the new efficiency- natural gas prices were the major factor
enhancing capital that is becoming boosting overall energy prices early this
available at declining cost in many year as tight inventories and concerns
cases. To be sure, the current weakness about potential stock-outs pushed spot
in business investment will likely damp prices to extremely high levels; natu-
the growth of the capital stock relative ral gas prices have since receded as
to the pace of the past couple of years. additional supplies have come on line
But once the cyclical weakness in the and inventories have been rebuilt. In
economy dissipates, continued advances the spring, gasoline prices soared in
in technology should provide impetus to response to strong demand, refinery
renewed capital spending and a return to disruptions, and concerns about lean
solid increases in productivity. inventories; with refineries back on line,
imports up, and inventories restored,
gasoline prices have since fallen notice-
Prices ably below their mid-May peaks. Elec-
Inflation moved higher in early 2001 but tricity prices also rose substantially
has moderated some in recent months. in the first half of the year, reflecting
After having risen 21⁄4 percent in 2000, higher natural gas prices as well as the
the chain price index for personal con- problems in California. Capacity prob-
sumption expenditures (PCE) increased lems in California and the hydropower
about 31⁄4 percent in the first quarter of shortages in the Northwest persist,
2001 as energy prices soared and as core though California’s electricity consump-
consumer prices—which exclude food tion has declined recently and whole-
and energy—picked up. Energy prices sale prices have dropped. In contrast,
continued to rise rapidly in April and capacity in the rest of the country
Monetary Policy Reports, July 89

has expanded appreciably over the past firms facing foreign competition to
year and, on the whole, appears ade- raise prices for fear of losing market
quate to meet the normal seasonal rise in share. In addition, apart from energy,
demand. price pressures at earlier stages of
Core PCE prices rose at a 21⁄2 percent processing have been minimal. Indeed,
annual rate in the first quarter—a hefty excluding food and energy, the producer
increase by the standards of recent price index (PPI) for intermediate mate-
years. But the data are volatile, and the rials has been flat over the past year, and
first-quarter increase, no doubt, exagger- the PPI for crude materials has fallen
ates any pickup. Based on monthly data 11 percent. Moreover, inflation expec-
for April and May, core PCE inflation tations, on balance, seem to have
appears to have slowed considerably in remained quiescent: According to the
the second quarter; the slowing was con- Michigan survey, the median expecta-
centrated in the goods categories and tion for inflation over the upcoming year
seems consistent with reports that retail- generally has been running about 3 per-
ers have been cutting prices to spur sales cent this year, similar to the readings in
in an environment of soft demand. 2000.
Core consumer price inflation— In contrast to the step-up in consumer
whether measured by the PCE index or prices, prices for private investment
by the CPI—in recent quarters almost goods in the NIPA were up only a little
certainly has been boosted by the effects in the first quarter after having risen
of higher energy prices on the costs of about 2 percent last year. In large part,
producing other goods and services. this pattern was driven by movements in
Additional pressure has come from the the price index for computers, which fell
step-up in labor costs. That said, firms at an annual rate of nearly 30 percent in
appear to have absorbed much of these the first quarter as demand for high-tech
cost increases in lower profit margins. equipment plunged. This drop in com-
Meanwhile, non-oil import prices have puter prices was considerably greater
remained subdued, thus continuing to than the average decrease of roughly
restrain input costs for many domestic 20 percent per year in the second half
industries and to limit the ability of of the 1990s and the unusually small

Alternative Measures of Price Change

Percent, Q1 to Q1

1998 1999 2000

Price measure to to to
1999 2000 2001

Gross domestic product . . . . . . . . . . . . . . . . . . . . . . . . . . 1.5 1.8 2.3
Gross domestic purchases . . . . . . . . . . . . . . . . . . . . . . . . 1.2 2.3 2.2
Personal consumption expenditures . . . . . . . . . . . . . . . 1.5 2.5 2.2
Excluding food and energy . . . . . . . . . . . . . . . . . . . . . 1.8 1.6 1.7

Consumer price index . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.7 3.3 3.4
Excluding food and energy . . . . . . . . . . . . . . . . . . . . . 2.2 2.2 2.7

Note. A fixed-weight index uses quantity weights to change each year. The consumer price indexes are for
from a base year to aggregate prices from each distinct all urban consumers. Changes are based on quarterly
item category. A chain-type index is the geometric aver- averages.
age of two fixed-weight indexes and allows the weights
90 88th Annual Report, 2001

11 percent decrease in 2000. Monthly first half of this year as near-term cor-
PPI data suggest that computer prices porate earnings were revised down sub-
were down again in the second quarter, stantially. Rates on longer-term Trea-
though much less than in the first sury issues rose a little, but those on
quarter. corporate bonds were about unchanged,
All told, the GDP chain-type price with the narrowing spread reflecting
index rose at an annual rate of 31⁄4 per- greater investor confidence in the out-
cent in the first quarter and has risen look. But risk spreads remained wide
21⁄4 percent over the past four quarters, by historical standards for businesses
an acceleration of 1⁄2 percentage point whose debt was rated as marginally
from the comparable year-earlier period. investment grade or below; many of
The price index for gross domestic these firms had been especially hard
purchases—which is defined as the hit by the slowdown and the near-term
prices paid for consumption, investment, oversupply of high-tech equipment and
and government purchases—also accel- services, and defaults by these firms
erated in the first quarter—to an increase became more frequent. Nevertheless, for
of about 23⁄4 percent; the increase in this most borrowers the environment for
measure over the past year was 21⁄4 per- long-term financing was seen to be quite
cent, about the same as over the preced- favorable, and firms and households
ing year. Excluding food and energy, the tended to tap long-term sources of credit
latest four-quarter changes in both GDP in size to bolster their financial condi-
and gross domestic purchases prices tions and lock in more favorable costs.
were roughly the same as over the pre-
ceding year. Interest Rates
In response to the abrupt deceleration
U.S. Financial Markets in economic growth and prospects for
Longer-term interest rates and equity continued weakness in the economy, the
prices have shown remarkably small net FOMC lowered the target federal funds
changes this year, given the consider- rate 23⁄4 percentage points in six steps
able shifts in economic prospects and in the first half of this year, an unusually
major changes in monetary policy. To steep decline relative to many past eas-
some extent, the expectations of the eco- ing cycles. Through March, the policy
nomic and policy developments in 2001 easings combined with declining equity
had already become embedded in finan- prices and accumulating evidence that
cial asset prices as last year came to a the slowdown in economic growth was
close; from the end of August through more pronounced than had been ini-
year-end, the broadest equity price tially thought led to declines in yields
indexes fell 15 percent and investment- on intermediate- and longer-term Trea-
grade bond yields declined 40 to sury securities. Over the second quar-
70 basis points. In addition, however, ter, despite the continued decrease in
equity prices and long-term interest rates short-term rates and further indications
were influenced importantly by growing of a weakening economy, yields on
optimism in financial markets over the intermediate-term Treasury securities
second quarter of 2001 that the econ- were about unchanged, while those on
omy and profits would rebound strongly longer-term securities rose appreciably.
toward the end of 2001 and in 2002. On On net, yields on intermediate-term
net, equity prices fell 6 percent in the Treasury securities fell about 3⁄4 per-
Monetary Policy Reports, July 91

centage point in the first half of this vated. Spreads of corporate bond yields
year, while those on longer-term Trea- relative to swap rates narrowed a bit,
sury securities rose about 1⁄4 percentage although they still remain high. Amidst
point. signs of deteriorating credit quality and
The increase in longer-term Treasury a worsening outlook for corporate earn-
yields in the second quarter appears to ings, risk spreads on speculative-grade
have been the result of a number of bonds had risen by about 2 percentage
factors. The main influence seems to points late last year, reaching levels not
have been increased investor confidence seen since 1991. Much of this widening
that the economy would soon pick up. was reversed early in the year, as inves-
That confidence likely arose in part from tors became more confident that corpo-
the aggressive easing of monetary pol- rate balance sheets would not deterio-
icy and also in part from the improving rate substantially, but speculative-grade
prospects for, and passage of, a sizable bond spreads widened again recently in
tax cut. The tax cut and the growing response to negative news about second-
support for certain spending initiatives quarter earnings and declines in share
implied stronger aggregate demand and prices, leaving these spreads at the end
less federal saving than previously of the second quarter only slightly
anticipated. The prospect that the fed- below where they began the year. None-
eral debt might be paid down less rap- theless, investors, while somewhat
idly may also have reduced slightly selective, appear to remain receptive
the scarcity premiums investors were to new issues with speculative-grade
willing to pay for Treasury securities. ratings.
Finally, a portion of the rise may have Interest rates on commercial paper
been the result of increased inflation and C&I loans have fallen this year by
expectations. Inflation compensation as about as much as the federal funds rate,
measured by the difference between although some risk spreads widened.
nominal Treasury rates and the rates The average yield spread on second-tier
on inflation-indexed Treasury securities commercial paper over top-tier paper
rose about 1⁄4 percentage point in the widened to about 100 basis points in
second quarter. Despite this increase, late January, about four times its typi-
there is little evidence that inflation is cal level, following defaults by a few
expected to go up from its current level. prominent issuers. As the year pro-
At the end of last year, inflation com- gressed, investors became less con-
pensation had declined to levels suggest- cerned about the remaining commer-
ing investors expected inflation to fall, cial paper borrowers, and this spread
and the rise in inflation compensation in has returned to a more normal level.
the second quarter largely reversed those According to preliminary data from the
declines. Moreover, survey measures of Federal Reserve’s quarterly Survey of
longer-term inflation expectations have Terms of Business Lending, the spread
changed little since the middle of last over the target federal funds rate of
year. the average interest rate on commercial
Yields on longer-maturity corporate bank C&I loans edged up between
bonds were about unchanged, on net, November and May and remains in the
over the first half of this year. Yields on elevated range it shifted to in late 1998.
investment-grade bonds are near their Judging from the widening since 1998
lows for the past ten years, but those of the average spread between rates on
on speculative-grade bonds are ele- riskier and less-risky loans, banks have
92 88th Annual Report, 2001

become especially cautious about lend- time. This measure of the earnings–
ing to marginal credits. price ratio remains near the levels
reached in 1999, suggesting that inves-
Equity Markets tors still anticipate robust long-term
earnings growth, likely reflecting expec-
After rising in January in response to the tations for continued strong gains in
initial easing of monetary policy, stock productivity.
prices declined in February and March Despite the substantial variation in
in reaction to profit warnings and weak share prices over the first half of this
economic data, with the Wilshire 5000, year, trading has been orderly, and
the broadest major stock price index, financial institutions appear to have
ending the first quarter down 13 percent. encountered no difficulties that could
Stock prices retraced some of those pose broader systemic concerns. Market
losses in the second quarter, rising 7 per- volatility and a less ebullient outlook
cent, as first-quarter earnings releases have led investors to buy a much smaller
came in a little above sharply reduced share of stock on margin. At the end of
expectations and as investors became May, margin debt was 1.15 percent of
more confident that economic growth total market capitalization, equal to its
and corporate profits would soon pick level at the beginning of 1999 and well
up. On net, the Wilshire 5000 ended the below its high of 1.63 percent in March
half down 6 percent, the DJIA declined of last year.
3 percent, and the tech-heavy Nasdaq
fell 13 percent. Earnings per share of the
Federal Reserve Open Market
S&P 500 in the first quarter decreased
10 percent from a year earlier. A dispro-
portionate share of the decline in S&P As noted earlier, the Federal Reserve
earnings—more than half—was attribut- has responded to the diminished size of
able to a plunge in the technology sec- the auctions of Treasury securities by
tor, where first-quarter earnings were modifying its procedures for acquiring
down nearly 50 percent from their peak such securities. To help maintain supply
in the third quarter of last year. in private hands adequate for liquid mar-
The decline in stock prices has left kets, since July of last year the System
the Wilshire 5000 down by about has limited its holdings of individual
20 percent, and the Nasdaq down by securities to specified percentages, rang-
about 60 percent, from their peaks in ing from 15 percent to 35 percent, of
March 2000. Both of these indexes are outstanding amounts. To stay within
near their levels at the end of 1998, these limits, the System has at times not
having erased the sharp run-up in rolled over all of its holdings of matur-
prices in 1999 and early 2000. But both ing securities, generally investing the
indexes remain more than two and one- difference by purchasing other Treasury
half times their levels at the end of securities on the open market. The Fed-
1994, when the bull market shifted into eral Reserve also has increased its hold-
a higher gear. The ratio of expected one- ings of longer-term repurchase agree-
year-ahead earnings to equity prices ments (RPs), including RPs backed by
began to fall in 1995 when, as produc- agency securities and mortgage-backed
tivity growth picked up, investors began securities, as a substitute for outright
to build in expectations that increases purchases of Treasury securities. In the
in earnings would remain rapid for some first half of the year, longer-term RPs,
Monetary Policy Reports, July 93

typically with maturities of twenty-eight in the growth of nonfederal and federal

days, averaged $13 billion. debt this year have mostly offset each
As reported in the previous Monetary other. The growth of nonfederal debt
Policy Report, the FOMC also initiated moderated from 81⁄2 percent in 2000 to a
a study to evaluate assets to hold on its still-robust 71⁄4 percent pace in the first
balance sheet as alternatives to Treasury half of this year. Households’ borrowing
securities. That study identified several slowed some but was still substantial,
options for further consideration. In the buoyed by continued sizable home and
near term, the Federal Reserve is con- durable goods purchases. Similarly,
sidering purchasing and holding Ginnie business borrowing moderated even as
Mae mortgage-backed securities, which bond issuance surged, as a good portion
are explicitly backed by the full faith of the funds raised was used to pay
and credit of the U.S. government, down commercial paper and bank loans.
and engaging in repurchase operations Tending to boost debt growth was a
against foreign sovereign debt. For pos- slowing in the decline in federal debt to
sible implementation later, the Federal a 61⁄4 percent rate in the first half of this
Reserve is studying whether to auction year from 63⁄4 percent last year, largely
longer-term discount window credit, and because of a decline in tax receipts on
it will over time take a closer look at corporate profits.
a broader array of assets for repurchase The share of credit to nonfinancial
and for holding outright, transactions sectors held at banks and other deposi-
that would require additional legal tory institutions edged down in the first
authority. half of the year. Bank credit, which
accounts for about three-fourths of
depository credit, increased at a 31⁄2 per-
Debt and the Monetary Aggregates cent annual rate in the first half of the
The growth of domestic nonfinancial year, well off the 91⁄2 percent growth
debt in the first half of 2001 is estimated registered in 2000. Banks’ loans to busi-
to have remained moderate, slowing nesses and households decelerated even
slightly from the pace in 2000 as a more, in part because borrowers pre-
reduction in the rate of increase in non- ferred to lock in the lower rates avail-
federal debt more than offset the effects able from longer-term sources of funds
of smaller net repayments of federal such as bond and mortgage markets and
debt. In contrast, the monetary aggre- perhaps also in part because banks
gates have grown rapidly so far this firmed up their lending stance in reac-
year, in large part because the sharp tion to concerns about loan perfor-
decline in short-term market interest mance. Loan delinquency and charge-
rates has reduced the opportunity cost of off rates have trended up in recent
holding the deposits and other assets quarters, and higher loan-loss provisions
included in the aggregates. have weighed on profits. Nevertheless,
through the first quarter, bank profits
Debt and Depository Intermediation remained in the high range recorded for
the past several years, and virtually all
The debt of the domestic nonfinancial banks—98 percent by assets—were well
sectors is estimated to have expanded at capitalized. With banks’ financial condi-
a 43⁄4 percent annual rate over the first tion still quite sound, they remain well
half of 2001, a touch below the 51⁄4 per- positioned to meet future increases in
cent growth recorded in 2000. Changes the demand for credit.
94 88th Annual Report, 2001

The Monetary Aggregates kept headline inflation rates somewhat

elevated, but even though core rates of
The monetary aggregates have expanded inflation have edged up in countries
rapidly so far this year, although growth where economic slack has diminished,
rates have moderated somewhat inflationary pressures appear to be well
recently. M2 rose 101⁄4 percent at an under control.
annual rate in the first half of this year Monetary authorities in most cases
after having grown 61⁄4 percent in 2000. reacted to signs of slowdown by lower-
The interest rates on many of the com- ing official rates, but by less than in the
ponents of M2 do not adjust quickly or United States. Partly in response to these
fully to changes in market interest rates. actions, yield curves have steepened
As a consequence, the steep declines in noticeably so far in 2001. Although
short-term market rates this year have long-term interest rates moved down
left investments in M2 assets relatively during the first quarter, they more than
more attractive, contributing importantly reversed those declines in most cases
to the acceleration in the aggregate. M2 as markets reacted to a combination of
has also probably been buoyed by the the anticipation of stronger real growth
volatility in the stock market this year, and the risk of increased inflationary
and perhaps by lower expected returns pressure. Foreign equity markets—
on equity investments, leading investors especially for high-tech stocks—were
to seek the safety and liquidity of M2 buffeted early this year by many of
assets. the same factors that affected U.S.
M3, the broadest monetary aggre- share prices: negative earnings reports,
gate, rose at a 131⁄4 percent annual rate weaker economic activity, buildups of
through June, following 91⁄4 percent inventories of high-tech goods, and
growth in 2000. All of the increase in uncertainties regarding the timing and
M3, apart from that accounted for by extent of policy responses. In recent
M2, resulted from a ballooning of insti- months, the major foreign equity
tutional money market funds, which indexes moved up along with U.S. stock
expanded by nearly a third. Yields on prices, but they have edged off lately
these funds lag market yields somewhat, and in most cases are down, on balance,
and so the returns to the funds, like for the year so far.
those on many M2 assets, became rela- Slower U.S. growth, monetary easing
tively attractive as interest rates on by the Federal Reserve, fluctuations
short-term market instruments declined. in U.S. stock prices, and the large U.S.
external deficit have not undermined
International Developments dollar strength. After the December
2000 FOMC meeting, the dollar lost
So far this year, average foreign growth ground against the major currencies; but
has weakened further and is well below shortly after the FOMC’s surprise rate
its pace of a year ago. Activity abroad cut on January 3, the dollar reversed all
was restrained by the continued high of that decline as market participants
level of oil prices, the global slump evidently reassessed the prospects for
of the high-technology sector, and recovery in the United States versus that
spillover effects from the U.S. eco- in our major trading partners. The dollar
nomic slowdown, but in some countries as measured by a trade-weighted index
domestic demand softened as well in against the currencies of major indus-
reaction to local factors. High oil prices trial countries gained in value steadily
Monetary Policy Reports, July 95

in the first three months of 2001, reach- inflation moves up to zero or above.
ing a fifteen-year high in late March. After the yen had moved near the end of
Continued flows of foreign funds into March to its weakest level relative to the
U.S. assets appeared to be contribut- dollar in more than four years, Japanese
ing importantly to the dollar’s increase. financial markets were buoyed by the
Market reaction to indications that the surprise election in May of Junichiro
U.S. economy might be headed toward Koizumi to party leadership and thereby
a more prolonged slowdown undercut to prime minister. The yen firmed
the dollar’s strength somewhat in early slightly for several weeks thereafter, but
April, and the dollar eased further after continued weak economic fundamentals
the unexpected April 18 rate cut by the and increased market focus on the
FOMC. However, the dollar has more daunting challenges facing the new gov-
than made up that loss in recent months ernment helped push the yen back down
as signs of weakness abroad have and beyond its previous low level.
emerged more clearly. On balance, the At the start of 2001, economic activ-
dollar is up about 7 percent against the ity in the euro area had slowed notice-
major currencies so far this year; against ably from the more rapid rates seen
a broader index that includes currencies early last year but still was fairly robust.
of other important trading partners, the Average GDP growth of near 2 per-
dollar has appreciated 5 percent. cent was only slightly below estimated
The dollar has gained about 9 percent rates of potential growth, although some
against the yen, on balance, as the Japa- key countries (notably Germany) were
nese economy has remained troubled showing signs of faltering further.
by structural problems, stagnant growth, Although high prices for oil and food
and continuing deflation. Industrial pro- had raised headline inflation, the rate of
duction has been falling, and real GDP change of core prices was below the
declined slightly in the first quarter, with 2 percent ceiling for overall inflation set
both private consumption and invest- by the European Central Bank (ECB).
ment contracting. Japanese exports also The euro also was showing some signs
have sagged because of slower demand of strength, having moved well off the
from many key trading partners. Early low it had reached in October. However,
in the year, under increasing pressure to negative spillovers from the global
respond to signs that their economy was slowdown started to become more evi-
weakening further, the Bank of Japan dent in weaker export performance in
(BOJ) slightly reduced the uncollateral- the first quarter, and leading indicators
ized overnight call rate, its key policy such as business confidence slumped.
interest rate. By March, the low level Nevertheless, the ECB held policy
of equity prices, which had been declin- steady through April, as further weaken-
ing since early 2000, was provoking ing of the euro against the dollar (fol-
renewed concerns about the solvency of lowing a trend seen since the FOMC’s
Japanese banks. In mid-March, the BOJ rate cut in early January), growth of M3
announced that it was shifting from aim- in excess of the ECB’s reference rate,
ing at a particular overnight rate to tar- and signs of an edging up of euro-area
geting balances that private financial core inflation were seen as militating
institutions hold at the Bank, effectively against an easing of policy.
returning the overnight rate to zero; In early May, the ECB surprised mar-
the BOJ also announced that it would kets with a 25 basis point reduction of
continue this easy monetary stance until its minimum bid rate and parallel reduc-
96 88th Annual Report, 2001

tions of its marginal lending and deposit dian dollar has regained much of the
rates. In explaining the step, the ECB ground it had lost earlier and is down
noted that monetary developments no about 2 percent on balance since the
longer posed a threat to price stability beginning of the year.
and projected that moderation of GDP Global financial markets were rattled
growth would damp upward price pres- in February by serious problems in the
sure. The euro has continued to fall Turkish banking sector. Turkish interest
since then and, on balance, has declined rates soared and, after market pressures
9 percent against the dollar since the led authorities to allow the Turkish lira
beginning of the year. Faced with a simi- to float, it experienced a sharp deprecia-
lar slowdown in the U.K. economy that tion of more than 30 percent. An IMF
was exacerbated by the outbreak of foot- program announced in mid-May that
and-mouth disease, the Bank of England will bring $8 billion in support this year
also cut its official call rate three times and require a number of banking and
(by a total of 75 basis points) during the other reforms helped steady the situa-
first half of the year. The Labor Party’s tion temporarily, but market sentiment
victory in parliamentary elections in started to deteriorate again in early July.
early June seemed to raise market In Argentina, the weak economy and
expectations of an early U.K. euro refer- the government’s large and growing
endum and put additional downward debt burden stoked market fears that
pressure on sterling, but that was partly the government would default on its
offset by signs of stronger inflationary debt and alter its one-for-one peg of the
pressure. On balance, the pound has lost peso to the dollar. In April, spreads
about 6 percent against the dollar this on Argentina’s internationally traded
year, while it has strengthened against bonds moved up sharply, and interest
the euro. rates spiked. In June, the government
The exchange value of the Canadian completed a nearly $30 billion debt
dollar has swung over a wide range in exchange with its major domestic and
2001. In the first quarter, the Canadian international creditors aimed at alleviat-
dollar fell about 5 percent against the ing the government’s cash flow squeeze,
U.S. dollar as the Canadian economy improving its debt amortization profile,
showed signs of continuing a decelera- and giving it time to enact fiscal reforms
tion of growth that had started in late and revive the economy. Argentine
2000. Exports—especially autos, auto financial conditions improved somewhat
equipment, and electronic equipment— following agreement on the debt swap.
suffered from weaker U.S. demand. However, this improvement proved tem-
Softer global prices for non-oil com- porary, and an apparent intensification
modities also appeared to put downward of market concerns about the possibility
pressure on the Canadian currency. With of a debt default triggered a sharp fall in
inflation well within its target range, the Argentine financial asset prices at mid-
Bank of Canada cut its policy rate sev- July. This financial turbulence in Argen-
eral times by a total of 125 basis points. tina negatively affected financial mar-
So far this year, industries outside of kets in several other emerging market
manufacturing and primary resources economies. The turmoil in Argentina
appear to have been much less affected took a particular toll on Brazil, where an
by external shocks, and domestic energy crisis added to other problems
demand has maintained a fairly healthy that have kept growth very slow since
pace. Since the end of March, the Cana- late last year. Intervention purchases of
Monetary Policy Reports, July 97

the real by the Brazilian central bank Singapore, and Hong Kong, for exam-
and a 300 basis point increase in its ple, fell from a 15 percent annual rate in
main policy interest rate helped take late 2000 to close to zero in mid-2001.
some pressure off the currency, but the The turnaround of the high-tech compo-
real has declined about 24 percent so far nent of industrial production in those
this year. countries was even more abrupt—from
The weak performance of the Mexi- more than a 30 percent rate of increase
can economy at the end of last year to a slight decline by midyear. In the
caused largely by a fall in exports to Philippines and Indonesia, economic
the United States (notably including a difficulties were compounded by serious
sharp drop in exports of automotive political tensions. Currencies in many
products) and tight monetary policy car- of these countries moved down versus
ried over into early 2001. With inflation the dollar, and stock prices declined.
declining, the Bank of Mexico loosened In Korea, the sharp slump in activity
monetary policy in May for the first that began late last year continued into
time in three years. Problems with 2001, as weakness in the external sector
Mexican growth did not spill over to spread to domestic consumption and
financial markets, however. The peso investment. The Bank of Korea lowered
has remained strong and is up about its target interest rate a total of 50 basis
3 percent so far this year, and stock points over the first half of the year in
prices have risen. response to the weakening in activity.
Average growth in emerging Asia The Chinese economy, which is less
slowed significantly in the first half; dependent on technology exports than
GDP grew more slowly or even declined many other countries in the region, con-
in economies that were more exposed to tinued to expand at a brisk pace in the
the effects of the global drop in demand first half of this year, as somewhat softer
for high-tech products. Average growth export demand was offset by increased
of industrial production in Malaysia, government spending.

Domestic Open Market Operations during 2001

Implementation of in the following section. The conduct of

Monetary Policy in 2001 open market operations in the aftermath
of the terrorist attacks on the World
The directives pertinent to the imple-
Trade Center and Pentagon on Septem-
mentation of domestic open market
ber 11 is reviewed in the final section.
operations issued by the Federal Open
Market Committee (FOMC) instruct the
Trading Desk at the Federal Reserve Overview of Operating Procedures
Bank of New York (FRBNY) to foster to Control the Federal Funds Rate
conditions in the market for reserves The FOMC lowered the federal funds
consistent with maintaining the federal rate target on eleven different occasions
funds rate at an average around a speci- during 2001, reducing it by a cumula-
fied rate. This indicated rate is com- tive 43⁄4 percentage points to end the
monly referred to as the federal funds year at a level of 13⁄4 percent (table).
rate target. The Desk arranges open mar- Three of these rate changes were made
ket operations to target the funds rate, between regularly scheduled FOMC
while at the same time achieving cer- meetings. Associated with each FOMC
tain other objectives that may affect the policy move, the Board of Governors
structure of the Federal Reserve balance approved an equal-sized reduction in the
sheet. basic discount rate, which preserved a
This report reviews the conduct of 50 basis point spread of the target funds
open market operations in 2001. It rate over the discount rate.
begins with a description of the operat- To target the federal funds rate, the
ing procedures that are used to control Desk uses open market operations to
the funds rate and a summary of the key
new developments in the policy imple- Changes in the Federal Funds Rate
mentation framework. The demand for Specified in FOMC Directives
balances at the Federal Reserve and the Percent
behavior of autonomous factors outside
the control of the Desk that affect the Date of change
Target federal Associated
funds rate discount rate
supply of these balances are described
in the following sections. Next, the dif- May 16, 2000 . . . . . . 6 1⁄ 2 6
ferent domestic financial assets held January 3, 2001 1 . . . 6 5 3⁄ 4
by the Federal Reserve, and the various (51⁄2 on Jan. 4)
types of open market operations used to January 31 . . . . . . . . . 5 1⁄ 2 5
March 20 . . . . . . . . . . 5 4 1⁄ 2
adjust them, are reviewed. The behavior April 18 1 . . . . . . . . . . 4 1⁄ 2 4
May 15 . . . . . . . . . . . 4 3 1⁄ 2
of the federal funds rate in 2001 and use June 27 . . . . . . . . . . . 3 3⁄ 4 3 1⁄ 4
of the discount window are discussed
August 21 . . . . . . . . . 31⁄2 3
September 17 1 . . . . . 3 21⁄ 2
October 2 . . . . . . . . . 21⁄2 2
Note. This chapter is adapted from the annual November 6 . . . . . . . 2 1 1⁄ 2
report of the Manager of the System Open Market December 11 . . . . . . 13⁄4 1 1⁄ 4
Account to the Federal Open Market Commit-
tee. The original report is available at http:// 1. Policy change came between regularly scheduled meetings.
100 88th Annual Report, 2001

align the supply of balances held by their holdings of balances over the days
depository institutions at the Federal within a maintenance period to meet
Reserve—or Fed balances—with banks’ their requirements gives them consider-
demand for holding balances at the tar- able leeway in managing their accounts
get rate. Each morning, the Desk consid- from day to day. This flexibility limits
ers whether open market operations are the volatility in rates that can develop
needed based on estimates of the supply when the Desk mis-estimates either the
of and demand for balances, taking supply of or demand for balances. None-
account of possible forecast errors and theless, the funds rate will firm if the
minimal levels of aggregate Fed bal- level of balances falls so low that some
ances that in practice are needed to banks have difficulty finding sufficient
facilitate settlement of wholesale finan- funds to cover late-day deficits in their
cial payments by banks. When the funds Fed accounts; the rate will soften if
rate is already near its target, the Desk balances are so high that some banks
aims to supply a level of balances in line risk ending a period holding undesired
with its best estimate of demand. And excess balances.
when the funds rate deviates from the
target, the Desk may adjust the level of
Fed balances it aims to supply accord-
New Developments in 2001
ingly, to nudge the rate in the appro- There were no changes made to the
priate direction. Operations designed FOMC’s Authorization for Domestic
to alter the supply of Fed balances that Open Market Operations in 2001
same day, most commonly of a short- (appendix A). At its January meeting,
term temporary nature, are typically the FOMC once again extended tempo-
arranged around 9:30 a.m. eastern time rarily, through its first regularly sched-
each morning, shortly after a complete uled meeting in 2002, its authorization
set of estimates is available. Open mar- for an expanded pool of eligible collat-
ket operations that are designed pri- eral for the Desk’s repurchase agree-
marily to meet other objectives that ments (RPs). The principal effect was
influence the size or composition of to continue the inclusion of pass-through
the Fed’s balance sheet can generally be mortgage securities of the Government
arranged at other times of the day, but National Mortgage Association, Freddie
their use must be coordinated with those Mac, and Fannie Mae, and of stripped
operations geared toward achieving a securities of government agencies. To
particular level of Fed balances on each implement this decision, the FOMC
day. voted to extend temporarily its suspen-
The average level of balances banks sion of several provisions of its ‘‘Guide-
demand over two-week reserve mainte- lines for the Conduct of System Open
nance periods is in large measure deter- Market Operations in Federal Agency
mined by certain requirements to hold Issues,’’ which impose restrictions on
balances, with only a small level of transactions in federal agency securities
additional, or excess, balances typically (appendix B). Late in 2001, the Desk
demanded. Levels of requirements and began to accept permanently the direct
period-average demands for excess are debt obligations of the Student Loan
relatively insensitive to changes in the Marketing Association as collateral on
target level of the federal funds rate or its repurchase transactions.
only respond with some lag. The ability The Desk continued to operate under
of depository institutions to average the guidelines first articulated in July
Domestic Open Market Operations during 2001 101

2000 that limit the permanent holdings and, under lagged reserve accounting
of single Treasury securities in the rules in effect since August 1998,
System Open Market Account (SOMA) reserve balance requirements are deter-
to a given share of the total outstand- mined prior to the start of each mainte-
ing amount.1 These guidelines were nance period, which facilitates estima-
prompted by the prospect of paydowns tion of the demand for Fed balances.
of marketable debt associated with But not all as-of adjustments are known
projected budget surpluses. Meanwhile, when a period starts. Most problemati-
Federal Reserve staff continued work cally, when large as-of adjustments are
begun in 2000 on various studies of applied or reported to the Desk on the
alternative assets the Federal Reserve settlement day, it affords the Desk little
might hold in its portfolio. or no opportunity to adjust its estimates
of demand and its operations.
Decreases in short-term interest rates
Banks’ Demand for Fed Balances contributed to an increase in the under-
The Desk aims to satisfy banks’ demand lying level of requirements, particularly
for holding Fed balances. Total demand over the second half of the year (chart).
may be viewed as the sum of two com- Falling interest rates spurred growth
ponents: the portion needed to meet all in reservable deposits over the year.3
requirements, and the portion held in As a consequence, aggregate reserve
excess of requirements. requirements rose above the level of
banks’ applied vault cash, lifting the
level of reserve balance requirements
Total Balance Requirements in a sustained fashion for the first time
A bank’s total balance requirement mea- since the wholesale adoption of sweep
sures the level of balances it must hold programs in 1995. The reduction in
at the Federal Reserve on average over interest rates also contributed to a rise
a two-week maintenance period to meet in clearing balance requirements, which
various regulatory obligations. Total registered their first significant increase
balance requirements may be decom- in several years. With the Fed using
posed into two basic parts: reserve bal- lower interest rates linked to the target
ance requirements (the level of reserve funds rate to compute earning credits
requirements not met with applied vault on clearing balance requirements, banks
cash) and clearing balance requirements. that wish to have the maximum useful
In addition, various as-of accounting
adjustments may be applied that affect
bank’s total balance requirements, and hence its
the actual level of Fed balances a bank demand for Fed balances. In published data on
must hold to meet all these require- reserves, these three variables are treated as
ments.2 Clearing balance requirements sources of reserve supply.
3. At the same time, there was little further
growth in new sweep account programs, which in
1. A detailed description of these guidelines the past had been a major source of decline in
and their motivation can be found on the web reserve requirements. The estimated amount of
site of the Federal Reserve Bank of New York demand deposits swept by commercial banks
at through the introduction of new sweep programs
2000/an000705.html. They were also discussed in during 2001 was about $40 billion, somewhat
more detail in the Domestic Open Market Opera- down from recent years and well below the peak
tions report for 2000. level. A reduction in interest rates also reduces the
2. Clearing balance requirements, applied vault incentive banks have to expand sweeps to reduce
cash, and as-of adjustments affect the level of a the level of their requirements.
102 88th Annual Report, 2001

Total Balance Requirements Excess Demands and

and Components Actual Excess Levels
Billions of dollars Period-average and daily levels of Fed
balances are measured relative to the
Total balance requirements 20
period-average level of requirements,
to obtain measures of excess balances.
15 Demands for excess balances display
fairly stable and predictable patterns that
Reserve balance requirements1 10 are insensitive to the level of require-
ments, and the Desk must estimate these
Clearing balance requirements excess demand patterns as part of esti-
mating total demand for Fed balances.4
1998 1999 2000 2001
The reasons for the severe distortions
Note. Maintenance period averages through Janu- to excess levels in the aftermath of the
ary 9, 2002. September 11 attacks are described in
1. Reserve requirements minus applied vault cash, and
less all as-of adjustments. the final section of this report.
Over the last two months of the year,
period-average levels of excess balances
level of clearing balance requirements,
became more elevated, most notably at
that is, the level that generates just
smaller banking institutions where posi-
enough income credits to pay for all
tive excess levels historically are con-
covered Fed services, had room to
centrated (chart). To some degree, typi-
increase these requirements. Over the
twelve months ending in December,
the underlying level of total balance
requirements rose about $5 billion, with 4. In this section, actual levels of excess bal-
ances on average over time are used as an approxi-
somewhat more than half coming from mation of excess demand, even though a number
the higher reserve balance requirements. of factors can cause actual excess levels to deviate
This aggregate increase is not large from demand on any day or for any period.
when measured against the size of the
Fed’s balance sheet, but it is significant
as a portion of total requirements. Excess Balances
Total balance requirements increased
dramatically, but temporarily, in the two Billions of dollars
maintenance periods ended October 17
and October 31, as a byproduct of dis- 3.0
ruptions following the September 11 2.5
attacks. Reservable deposits soared at All institutions 2.0
a handful of key money center banks 1.5
that were not able to transfer out funds 1.0
on behalf of their customers, and under Large banks
lagged reserve accounting rules, these +
institutions faced much higher reserve –
requirements in October. These banks 1999 2000 2001
were able to restore their operational
capabilities within days, and the higher Note. Maintenance period averages through Janu-
ary 9, 2002.
levels of reserve requirements were Period ended September 19, 2001, not shown (total
transitory. excess, $38 billion).
Domestic Open Market Operations during 2001 103

Median Levels of Excess Balances, adopt a lower target rate at its meetings
by Day in a Maintenance Period during the year, most of which happened
Millions of dollars to fall on the second Tuesday of a main-
tenance period, which pushed demands
Day of period 1998–2000 2001
for balances toward the end of these
Week 1 periods.
Thursday . . . . . . . . . . . . . . 725 775
Friday . . . . . . . . . . . . . . . . . −400 −1,000
Monday . . . . . . . . . . . . . . . 975 200
Tuesday . . . . . . . . . . . . . . . 675 0 Autonomous Factors Affecting
Wednesday . . . . . . . . . . . . 725 0 the Supply of Fed Balances
Week 2 Autonomous factors are the assets and
Thursday . . . . . . . . . . . . . . 675 −475
Friday . . . . . . . . . . . . . . . . . −175 −625 liabilities on the Federal Reserve bal-
Monday . . . . . . . . . . . . . . . 3,450 2,550
Tuesday . . . . . . . . . . . . . . . 2,925 4,250 ance sheet that are outside the direct
Wednesday . . . . . . . . . . . . 6,075 8,150 control of the Trading Desk.6 They
exclude the domestic financial assets
controlled through open market opera-
cal seasonal factors, the size of which tions, discount window loans, and the
can vary from year to year, may account deposit balances held by depository
for this late-year increase. But anec- institutions at the Fed. Federal Reserve
dotal evidence also suggests that the low note liabilities represent the largest
absolute level to which interest rates single autonomous factor on the Fed’s
have dropped, thereby lowering the op- balance sheet by far, and for this reason
portunity cost of holding excess bal- the net value (assets minus liabilities) of
ances, may have contributed to the all autonomous factors has a large nega-
increase. No evidence suggests that tive value; the net value of all other
excess demand at larger banks has been factors is close to zero. Net movements
increasing. in autonomous factors affect the supply
The daily intraperiod distribution of of Fed balances, and thereby create a
excess balances in 2001 continued to need for open market operations to
reflect banks’ strong preference for con- change the levels of the various domes-
centrating their accumulation of Fed bal- tic financial assets on the Fed’s balance
ances late in a maintenance period, after sheet to offset the effects of these fac-
the second weekend (table).5 The degree tors.7 The behavior of key factors in the
of skew was more pronounced over this aftermath of the September 11 attacks
past year, with banks typically holding is discussed in the final section of this
somewhat lower levels of excess on report.
most days ahead of the second weekend
and larger excess balances on the settle-
ment day. This greater concentration of
excess accumulated on the final day was 6. Autonomous factors are defined to include
encouraged by strongly held market liabilities arising from matched sale–purchase
agreements arranged with foreign official insti-
expectations that the FOMC would tutions as part of the foreign RP pool. The for-
eign RP pool is not reported directly on the Fed’s
balance sheet, but it is a factor that affects the
5. Median values are shown in table 2 because supply of Fed balances.
they are less influenced than average values by the 7. In fact, the Desk retains a small degree of
extreme and unrepresentative deviations from nor- discretionary influence over the levels of some
mal levels of daily excess that arise from time to autonomous factors, which may be used to shape
time. the need for open market operations on some days.
104 88th Annual Report, 2001

Federal Reserve Notes Changes in

Federal Reserve notes expanded by
Other Autonomous Factors
nearly $50 billion over the year and By comparison, the change in the net
were once again the largest source of value of all other autonomous factors
exogenous change on the Fed’s balance was small over the year. Some huge
sheet (chart).8 Federal Reserve notes temporary changes in the foreign RP
outstanding increased at an 8 percent pool, Federal Reserve float, and foreign
pace over the twelve-month period end- exchange holdings followed the Septem-
ing in December, somewhat faster than ber 11 attacks, but most quickly returned
their 63⁄4 percent average annual rate of to their pre-attack values. The greatest
expansion over the preceding five-year exception was the level of the foreign
interval. Lower interest rates likely RP pool, which remained elevated
spurred demand for Federal Reserve throughout the fourth quarter of the year.
notes in 2001 by reducing the economic Primarily as a consequence of these
cost of holding non-interest-bearing higher pool levels, the net value of
notes. Foreign demand also contributed autonomous factors other than Federal
to faster growth late in the year, com- Reserve notes fell a bit, by roughly
pounding the seasonal increase in $2 billion, over 2001.
Federal Reserve notes that occurred
ahead of the holidays. Unsettled eco-
nomic conditions in Argentina seemed Volatility and Predictability of
to stimulate demand throughout much Key Autonomous Factors
of the second half of the year.
Excluding the roughly two-week period
following the September 11 attacks, the
8. The unusual decline in Federal Reserve notes average of the daily absolute changes
over the twelve months ended in December 2000 in the net value of autonomous factors
was a byproduct of the temporary bulge in Federal
Reserve notes outstanding around the century date was down from the previous year, and
change. same-day predictability showed a slight
improvement (table). Reduced volatility
in currency in circulation, which is used
Net Value of All Autonomous Factors and as a proxy for Federal Reserve notes
Value of Federal Reserve Notes in putting together daily forecasts of
autonomous factors, mostly reflected the
Billions of dollars
impact of the huge swings in this factor
–450 around the century date change, which
All autonomous factors –475 elevated volatility in each of the two
Federal –500
previous years.9 Although the foreign
RP pool was somewhat more volatile
9. Currency in circulation consists mostly of
Federal Reserve notes, but it also includes about
$30 billion of coins, which are liabilities of the
1998 1999 2000 2001
Treasury. In absolute terms, changes in currency
Note. Net value equals assets minus liabilities. Main- in circulation almost entirely reflected movements
tenance period averages through January 9, 2002. in Federal Reserve notes.
Domestic Open Market Operations during 2001 105

Daily Changes and Forecast Misses in Key Autonomous Factors:

Average and Maximum of Absolute Values
Millions of dollars

2001 2001,
1999 2000 excluding Sept.11–28
Item Sept. 11–28

Average Maximum Average Maximum Average Maximum Average Maximum

Daily change
Currency in
circulation . . . . . . 918 5,379 970 8,087 851 2,696 919 2,537
Treasury balance . . . . . 911 7,446 1,460 23,434 823 7,413 2,297 5,671
Foreign RP pool . . . . . . 588 6,050 485 4,015 586 3,273 3,699 7,812
Float . . . . . . . . . . . . . . . . 712 6,217 887 9,677 894 4,923 6,888 32,099
Net value . . . . . . . . . . . . 1,709 17,653 2,058 23,896 1,828 7,918 7,028 30,770
Daily forecast miss
Currency in
circulation . . . . . . 233 1,361 238 1,648 210 1,043 502 1,135
Treasury balance . . . . . 599 3,284 615 6,866 534 2,975 608 1,821
Foreign RP pool . . . . . . 224 1,817 129 976 81 1,127 2,070 4,966
Float . . . . . . . . . . . . . . . . 394 4,274 392 2,742 447 2,084 2,312 10,398
Net value . . . . . . . . . . . . 811 5,443 787 7,218 762 3,503 2,568 12,723

Note. Forecast misses are based on New York staff

estimates. Currency in circulation is used as a proxy for
Federal Reserve notes.

during 2001, forecasting errors were cash balances. This helped moderate
down. volatility in the Treasury’s Fed balance
The Treasury’s Fed balance was by reducing the number of days on
much less volatile during 2001 than it which the Fed balance jumped because
was during 2000, and somewhat more of insufficient TT&L capacity, and it
predictable. Over the past few years, the also may have improved indirectly the
ability of the staff to forecast the Trea- ability to forecast the Treasury’s Fed
sury’s Fed balance on a same-day basis balance.10
has benefited from improved methods
for collecting tax payment information
early each morning from around the
Domestic Financial Assets on the
financial system. In 2001, predictability
Federal Reserve Balance Sheet
was also enhanced by a new cash
and Open Market Operations
management technique adopted by the The total value of all domestic financial
Treasury, called dynamic investing, that assets (less any matched sale–purchase
enabled it to move some portion of
unexpected flows arriving in its Fed 10. In 2001, the Treasury’s general cash bal-
account into its Treasury tax and loan ance exceeded TT&L capacity, including Special
(TT&L) accounts at commercial banks Direct Investment capacity, by more than the nor-
mal level of balances placed at the Fed (usually
on a same-day basis. Throughout the $5 billion) on only two days, compared with six
year, TT&L capacity remained high days in 2000. The number of such occasions was
relative to the level of Treasury’s total seven in 1999 and sixteen in 1998.
106 88th Annual Report, 2001

agreements arranged in the market) roughly corresponded to the increase in

held by the Federal Reserve mirrors Federal Reserve note liabilities.14
the net level of autonomous factors The distribution of SOMA holdings
and of Fed balances.11 More substan- by remaining maturity and across indi-
tively, the behavior of various autono- vidual issues is intended to achieve vari-
mous factors and of sources of demand ous objectives associated with having
for Fed balances will influence the a liquid portfolio without distorting the
choice of open market operations used yield curve or impairing the liquidity
to adjust the Fed’s domestic financial of the market for individual Treasury
portfolio.12 securities. In pursuit of these objectives,
the Desk continued to adhere to the
per-issue guideline limits on SOMA
Permanent Holdings in the holdings of individual Treasury issues,
System Open Market Account articulated in July 2000. It also contin-
and Outright Open Market Activity ued to limit SOMA purchases of newly
The domestic SOMA includes all the issued Treasury securities, as it has no
domestic securities held on an outright particular portfolio need for some of the
basis. By and large, changes in the level liquidity characteristics that can add to
of the SOMA have been used to accom- the value of these issues in the market.
modate net changes in autonomous
factors and in demands for Fed balances
that are expected to endure. For this
Auction Participation
reason, these holdings are often charac-
and Redemptions
terized as being ‘‘permanent,’’ although Typically, any needed expansion of the
their net value can be reduced whenever SOMA is achieved by making outright
needed. The par value of the SOMA purchases of Treasury securities in the
stood at $575 billion at year-end, con- secondary market, which are then sus-
sisting almost entirely of Treasury secu- tained by replacing maturing holdings
rities, about $42 billion higher than with newly issued debt at Treasury auc-
one year earlier.13 The expansion in tions. At Treasury auctions of coupons
the SOMA in 2001, as in many years, and bills in 2001, the FRBNY continued
to place add-on bids for the SOMA
11. In this report, the securities sold under tem- equal to the lesser of (1) its maturing
porary matched sale–purchase agreements (MSPs) holdings on the issue date of a new
as part of the foreign RP pool or in the market are security or (2) the amount that would
considered financial assets held by the Fed, bring SOMA holdings as a percentage
although they are not officially recorded as such
on the Fed’s balance sheet. See footnote 6 for the
of the issue to the percentage guideline
treatment of the foreign RP pool as an autonomous limits.15 There were no issues maturing
factor liability. In keeping with this treatment, in
this report MSPs arranged in the market are con-
sidered a financial liability arranged at the discre- 14. By comparison, the slight increase in net
tion of the Desk. balance sheet liabilities from movements in other
12. Discount window activity is discussed in autonomous factors and the rise in total balance
the section ‘‘The Federal Funds Rate and Discount requirements added only modestly to any need for
Window Credit.’’ a ‘‘permanent’’ increase in the value of financial
13. The increase reflects almost entirely new assets in the Fed’s portfolio.
purchases in excess of redemptions but also 15. Foreign add-ons, which are not known at
includes a $529 million increase in the inflation the time the Desk determines its level of participa-
compensation component of inflation-indexed tion at auctions, were assumed to be zero in this
securities, bringing its level to $961 million. calculation.
Domestic Open Market Operations during 2001 107

on dates when newly auctioned Trea- budget situation and Treasury issuance
sury Inflation Indexed Securities (TIIS) patterns. Also during the year, $120 mil-
settled. In cases where maturing hold- lion of holdings of Federal agency secu-
ings were to be rolled into more than rities were called, which left a mere
one new issue of different maturities, $10 million of agency holdings in the
the Desk allocated the maturing amount SOMA at year-end.
in such a way as to leave the same gap,
measured in percentage points, between Secondary Market Purchases and
the per-issue cap and the actual per- Operational Techniques
centage holding of each new issue. A
slightly different approach was taken for With redemptions again so large over
the weekly bill auctions after the intro- the year as a whole and growth in Fed-
duction of the new twenty-eight-day eral Reserve notes strong, the necessary
bill because of the potential volatility in expansion of the SOMA required a
amounts of twenty-eight-day bills auc- record value of outright purchases of
tioned from week to week. The Desk Treasury securities by the Trading Desk,
determined the amount of maturing bills amounting to $68.5 billion (table). There
to be rolled over and its allocation on were no sales of securities.
the basis of the smallest twenty-eight- About $15 billion of bills were pur-
day bill auction size experienced to date, chased, and bill holdings increased by a
rather than the actual auction size. significant amount for the first time in
Remaining within the per-issue per- several years. Altogether, the Desk pur-
centage caps while the Treasury contin- chased $8 billion of bills in the market
ued to cut back on auction sizes through in four operations. Another $7 billion
the first half of the year forced another were purchased directly from foreign
$27 billion of redemptions of matur- central banks, in small daily increments
ing Treasury holdings in 2001, roughly on days when sell orders from these
equal to the previous year’s total; this accounts were available and consistent
includes about $1.5 billion of maturing with SOMA portfolio guidelines.16
holdings that were redeemed because
of the cancellation of a twenty-eight-day
16. The Desk sets a $250 million limit on total
bill auction on September 11. Redemp- daily purchases from foreign accounts, subject
tions tapered off over the year, largely as to review if reserve needs or orders warrant an
a consequence of the changed federal exception.

Purchases and Redemptions of Treasury Bills and Coupons

Billions of dollars

Item 1997 1998 1999 2000 2001

Treasury bills
Purchased outright . . . . . . . . . . . . . 5.5 0 0 6.2 8.4
Purchased from internal
foreign accounts . . . . . . . . . . . 3.6 3.6 0 2.5 7.1
Redemptions . . . . . . . . . . . . . . . . . . 0 −2.0 0 −23.8 −10.1

Treasury coupons
Purchased outright . . . . . . . . . . . . . 35.0 26.4 45.4 35.7 53.2
Redemptions . . . . . . . . . . . . . . . . . . −2.0 −.6 −1.4 −4.1 −16.8
108 88th Annual Report, 2001

The Desk also purchased $53 billion $228 billion of marketable Treasury
of coupon securities in the market, securities remained purchasable under
arranging a record sixty-four coupon the Desk’s guidelines for percentage
operations.17 These operations contin- holdings—compared with $260 billion
ued to be segmented into separate at the end of the previous year. The
tranches across different portions of the gross remaining purchasable amount
yield curve to facilitate rapid execution. was $183 billion if account is taken
Given the frequent need for secondary of the practices of avoiding purchases
market purchases, the Desk sought to of recently issued debt, purchases that
distribute its purchases evenly over time would contribute to sizable redemptions,
as much as possible and did not attempt and purchases of issues that mature
to concentrate operations in periods within four weeks.
when Federal Reserve note growth was
The selection of specific issues in
Temporary Holdings and
each operation was based on the rela-
Open Market Operations
tive attractiveness of propositions and Long-Term Repurchase Agreements
portfolio considerations. In addition to
remaining within the per-issue-guideline Over the past two years, long-term RPs,
limits and avoiding on-the-run issues, defined as operations with an original
the Desk avoided purchases that would maturity of more than fifteen days,
be expected to cause a sizable redemp- have been a standard asset in the Fed’s
tion on any day in the foreseeable future, domestic financial portfolio.18 Tempo-
and it bought no issues in the secondary rarily increasing the total size of out-
market that had less than four weeks standing long-term RPs has proved to be
remaining to maturity. an effective way of addressing signifi-
cant increases in the net value of autono-
General Characteristics of mous factor liabilities or increases in
Domestic Permanent SOMA Holdings demands for Fed balances that are
at Year-End expected to last for a number of weeks
or months, but not permanently. Long-
The average maturity of the entire term RPs can also be adjusted readily
SOMA portfolio of Treasury securities to accommodate an extended mismatch
was 53.5 months at year-end, up slightly between changes in the permanent
from 52.9 months one year earlier. SOMA and in levels of autonomous fac-
The share of all outstanding marketable tors and total balance requirements.
Treasury securities held in the SOMA During the year, the Desk adhered to
was 19 percent, about a percentage point the practice of arranging an RP with a
higher than a year earlier. The SOMA
held 25 percent of all bills (compared
with 31 percent a year ago), and 17 per- 18. The choice of any maturity to distinguish
cent of all coupons including TIIS (com- long-term from short-term RPs is somewhat arbi-
pared with 14 percent a year earlier). trary. Fifteen days had been the maximum allow-
able maturity under the FOMC’s Authorization for
At the end of the year, approximately many years until 1998, and it approximates the
length of a reserve maintenance period. Fifteen
days is designated to be the longest ‘‘short-term’’
17. This total includes five TIIS operations, maturity because, as noted in this section, the RPs
totaling $3.3 billion. On one day, two separate the Desk used that carried a fifteen-day maturity
coupon operations were arranged. had a clear short-term operational focus.
Domestic Open Market Operations during 2001 109

twenty-eight-day maturity on the Mon- Temporary Operations Outstanding

day or Thursday (or both) of each
Billions of dollars
week.19 These operations are typically
arranged early in the morning, before 60
final daily reserve estimates are avail- Long-term 50
able, as their use is not geared toward
addressing daily volatility in autono- Short-term 30
mous factors and excess demands. In
other respects, these RPs are opera-
tionally just like those for short-term +
maturities. Dealer participation in these MSPs –
long-term RPs has consistently been 1999 2000 2001
very strong, measured by the size of
Note. Maintenance period averages through Janu-
propositions. ary 9, 2002.
The sizes of the twenty-eight-day RPs
arranged over the year ranged from
$2 billion to $5 billion. Over most of the day volatility in autonomous factors and
first half of 2001, their total outstanding in demands for Fed balances. These
value stood at $12 billion, which was operations are also used to fill tempo-
also the lowest outstanding total for rarily the gaps left by more-enduring
the year (chart). In the third quarter, the changes in autonomous factors and Fed
Desk built up their underlying level balance demands that are not immedi-
modestly, but in the immediate after- ately met by changes in the permanent
math of the September 11 attacks the SOMA or long-term RPs outstanding.
Desk allowed two long-term RPs to Daily volatility in short-term tempo-
mature without replacement, to simplify rary operations outstanding (RPs less
its market involvement at the time. As MSPs), measured by the average of
reserve deficiencies deepened late in the absolute daily changes in short-term
year, at first when requirements bulged agreements outstanding, has been
in October and then as Federal Reserve around $31⁄2 billion in each of the past
notes began to grow from seasonal two years. Daily levels of net short-
factors, long-term RPs were gradually term operations outstanding ranged
increased, peaking at a level of $31 bil- from −$4 billion to +$81 billion; exclud-
lion in the year-end maintenance period. ing the days immediately following
the September 11 attacks, the peak
Short-term RPs and MSPs was +$31 billion. On a period-average
basis, short-term operations outstanding
Short-term temporary operations, RPs
ranged from $4 billion to $38 billion;
and matched sale-purchases (MSPs), are
excluding the two exceptionally high
the primary tool used to address day-to-
period-average levels that covered late
September, the period-average peak was
19. This practice was first begun in March $14 billion. For the year as a whole,
2000. In January 2002, the Desk began to arrange short-term temporary operations out-
these twenty-eight-day RPs just once per week, on standing averaged $10 billion. The aver-
each Thursday, adjusting the size of each opera- age was closer to $8 billion excluding
tion to achieve the same desired total outstanding
amount. This weekly schedule will continue to the September 19 maintenance period,
provide the desired flexibility to the portfolio at which was somewhat above the $5 bil-
even lower operational cost. lion average outstanding level in 2000.
110 88th Annual Report, 2001

Number of Temporary Operations, by Maturity and Type

Item 1998 1999 2000 2001

One business day . . . . . . . . . . . . . . . . . . . . 144 147 142 133

Term RPs up to fifteen days . . . . . . . . . . 62 83 46 85
Term RPs over fifteen days . . . . . . . . . . 3 14 61 88
One-business-day MSPs . . . . . . . . . . . . . 21 13 16 10
Term MSPs . . . . . . . . . . . . . . . . . . . . . . . . . 1 0 3 0

Volatility in autonomous factors and dates, by the time the Desk was pre-
in demand for Fed balances requires the pared to arrange its short-term opera-
Desk to be prepared to arrange these tions, dealers had already met a greater-
operations each day, and often an over- than-normal share of their total over-
lapping structure of short-term opera- night borrowing needs, in response to
tions is constructed. By far the most heightened demand from their institu-
common operation was an overnight RP tional customers. These cash investors
(which includes all RPs that cover just had greater amounts to invest on an
one business day), of which 133 were overnight basis with the dealers because
arranged in 2001 (table). As usual, the the borrowers with whom they normally
Fed’s portfolio continued to be struc- placed cash on a term basis were issuing
tured in such a way as to keep reliance less term debt on days of expected rate
on MSPs relatively low.20 cuts.
In general, propositions were suffi- Also in 2001, the Desk arranged two
cient to cover the intended size of the short-term RPs, an overnight operation
short-term operations the Desk wished and a term agreement of up to fifteen
to arrange. However, ahead of days on days, on seven different maintenance
which propositions were expected to period settlement dates, usually out of
run low, the Desk sometimes layered- concern that propositions on the over-
in term agreements of short duration night RP alone might not be adequate to
to ensure this outcome. For example, address all of the remaining period need.
dealer participation on overnight RPs Given banks’ usual preference for hold-
was relatively low on quarter-end dates, ing higher excess levels on settlement
when high excess needs usually required dates, which was even more pronounced
a large amount of short-term RPs to be in 2001, the Desk sometimes faced a
outstanding. Propositions on RPs on larger remaining ‘‘add need’’ on these
FOMC meeting dates in 2001 also days than it was comfortable addressing
tended to be low, as a byproduct of with a single, overnight operation. The
expected imminent rate cuts. On these term agreements arranged on these occa-
sions were used to help meet needs in
20. One reason the Desk avoids heavy reliance the following maintenance period.
on MSPs is that propositions on these operations
in general are low compared with RPs, reflecting
dealers’ net borrowing needs. Also, given the
Collateral Distribution
structure of the Fed’s balance sheet, routine reli- The Desk solicited propositions across
ance on MSPs would require expanding the Fed’s
holdings of financial assets above the level that is the entire pool of eligible collateral on
needed to meet its net autonomous factor liabili- all RPs arranged in 2001. But with the
ties and demands for Fed balances. exception of nine RPs arranged on the
Domestic Open Market Operations during 2001 111

Average Annual RPs Outstanding, by Collateral Tranche

Billions of dollars

2000 2001
Short-term RPs Long-term RPs Short-term RPs Long-term RPs

Treasury . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3 7.1 4.1 8.0

Agency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.3 3.7 2.2 4.1
Mortgage-backed . . . . . . . . . . . . . . . . . . . . 1.5 5.3 3.4 4.5

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.1 16.1 9.7 16.6

days immediately following the Septem- the next. In 2001, tranches in which
ber 11 attacks, all RPs were arranged as mortgage-backed securities were eli-
three separate simultaneous operations gible tended to account for a somewhat
differentiated by type of collateral eli- smaller share of total outstanding RPs.
gible. In the first of these, only Treasury Their share on short-term RPs in 2001
debt was accepted; in the second, direct was about the same as in the previous
federal agency obligations (in addition year, but only because of the large,
to Treasury debt) were eligible; and in single-tranche RPs arranged in the after-
the third, mortgage-backed agency debt math of September 11 (table).21
was eligible (in addition to the other two
categories of debt). For the purposes of
this report, these separate operations are
The Federal Funds Rate and
counted as different tranches of a single
Discount Window Credit
RP. In order to simplify the structure of
its operations, for several days after Sep-
The Federal Funds Rate
tember 11 the Desk arranged only RPs Daily volatility in the federal funds rate
with a single tranche, under which deal- and deviations of effective rates from
ers had the option to deliver Treasury, target in 2001 were slightly higher than
agency, or mortgage-backed collateral. in the preceding year, but still to the low
All RPs arranged in 2001 settled under side of recent norms (table). Deviations
the triparty agreements established with of morning funds rates from target, often
two clearing banks in 1999. Under a measure of market expectations for
these agreements, dealers have flexibil- likely rate behavior later in the day, con-
ity to choose, and to change from day to tinued to show the kinds of recurring
day, the specific securities they deliver patterns associated with certain calen-
within each tranche. dar events seen in previous years. The
The distribution of accepted propo- deviations of the morning rate from tar-
sitions across collateral categories on get on high-payment-flow days and on
multi-tranche RPs was determined by Fridays were a touch smaller than in
the relative attractiveness of rates in past years. However, morning premiums
each tranche benchmarked against cur-
rent market financing rates for that class
of collateral. Distributions of collateral 21. These tranches reflect options that dealers
have for delivering different categories of collat-
by tranche on outstanding RPs tend eral on outstanding RPs where, for example, a
to be reasonably stable, but they can dealer has the option to deliver Treasury debt on
be very volatile from one operation to agency RPs but not vice versa.
112 88th Annual Report, 2001

Federal Funds Rate Behaviors: Medians and Averages of Daily Values

Basis points

Item 1998 1999 2000 2001

Deviations of effective rate from target

Median . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 −1 1 0
Average . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 −1 2 −1
Absolute deviations of effective rate from target
Median . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 7 4 5
Average . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 11 7 9
Intraday standard deviations
Median . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 9 6 7
Medians of morning rates less target rate on
High-payment-flow days (excluding quarter-ends) . . . . 25 19 19 16
Fridays . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . −6 −6 −6 −3
Maintenance period settlement days . . . . . . . . . . . . . . . . . 13 0 0 6

on maintenance period settlement days, credit is seasonal borrowing, which

which had been common in the past behaviorally is more akin to an autono-
but which had largely disappeared over mous factor in terms of its implications
the preceding couple of years, were for open market operations.22 Adjust-
again evident in 2001, averaging around ment credit is typically quite small, but
6 basis points. The higher levels of the existence of the adjustment credit
excess reserves that had to be accumu- facility is an important part of the mone-
lated on the final day to meet require- tary policy implementation framework.
ments in 2001 may have contributed It acts as a stabilizer, moderating the
to funding anxieties of bank reserve upward movements in the federal funds
managers. rate in the event a shortage of Fed bal-
ances leaves a bank overdrawn on its
Fed account at the end of any day or
Discount Window Credit deficient in meeting its requirements on
Discount window credit makes up a a maintenance period settlement day.
relatively small portion of the total
domestic financial assets held by the 22. There were no instances of extended credit
Federal Reserve (table). Much of this borrowing at the discount window.

Discount Window Borrowing Activity

Item 1998 1999 2000 2001 excluding
Sept. 11–13

Average daily amount outstanding

(millions of dollars)
Seasonal credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 127 258 73 73
Adjustment credit . . . . . . . . . . . . . . . . . . . . . . . . . . 66 95 108 319 77

Number of days on which total

adjustment borrowing by large banks
More than $100 million–$500 million . . . . . . . 23 17 12 10 10
More than $500 million . . . . . . . . . . . . . . . . . . . . 10 13 14 11 8
Domestic Open Market Operations during 2001 113

The critical role of the adjustment credit night basis. Communications disruptions
facility during times of severe stress in prevented many borrowers from having
financing markets is highlighted by the normal access to their investor base for
discussion in the following section of its the first few days after September 11,
use immediately following the Septem- even among those not directly affected
ber 11 attacks. For meeting more-routine by the attacks, and the impaired ability
reserve shortfalls and payments difficul- of a major clearing bank to process
ties, even levels of adjustment borrow- funds and securities transfers for itself
ing that are small relative to the total and on behalf of its customers created
supply of Fed balances can help allevi- additional uncertainties. Banks and deal-
ate the degree of upward rate pressure ers, uncertain about their general cash
that can develop in the market. position or the availability of financing,
Large banks as a group borrowed an tended to refrain from making cash out-
amount in excess of $500 million on lays until later than normal in the day.
eleven different days in 2001, including In the federal funds market, several of
three occasions coming in the imme- the major brokers ceased operations for
diate aftermath of the September 11 a time, and many large banks resorted
attacks. This total is in line with the to arranging trades directly with one
number of occasions banks borrowed another. Although not fully back to nor-
at least that much in the preceding mal levels of operating efficiency, the
three years. Large banks borrowed a payments and communications infra-
somewhat smaller but still significant structure most critical to the functioning
amount, in excess of $100 million, on of the financing market had recovered
another ten occasions in 2001, but this considerably by Monday, September 17,
number was somewhat below the fre- and participation levels were much
quency in most other recent years. improved.

The Conduct of Monetary Behavior of Autonomous Factors

Operations after September 11 Levels of several of the autonomous fac-
This section presents an overview of the tors on the Fed’s balance sheet were
context and conduct of open market dramatically affected by some of the
operations in the aftermath of the ter- responses to the World Trade Center
rorist attacks on the World Trade Cen- and Pentagon attacks. Over the three-
ter and Pentagon on Tuesday, Septem- day interval September 12 through
ber 11. September 14 (Wednesday through Fri-
day), net autonomous factor movements
increased the supply of Fed balances
General Financing Market
dramatically, and then net factor move-
ments began to drain large quantities.
Immediately following the attacks, The level of float in the banking system,
many financial markets effectively normally around $1 billion, peaked at
ceased operations. But with Fedwire $47 billion on that Thursday as a result
and other wholesale payments networks of the temporary curtailment of air traf-
remaining open, securities dealers and fic nationwide. Another $20 billion of
banks faced a continuing need to obtain Fed balances was created that day when
funding for large pre-existing positions the European Central Bank drew on a
that they typically finance on an over- temporary foreign currency swap line
114 88th Annual Report, 2001

that had just been established. Mean- demands for financing far surpassed any
while, investments in the foreign RP need to arrange operations simply to
pool jumped between $15 billion and provide an aggregate level of Fed bal-
$20 billion above recent norms, reduc- ances that would help banks meet their
ing the supply of Fed balances. The requirements or their desired end-of-day
factors that were adding to the supply holdings of balances at the Fed. To more
of Fed balances returned to something effectively serve as a source of financ-
like normal levels by Monday, Septem- ing of last resort and to help encourage
ber 17, but persistent high levels of the dealers to continue to intermediate on
pool began to leave large underlying behalf of some of their own customers,
deficiencies. the Desk operated relatively late in the
day, after dealers had a good opportu-
nity to assess their full financing needs
Federal Reserve Monetary and to secure all available financing in
Operations, and the Level and the market.
Distribution of Fed Balances The size of the overnight RPs,
On the morning of September 11, the which typically may be around $3 bil-
Federal Reserve issued a public release lion, peaked on Thursday and Friday at
stating, ‘‘The Federal Reserve System $70 billion and $81 billion, respectively,
is open and operating. The discount the same days that autonomous factors
window is available to meet liquidity also added the most to the supply of Fed
needs,’’ to encourage banks to view the balances. Before discount window bor-
discount window as a source of liquid- rowing, Fed balances on both those days
ity. September 11 fell in the middle of topped $110 billion, and, in general, Fed
the maintenance period ended Septem- balances before borrowing were extraor-
ber 19; for the remainder of that period, dinarily elevated from Wednesday
the Desk arranged only overnight RPs through Monday (chart). But even with
for same-day settlement because of the such high levels of Fed balances, severe
high degree of volatility in the needed dislocations that interfered with their
level of RPs outstanding from one day distribution in the first few days after
to the next.
From Wednesday through the follow-
ing Monday, the sizes of open market
Total Federal Reserve Balances
operations were aimed at satisfying all around September 11
the financing that dealers wished to
arrange with the Desk, in order to miti- Billions of dollars
gate to the extent possible the disrup-
tions to normal trading and settlement balances 100
arrangements.23 On these four days, all
propositions with rates at or above the 80
prevailing target were accepted, which Borrowed 60
was the vast majority. Dealers’ total balances

23. The RP on September 12 was arranged
from the FRBNY’s Main Building.
9/5 9/11 9/17 9/19 10/3
Note. Vertical dashed lines separate reserve mainte-
nance periods.
Domestic Open Market Operations during 2001 115

the attacks caused many banks to bor- In part to simplify the nature of our
row at the discount window to cover direct market involvement under exi-
overdraft positions. As a result, levels of gent circumstances, from September 11
adjustment borrowing soared to record through the remainder of the mainte-
levels on Tuesday and Wednesday. nance period under way, the Desk did
By the final days of the maintenance not replace any of its maturing long-
period, after financing markets began to term RPs, and it arranged no outright
function more normally, the Desk aimed operations. On the settlement day,
its operations at maintaining a more the Desk arranged three term RPs that
traditional balance between the supply settled on a forward basis on the first
of and demand for Fed balances, consis- day of the following maintenance
tent with the federal funds rate trading period, totaling $23 billion, in order to
around the target level, lowered to 3 per- reduce the level of intervention that
cent on September 17. With cumula- would be needed in financing mar-
tive excess positions so high and with kets in upcoming days. Other changes
financing rates generally quite low, were also made to simplify operations.
reflecting the weight of these excess Instead of differentiating between collat-
positions, the Desk was aiming to leave eral types, each RP was arranged as a
relatively low levels of Fed balances single tranche where dealers had the
in place each day. The size of the RPs option to deliver any of the three catego-
needed to provide even these relatively ries of collateral. Because some dealers
low levels of balances remained large lacked connectivity at their contingency
for a time, reflecting the impact of sites, the Desk operated in a semi-
autonomous factors that were now manual mode, inputting propositions for
reducing the supply of Fed balances many dealers (although the automated
below normal levels. As dealers increas- trade processing system continued to
ingly were able to communicate with operate uninterrupted). Because of the
and obtain financing from their usual time required to establish voice commu-
customers, the Desk had to move up nications with dealers lacking electronic
its operating time to ensure a suffi- connections and the time needed to
cient level of participation for the receive bids by phone, the time between
large RPs that were still needed, and when an operation was first announced
it had to accept the vast majority of and when it was closed was lengthened,
propositions—even those offered at and the Desk often pre-announced its
rates well below the new 3 percent tar- time frame for operating.
get level—in order to arrange RPs of
sufficient size.
Even with the low levels of excess
Financing Rate Behavior
provided late in the maintenance period, From Tuesday, September 11, through
the average level of excess balances most of Thursday, September 13, mar-
for the period ended September 19 was ket participants in both the government
$38 billion. This excess was highly con- securities RP markets and in the federal
centrated at a small number of institu- funds market simply priced their trades
tions that accumulated high balances as at the target funds rate, a response to the
a result of an inability to make payments attacks that likely helped maintain some
or to sell funds in the first days after the order in these markets. The high levels
attacks, and it did not reflect any desire of excess balances provided through the
to hold huge excess balances. Desk’s RPs first began to weigh heavily
116 88th Annual Report, 2001

Federal Funds Rates around September 11 zation in effect at the end of 2001 is
reprinted below.
Percentage points

Target rate
Authorization for Domestic
Open Market Operations
1. The Federal Open Market Committee
Effective authorizes and directs the Federal Reserve
Bank of New York, to the extent neces-
sary to carry out the most recent domestic
policy directive adopted at a meeting of the
9/5 9/11 9/17 9/19 10/3 (a) To buy or sell U.S. Government
Note. Vertical dashed lines separate reserve mainte-
securities, including securities of the Federal
nance periods. Financing Bank, and securities that are direct
obligations of, or fully guaranteed as to
principal and interest by, any agency of the
United States in the open market, from or
on the funds rate during late trading on to securities dealers and foreign and inter-
Thursday and again on Friday, although national accounts maintained at the Federal
through Monday, September 17, morn- Reserve Bank of New York, on a cash, regu-
ing rates generally reverted back to lar, or deferred delivery basis, for the System
Open Market Account at market prices, and,
the target (chart). Thereafter, extremely for such Account, to exchange maturing U.S.
low rates prevailed in the funds and RP Government and Federal agency securities
markets for several days, falling even with the Treasury or the individual agencies
below 1 percent. These low rates in or to allow them to mature without replace-
large measure reflected misperceptions ment; provided that the aggregate amount of
U.S. Government and Federal agency securi-
that the Desk was continuing to provide ties held in such Account (including forward
high levels of balances, a view rein- commitments) at the close of business on the
forced by the continuing large sizes day of a meeting of the Committee at which
of the RPs and widespread reports that action is taken with respect to a domestic
were crediting the Desk with providing policy directive shall not be increased or
abundant liquidity to the market. Sev- decreased by more than $12.0 billion during
the period commencing with the opening of
eral episodes of rates being pushed business on the day following such meeting
higher in late-day trading, induced by and ending with the close of business on the
the relatively low levels of Fed balances day of the next such meeting;
the Desk was leaving in place, were (b) To buy U.S. Government securities,
needed to nullify these perceptions and obligations that are direct obligations of, or
to bring the funds rate back up closer to fully guaranteed as to principal and interest
the target. by, any agency of the United States, from
dealers for the account of the Federal
Reserve Bank of New York under agree-
ments for repurchase of such securities or
Appendix A: obligations in 65 business days or less, at
Authorization for Domestic rates that, unless otherwise expressly autho-
Open Market Operations rized by the Committee, shall be determined
by competitive bidding, after applying rea-
Open market operations were conducted sonable limitations on the volume of agree-
under the Authorization for Domestic ments with individual dealers; provided that
Open Market Operations. The Authori- in the event Government securities or agency
Domestic Open Market Operations during 2001 117

issues covered by any such agreement are imposed on purchases and sales of securities
not repurchased by the dealer pursuant to the in paragraph 1(b), repurchase agreements in
agreement or a renewal thereof, they shall be U.S. Government and agency securities, and
sold in the market or transferred to the Sys- to arrange corresponding sale and repurchase
tem Open Market Account. agreements between its own account and
foreign and international accounts main-
(c) To sell U.S. Government securities tained at the Bank. Transactions undertaken
that are direct obligations of, or fully guar- with such accounts under the provisions of
anteed as to principal and interest by, any this paragraph may provide for a service fee
agency of the United States to dealers for when appropriate.
System Open Market Account under agree-
ments for the resale by dealers of such secu- 4. In the execution of the Committee’s
rities or obligations in 65 business days or decision regarding policy during any inter-
less, at rates that, unless otherwise expressly meeting period, the Committee authorizes
authorized by the Committee, shall be deter- and directs the Federal Reserve Bank of
mined by competitive bidding, after apply- New York, upon the instruction of the Chair-
ing reasonable limitations on the volume of man of the Committee, to adjust somewhat
agreements with individuals dealers. in exceptional circumstances the degree of
pressure on reserve positions and hence the
2. In order to ensure the effective conduct intended federal funds rate. Any such adjust-
of open market operations, the Federal Open ment shall be made in the context of the
Market Committee authorizes the Federal Committee’s discussion and decision at its
Reserve Bank of New York to lend on an most recent meeting and the Committee’s
overnight basis U.S. Government securities long-run objectives for price stability and
held in the System Open Market Account to sustainable economic growth, and shall be
dealers at rates that shall be determined by based on economic, financial, and mone-
competitive bidding but that in no event shall tary developments during the intermeeting
be less than 1.0 percent per annum of the period. Consistent with Committee prac-
market value of the securities lent. The Fed- tice, the Chairman, if feasible, will consult
eral Reserve Bank of New York shall apply with the Committee before making any
reasonable limitations on the total amount of adjustment.
a specific issue that may be auctioned and on
the amount of securities that each dealer may
borrow. The Federal Reserve Bank of New Appendix B:
York may reject bids which could facilitate Guidelines for the Conduct of
a dealer’s ability to control a single issue System Open Market Operations
as determined solely by the Federal Reserve in Federal Agency Issues
Bank of New York.
The FOMC has established specific
3. In order to ensure the effective conduct guidelines for operations in agency
of open market operations, while assisting
in the provision of short-term investments securities to ensure that Federal Reserve
for foreign and international accounts main- operations do not have undue market
tained at the Federal Reserve Bank of New effects and do not serve to support
York, the Federal Open Market Committee individual issuers. Provisions 3–6 of
authorizes and directs the Federal Reserve the guidelines were first temporarily
Bank of New York (a) for System Open
Market Account, to sell U.S. Government suspended in August 1999, in order to
securities to such foreign and international expand the types of agency securities
accounts on the bases set forth in para- the Desk could accept in its operations
graph 1(a) under agreements providing for around the century date change. This
the resale by such accounts of those securi- suspension was extended in March
ties in 65 business days or less on terms 2000, in light of anticipated paydowns
comparable to those available on such trans-
actions in the market; and (b) for New York of federal debt, and it was reaffirmed in
Bank account, when appropriate, to under- January 2001 until the FOMC’s first
take with dealers, subject to the conditions meeting in 2002.
118 88th Annual Report, 2001

Guidelines for the Conduct of 4. Purchases will be limited to fully tax-

System Open Market Operations able issues not eligible for purchase by the
Federal Financing Bank, for which there is
in Federal Agency Issues an active secondary market. Purchases will
1. System open market operations in Fed- also be limited to issues outstanding in
eral agency issues are an integral part of total amounts of $300 million or over in cases
System open market operations designed to where the obligations have maturity of five
influence bank reserves, money market con- years or less at the time of issuance, and to
ditions, and monetary aggregates. issues outstanding in amounts of $200 mil-
lion or over in cases where the securities
2. System open market operations in Fed- have a maturity of more than five years at
eral agency issues are not designed to sup- the time of issuance.
port individual sectors of the market or 5. System holdings of any one issue at
to channel funds into issues of particular any one time will not exceed 30 percent of
agencies. the amount of the issue outstanding. Aggre-
gate holdings of the issues of any one agency
3. System holdings of agency issues shall will not exceed 15 percent of the amount of
be modest relative to holdings of U.S. Gov- outstanding issues of that agency.
ernment securities, and the amount and tim-
ing of System transactions in agency issues 6. All outright purchases, sales, and hold-
shall be determined with due regard for the ings of agency issues will be for the System
desirability of avoiding undue market effects. Open Market Account.
Federal Reserve Operations

Consumer and Community Affairs

In 2001, the Division of Consumer limitations on, and additional disclosure
and Community Affairs of the Federal requirements in connection with, home
Reserve Board was active in several equity loans that have interest rates
important areas: above a certain level or fees above a
certain amount. It also authorizes the
• Curbing abusive lending practices Board to expand HOEPA’s coverage to
more loans and to prohibit certain acts
• Fostering research in community de- and practices in mortgage lending. The
velopment and consumer economics Board had published proposed revisions
to Regulation Z in December 2000.
• Preparing for a review of the regula- The final revisions broaden the scope
tions that implement the Community of loans subject to HOEPA’s protections
Reinvestment Act by adjusting the price triggers that deter-
mine coverage under the act. The rate-
• Expanding access to consumer infor- based trigger was lowered two per-
mation. centage points for first-lien loans (from
10 to 8 percentage points) but was kept
In addition, the division continued at 10 percentage points for subordinate-
its work in drafting regulations that lien loans. The fee-based trigger was
govern providers of consumer finan- revised to count as fees any amounts
cial services; reviewing applications for paid at closing for optional credit insur-
mergers and acquisitions; monitoring ance and similar debt-protection prod-
fair lending activities and compliance ucts obtained in connection with the
with the Community Reinvestment Act; mortgage.
supporting community development The revisions also restrict certain
activities throughout the System; ana- acts and practices in home-secured
lyzing data gathered under the Home transactions. For example, creditors may
Mortgage Disclosure Act; monitoring not refinance their HOEPA loans within
compliance with consumer protection one year of extension if the refinanc-
regulations; and addressing consumer ing is not in the borrower’s interest.
complaints. To strengthen the existing prohibition
against extending credit on the basis
of homeowner equity without regard to
Curbing Abusive Lending ability to repay, creditors must verify
In December, the Board of Governors and document the homeowner’s repay-
revised the provisions of Regulation Z ment ability. The disclosures that must
(Truth in Lending) that implement the be given three days before closing to
Home Ownership and Equity Protection borrowers obtaining HOEPA-covered
Act (HOEPA). Enacted in 1994 in loans must state the total amount bor-
response to evidence of abusive lending rowed and must indicate whether that
practices in the home-equity-lending amount includes payment for optional
markets, the act imposes substantive credit insurance or similar products.
122 88th Annual Report, 2001

Fostering Research • ‘‘Making Small Cities and Towns

Work’’ (Philadelphia and Richmond
The Federal Reserve continues to foster Reserve Banks)
research in community development
and consumer economics. In April, the • ‘‘New Roads and e-Roads: Market
System’s Community Affairs Offices Innovations in Community Develop-
held a second biennial research confer- ment’’ (Dallas Reserve Bank).
ence, ‘‘Changing Financial Markets and
Community Development.’’ The con- On the consumer economics side,
ference featured the work of economists members of the Board’s Consumer Poli-
and other scholars on the delivery cies staff conducted research on a wide
of financial services to lower-income range of subjects. Studies on households
populations and small businesses; pre- with high-cost home-secured loans and
sentations were made on the Commu- consumers’ choice of financial insti-
nity Reinvestment Act, predatory lend- tutions for home-secured loans were
ing, credit scoring, wealth creation, conducted in support of the division’s
and alternative financial services. The efforts to address concerns about abu-
importance of financial literacy and sive lending practices. Studies on low-
consumer education was discussed by income and underserved consumers,
Board Chairman Alan Greenspan in including research on reasons consum-
his keynote address. The proceedings ers do not have checking accounts and
of the conference, including speeches, on changes in account ownership over
papers, and discussant statements, are time, supported Federal Reserve initia-
available on the web site of the tives regarding financial access for the
Federal Reserve Bank of Chicago, at unbanked. Other research focused on electronic banking, consumers’ com-
sessionone.cfm. Members of the Board’s plaints about credit card problems, con-
Community Affairs staff, in partnership sumers’ satisfaction with the Federal
with research colleagues at the Board Reserve’s complaint process, and finan-
and the Reserve Banks, are now plan- cial literacy. The division staff received
ning for the 2003 research conference, an award from the Association for
which will focus on ‘‘Sustainable Com- Financial Planning and Counseling Edu-
munity Development: What Works, cation for research on the ability of low-
What Doesn’t, and Why.’’ income households to save.
Also during the year, the Reserve
Banks sponsored programs focused on
emerging issues in community develop- Preparing for the Community
ment to encourage research and facili- Reinvestment Act Review
tate discussion among academics and The current regulations implement-
practitioners. Topics included ing the Community Reinvestment Act
• ‘‘Smart Growth and Community (CRA) were adopted in 1995 by the
Development: Working Together supervisory agencies that have CRA
Smartly’’ (Philadelphia, Richmond, responsibilities—the Federal Reserve,
and Atlanta Reserve Banks) the Federal Deposit Insurance Corpo-
ration (FDIC), the Office of the Comp-
• ‘‘Smart Codes: A Local Perspective troller of the Currency (OCC), and the
on Planning and Growth’’ (St. Louis Office of Thrift Supervision (OTS). The
Reserve Bank) regulations reflect the agencies’ efforts
Consumer and Community Affairs 123

to (1) emphasize an institution’s actual publishing an advance notice of pro-

performance in addressing its CRA posed rulemaking.
responsibilities rather than the process, By the end of 2001, the agencies
(2) promote consistency in evaluations, had received approximately 400 com-
and (3) eliminate unnecessary burden on ments in response to the notice. These
institutions. To this end, CRA examina- comments will be taken into account in
tions focus on the quantitative aspects the agencies’ analysis for determining
of an institution’s performance, such as whether regulatory changes are needed
the number and dollar amount of loans to increase the CRA regulations’
and investments made; they also include effectiveness.
a review of qualitative aspects, such as
whether the bank is innovative in meet-
ing the credit needs of the community.
Expanding Access to
The regulations require large institu-
Consumer Information
tions to collect, report, and disclose data The Board substantially expanded the
on small-business, small-farm, and com- Spanish-language offerings of its con-
munity development loans and, for insti- sumer education program in 2001:
tutions already reporting Home Mort- Spanish-language versions of material
gage Disclosure Act data, data on home on three subjects—mortgages, vehicle
mortgage lending outside metropolitan leasing, and consumer complaints—
areas.1 Large retail institutions are were launched on the Board’s public
evaluated on their record of providing web site, and Spanish-language versions
loans, investments, and services to their of two consumer brochures—Looking
communities. Small institutions, in con- for the Best Mortgage and How to File
trast, are evaluated under a streamlined a Consumer Complaint—were released.
approach that focuses on their lending; The materials can be found at http://
some small institutions elect to have
their investment and service activities In 2001, the Board also completed a
reviewed as well in order to be consid- major revision of its consumer brochure
ered for an ‘‘outstanding’’ CRA rating. on credit cards, Shop—The Credit Card
The regulations also include a commu- You Pick Can Save You Money, incor-
nity development test for limited- porating information on new disclosure
purpose and wholesale banks and an requirements under Regulation Z and
option for any bank to be examined information from the re-instituted Sur-
under a strategic plan. vey of Credit Card Plans conducted by
When they adopted the regulations, the Board. A design review of all the
the supervisory agencies committed to Board’s consumer education publica-
conducting a full review in 2002 to tions is under way to ensure that the
determine whether their stated goals are materials are meeting consumers’ needs.
being achieved. The agencies began In addition to enhancing its own con-
the review process in July 2001 by sumer education program, the Board
also worked with other agencies on
resources to help consumers make deci-
1. A large institution is an institution that as of sions on financial privacy (see box) and
December 31 of the previous two calendar years avoid abusive lending practices.
either had total assets of $250 million or more or
was affiliated with a holding company that had
In recognition of the importance
total banking and thrift assets of $1 billion or of financial education in increasing
more. economic opportunity, the Community
124 88th Annual Report, 2001

Financial Information and Consumers’ Rights to Privacy

Gramm–Leach–Bliley also contains very important and far-reaching privacy
provisions. . . . Our objective is to devise disclosure requirements and consumer
‘‘opt-out’’ procedures that protect consumer privacy without overwhelmingly
burdening financial institutions or consumers.
Laurence H. Meyer, Member, Board of Governors

July 1, 2001, marked the deadline for mation is shared with a third party. In addi-
financial companies—banks, brokers, and tion to this initial notice, customers, as
insurance companies, among others—to long as they remain customers, must be
provide privacy notices to their existing given an annual notice describing the com-
customers. Companies were required to tell pany’s privacy policies and practices.
their customers Consumers must be given an opportu-
nity to tell the company not to share the
• What kinds of personal information the information—that is, they must be allowed
company collects (for example, income, to ‘‘opt out.’’ Opting out must be reason-
assets, and account balances) ably convenient—accomplished by check-
ing a box on an application, returning a
• How the company uses the information, preaddressed reply form, or calling a toll-
and whether it intends to make the infor- free telephone number, for example. And
mation available to nonaffiliated third consumers must be allowed a ‘‘reason-
parties (such as mortgage brokers, direct able’’ length of time to respond (generally
marketers, or nonprofit organizations) thirty days).
The opt-out right does not apply to all
• What customers can do to limit some of types of personal information. For exam-
that information sharing ple, it does not apply to a consumer’s tele-
phone number if that number is published
• How the company safeguards personal in a telephone directory. The right also
nonpublic information against fraudulent does not apply in certain situations—for
access. example, consumers may not stop their
banks from sharing information needed to
Consumers must now be given a privacy process their credit card or check transac-
notice at the time they enter into a cus- tions, to comply with a court order, or to
tomer relationship with the company— prevent fraud. A financial company may
for instance, when they open a checking also disclose personal financial informa-
account. And consumers, whether or not tion to comply with federal, state, or local
they have actually become ‘‘customers’’ requirements—such as a local law requir-
(for example, consumers who have simply ing mortgage documents to be recorded
filled out an application), must be given a in public records—without providing con-
notice before their personal financial infor- sumers an opt-out right.

Affairs Offices at the Board and the preparation for home ownership and
Reserve Banks offer resources and pro- on the effective use of credit. The Dallas
grams to promote personal financial Reserve Bank launched an interactive
literacy skills. In 2001, the Community web-based version of Building Wealth:
Affairs staff at the Board organized A Beginner’s Guide to Securing Your
workshops for Board employees on Financial Future, a program to help
Consumer and Community Affairs 125

Origins of the New Rights Compliance with the

to Financial Privacy Privacy Provisions
Financial companies share information Financial companies supervised by the
about customers for a variety of reasons. In FFIEC agencies are subject to examination
some instances, they may do so simply in to ensure that they are complying with the
the course of providing basic services to provisions of the Gramm–Leach–Bliley
their customers—when they process credit Act. Examination procedures were devel-
card payments or arrange for the printing oped by the FFIEC, and examinations
of personalized checks, for example. They began in July 2001 as part of regular
may also use the information in offer- consumer compliance examinations. As
ing additional services or introducing new of the end of 2001, few violations had
banking products. Some consumers want been found. Of those that were found,
to take advantage of these opportunities many concerned not giving notices on time
and are willing to have their personal or giving notices that did not contain all of
financial information shared with third the necessary information.
parties. Others prefer to limit the promo- To help financial institutions in their
tional materials they receive and do not efforts, the Board, working with the other
want marketers and others to have such agencies, has issued a set of frequently
information. asked questions for financial institutions
Concern about consumer privacy led (available at
to passage of federal legislation govern- boarddocs/press/general/2001/200112122/
ing the protection and disclosure of non- attachment.pdf).
public personal information by financial The eight federal agencies hosted a day-
companies as part of the Gramm–Leach– long workshop, ‘‘Get Noticed: Effective
Bliley Act. Regulations implementing the Financial Privacy Notices,’’ in December
act’s privacy provisions were issued in 2001 to discuss how financial institutions
June 2000 and became effective the follow- can provide consumers with more effective
ing November. Eight federal agencies have notice of their privacy policies and prac-
responsibilities for enforcing the privacy tices. Information on the workshop is avail-
provisions: the Board of Governors of the able at
Federal Reserve System, the Office of the glb/index.html.
Comptroller of the Currency, the Federal
Deposit Insurance Corporation, the Office
Consumer Education
of Thrift Supervision, and the National
Credit Union Administration (which col- The Board and the other agencies have
lectively make up the Federal Finan- prepared information for consumers
cial Institutions Examination Council, or explaining their financial privacy rights
FFIEC); the Securities and Exchange under Gramm–Leach–Bliley. The infor-
Commission; the Federal Trade Commis- mation is available at http://www.
sion; and the Commodity Futures Trading

consumers develop a plan for building continues to support the Consumer Fed-
personal wealth that includes setting eration of America’s ‘‘Cleveland Saves’’
financial goals, budgeting, saving and program to help low- and moderate-
investing, and managing debt (http:// income families create personal savings / htm / wealth / index. plans. The New York and San Francisco
html). The Cleveland Reserve Bank Reserve Banks, in cooperation with a
126 88th Annual Report, 2001

national nonprofit organization dedi- In addition to these rulemaking activi-

cated to the economic self-sufficiency of ties, the Board took the following regu-
inner-city residents, are developing pro- latory and interpretive actions during the
grams focused on enhancing economic year:
as well as computer literacy.
• Raised from $465 to $480 the total
dollar amount of points and fees that
Regulatory Matters trigger additional requirements for
In March 2001, the Board revised Regu- certain mortgage loans under HOEPA,
lation E to implement amendments to to reflect changes in the consumer
the Electronic Fund Transfer Act con- price index (CPI), effective in January
cerning ATM fees. Under the amend- 2002
ments, ATM operators that impose a fee
on consumers for providing electronic • Increased from $31 million to
fund transfer (EFT) services must post a $32 million the exemption threshold
notice to that effect in a prominent loca- for depository institutions required to
tion on or at the ATM where the transfer collect data in the year 2002 under the
is initiated. Before a consumer com- Home Mortgage Disclosure Act, to
mits to completing the transaction, the reflect changes in the consumer price
operator must disclose that a fee will index for urban wage earners and
be imposed and the amount of the fee. clerical workers (CPI–W), as pre-
When a consumer contracts with a scribed by the statute
financial institution for an EFT service,
such as obtaining an ATM or debit card, • Revised the official staff commentary
the institution’s initial disclosures must for Regulation E to provide guidance
include notice that a fee may be charged on transactions that involve electronic
for transfers initiated at an ATM oper- check conversion, whereby a con-
ated by another entity. sumer authorizes a merchant’s use
Also in March, the Board published of a check to capture encoded infor-
interim rules establishing standards for mation that is then used to initiate
the electronic delivery of federally man- an electronic debit from the con-
dated disclosures under five consumer sumer’s account. The commentary
protection regulations: Regulation B revisions also provide guidance on
(Equal Credit Opportunity), Regula- computer-initiated bill payments, the
tion E (Electronic Fund Transfers), authorization of recurring debits from
Regulation M (Consumer Leasing), a consumer’s account, and telephone-
Regulation Z (Truth in Lending), and initiated transfers.
Regulation DD (Truth in Savings). In
keeping with the Electronic Signatures
in Global and National Commerce Act
CRA Bank Examinations
(the ‘‘E–Sign Act’’), which was enacted
and Activities
in June 2000, financial institutions, The Community Reinvestment Act
creditors, and others may, under the requires the Board and other banking
Board’s interim rules, deliver disclo- agencies to encourage financial insti-
sures electronically if they obtain the tutions to help meet the credit needs of
consumer’s consent. The interim rules the local communities in which they do
are not final; they serve as guidance business, consistent with safe and sound
until final rules are adopted. business practices. To carry out this
Consumer and Community Affairs 127

mandate, the Federal Reserve has a ments), the implementing regulation

three-faceted program that includes for the CRA Sunshine provisions of
the Gramm–Leach–Bliley Act. The act
• Examining institutions to assess com- requires insured depository institutions
pliance with the CRA and nongovernmental entities or per-
sons who are parties to CRA-related
• Analyzing applications for mergers
agreements to make certain of those
and acquisitions from state member
agreements public and to file annual
banks and bank holding companies in
reports about their activities under the
relation to CRA performance
• Disseminating information on com-
munity development techniques to Analysis of Applications in
bankers and the public through Com- Relation to CRA Performance
munity Affairs Offices at the Reserve
Banks. Actions on bank and bank holding com-
pany applications during 2001 included
the following:
Examinations for
Compliance with the CRA • In February, the Board approved an
The Federal Reserve assesses the CRA application by FleetBoston Corp.
performance of state member banks dur- (Boston, Mass.) to acquire Summit
ing regularly scheduled examinations Bancorp (Princeton, N.J.).
for compliance with consumer protec-
tion regulations. By law, small banks • Also in February, the Board approved
(banks with assets of less then $250 mil- an application by MetLife, Inc. (New
lion) that are rated ‘‘satisfactory’’ for York, N.Y.), to become a bank holding
CRA performance are examined not company by acquiring Grand Bank,
more than once every forty-eight N.A. (Kingston, N.J.). This was the
months, and those that are rated ‘‘out- first application by an insurance
standing’’ for CRA purposes are exam- company to become simultaneously a
ined not more than once every sixty bank holding company and a financial
months. During the 2001 reporting holding company under the Gramm–
period, the Federal Reserve conducted Leach–Bliley Act.
183 CRA examinations.2 Of the banks
examined, 29 were rated ‘‘outstanding’’ • In April, the Board approved an
in meeting community credit needs, 151 application by Countrywide Credit
were rated ‘‘satisfactory,’’ 1 was rated Industries, Inc. (Calabasas, Calif.), to
‘‘needs to improve,’’ and 2 were rated as acquire Treasury Bank, Ltd. (Wash-
being in ‘‘substantial noncompliance.’’ ington, D.C.). This was the first appli-
Also during 2001, the Federal cation by a nonbanking financial com-
Reserve worked with the other agencies pany engaged primarily in mortgage
that have CRA responsibilities (the banking activities to become simulta-
FDIC, OCC, and OTS) and issued the neously a bank holding company and
Board’s Regulation G (Disclosure and a financial holding company under the
Reporting of CRA-Related Agree- Gramm–Leach–Bliley Act.

2. The 2001 reporting period was from July 1, • In July, the Board approved an appli-
2000, through June 30, 2001. cation by Citigroup, Inc. (New York,
128 88th Annual Report, 2001

N.Y.), to acquire European American ratings (that is, ‘‘needs to improve’’

Bank (Uniondale, N.Y.). or ‘‘substantial noncompliance’’) and
another thirty-nine applications involv-
• Also in July, the Board approved an ing other issues related to the CRA, fair
application by Citigroup, Inc. (New lending, or compliance with consumer
York, N.Y.), to acquire Grupo Finan- credit protection laws.3
ciero Banamex Accival, S.A. de C.V.
and Banco Nacional de Mexico, S.A.
(both in Mexico City, Mexico).
Dissemination of Community
Development Information
• In August, the Board approved an The Community Affairs Offices at the
application by First Union Corp. Reserve Banks continue to hold regular
(Charlotte, N.C.) to acquire Wachovia roundtable discussions with financial
Corp. (Winston–Salem, N.C.). Sun- institutions in their Districts on issues
Trust Banks, Inc. (Atlanta, Ga.), sub- related to the Community Reinvestment
mitted a competing bid for Wachovia, Act and community development. Dur-
which it withdrew after Wachovia ing 2001, some of the Banks sponsored
shareholders voted against SunTrust’s training for lenders and community
proposal. groups on the disclosure and reporting
requirements for CRA-related agree-
Comments from the public on each ments. (Also see the next section,
of these applications in relation to CRA ‘‘Community Affairs.’’)
performance raised allegations primar-
ily about predatory lending, insuffi-
cient lending to lower-income areas, or
Community Affairs
inadequate banking services in lower- The System’s Community Affairs pro-
income areas. In each case, the Board gram supports the economic growth
found that the CRA records of the objectives of the Federal Reserve by
depository institutions were consistent providing information and technical
with approval. In the case of the acqui- assistance to facilitate efficient markets
sition of European American Bank, the in historically underserved communi-
Board ordered an on-site examination of ties. The year 2001 marked twenty years
Citigroup’s subprime-lending affiliates. since the program’s inception.
The Board also stipulated that Citigroup Community Affairs Offices through-
must report quarterly for two years out the System continued outreach
on the status of litigation involving activities and programs in rural markets.
subprime lending and on their compli- The Federal Reserve Banks of Atlanta,
ance with court orders or court-approved Cleveland, Richmond, Kansas City,
settlements. and Minneapolis sponsored conferences
During the year, the Board acted on to foster workforce development and
fourteen other bank and bank holding encourage integration of community-
company applications that involved pro-
tests by members of the public concern-
ing the performance of insured deposi- 3. In addition, one application involving a CRA
tory institutions in relation to the CRA. protest, another application involving an adverse
CRA rating, and nine applications involving other
The Federal Reserve also reviewed CRA issues, fair lending issues, or compliance
three applications involving institutions with consumer credit protection regulations were
having less than ‘‘satisfactory’’ CRA withdrawn in 2001.
Consumer and Community Affairs 129

based research, policies, and practices The preservation of affordable hous-

with community development activities. ing remains a central concern of the
The Board’s staff continued to work Community Affairs program. During
with the Rural Home Loan Partnership, 2001, Board staff served in various
an interagency group committed to capacities to support housing activities
increasing affordable housing in rural conducted by external partners. They
communities. served as liaison to the advisory board
The San Francisco, Minneapolis, and for the Local Initiatives Support Cor-
Chicago Reserve Banks convened meet- poration’s Center for Home Ownership
ings and workshops for bankers, devel- and assisted with planning an annual
opers, and tribal representatives to pro- summit on housing issues. They also
vide information on the legal and policy provided support to Board member
aspects of financing housing and small Edward Gramlich, who chairs the board
businesses on Native American tribal of directors of the Neighborhood Rein-
lands. The Board’s Community Affairs vestment Corporation—a national non-
staff continued to participate in a task profit organization charged by the Con-
force with representatives of other fed- gress with revitalizing older, distressed
eral agencies, nonprofit organizations, communities.
financial institutions, and other entities Also during the year, the Board’s
to promote financial literacy programs Community Affairs Office engaged in
for members of Native American interagency efforts to raise awareness of
communities. issues having national scope. For exam-
Recognizing the importance of sup- ple, staff members worked with other
port services to workforce development, agencies to publish Crossing the Bridge
the Community Affairs Offices partici- to Self-Employment: A Federal Micro-
pated in programs to improve access to enterprise Resource Guide.
child care. The Seattle Branch of the Through the programs described
San Francisco Reserve Bank facilitated above, the Federal Reserve System
development of a micro-loan fund for during 2001 sponsored more than 300
child-care providers unable to secure conferences and workshops, conducted
conventional lending, and the New York approximately 1,500 outreach meetings,
and Philadelphia Reserve Banks spon- facilitated research, and distributed more
sored a conference on investment and than 250,000 community economic
lending models for child-care facilities. development publications.
The Community Affairs program
has expanded its reach to diverse
communities and populations through Consumer Advisory Council
effective use of information tech-
nology and communication tools. The The Consumer Advisory Council,
Boston Reserve Bank cosponsors whose members represent consumer and
a web site to support faith-based community organizations, the financial
community developers (http://www. services industry, academic institutions,, and and state agencies, advises the Board of
the Dallas Reserve Bank publishes Governors on matters concerning laws
e–Perspectives, an electronic version that the Board administers and other
of its community affairs newsletter issues related to consumer financial ser-
( / htm / pubs / vices. Council meetings are open to the
perspectonline.html). public.
130 88th Annual Report, 2001

In 2001, the Council met in March, to Regulation C to improve the quality,

June, and October. The rules implement- clarity, and utility of data collected
ing the Community Reinvestment Act, under the Home Mortgage Disclosure
scheduled for review by banking and Act. At both meetings, members focused
thrift institution regulators in 2002, were on the proposed requirements regarding
a major topic at all three meetings. the reporting of the annual percentage
In March and June, Council members rate (APR) on home mortgage loans and
commented on the definition of ‘‘assess- discussed the burdens and benefits of
ment area,’’ the investment test, and having lenders report pricing and other
the service test. They agreed that the data. Some members asserted that the
assessment area definition needs to rec- reliability and validity of APR data for
ognize that technological change has pricing analysis was questionable, but
affected how and where financial insti- others believed that the reporting of the
tutions conduct business. Regarding the data would facilitate public debate and
investment and service tests, members enable pricing concerns to be more
concluded that investments are impor- readily addressed.
tant but challenging and difficult to Also discussed during 2001 were the
make and that the service test provides interim final rules governing the elec-
opportunities for lenders to find inno- tronic delivery of disclosures required
vative ways to serve communities and under Regulations B (Equal Credit
build banking relationships. In October, Opportunity), E (Electronic Fund Trans-
members offered views on the defini- fers), M (Consumer Leasing), Z (Truth
tion of small-business and community- in Lending), and DD (Truth in Savings).
development lending and on whether In June and October, Council members
loan originations should receive more discussed the requirement that an e-mail
credit than loan purchases under the message be sent to the consumer when a
lending test. disclosure is placed on a company’s web
The proposed amendments to Regu- site and supported flexibility in the rules
lation Z, designed to broaden the scope for delivery of these alerts. They also
of mortgage loans subject to the Home discussed the challenges of re-delivering
Ownership and Equity Protection Act, returned e-mail messages and provided
were a key topic at the March and June differing views on the requirement that
meetings. In March, Council members an institution maintain disclosures on a
discussed expanding the dollar test web site for ninety days.
applied to the points and fees trigger In October, the Council began to iden-
to include amounts paid at loan closing tify issues for an upcoming review by
for single-premium credit life insur- the Board of Regulation Z. Members
ance. The June discussion focused on a discussed the differences in disclosure
proposal that creditors be prohibited requirements for open- and closed-end
from refinancing a zero-interest or low- lending and noted that greater flexi-
interest loan into a higher-rate loan dur- bility exists for open-end disclosures.
ing the first five years of the loan unless Future discussions will focus on the
the refinancing is in the borrower’s types of disclosures that are impor-
interest; members considered the diffi- tant for credit card products and on
culty of defining ‘‘borrower’s interest’’ streamlining the disclosures for closed-
and of identifying low-cost loans. end mortgage loans to facilitate con-
In March and June, the Council dis- sumer comparisons of loan costs among
cussed the Board’s proposed changes lenders.
Consumer and Community Affairs 131

HMDA Data and The FFIEC prepared individual dis-

Mortgage Lending Patterns closure statements for each lender that
reported data—one statement for each
The Home Mortgage Disclosure Act metropolitan area in which the lender
requires that mortgage lenders covered had offices and reported loan activity. In
by the act collect and make public cer- 2001, the FFIEC prepared 52,776 dis-
tain data about their home purchase, closure statements, reporting data for
home improvement, and refinancing calendar year 2000. Each institution
loan transactions. Depository institu- made its disclosure statement public in
tions generally are covered if they were July, and reports containing aggregate
located in metropolitan areas, met the data for all lenders in a given metro-
asset threshold at the end of the preced- politan area were made available at cen-
ing year, and originated at least one tral depositories in the nation’s approxi-
home purchase loan (or refinancing) in mately 330 metropolitan areas. These
the preceding year. For 2000, the asset data are used by the FFIEC member
threshold was $30 million; for 2001, it agencies, the reporting institutions, the
was $31 million. Mortgage companies public, the Department of Justice, and
are covered if (1) they were located in or HUD. The data also assist HUD, the
made loans in metropolitan areas, Department of Justice, and state and
(2) had assets of more than $10 million local agencies in responding to allega-
(when combined with the assets of any tions of lending discrimination and in
parent company) at the end of the pre- targeting lenders for further inquiry.5
ceding year or originated 100 or more The data reported for 2000 covered
home purchase loans and refinancings 19.2 million loans and applications,
in the preceding year, and (3) their about 16 percent fewer than in 1999.
home purchase loans (and refinancings) The decline was due primarily to a
accounted for 10 percent or more of decline of about 30 percent in refinanc-
their total loans by dollar volume. ing activity. The number of home pur-
In 2001, a total of 6,704 depository chase loans extended in 2000 compared
institutions and affiliated mortgage com- with 1999 increased 8 percent for Asians
panies and 1,009 independent mortgage and 7 percent for Hispanics but fell
companies reported HMDA data for 1 percent for blacks, 5 percent for
calendar year 2000. Lenders submitted Native Americans, and 6 percent for
information about the geographic loca- whites. Between 1993 and 2000, the
tion of the properties related to loans number of home purchase loans
and loan applications, the disposition of extended increased 138 percent for His-
loan applications, and, in most cases, the panics, 109 percent for Native Ameri-
race or national origin, income, and sex
of applicants and borrowers. The Fed-
eral Financial Institutions Examination Federal Deposit Insurance Corporation, the Office
Council (FFIEC) processed the data of the Comptroller of the Currency, the Office of
and produced disclosure statements on Thrift Supervision, and the National Credit Union
behalf of the Department of Housing 5. On behalf of the nation’s seven active pri-
and Urban Development (HUD) and the vate mortgage insurance (PMI) companies, the
FFIEC member agencies.4 FFIEC also compiles information on applications
for PMI similar to the information on home mort-
gage lending collected under HMDA. Lenders
4. The FFIEC member agencies are the Board typically require PMI for conventional mortgages
of Governors of the Federal Reserve System, the that involve small down payments.
132 88th Annual Report, 2001

cans, 89 percent for blacks, 84 percent costs as well as the benefits of the act
for Asians, and 25 percent for whites. for consumers.
For most income categories, the num- The proportion of U.S. households
ber of home purchase loans extended using EFT services has grown over the
was lower in 2000 than in 1999; the past decade at an annual rate of 3 per-
number made to lower-income appli- cent, according to data from the Survey
cants fell 4 percent, but the number of Consumer Finances (the most recent
made to upper-income applicants rose data available from these triennial sur-
3 percent. From 1993 through 2000, veys were gathered in 1998; data from
the number of home purchase loans to the 2001 survey are not yet available).
lower-income and upper-income appli- Approximately 85 percent of households
cants increased 79 percent and 56 per- use one or more EFT services—for
cent respectively. example, they use an ATM or debit card,
In 2000, 31 percent of Hispanic appli- direct deposit, or direct payment.
cants and 27 percent of black appli- Automated teller machines remain the
cants for home purchase loans sought most widely used EFT service. About
government-backed mortgages; the two-thirds of U.S. households have an
comparable figure for white and Native ATM card. In 2001, the average number
American applicants was 14 percent, of ATM transactions a month exceeded
and for Asian applicants 9 percent. 1.1 billion, a slight increase over the
Twenty-five percent of lower-income preceding year. The number of installed
applicants for home purchase loans, ATMs rose about 19 percent, to about
compared with 9 percent of upper- 324,000.
income applicants, applied for Direct deposit is also widely used.
government-backed mortgages. About 60 percent of U.S. households
Overall, the denial rate for conven- have funds deposited directly into their
tional (that is, non-government-backed) transaction accounts (checking or sav-
home purchase loans was 27 percent in ings). Use of the service is particularly
2000. The rate rose steadily from 1993 common in the public sector, accounting
through 1998 but has now fallen slightly for 78 percent of social security pay-
(about 1 percentage point) for the sec- ments, 98 percent of federal salary and
ond consecutive year. Denial rates for retirement payments, and 33 percent of
conventional home purchase loans in federal income tax refunds during fiscal
2000 were 45 percent for black appli- year 2001.
cants, 42 percent for Native American A less widely used EFT payment
applicants, 31 percent for Hispanic mechanism is direct bill-paying. About
applicants, 22 percent for white appli- 36 percent of U.S. households have pay-
cants, and 12 percent for Asian appli- ments automatically deducted from their
cants. Except for Asian applicants, each transaction accounts.
of these rates was lower than the compa- About one-third of U.S. households
rable rate for 1999. have debit cards, which are used at mer-
chant terminals to debit their transaction
accounts. Point-of-sale (POS) systems
Economic Effects of the account for a fairly small share of elec-
Electronic Fund Transfer Act tronic transactions, but their use contin-
As required by the Electronic Fund ued to grow rapidly in 2001. From 2000
Transfer Act (EFTA), the Board moni- to 2001, the average number of POS
tors the effects of the act on institutions’ transactions a month rose about 34 per-
Consumer and Community Affairs 133

cent, from about 258.9 million to about visory resources are targeting higher-
348.0 million, and the number of POS risk areas, a consumer compliance risk-
terminals rose about 30 percent, to about focused supervision program was fully
3.6 million. implemented in 2001. The program
The incremental costs associated emphasizes evaluating the appropriate-
with the EFTA are difficult to quantify ness of an institution’s risk-management
because no one knows how industry practices and tailors supervisory activi-
practices would have evolved in the ties to fit the institution’s risk profile.
absence of statutory requirements. The The program also incorporates various
benefits of the act to consumers are also monitoring procedures that are designed
difficult to measure, because the protec- to identify high-risk institutions and to
tions afforded by the act cannot be iso- facilitate a more continuous supervisory
lated from protections that would have process.
been provided in the absence of regula-
tion. The available evidence suggests
that there have been no serious con-
Fair Lending
sumer problems in relation to the act Pursuant to a 1991 amendment to the
(see the section ‘‘Agency Reports on Equal Credit Opportunity Act, the Board
Compliance with Consumer Protection refers to the Department of Justice any
Laws and Regulations’’). violation of the act that it has reason
to believe constitutes a ‘‘pattern or prac-
Compliance Activities tice’’ of discrimination. During 2001 the
Board referred one case involving dis-
The Federal Reserve conducts com- parate treatment in the underwriting of
pliance examinations to carry out its automobile loans.
responsibility for ensuring that state In May the Board supplemented the
member banks and certain foreign bank- interagency procedures for fair lending
ing organizations comply with fed- examinations by adopting alternative
eral laws and regulations concerning procedures for banks having low-
fair lending and consumer protections. discrimination-risk profiles. Typically,
The Board provides consumer compli- such banks are stable community banks,
ance training for the System’s spe- commonly specializing in commercial
cialized examiners and participates in or agricultural lending, that are located
compliance-related activities of the Fed- in suburban or rural markets having
eral Financial Institutions Examination a low percentage of minority residents.
Council. The alternative procedures are expected
to reduce the resources devoted to these
Compliance Examinations banks and to facilitate the allocation of
During the 2001 reporting period resources for more intensive analysis of
(July 1, 2000, through June 30, 2001), higher-risk institutions.
the Federal Reserve conducted 343
consumer compliance examinations— under section 25 or 25(a) of the Federal Reserve
261 examinations of state member banks Act (Edge Act and agreement corporations) and
state-chartered commercial lending companies
and 82 examinations of foreign banking owned or controlled by foreign banks. These insti-
organizations.6 To ensure that super- tutions are not subject to the Community Reinvest-
ment Act and typically engage in relatively few
6. The foreign banking organizations examined activities that are covered by consumer protection
by the Federal Reserve are organizations operating laws.
134 88th Annual Report, 2001

Examiner Training agencies, and other federal supervisory

Reserve Bank examiners receive train-
ing in consumer protection laws, fair
lending laws, and the Community Regulation B
Reinvestment Act as well as in com- (Equal Credit Opportunity)
plaint analysis and investigation. During The FFIEC agencies reported that
the 2001 reporting period, 221 examin- 83 percent of the institutions examined
ers were trained in thirteen sessions during the 2001 reporting period were
of varying lengths. Offerings included in compliance with Regulation B, com-
basic and advanced compliance courses pared with 81 percent for the 2000
and courses on fair lending, the Commu- reporting period. Of the institutions not
nity Reinvestment Act, and commercial in full compliance, 20 percent had five
lending. The consumer compliance cur- or fewer violations. The most frequent
riculum is continually monitored and violations involved the failure to take
updated to reflect regulatory and mar- one or more of the following actions:
ketplace changes.
• Provide a written notice of credit
denial or other adverse action contain-
Participation in FFIEC Activities ing a statement of the action taken,
Through cooperation among its member the name and address of the creditor,
agencies, the FFIEC develops uniform a notice of rights, and the name and
examination principles, standards, pro- address of the federal agency that
cedures, and report formats. In 2001, the enforces compliance
FFIEC issued a revised report format
and standardized tables for use in CRA • Provide a statement of reasons for
performance evaluations; host-state credit denial or other adverse action
loan-to-deposit ratios for determining that is specific and indicates the prin-
compliance with section 109 of the cipal reasons for the adverse action
Riegle–Neal Interstate Banking and
Branching Efficiency Act of 1994; and • Collect information for monitoring
documents providing answers to fre- purposes about the race or national
quently asked questions about Regu- origin, sex, marital status, and age of
lation P (Consumer Privacy) and the the applicants seeking credit primarily
CRA. for the purchase or refinancing of a
principal residence

• Notify the credit applicant of the

Agency Reports on Compliance action taken within the time frames
with Consumer Protection Laws specified in the regulation.
and Regulations
The Board is required to report annually Four formal enforcement actions con-
on compliance with consumer protec- taining provisions relating to Regula-
tion laws and regulations by entities
supervised by the various federal agen- 7. Because the agencies use different methods
to compile the data, the information presented
cies. Summarized in this section are here supports only general conclusions. The 2001
data collected from the twelve Federal reporting period was from July 1, 2000, through
Reserve Banks, the FFIEC member June 30, 2001.
Consumer and Community Affairs 135

tion B were issued during the 2001 failure to comply with the following
reporting period—three by the FDIC requirements:
and one by the OCC. The Federal Trade
Commission (FTC) filed one action and • Investigate an alleged error promptly
continued other litigation against two after receiving a notice of error
mortgage lenders for alleged violations
of the Equal Credit Opportunity Act • Determine whether an error actually
(ECOA). The alleged violations include, occurred, and transmit the results of
among other things, failing to take writ- the investigation and determination to
ten applications for mortgage loans, the consumer within ten business days
failing to provide rejected applicants
with written notice of adverse action, • Credit the customer’s account in the
and failing to collect required infor- amount of the alleged error within ten
mation about the race or national ori- business days of receiving the error
gin, sex, marital status, and age of notice if more time is needed to con-
applicants. duct the investigation
The other agencies that enforce the
ECOA—the Farm Credit Administra- • Provide initial disclosures at the time
tion (FCA), the Department of Trans- a consumer contracts for an electronic
portation (DOT), the Securities and fund transfer service or before the first
Exchange Commission (SEC), the Small electronic fund transfer involving the
Business Administration (SBA), and the consumer’s account is made.
Grain Inspection, Packers and Stock-
yards Administration of the Department In 2001, the FDIC issued three formal
of Agriculture—reported substantial enforcement actions containing provi-
compliance among the entities they sions relating to Regulation E. The FTC
supervise. The FCA’s examination and continued its efforts to educate con-
enforcement activities revealed viola- sumers and businesses in this area and
tions of the ECOA mostly attributable to released a new brochure, Electronic
creditors’ failure to collect information Check Conversion, that gives consumers
for monitoring purposes and failure to information about this new form of elec-
comply with rules regarding adverse tronic banking.
action notices. No formal enforcement
actions containing provisions relating
to Regulation B were initiated by these Regulation M (Consumer Leasing)
The FFIEC agencies reported that more
than 99 percent of the institutions exam-
Regulation E ined during the 2001 reporting period
(Electronic Fund Transfers) were in full compliance with Regula-
tion M. This level of compliance is
The FFIEC agencies reported that comparable to the level during the 2000
approximately 95 percent of the institu- reporting period. The few violations
tions examined during the 2001 report- noted involved failure to adhere to spe-
ing period were in compliance with cific disclosure requirements. The agen-
Regulation E, compared with 94 per- cies did not issue any formal enforce-
cent for the 2000 reporting period. The ment actions containing provisions
most frequent violations involved the relating to Regulation M.
136 88th Annual Report, 2001

Regulation Z (Truth in Lending) In 2001, the FTC continued its efforts

to curb abusive practices by some
The FFIEC agencies reported that subprime mortgage lenders, initiating
79 percent of the institutions examined one new action and pursuing two ongo-
during the 2001 reporting period were ing litigations against mortgage lenders
in compliance with Regulation Z, com- for alleged violations of the Truth and
pared with 77 percent for the 2000 Lending Act (TILA) and the Home
reporting period. Of the institutions Ownership and Equity Protection Act.
not in full compliance, 75 percent had In addition, the FTC obtained settle-
five or fewer violations, compared with ments in two cases that alleged vio-
64 percent in 2000. The most frequent lations of the TILA and Regula-
violations involved the failure to take tion Z—one involving vacation travel
one or more of the following actions: packages and the other, Internet-access
products and services.
• Accurately disclose the finance The DOT is currently investigating
charge, payment schedule, annual per- cases involving four different air carri-
centage rate, security interest in collat- ers regarding possible violations of the
eral, or amount financed TILA. All four cases involve the timeli-
ness of processing requests for credit
• Disclose the annual percentage rate card refunds. In 2001, the DOT contin-
on a periodic statement using the term ued to prosecute a cease-and-desist con-
‘‘annual percentage rate’’ sent order issued in 1993 against a travel
agency and a charter operator. The com-
• Provide disclosures within three busi- plaint alleged that the two organizations
ness days of application as required had violated Regulation Z by routinely
for applications for residential mort- failing to send credit statements for
gages covered by the Real Estate refund requests to credit card issuers
Settlement Procedures Act within seven days of receiving fully
documented credit refund requests from
• Ensure that disclosures reflect the customers.
terms of the legal obligation between
the parties
Regulation AA
• Provide the index value for adjust-
(Unfair or Deceptive Acts
ments to variable-rate loans.
or Practices)
The three banking regulators with
Four formal enforcement actions con- responsibility for enforcing Regula-
taining provisions relating to Regula- tion AA’s Credit Practices Rule—the
tion Z were issued during the 2001 Federal Reserve, the OCC, and the
reporting period—three by the FDIC FDIC—reported that 99 percent of insti-
and one by the OCC. In addition, tutions examined during the 2001 report-
218 institutions supervised by the Fed- ing period were in compliance. Of the
eral Reserve, the FDIC, or the OTS were institutions not in full compliance, the
required, under the Interagency Enforce- most frequently cited violations involved
ment Policy on Regulation Z, to refund
a total of approximately $891,000 to • Failing to provide a clear, conspicuous
consumers in 2001 because of improper disclosure regarding a cosigner’s lia-
disclosures. bility for a debt
Consumer and Community Affairs 137

• Entering into a consumer credit con- • Failure to provide all applicable infor-
tract containing a nonpossessory secu- mation on account disclosures.
rity interest in household goods.
No formal enforcement actions con-
No formal enforcement actions con- taining provisions relating to Regula-
taining provisions relating to Regula- tion DD were issued during the 2001
tion AA were issued during the 2001 reporting period.
reporting period.

Regulation DD (Truth in Savings) Consumer Complaints

The FFIEC agencies reported that The Federal Reserve investigates com-
88 percent of institutions examined dur- plaints against state member banks and
ing the 2001 reporting period were in forwards to the appropriate enforce-
compliance with Regulation DD. Of ment agency complaints it receives that
the institutions not in full compliance, involve other creditors and businesses.
the most frequently cited violations During 2001, the Federal Reserve
involved fully implemented an automated sys-
tem for generating letters designed to
• Advertisements that were inaccurate help Reserve Banks expedite responses
or misleading (or both) to consumer complaints. The letter-
generation system is a component of the
• Use of the phrase ‘‘annual percentage Complaints Analysis Evaluation System
yield’’ in an advertisement without and Reports (CAESAR) database, which
disclosing additional terms and condi- is used to track complaints and inquir-
tions of customer accounts ies. The CAESAR system produces

Consumer Complaints against State Member Banks and Other Institutions Received by the
Federal Reserve System, 2001

State member Other

Subject Total
banks institutions 1

Regulation B (Equal Credit Opportunity) . . . . . . . . . . . . . . . . . . . . . . . 59 27 86

Regulation E (Electronic Fund Transfers) . . . . . . . . . . . . . . . . . . . . . . . 41 55 96
Regulation H (Bank Sales of Insurance) . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 0
Regulation M (Consumer Leasing) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 1 1
Regulation P (Privacy of Consumer Financial Information) . . . . . . . 14 19 33
Regulation Q (Payment of Interest) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 0

Regulation Z (Truth in Lending) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 560 860

Regulation BB (Community Reinvestment) . . . . . . . . . . . . . . . . . . . . . 3 2 5
Regulation CC (Expedited Funds Availability) . . . . . . . . . . . . . . . . . . 22 28 50
Regulation DD (Truth in Savings) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 55 93
Fair Credit Reporting Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178 270 448
Fair Debt Collection Practices Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 13 21

Fair Housing Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 5 13

Flood insurance rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 5 7
Regulations T, U, and X . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 0
Real Estate Settlement Procedures Act . . . . . . . . . . . . . . . . . . . . . . . . . . 7 11 18
Unregulated practices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,359 1,412 2,771

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,039 2,463 4,502

1. Complaints against these institutions were referred

to the appropriate regulatory agencies.
138 88th Annual Report, 2001

Consumer Complaints Received by the Federal Reserve System,

by Subject of Complaint, 2001

Complaints against state member banks

Total Not investigated Investigated

Bank legally correct

Subject of complaint Unable
to obtain Explanation Goodwill
sufficient of law No reim-
Number Percent reimburse-
information provided bursement ment or
from to consumer or other other
consumer accommo- accommo-
dation dation

Discrimination alleged
Real estate loans . . . . . . . . . . 15 1 0 3 4 1
Credit cards . . . . . . . . . . . . . . 19 1 0 1 13 2
Other loans . . . . . . . . . . . . . . . 25 1 1 8 5 0
Other type of complaint
Real estate loans . . . . . . . . . . 22 1 1 7 10 0
Credit cards . . . . . . . . . . . . . . 797 39 7 25 213 460
Other loans . . . . . . . . . . . . . . . 254 13 2 75 94 28

Deposits . . . . . . . . . . . . . . . . . . . . . . 608 30 5 99 257 112

Electronic fund transfers . . . . . . . 41 2 0 5 17 7
Trust services . . . . . . . . . . . . . . . . . 25 1 2 8 11 0
Other . . . . . . . . . . . . . . . . . . . . . . . . . 233 11 12 75 79 18

Total . . . . . . . . . . . . . . . . . . . . . . . . . 2,039 100 30 306 703 628

acknowledgment letters based on infor- Complaints against

mation maintained in the database but State Member Banks
also allows Reserve Banks to tailor let-
ters to particular circumstances. In 2001 the Federal Reserve received
Besides conducting training for a total of 4,502 complaints—3,875 by
Reserve Bank staff in complaint analy- mail, 545 by telephone, 10 in person,
sis and investigation during the year, and 72 electronically via the Internet.
Board staff also held sessions on the Complaint volume was reduced in the
CAESAR query facility, which allows fourth quarter because of problems in
the System to track individual com- the national mail system, including mail
plaints as well as to aggregate data for facilities in the Washington metropoli-
purposes of trend analysis. tan area.
Also continuing in 2001 was the About 45 percent of the complaints
System’s residency program for Reserve were against state member banks (see
Bank staff who come to the Board tables). Of the complaints against state
for several weeks at a time to work with member banks, 56 percent involved
complaint staff on projects and to gain credit transactions: 3 percent alleged
familiarity with complaint operations in discrimination on a basis prohibited
Washington. by law (race, color, religion, national
Consumer and Community Affairs 139

Consumer Complaints Received—Continued

Complaints against state member banks


Referred to Total
Factual or Possible other complaints
contractual bank Pending, agencies
Customer Bank dispute— violation— Matter in December 31
error error resolvable bank took litigation
only corrective
by courts action

0 0 0 1 0 6 13 28
0 0 0 0 0 3 8 27
0 0 1 1 1 8 6 31

0 1 0 1 2 0 18 40
1 59 6 0 1 25 807 1,604
1 30 9 1 7 7 401 655

1 80 19 0 12 23 509 1,117
0 6 1 2 2 1 55 96
0 0 3 0 1 0 14 39
1 21 10 1 3 13 632 865

4 197 49 7 29 86 2,463 4,502

origin, sex, marital status, age, the fact or other practices. Information on the
that the applicant’s income comes from outcomes of the investigations of these
a public assistance program, or the fact complaints is provided in the table.
that the applicant has exercised any right During 2001, the System completed
under the Consumer Credit Protection investigations of 181 complaints against
Act), and 53 percent concerned other state member banks that were pending
credit-related practices, such as the im- at year-end 2000 and found three vio-
position of annual membership fees on lations of regulations. In the vast major-
credit card accounts, the amount of ity of cases, the banks had correctly
interest banks charge on credit card handled customers’ accounts; notwith-
accounts, or credit denial on a basis not standing, banks chose to reimburse or
prohibited by law (for example, credit otherwise accommodate consumers in
history or length of residence). Thirty more than half of these cases.
percent of the complaints against state The Federal Reserve received more
member banks involved disputes about than 1,800 inquiries about consumer
interest on deposits and general deposit credit and banking policies and prac-
account practices, and the remaining tices during the year. In responding
14 percent concerned disputes about to these inquiries, the Board and the
electronic fund transfers, trust services, Reserve Banks gave specific explana-
140 88th Annual Report, 2001

tions of laws, regulations, and banking credit cards (113), and customer service
practices and provided relevant printed problems (101). The remainder of the
materials on consumer issues. complaints concerned a wide range of
To assess satisfaction with the Sys- unregulated practices in other areas,
tem’s handling of complaints, the Board including such matters as check-cashing
sends complainants follow-up question- problems experienced by non–account
naires. Because of mail disruptions dur- holders, consumer dissatisfaction with
ing the fourth quarter of 2001, analysis reduced availability of branch tellers,
of data for the entire year was impos- and the marketing practice of banks’
sible. However, data for the first three sending what appear to be ‘‘live’’ checks
quarters show that consumers were sat- in the mail.
isfied or very satisfied with the Sys-
tem’s handling of their complaints.
Complaint Referrals to HUD
In 2001 the Federal Reserve, in accor-
Unregulated Practices dance with a memorandum of under-
As required by section 18(f ) of the Fed- standing between the Department of
eral Trade Commission Act, the Board Housing and Urban Development and
continues to monitor complaints about the federal bank regulatory agencies,
banking practices that are not subject referred nine complaints to HUD that
to existing regulations and to focus on alleged state member bank violations of
those complaints that concern possible the Fair Housing Act. Of the six inves-
unfair or deceptive practices. In 2001 tigations completed by the Federal
the Board received a wide range of com- Reserve, five revealed no evidence of
plaints about unregulated practices. The unlawful discrimination. The parties in
category that received the most com- the sixth complaint were seeking reso-
plaints involved credit cards: Consum- lution through the courts; the Federal
ers complained about penalty charges Reserve does not intervene in consumer
(125), interest rates and terms (118), cases that are in litigation.
other miscellaneous problems involving

Banking Supervision and Regulation

The U.S. banking system maintained charge-off rates, both of which reached
its overall financial strength in 2001 the highest levels since 1992. Commer-
despite having weathered some of the cial net charge-off rates surged, reflect-
most challenging operating conditions ing the adverse effect on corporate
in a decade. An already slowing econ- earnings of a retrenchment in business
omy slid into recession, dampening con- investment, particularly investment in
sumer confidence and equity markets equipment and software. With unem-
generally. Conditions became even ployment rates and personal bankrupt-
worse in the aftermath of the Septem- cies rising, consumer net charge-off
ber 11 terrorist attacks in New York rates rose moderately. Compared with
and Washington, D.C. The effects of the the previous year, the banking industry’s
attacks and the bursting of the high-tech nonperforming assets grew 28 percent,
bubble, together with the largest chap- to $44.9 billion, or 1.1 percent of loans
ter 11 bankruptcy ever (filed by domes- and foreclosed assets, still well below
tic energy-trading company Enron) and the peak that prevailed during the last
events in Argentina, exacerbated a dete- recession. Through this period, banks
rioration in credit conditions. maintained adequate loss reserves and
Nevertheless, banking industry net improved their capital ratios.
income rose 6 percent during the year. The generally benign effect of rela-
Asset growth continued, and the return tively stressful events on the financial
on assets remained at a historically high condition of U.S. banks in 2001 may
level. Net interest margins narrowed reflect, at least in part, the progress that
slightly, particularly at community banks and their regulators have made
banks, in response to very low market in identifying and responding promptly
interest rates and reluctance by banks to emerging weakness. Many banking
to fully reflect lower rates in their organizations, particularly large orga-
core deposit pricing. Monetary easing nizations, have developed and are
induced a record volume of mortgage implementing more sophisticated risk-
loan originations and refinancings, measurement and risk-management sys-
which contributed to strong growth in tems that help them evaluate and price
fee income. However, depressed finan- credit risk better and identify changing
cial markets constrained larger banks’ levels of risk as they occur.
ability to generate revenue from non- Through the Basel Committee on
traditional banking activities, particu- Banking Supervision, the Federal
larly investment banking, asset man- Reserve and other bank supervisors
agement, private equity investments, worldwide are building on banks’ inter-
and trading. Even with reduced market- nal risk-measurement systems in revis-
sensitive revenues, total non-interest ing regulatory capital requirements for
income improved somewhat, buttressed internationally active banks. In January
by securities gains (versus losses a year 2001, the Basel Committee issued for
earlier). public comment a proposal to base capi-
Credit costs mounted as banks raised tal requirements on an institution’s inter-
provisioning rates in excess of net nal credit-risk ratings and other factors,
142 88th Annual Report, 2001

such as its estimates of expected loss. remains strong in its ability to deal with
This development effort continues. adversities and to continue supporting
The terrorist attacks of September 11 domestic and worldwide economic
temporarily disrupted many interbank growth.
and securities settlement activities and
strained the activities of key institu- Scope of Responsibilities for
tions in these markets before commu- Supervision and Regulation
nications and operating systems were
fully restored. Throughout the period, The Federal Reserve is the federal
Federal Reserve System supervisory supervisor and regulator of all U.S. bank
staff facilitated communications within holding companies (including financial
the banking and regulatory systems and holding companies formed under the
worked to minimize the disruptive authority of the Gramm–Leach–Bliley
effects. The experience highlighted the Act) and of state-chartered commercial
need to review and strengthen contin- banks that are members of the Federal
gency plans within the financial system Reserve System. In overseeing these
and its oversight process. That work is organizations, the Federal Reserve seeks
also actively under way. primarily to promote their safe and
November 2001 marked the sec- sound operation and their compliance
ond anniversary of enactment of with laws and regulations, including the
the Gramm–Leach–Bliley Act, which Bank Secrecy Act and consumer protec-
allows bank holding companies to tion and civil rights laws.1
become ‘‘financial holding compa- The Federal Reserve also has respon-
nies’’ (FHCs) and to conduct a broad sibility for the supervision of all Edge
range of banking, securities, and Act and agreement corporations; the
insurance-underwriting activities. As the international operations of state member
‘‘umbrella supervisor’’ of all FHCs, the banks and U.S. bank holding companies;
Federal Reserve relies as much as pos- and the operations of foreign banking
sible on the supervisory efforts of an companies in the United States.
institution’s primary bank supervisor The Federal Reserve exercises impor-
and nonbank functional regulator(s) to tant regulatory influence over entry into
ensure that any nonbank activities do the U.S. banking system and the struc-
not present unacceptable risks to affili- ture of the system through its adminis-
ated banks. By year-end, 567 domestic tration of the Bank Holding Company
bank holding companies and 23 foreign
banking organizations had received 1. The Board’s Division of Consumer and
Community Affairs is responsible for coordinating
FHC status, suggesting potentially wide- the Federal Reserve’s supervisory activities with
spread interest in the expanded powers regard to the compliance of banking organizations
provided by the legislation. To date, with consumer protection and civil rights laws. To
however, many FHCs are such in name carry out this responsibility, the Federal Reserve
only, conducting little or no expanded trains a number of its bank examiners in the evalu-
ation of institutions with regard to such compli-
activity permissible under the law (see ance. The chapter of this volume covering con-
box, ‘‘Organizational Evolution: Results sumer and community affairs describes these
of the Gramm–Leach–Bliley Act’’). regulatory responsibilities. Compliance with other
Uncertainty is a key factor in any banking statutes and regulations, which is treated
in this chapter, is the responsibility of the Board’s
commercial activity, and 2001 presented Division of Banking Supervision and Regulation
significant challenges to many banks. and the Federal Reserve Banks, whose examiners
Nevertheless, the U.S. banking system also check for safety and soundness.
Banking Supervision and Regulation 143

Act, the Bank Merger Act (with regard trols, and operations, (4) an assessment
to state member banks), the Change in of the key financial factors of capital,
Bank Control Act (with regard to bank earnings, liquidity, and sensitivity to
holding companies and state member market risk, and (5) a review for
banks), and the International Banking compliance with applicable laws and
Act. The Federal Reserve is also respon- regulations.
sible for imposing margin requirements
on securities transactions. In carrying State Member Banks
out these responsibilities, the Federal
At the end of 2001, 970 state-chartered
Reserve coordinates its supervisory
banks (excluding nondepository trust
activities with other federal banking
companies and private banks) were
agencies, state agencies, functional reg-
members of the Federal Reserve Sys-
ulators, and the bank regulatory agen-
tem. These banks represented approxi-
cies of other nations.
mately 12.1 percent of all insured U.S.
commercial banks and held approxi-
Supervision for mately 25.9 percent of all insured com-
Safety and Soundness mercial bank assets in the United States.
The guidelines for Federal Reserve
To ensure the safety and soundness examinations of state member banks
of banking organizations, the Federal are fully consistent with section 10 of
Reserve conducts on-site examinations the Federal Deposit Insurance Act, as
and inspections and off-site surveil- amended by section 111 of the Federal
lance and monitoring. It also undertakes Deposit Insurance Corporation Improve-
enforcement and other supervisory ment Act of 1991 and by the Riegle
actions. Community Development and Regu-
latory Improvement Act of 1994. A
Examinations and Inspections full-scope, on-site examination of these
banks is required at least once a year;
The Federal Reserve conducts examina-
exceptions are certain well-capitalized,
tions of state member banks, branches
well-managed institutions having assets
and agencies of foreign banks, and Edge
of less than $250 million, which may be
Act and agreement corporations. In a
examined once every eighteen months.
process distinct from examinations, it
During 2001 the Federal Reserve
conducts inspections of holding compa-
Banks conducted 534 examinations of
nies and their nonbank subsidiaries. Pre-
state member banks (some of them
examination planning and on-site review
jointly with state agencies), and state
of operations are integral parts of the
banking departments conducted 264
overall effort to ensure the safety and
independent examinations of state mem-
soundness of financial institutions.
ber banks.
Whether it is an examination or an
inspection, the review entails (1) an
Bank Holding Companies
assessment of the quality of the pro-
cesses in place to identify, measure, At year-end 2001, a total of 6,318 U.S.
monitor, and control risks, (2) an bank holding companies were in opera-
appraisal of the quality of the insti- tion. These organizations controlled
tution’s assets, (3) an evaluation of 6,420 insured commercial banks and
management, including an assessment held approximately 94.2 percent of all
of internal policies, procedures, con- insured commercial bank assets.
144 88th Annual Report, 2001

Organizational Evolution:
Results of the Gramm–Leach–Bliley Act

With passage of the Gramm–Leach–Bliley reported $6.1 trillion in total assets, or

Act (GLBA) in 1999, the Congress about 80 percent of U.S. bank holding com-
removed long-standing legal impediments pany assets. Many large FHCs have used
to the combining of banking, insurance, the authority granted by the GLBA to
and securities activities within a single conduct securities underwriting and mer-
financial institution. Since then, more than chant banking activities; several have also
550 domestic bank holding companies engaged in insurance underwriting. About
have elected to become financial holding one-fifth of domestic financial holding
companies (FHCs). In addition, a few U.S. companies have established insurance
securities firms and one large insurance agencies under GLBA authority; insurance
company have elected financial holding brokerage is the only financial activity that
company status. Data collected by the many smaller FHCs are conducting under
Federal Reserve (summarized in the table) the act.
document the increase in the number of Twenty-three foreign banking organi-
domestic financial holding companies since zations had also received FHC status as of
the act’s implementation. They also show a December 31, 2001. Sixteen of these com-
substantial increase in U.S. financial hold- panies were conducting financial activi-
ing company assets associated with GLBA ties under GLBA authority as of year-end
activities. 2001, primarily as broker–dealers (thir-
Many of the largest bank holding teen) and merchant banks (nine). Five of
companies are FHCs; most domestic the sixteen had insurance underwriting sub-
FHCs, however, are relatively small. As sidiaries, and two were operating insurance
of December 31, 2001, domestic FHCs agencies.

Federal Reserve guidelines call for Small, non-complex bank holding

annual inspections of large bank holding companies—those that have less than
companies as well as smaller companies $1 billion in consolidated assets, do
that have significant nonbank assets. not have debt outstanding to the public,
In judging the financial condition of and do not engage in significant non-
the subsidiary banks owned by holding bank activities—are subject to a special
companies, Federal Reserve examiners supervisory program that became effec-
consult examination reports prepared by tive in 1997.2 The program permits a
the federal and state banking authorities more flexible approach to supervision of
that have primary responsibility for the those entities in a risk-focused environ-
supervision of these banks, thereby ment. Each such holding company is
minimizing duplication of effort and subject to off-site review once dur-
reducing the burden on banking organi- ing the examination cycle for the com-
zations. In 2001, Federal Reserve exam-
iners conducted 1,212 bank holding
company inspections, of which 1,118 2. Certain modifications to this supervisory
program will be adopted at the beginning of 2002.
were on site and 94 were off site, and These modifications will extend the program to all
state examiners conducted 79 indepen- bank holding companies that have less than $1 bil-
dent inspections. lion in consolidated assets.
Banking Supervision and Regulation 145

Domestic FHCs and their activities under GLBA authority

2000 2001
June 30 Dec. 31 June 30 Dec. 31

Number of FHCs
Large . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74 91 112 114
Small . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 371 416 453

Using GLBA authority

Large . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 44 58 58
Small . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 47 60 77

GLBA activities, by number of FHCs

and related assets or investments
(billions of dollars)
Securities underwriting activities
Number . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 35 41 39
Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 529 519 619 668

Merchant banking activities

Number . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 16 21 25
Carrying value of investments . . . . . . . . 5 8 9 8

Insurance underwriting activities

Number . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 11 15 21
Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 116 327 342

Insurance agency activities

Large . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 19 30 33
Small . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 43 58 68

Note. Large financial holding companies (FHCs) or more; small FHCs, those with assets of less than
are defined here as those with assets of $1 billion $1 billion.

pany’s lead bank. In 2001 the Federal tions in the areas of information technol-
Reserve conducted 2,594 reviews of ogy, fiduciary activities, transfer agent
these companies. activities, and government and munici-
pal securities dealing and brokering. The
Financial Holding Companies Federal Reserve also conducts special-
As of year-end 2001, 567 domestic bank ized examinations of certain entities,
holding companies and 23 foreign bank- other than banks, brokers, or dealers,
ing organizations had received finan- who extend credit subject to the Board’s
cial holding company status. Of the margin regulations.
domestic institutions, 34 had consoli- With passage of the Gramm–Leach–
dated assets of $15 billion or more, Bliley Act in 1999, the Federal Reserve
80 between $1 billion and $15 billion, ceased conducting routine annual
54 between $500 million and $1 billion, examinations of securities underwriting
and 399 less than $500 million. and dealing activities through so-called
section 20 subsidiaries of bank holding
Specialized Examinations companies. Under the act, the Federal
Reserve is generally required to rely on
The Federal Reserve conducts special- the supervisory activities of the ‘‘func-
ized examinations of banking organiza- tional regulator’’ for broker–dealer sub-
146 88th Annual Report, 2001

sidiaries unless the Board has cause to fiduciary principles and potential con-
believe that a broker–dealer poses a flicts of interest are reviewed; its man-
material risk to an insured depository agement and operations, including its
affiliate. No such examinations for cause asset- and account-management, risk-
were conducted during 2001. management, and audit and control
The Federal Reserve has developed a procedures, are also evaluated. In 2001,
series of case studies to educate System Federal Reserve examiners conducted
personnel responsible for supervising 177 on-site trust examinations.
nonbank activities about communica-
tions with, and reliance on the super-
visory activities of, functional regulators Transfer Agents and
(that is, regulators for securities, com- Securities Clearing Agencies
modities, and insurance activities).
As directed by the Securities Exchange
Act of 1934, the Federal Reserve con-
Information Technology ducts specialized examinations of those
state member banks and bank holding
In recognition of the importance of companies that are registered with the
information technology to safe and Board as transfer agents. Among other
sound operations in the financial indus- things, transfer agents countersign and
try, the Federal Reserve reviews the monitor the issuance of securities, reg-
information technology activities of the ister the transfer of securities, and
banking institutions it examines as well exchange or convert securities. On-site
as certain independent data centers that examinations focus on the effective-
provide information technology services ness of the institution’s operations and
to these institutions. In 2000, the infor- its compliance with relevant securities
mation technology reviews of banking regulations. During 2001, the Federal
institutions were integrated into the Reserve conducted on-site examinations
overall process of supervision, and thus at 33 of the 108 state member banks and
all safety and soundness examinations bank holding companies that were reg-
are now expected to include a review istered as transfer agents. Also during
of information technology risks and the year the Federal Reserve examined
activities. During the year, the Federal one state member limited-purpose trust
Reserve was the lead agency in one company acting as a national securities
examination of a large, multiregional depository.
data processing servicer examined in
cooperation with the other federal bank-
ing agencies. Government and Municipal Securities
Dealers and Brokers

Fiduciary Activities The Federal Reserve is responsible for

examining state member banks and for-
The Federal Reserve has supervisory eign banks for compliance with the Gov-
responsibility for institutions that ernment Securities Act of 1986 and with
together hold more than $15 trillion of Department of the Treasury regulations
assets in various fiduciary capacities. governing dealing and brokering in
During on-site examinations of fidu- government securities. Thirty-nine state
ciary activities, the institution’s compli- member banks and 9 state branches
ance with laws, regulations, and general of foreign banks have notified the
Banking Supervision and Regulation 147

Board that they are government securi- ing 346 lenders were subject to either a
ties dealers or brokers not exempt biennial or triennial inspection. Sixty-
from Treasury’s regulations. During five inspections were conducted during
2001 the Federal Reserve conducted the year, compared with 147 in 2000.
11 examinations of broker–dealer activi-
ties in government securities at these
institutions. Enforcement Actions
The Federal Reserve is also respon- and Civil Money Penalties
sible for ensuring compliance with the
In 2001 the Federal Reserve initiated 21
Securities Act Amendments of 1975 by
enforcement cases involving 30 separate
state member banks and bank holding
actions, such as cease-and-desist orders,
companies that act as municipal securi-
written agreements, removal and prohi-
ties dealers. Of the 31 entities that dealt
bition orders, and civil money penalties.
in municipal securities during 2001,
The Board of Governors collected
10 were examined during the year.
$66.4 million in civil money penalties,
which included a substantial collection
Securities Credit Lenders from the BCCI case, a long-standing
litigation matter. All funds collected
Under the Securities Exchange Act of
were remitted to the U.S. Department of
1934, the Federal Reserve Board is
the Treasury.
responsible for regulating credit in cer-
All final enforcement orders issued
tain transactions involving the purchase
by the Board and all written agree-
or carrying of securities. In addition to
ments executed by the Reserve Banks
examining banks under its jurisdiction
in 2001 are available to the public and
for compliance with the Board’s margin
can be accessed from the Board’s public
regulations as part of its general exami-
web site (
nation program, the Federal Reserve
maintains a registry of persons other
In addition to formal enforcement
than banks, brokers, and dealers who
actions, the Reserve Banks in 2001
extend credit subject to those regula-
completed 111 informal enforcement
tions. The Federal Reserve may conduct
actions, such as resolutions with boards
specialized examinations of these lend-
of directors and memorandums of
ers if they are not already subject to
supervision by the Farm Credit Admin-
istration, the National Credit Union
Administration, or the Office of Thrift Risk-Focused Supervision
At the end of 2001, 802 lenders other In recent years the Federal Reserve has
than banks, brokers, or dealers were created several programs aimed at
registered with the Federal Reserve. enhancing the effectiveness of the super-
Other federal regulators supervised 183 visory process. The main objective of
of these lenders, and the remaining 619 these initiatives has been to sharpen the
were subject to limited Federal Reserve focus on (1) those business activities
supervision. On the basis of regulatory posing the greatest risk to banking orga-
requirements and annual reports, the nizations and (2) the organizations’
Federal Reserve exempted 273 lenders management processes for identifying,
from its on-site inspection program. The measuring, monitoring, and controlling
securities credit activities of the remain- their risks.
148 88th Annual Report, 2001

Regional Banking Organizations tion’s condition, (3) assigning to each

LCBO a supervisory team composed of
The risk-focused supervision program Reserve Bank staff members who have
for regional banking organizations skills appropriate for the organization’s
applies to institutions having a func- risk profile (the team leader is the cen-
tional management structure, a broad tral point of contact, has responsibility
array of products, and operations that for only one LCBO, and is supported by
span multiple supervisory jurisdictions. specialists skilled in evaluating the risks
For smaller regional banking organi- of LCBO business activities and func-
zations, the supervisory program may tions), and (4) promoting Systemwide
be implemented with a point-in-time and interagency information-sharing
inspection; for larger institutions, the through an automated system.
program may take the form of a series of Supporting the supervision process
targeted reviews. For the largest, most is an automated application and
complex institutions, the process is con- database—the Banking Organization
tinuous, as described in the next section. National Desktop (BOND)—which is
To minimize burden on the institution, being developed to facilitate real-time,
work is performed off site to the greatest secure information-sharing and collabo-
extent possible. Additionally, to reduce ration across the Federal Reserve Sys-
the number of information requests to tem and with certain other federal and
the institution, examiners make use of state regulators. The final stage of
public and regulatory financial reports, phase I of BOND development was
market data, information from the auto- implemented during 2001, and work
mated surveillance screening systems was begun on phase II, which will add
(see later section ‘‘Surveillance and functionality that promotes analysis
Monitoring Programs’’), and internal across institutions.
management reports. The events of September 11, 2001,
directly and adversely affected the func-
Large, Complex Banking Organizations tioning of U.S. payment and clearing
The Federal Reserve applies a risk- systems, requiring an extraordinary
focused supervision program to large, cooperative and coordinated effort
complex banking organizations among bank supervisory agencies both
(LCBOs).3 The key features of the domestically and internationally. In
LCBO supervision program are (1) iden- addition to providing supervisory guid-
tifying those LCBOs that, based on their ance for regulated institutions during the
shared risk characteristics, present the crisis, LCBO supervisory staffs across
highest level of supervisory risk to the the Federal Reserve System facilitated
Federal Reserve System, (2) maintain- the sharing of information among finan-
ing continual supervision of these cial regulatory agencies worldwide; in
institutions to keep current the Federal many instances, examiners were sent on
Reserve’s assessment of each organiza- site to lend assistance to and assess the
status of key institutions.

3. For an overview of the Federal Reserve’s

LCBO program, see the article by Lisa M. Community Banks
DeFerrari and David E. Palmer, ‘‘Supervision of
Large Complex Banking Organizations,’’ in the
The risk-focused supervision program
Federal Reserve Bulletin, vol. 87 (February 2001), for community banks emphasizes that
pp. 47–57. certain elements are critical to the suc-
Banking Supervision and Regulation 149

cess of the risk-focused process. These pany cash flow, intercompany trans-
elements include adequate planning actions, parent company leverage, and
time, completion of a pre-examination consolidated capital ratios. Also during
visit, preparation of a detailed scope- the year the Federal Reserve revised the
of-examination memorandum, thorough Bank Holding Company Performance
documentation of the work done, and Report to incorporate new information
preparation of an examination report on sources of nonbank income and on
tailored to the scope of the examination. insurance activities.
The framework for risk-focused super- The Federal Reserve works with the
vision of community banks was devel- other federal banking agencies to
oped jointly with the Federal Deposit enhance and coordinate surveillance
Insurance Corporation and has been activities through the Task Force on Sur-
adopted by the Conference of State veillance Systems of the Federal Finan-
Bank Supervisors. cial Institutions Examination Council
Surveillance and Monitoring
Programs International Activities
The Federal Reserve uses automated The Federal Reserve supervises the
screening systems to monitor the finan- foreign branches of member banks;
cial condition and performance of state overseas investments by member banks,
member banks and bank holding compa- Edge Act and agreement corporations,
nies between on-site examinations. The and bank holding companies; and
screening systems analyze supervisory investments by bank holding companies
data and regulatory financial reports to in export trading companies. It also
identify companies that appear to be supervises the activities that foreign
weak or deteriorating. This analysis banking organizations conduct through
helps to direct examination resources to entities in the United States, includ-
institutions exhibiting higher risk pro- ing branches, agencies, representative
files. Screening systems also assist in offices, and subsidiaries.
the planning of examinations by iden-
tifying companies that are engaging Foreign-Office Operations of
in new or complex activities. Also used U.S. Banking Organizations
in the monitoring process are quar-
The Federal Reserve examines the inter-
terly Bank Holding Company Perfor-
national operations of state member
mance Reports prepared by the Federal
banks, Edge Act corporations, and bank
holding companies principally at the
During 2001, the Federal Reserve
U.S. head offices of these organizations,
refined its surveillance program for
where the ultimate responsibility for
small bank holding companies to
their foreign offices lies. In 2001 the
respond to changes in supervisory
procedures for these institutions. The
revised screening systems focus on 4. The member agencies of the FFIEC are the
identifying potential problems at parent Board of Governors of the Federal Reserve Sys-
companies and nonbank subsidiaries tem, the Federal Deposit Insurance Corporation
(FDIC), the National Credit Union Administration
that could adversely affect affiliated (NCUA), the Office of the Comptroller of the
insured depository institutions. In par- Currency (OCC), and the Office of Thrift Super-
ticular, the screens address parent com- vision (OTS).
150 88th Annual Report, 2001

Federal Reserve examined 3 foreign international banking and foreign finan-

branches of state member banks and cial transactions. These corporations,
7 foreign subsidiaries of Edge Act cor- which in most cases are subsidiaries
porations and bank holding companies. of member banks, may (1) conduct a
The examinations abroad were con- deposit and loan business in states other
ducted with the cooperation of the than that of the parent, provided that
supervisory authorities of the countries the business is strictly related to inter-
in which they took place; when appro- national transactions, and (2) make for-
priate, the examinations were coordi- eign investments that are broader than
nated with the Office of the Comptroller those of member banks because they
of the Currency. Examiners also make may invest in foreign financial organiza-
visits to the overseas offices of U.S. tions, such as finance companies and
banks to obtain financial and operating leasing companies, as well as in foreign
information and, in some instances, banks.
to evaluate their efforts to implement Edge Act and agreement corporations
corrective measures or to test their numbered 75 and were operating 17
adherence to safe and sound banking branches at year-end 2001. These corpo-
practices. rations are examined annually.

Foreign Branches of Member Banks U.S. Activities of Foreign Banks

At the end of 2001, 64 member banks The Federal Reserve has broad authority
were operating 937 branches in foreign to supervise and regulate the U.S. activi-
countries and overseas areas of the ties of foreign banks that engage in
United States; 34 national banks were banking and related activities in the
operating 725 of these branches, and 30 United States through branches, agen-
state member banks were operating the cies, representative offices, commercial
remaining 212. In addition, 18 nonmem- lending companies, Edge Act corpora-
ber banks were operating 22 branches in tions, commercial banks, and certain
foreign countries and overseas areas of nonbank companies. Foreign banks con-
the United States. tinue to be significant participants in the
U.S. banking system.
As of year-end 2001, 208 foreign
Edge Act and Agreement Corporations
banks from 56 countries were operating
Edge Act corporations are international 287 state-licensed branches and agen-
banking organizations chartered by the cies (of which 13 were insured by the
Board to provide all segments of the Federal Deposit Insurance Corporation)
U.S. economy with a means of financ- as well as 51 branches licensed by the
ing international business, especially Office of the Comptroller of the Cur-
exports. Agreement corporations are rency (of which 6 had FDIC insurance).
similar organizations, state chartered or These foreign banks also directly owned
federally chartered, that enter into an 15 Edge Act corporations and 3 com-
agreement with the Board to refrain mercial lending companies; in addition,
from exercising any power that is not they held an equity interest of at least
permissible for an Edge Act corporation. 25 percent in 90 U.S. commercial banks.
Under sections 25 and 25(A) of the Further, 23 foreign banks and certain of
Federal Reserve Act, Edge Act and their affiliates were granted financial
agreement corporations may engage in holding company status.
Banking Supervision and Regulation 151

Altogether, these U.S. offices of for- program was refined further in light of
eign banks at the end of 2001 controlled experience in using it over the past five
approximately 19.0 percent of U.S. com- years.
mercial banking assets. These foreign
banks also operated 181 representative Technical Assistance
offices; an additional 97 foreign banks
operated in the United States solely In 2001 the Federal Reserve System
through a representative office. continued to provide technical assis-
State-licensed and federally licensed tance on bank supervisory matters
branches and agencies of foreign banks to foreign central banks and super-
are examined on site at least once every visory authorities. Technical assistance
eighteen months, either by the Federal involves visits by System staff members
Reserve or by a state or other federal to foreign authorities as well as consul-
regulator; in most cases, on-site exami- tations with foreign supervisors who
nations are conducted at least once every visit the Board or the Reserve Banks.
twelve months, but the period may be Technical assistance in 2001 was con-
extended to eighteen months if the centrated in Latin America, the Far East,
branch or agency meets certain criteria. and former Soviet bloc countries.
The Federal Reserve conducted or par- During the year, the Federal Reserve
ticipated with state and federal regula- offered supervision training courses in
tory authorities in 289 examinations dur- Washington, D.C., and in a number of
ing 2001. foreign jurisdictions exclusively for
foreign supervisory authorities. System
staff also took part in technical assis-
Joint Program for tance and training missions led by the
Supervising the U.S. Operations of International Monetary Fund, the World
Foreign Banking Organizations Bank, the Inter-American Develop-
The Federal Reserve, in cooperation ment Bank, the Asian Development
with the other federal banking agencies Bank, the Basel Committee on Banking
and with state banking agencies, con- Supervision, and the Financial Stability
ducts a joint program for supervising the Institute.
U.S. operations of foreign banking orga-
nizations. The program has two main Supervisory Policy
parts. One part focuses on the examina- Within the supervisory policy function,
tion process for those foreign banking the Federal Reserve develops guidance
organizations that have multiple U.S. for examiners and financial institutions
operations and is intended to improve as well as regulations for financial insti-
coordination among the various U.S. tutions under the supervision of the Fed-
supervisory agencies. The other part is a eral Reserve. Staff members also partici-
review of the financial and operational pate in international supervisory forums
profile of each organization to assess its and provide support for the work of the
general ability to support its U.S. opera- Federal Financial Institutions Examina-
tions and to determine what risks, if tion Council.
any, the organization poses through its
U.S. operations. Together, these two pro-
cesses provide critical information to
Capital Adequacy Standards
U.S. supervisors in a logical, uniform, During 2001 the Federal Reserve,
and timely manner. During 2001 the together with the other federal bank-
152 88th Annual Report, 2001

ing agencies, issued a final rule 25 percent are to be deducted from tier 1
that amended the capital standards for capital, which will have the effect of
recourse, direct credit substitutes, and reducing the leverage ratio as well as the
residual interests in asset securitizations. risk-based capital ratios. The portion of
The agencies also continued discussions the rule dealing with interest-only strips
on a possible notice of proposed rule- receivables will go into effect at the end
making to simplify the risk-based capi- of 2002.
tal framework. The Federal Reserve
revised its policy of generally applying
Simplified Capital Framework for
its capital adequacy guidelines to top-
Non-Complex Institutions
tier U.S. bank holding companies owned
by foreign banks qualifying as financial In November 2000, the federal banking
holding companies under the Gramm– agencies published an advance notice of
Leach–Bliley Act. Finally, the agencies proposed rulemaking and solicited com-
continued to work on developing final ments on proposals for creating a sim-
rules governing securities borrowing pler capital framework for non-complex
transactions and claims on securities domestic financial institutions. Most
firms. comments did not support significant
substantive changes to the existing
Recourse, Direct Credit Substitutes, framework. After considering the com-
and Residual Interests in ments, the agency staffs in 2001 decided
Asset Securitizations not to proceed with a simplified capital
approach. Instead, they are continuing
On November 29, 2001, the Federal discussions on possible ways to mod-
Reserve, together with the other federal ify the regulatory capital rules more
banking agencies, issued a final rule to broadly.
amend their respective risk-based and
leverage capital standards for the treat-
Supervisory Policy on the Application
ment of recourse obligations, direct
of Capital Requirements to Bank
credit substitutes, and residual interests
Holding Companies Owned by Foreign
that expose banks, bank holding compa-
Banking Organizations
nies, and thrift institutions to credit risk.
The final rule combined two earlier pro- In January 2001, the Federal Reserve
posals on these matters that had over- revised its policy of subjecting all top-
lapped in some respects. It makes use of tier U.S. bank holding companies to
external credit ratings to match the risk- the U.S. minimum regulatory capital
based capital assessment more closely requirements. A limited exception was
to an institution’s relative risk of loss in made for top-tier U.S. bank holding
asset securitizations. The rule requires companies owned by foreign banks
that institutions hold risk-based capital qualifying as financial holding com-
in an amount equal to the amount of panies under the Gramm–Leach–Bliley
residual interests that arise in securitiza- Act. For a foreign bank to qualify as a
tions (or other transfers of assets) and financial holding company, the Board
that are retained on the balance sheet. In must have determined that it is well
addition, credit-enhancing interest-only capitalized and well managed under
strips receivables, either purchased standards comparable to those applied
or retained, are limited to 25 percent to U.S. banks owned by bank holding
of tier 1 capital. Amounts exceeding companies qualifying as financial hold-
Banking Supervision and Regulation 153

ing companies. A top-tier U.S. bank intended to align the capital require-
holding company owned by such a for- ments for these transactions more appro-
eign bank will continue to be required priately with the risk involved and to
to report its capital under the U.S. capi- level the playing field for banking
tal adequacy guidelines for bank hold- organizations vis-à-vis their domestic
ing companies but will not be required and foreign competitors. Among the
to meet the regulatory minimums. Mini- public comments submitted by the due
mum levels of capital for these organi- date of January 19, 2001, support for the
zations will instead be determined on a interim rule was unanimous. The interim
supervisory basis. In making this revi- rule remains in effect.
sion, the Federal Reserve determined
that relying on the capital strength of Claims on Securities Firms
the consolidated foreign bank, as well
as requiring subsidiary banks to meet In December 2000, the federal bank-
appropriate capital and management ing agencies proposed to reduce from
standards, is consistent with the Fed- 100 percent to 20 percent the risk weight
eral Reserve’s supervisory assessment accorded to claims on, and claims
process for domestic bank holding guaranteed by, qualifying securities
companies. firms in countries that are mem-
bers of the Organisation for Economic
Capital for Nonfinancial Co-operation and Development. The
Equity Investments change would bring the risk weight in
line with a 1998 revision to the Basel
In February 2001, the Federal Reserve, Capital Accord. Qualifying U.S. securi-
together with the OCC and the FDIC, ties firms would be broker–dealers reg-
issued a proposal concerning the regula- istered with the Securities and Exchange
tory capital treatment of equity invest- Commission (SEC) that are in com-
ments in nonfinancial companies held pliance with the SEC’s net capital rule
by banks, bank holding companies, and and meet certain other requirements.
financial holding companies. The pro- Work continued during 2001, and the
posal represented a modification of a agencies expect to issue a final rule in
proposal that had been issued in March the first quarter of 2002.
2000. Under the revised proposal, a
capital charge would be imposed that Fiduciary Activities
would increase in steps as the banking
In February 2001, the Federal Reserve
organization’s level of concentration in
issued guidance concerning the inte-
equity investments increased. Agency
gration of trust and transfer agency
monitoring also would increase as the
examinations into safety and soundness
level of concentration in equity invest-
examinations. Fiduciary activities and
ments increased.
related services generally include tradi-
tional trust services—such as personal
Securities Borrowing Transactions
trust, corporate trust, and transfer agent
In December 2000, the Federal Reserve, services—and employee benefit account
together with the FDIC and the OCC, products and services, as well as cus-
issued an interim rule to revise the capi- todial and securities lending services
tal treatment of cash collateral that is and clearing-and-settlement, asset-
posted in connection with securities management, and investment-advisory
borrowing transactions. The change was activities. The intent of the guidance is
154 88th Annual Report, 2001

to improve integration of the super- the depository institution and may rap-
visory assessment of banking organi- idly shift funds to another institution or
zations’ fiduciary activities into the investment in search of a higher return.
overall safety and soundness super- The advisory states that banking organi-
vision process and to focus supervisory zations should employ appropriate sys-
resources on areas of greatest risk. tems to identify and control this risk.
Such systems include appropriate funds-
management policies, adequate due dili-
Securities Activities of gence in assessing deposit brokers and
State Member Banks financial risks, reasonable control and
On May 14, 2001, the Federal Reserve limit structures, adequate information
issued guidance to examiners and systems, and contingency funding plans.
other supervisory personnel regarding
changes to the permissible securities International Guidance on
activities of state member banks under Supervisory Policies
the Gramm–Leach–Bliley Act. The act
authorized well-capitalized state mem- As a member of the Basel Committee on
ber banks to underwrite, deal in, and Banking Supervision (Basel Commit-
invest in municipal revenue bonds with- tee), the Federal Reserve in 2001 par-
out limitation as to the level of these ticipated in efforts to revise the inter-
activities that may be conducted relative national capital regime and to develop
to the bank’s capital. Until that time, international supervisory guidance. The
state member banks could, without capi- Federal Reserve’s goals in these activi-
tal limitation, underwrite, deal in, or ties are to advance sound supervisory
invest in only general obligation munici- policies for internationally active bank-
pal bonds backed by the full faith and ing institutions and to improve the
credit of an issuer having general pow- stability of the international banking
ers of taxation. system. The efforts are described in the
following sections.
Joint Agency Advisory on Capital Adequacy
Rate-Sensitive Deposits
The Federal Reserve continued to par-
In May 2001, the Federal Reserve, ticipate in a number of technical work-
together with the other federal banking ing groups of the Basel Committee in
agencies, issued an interagency advisory efforts to develop a new capital accord.
outlining the risk-management proce- These groups, in grappling with a num-
dures that banking organizations should ber of difficult issues, released several
follow in assessing and controlling the consultative papers during 2001:
risks associated with significant reliance
on brokered and rate-sensitive deposits. • In January, the Basel Committee
The advisory states that deposits raised issued for public consultation a series
through intermediary sources, such as of papers setting forth proposals for a
deposit brokers, the Internet, and other new capital accord. This consultative
automated service providers, may be package laid the groundwork for for-
less stable than traditional deposits, mal and informal discussions with the
primarily because depositors making banking industry and other interested
deposits through intermediary sources parties on a revised international capi-
may not have other relationships with tal framework.
Banking Supervision and Regulation 155

• In continuing its work on a new capi- of sound practices for the management
tal accord, and in response to public of operational risk.
comments on the January consultative
package, the Basel Committee issued
Joint Forum
for further consultation a number
of technical working papers, includ- In its work with the Basel Committee,
ing ‘‘Internal Ratings-Based (IRB) the Federal Reserve also continued its
Treatment of Expected Losses and participation in the Joint Forum, a group
Future Margin Income’’ (July); ‘‘Risk- made up of representatives of the com-
Sensitive Approaches for Equity mittee, the International Organization
Exposures in the Banking Book for of Securities Commissions, and the
IRB Banks’’ (August); ‘‘Pillar 3— International Association of Insurance
Market Discipline’’ (September); Supervisors. The Joint Forum works to
‘‘Regulatory Treatment of Operational increase mutual understanding of issues
Risk’’ (September); ‘‘Internal Ratings- related to the supervision of firms oper-
Based Approach to Specialized Lend- ating in each of the financial sectors. In
ing Exposures’’ (October); and this regard, the Federal Reserve contrib-
‘‘Treatment of Asset Securitizations’’ uted to two Joint Forum papers issued
(October). in November 2001: ‘‘Risk Management
Practices and Regulatory Capital,’’
Risk Management which compares current industry prac-
tices in all three sectors, and ‘‘Core
The Federal Reserve contributed to a Principles: Cross-Sectoral Comparison,’’
number of supervisory policy papers, which identifies similarities and differ-
reports, and recommendations issued ences among the core principles of the
by the Basel Committee during 2001. three sectors.
These documents were generally aimed
at improving the supervision of banks’
Internal Control, Accounting,
risk-management practices. The paper
and Disclosure
‘‘Review of Issues Relating to Highly
Leveraged Institutions’’ (issued in Feb- The Federal Reserve participates in
ruary) set forth sound risk-management the Basel Committee’s Task Force on
practices when dealing with highly Accounting Issues and its Transparency
leveraged institutions. ‘‘Risk Manage- Group and represents the Basel Com-
ment Principles for Electronic Banking’’ mittee at international meetings on the
(issued in May) was intended to help issues addressed by these groups. In par-
banking institutions expand their exist- ticular, during 2001 the Federal Reserve
ing risk-management policies and prac- represented the Basel Committee at
tices to cover their electronic-banking meetings of the committee of the Inter-
activities. The paper ‘‘Customer Due national Accounting Standards Board
Diligence for Banks’’ (issued in Octo- (IASB) that works to improve account-
ber) provides guidance on effective ing guidance concerning financial in-
controls and procedures for getting to struments. In addition, a representative
know customers. The consultative paper of the Federal Reserve was appointed a
‘‘Sound Practices for the Management member of the IASB’s Standards Advi-
and Supervision of Operational Risk’’ sory Council.
(issued in December) solicited banking During 2001 the Federal Reserve also
industry comments on a proposed range contributed to a letter and several papers
156 88th Annual Report, 2001

on internal control, accounting, and dis- mittee (IAPC). Staff also represented
closure issued by the Basel Committee, the Basel Committee’s Task Force on
including the following: Accounting Issues at meetings with rep-
resentatives of the IAPC and the Inter-
• ‘‘Comment Letter on Fair Value national Forum on Accountancy Devel-
Accounting’’—In this letter (issued in opment to encourage the adoption of
September) the IASB solicited views enhanced international auditing stan-
on the benefits and costs associated dards and practices.
with a fair value accounting model for In December the Board sent a com-
financial instruments. The Basel Com- ment letter to the IASB on an inter-
mittee recommended that the IASB national proposal to adopt fair value
explore additional disclosure of fair accounting. The comment letter attached
value information and improve stan- a staff research report that explored a
dards for loan loss allowances and number of issues arising from the pro-
disclosures about credit risk in lieu posal’s suggestion that banks and other
of introducing a comprehensive fair companies use their internal credit-
value accounting model at this time. grading systems to estimate fair values
when certain criteria are met.
• ‘‘The Relationship Between Banking
Supervisors and Banks’ External
Auditors’’—This joint paper by the
Gramm–Leach–Bliley Act
Basel Committee and the International The Gramm–Leach–Bliley Act (GLBA)
Auditing Practices Committee (to be repealed those provisions of the Glass–
issued in January 2002) provides Steagall Act and the Bank Holding
guidance on ways to strengthen the Company Act that restricted the ability
relationship between bank auditors of bank holding companies to affiliate
and supervisors and incorporates the with securities firms and insurance com-
Basel Committee’s core principles for panies. The provisions of GLBA, and
effective banking supervision. the Federal Reserve’s final rule, which
was adopted in January 2001, establish
• ‘‘Internal Audit in Banks and the conditions that a bank holding company
Supervisor’s Relationship with or a foreign bank must meet to be
Auditors’’—This paper (issued in deemed a financial holding company
August) sets forth objectives and prin- and to engage in expanded activities.
ciples for an effective bank internal- In addition to controlling depository
audit function, the role of internal institutions, financial holding compa-
audit, and the banking supervisors’ nies may engage in securities underwrit-
views on ways to strengthen the rela- ing and dealing, serve as an insurance
tionship between banking supervisors agent and insurance underwriter, act as
and internal and external auditors. a futures commission merchant, and
engage in merchant banking. Permis-
Staff members also supported the sible activities also include activities
Basel Committee’s Task Force on that the Board and the Secretary of the
Accounting Issues in the development Treasury jointly determine to be finan-
of comment letters on major propos- cial in nature or incidental to financial
als of the International Federation of activities and activities that the Federal
Accountants (IFAC) and of IFAC’s Reserve determines are complementary
International Auditing Practices Com- to a financial activity and do not pose a
Banking Supervision and Regulation 157

substantial risk to the safety and sound- missions. Cross-sector forums provide
ness of depository institutions or the an opportunity for multiple supervisors
financial system generally. (both federal and state) to discuss issues
On January 2, 2001, the Federal of common interest and to enhance
Reserve and the Department of the Trea- communication and cooperation. At the
sury issued an interim rule defining the October meeting, the group focused on
following as permissible activities: lend- the impact and implications of the Sep-
ing, exchanging, transferring, investing tember 11 terrorist attacks on each of
for others, or safeguarding financial the sectors. Three cross-sector meetings
assets other than money or securities; are scheduled for 2002.
providing any device or other instru-
mentality for transferring money or Merchant Banking Activities
other financial assets; and arranging,
effecting, or facilitating financial trans- On January 31, 2001, the Board and
actions for the account of third parties. the Secretary of the Treasury jointly
In addition, in February 2001 the Fed- adopted a final rule governing merchant
eral Reserve and the Department of the banking investments made by financial
Treasury extended the comment period holding companies.5 The rule imple-
ments provisions of GLBA that permit
for a December 2000 proposal that
financial holding companies to make
would include real estate brokerage and
investments as part of a bona fide secu-
real estate management as permissible
rities underwriting or merchant or
activities under GLBA.
investment banking activity. The Board
Under GLBA, the Federal Reserve
and the Secretary incorporated a num-
has supervisory oversight authority and
ber of amendments to the final rule to
responsibility for bank holding com-
address issues raised by public com-
panies, including those that operate as
menters, to reduce potential regulatory
financial holding companies. The statute
burdens, and to clarify the application
streamlines the Federal Reserve’s super-
of the rule. These changes included
vision for all bank holding companies
expanding the definition of ‘‘securi-
and sets forth parameters for the rela-
ties affiliate’’ to include a department
tionship between the Federal Reserve
or division of a bank registered as a
and other regulators. The statute differ-
municipal securities dealer; modifying
entiates between the Federal Reserve’s
the provisions defining prohibited rou-
relations with regulators of depository
tine management and operation of port-
institutions and its relations with func-
folio companies; adopting a sunset pro-
tional regulators (that is, regulators for
vision for the investment thresholds
insurance, securities, and commodities).
under the interim rule and eliminating
During 2001, the Federal Reserve con-
the dollar-based threshold for the review
tinued its efforts to ensure that super-
of a financial holding company’s mer-
visory policies applied to banking insti-
chant banking activities; streamlining
tutions are consistent with the provisions
the rule’s reporting and recordkeeping
of GLBA.
requirements; broadening the definition
In its role as the holding company
supervisor, the Federal Reserve in 2001
hosted two cross-sector meetings with 5. ‘‘Merchant banking’’ investments may be
made in any type of ownership interest and in any
representatives of the banking agencies, type of nonfinancial entity (portfolio company)
securities and commodities and futures and may represent any amount of the equity of a
authorities, and state insurance com- portfolio company.
158 88th Annual Report, 2001

of ‘‘private equity’’ funds and clarifying things, the FFIEC issued substantial
the rule’s application to such funds; and revisions to the Call Report; a statement
adopting several safe harbors to the regarding a major revision of article 9 of
presumptions in the rule governing the the Uniform Commercial Code; a policy
definition of ‘‘affiliate’’ for purposes of statement on methodologies and docu-
sections 23A and 23B of the Federal mentation in connection with allow-
Reserve Act. The final rule became ances for loan and lease losses; and
effective February 15, 2001. guidance on risk-management issues.

Information-Security Standards Bank Call Reports

Under section 501(b) of GLBA, the fed- As the federal supervisor of state mem-
eral banking agencies are required to ber banks, the Federal Reserve, acting
issue standards for information security. in concert with the other federal banking
In February 2001, after soliciting pub- agencies through the FFIEC, requires
lic comment on a June 2000 proposal, banks to submit quarterly Reports of
the agencies published ‘‘Interagency Condition and Income (the Call Report).
Guidelines Establishing Standards for This report is the primary source of data
Safeguarding Customer Information.’’ used in the supervision and regulation of
The guidelines require banks and hold- banks and in the ongoing assessment
ing companies to establish a written of the overall soundness of the nation’s
information-security program and to financial structure. Call Report data,
control the risk of unauthorized access which also serve as benchmarks for the
or other threats to the security and confi- financial information required in many
dentiality of customer information. other Federal Reserve regulatory finan-
cial reports, are widely used by state and
Financial Subsidiary Provisions local governments, state banking super-
On August 16, 2001, the Board adopted visors, the banking industry, securities
a final rule implementing the financial analysts, and the academic community.
subsidiary provisions of GLBA for state For the 2001 reporting period, the
member banks. The act authorizes state FFIEC implemented substantial revi-
member banks that comply with the sions to the Call Report to streamline
requirements of the rule to control, or the reporting requirements and to add
hold an interest in, a financial subsidi- new items that focus on areas of increas-
ary, which may conduct certain finan- ing supervisory concern. The principal
cial activities that the parent bank may revisions included
not conduct directly. The final rule is
substantially similar to the interim rule • Combining the three separate report
adopted by the Board in March 2000. forms for banks of various sizes
that have only domestic offices
(FFIEC 032, 033, and 034) into a
Federal Financial Institutions single form (designated FFIEC 041),
Examination Council while retaining the separate form
for banks having foreign offices
During 2001, the Federal Reserve con- (FFIEC 031)
tinued its active participation as a mem-
ber of the Federal Financial Institutions • Eliminating a number of data items
Examination Council. Among other that were no longer warranted
Banking Supervision and Regulation 159

• Introducing a revised regulatory capi- contains a number of new or revised

tal schedule that takes a step-by-step rules for secured transactions that affect
‘‘building block’’ approach to comput- financial institutions’ procedures, sys-
ing the key elements of the capital tems, documentation, and the enforce-
ratios for all banks ability of security interests. In the state-
ment, the FFIEC advised financial
• Collecting new information on asset institutions and their legal counsel to
sales and certain nontraditional bank consider carefully the changes in state
activities. In addition, collection of law brought about by revised article 9 in
the Annual Report of Trust Assets order to ensure the attachment and per-
(FFIEC 001) and the Annual Report fection of their existing and future secu-
of International Fiduciary Activities rity interests.
(FFIEC 006) was discontinued and a
streamlined fiduciary-activities sched- Risk-Management Controls in the
ule was added to the Call Report. Use of Electronic Financial Services
Also, the Report of Assets and Liabili-
In August 2001, the Federal Reserve
ties of U.S. Branches and Agencies
issued a new policy, developed by the
of Foreign Banks (FFIEC 002) was
FFIEC member agencies, addressing
revised, effective with the June 2001
authentication in an electronic banking
report, to maintain consistency with
environment. In recognition of the
the Call Report.
importance of effective authentication
measures in reducing the risk of fraud
In October, the Federal Reserve and and strengthening information-security
the other federal banking agencies pro- programs, the guidance describes risk-
posed a few revisions to the Call Report management issues that banks should
to facilitate effective supervision. The consider as they design and update their
revisions would, effective with the on-line customer-authentication sys-
March 2002 report, add a few items tems. The main portion of the guid-
to conform with changes in generally ance gives background information
accepted accounting principles, spe- and describes sound risk-management
cifically, the reporting requirements of measures. Processes for verifying the
Statement of Financial Accounting Stan- identity of prospective customers and
dard No. 141, Business Combinations, authenticating existing customers who
and No. 142, Goodwill and Other Intan- use on-line systems, such as Internet
gible Assets. The revisions would also banking services, are discussed, and
add several items to address new safety details are provided concerning various
and soundness considerations. authentication technologies and issues
to consider when implementing these
Revisions to Article 9 of the processes.
Uniform Commercial Code
On February 28, 2001, the FFIEC issued Efforts to Enhance Transparency
a statement regarding a major revision and Bank Regulatory Financial
of article 9 of the Uniform Commercial Reports
Code and its effect on financial institu-
tions. Article 9 governs transactions The Federal Reserve has long supported
involving the granting of credit secured sound accounting policies and meaning-
by personal property. Revised article 9 ful public disclosure by banking and
160 88th Annual Report, 2001

financial organizations to improve mar- be systematic, consistently applied, and

ket discipline and foster stable financial auditable; validated periodically; and
markets. Effective market discipline modified as needed to incorporate new
can be an important complement to events or findings. The guidance also
bank supervision and regulation. As provides examples of appropriate docu-
financial institutions make more infor- mentation and illustrations showing how
mation available, market participants the guidance should be implemented.
are able to make better evaluations of
counterparty risk and better adjustments
Interagency Guidance on
to the availability and pricing of funds.
Loans Held for Sale
Thus, transparency can promote effi-
ciency in financial markets and sound In March the Federal Reserve, the other
practices by banks. The Federal Reserve federal banking agencies, and the
also seeks to strengthen audit and con- National Credit Union Administration
trol standards for banks; the quality of issued guidance regarding the appropri-
management information and financial ate treatment of loans that an institution
reporting is dramatically affected by in- intends to sell. Consistent with GAAP,
ternal control systems, including inter- the guidance requires an institution to
nal and external audit programs. record a charge-off against the ALLL
To advance these objectives, the Fed- when it decides to sell loans whose fair
eral Reserve works with other regula- value has declined for any reason other
tors, the accounting profession, and a than a change in the general market
wide variety of market participants, both level of interest or foreign exchange
domestically and internationally. rates.

Interagency Guidance on the Private-Sector Working Group on

Allowance for Loan and Lease Losses Public Disclosure
In July 2001, the Federal Reserve, the The Private-Sector Working Group on
Securities and Exchange Commission, Public Disclosure, a group composed of
and the other federal banking agencies senior executives from major domestic
issued joint guidance regarding docu- and foreign banking organizations and
mentation of the allowance for loan and securities firms, was established by the
lease losses. The Federal Reserve and Federal Reserve to recommend ways
the other federal banking agencies to enhance public financial statement
issued the guidance as an FFIEC policy disclosures. The SEC and OCC also
statement, and the SEC issued parallel participated in the effort. In January,
guidance as Staff Accounting Bulletin the working group released a report
102. The guidance clarifies the agen- recommending enhanced and more-
cies’ expectations in regard to documen- frequent public disclosure of financial
tation supporting the methodology used information by banking and securi-
to calculate allowances for loan and ties firms. Subsequently, the Federal
lease losses (ALLL). It requires that Reserve, SEC, and OCC issued super-
a financial institution’s ALLL meth- visory guidance encouraging banking
odology be consistent with generally organizations and securities firms to
accepted accounting principles (GAAP) follow these recommendations. Private-
and all outstanding supervisory guid- sector efforts, such as those of the
ance. Further, the methodology should working group, and official regulatory
Banking Supervision and Regulation 161

initiatives can help foster consensus and Improvement Act of 1994, which directs
advance thinking on what constitutes the banking agencies to review the infor-
sound or best practice regarding public mation that institutions report in the Call
disclosure. Report and the bank holding company
reports and eliminate requirements that
are not warranted for safety and sound-
Bank Holding Company ness or other public policy purposes.
Regulatory Financial Reports As part of the streamlining process,
The Federal Reserve requires that U.S. the Federal Reserve made changes to
bank holding companies submit peri- other FR Y–9 and FR Y–11 series
odic regulatory financial reports. These reports to introduce more uniformity to
reports, the FR Y–9 and FR Y–11 certain aspects of regulatory reporting.
series, provide information essential The changes not only increased uni-
to the supervision of the organizations formity within the holding company
and to the formulation of regulations reports but also brought several report-
and supervisory policies. The Federal ing items into closer alignment with the
Reserve also uses the information in Call Report and the Thrift Financial
responding to requests from the Con- Report. Other modifications to the hold-
gress and the public for information on ing company reports were made so that
bank holding companies and their non- their form and content would more
bank subsidiaries. closely resemble the manner in which
The FR Y–9 series of reports pro- information is presented in financial
vides standardized financial statements statements that banking organizations
for the consolidated bank holding prepare in accordance with generally
company. The reports are used to detect accepted accounting principles for other
emerging financial problems, review financial reporting purposes.
performance and conduct pre-inspection Besides streamlining the FR Y–9C
analysis, monitor and evaluate risk reporting requirements by eliminating
profiles and capital adequacy, evaluate information no longer of significant
proposals for bank holding company value, the Federal Reserve also
mergers and acquisitions, and analyze improved the relevance of the FR Y–9C
the holding company’s overall financial by identifying new types of information
condition. that are expected to be critical to the
The FR Y–11 series of reports aids Federal Reserve’s future supervisory
the Federal Reserve in determining the data needs. The improvements focus on
condition of bank holding companies new activities and other recent devel-
that are engaged in nonbanking activi- opments that may expose institutions to
ties and in monitoring the volume, new or different types of risk.
nature, and condition of their nonbank- In light of the Gramm–Leach–Bliley
ing subsidiaries. Act and the increased involvement
In March 2001, the Federal Reserve of banking organizations in merchant
implemented numerous revisions to the banking and equity investment in nonfi-
FR Y–9C report that streamlined the nancial companies, the Federal Reserve
reporting requirements. The streamlin- implemented the new Consolidated
ing was part of the Federal Reserve’s Bank Holding Company Report of
effort to achieve the objectives set forth Equity Investments in Nonfinancial
in section 307(c) of the Riegle Com- Companies (FR Y–12), effective Sep-
munity Development and Regulatory tember 30, 2001.
162 88th Annual Report, 2001

Supervisory Information tify, implement, and deploy a common

Technology document-management technology for
the supervision function on a System-
The Supervisory Information Technol- wide basis. In 2001, as part of its
ogy (SIT) function within the Board’s project-management training for Board
Division of Banking Supervision and and Reserve Bank staff, it also revised
Regulation facilitates management of and updated the project managers’ hand-
information technology within the Fed- book, which draws on the best practices
eral Reserve’s supervision function. Its in private industry and government.
goals are to ensure that

• IT initiatives support a broad range of Enhancements to the

supervisory activities without duplica- National Information Center
tion or overlap The National Information Center (NIC)
is the Federal Reserve’s comprehensive
• The underlying IT architecture fully repository for supervisory, financial, and
supports those initiatives banking-structure data and documents.
NIC includes the National Examination
• The supervision function’s use of Data (NED) system, software that pro-
technology takes advantage of the vides supervisory personnel and state
systems and expertise available more banking authorities with access to NIC
broadly within the Federal Reserve data, and the Central Document and
System. Text Repository (CDTR), which con-
tains documents supporting the super-
SIT works through assigned staff at visory process.
the Board of Governors and the Reserve In 2001 much work was accom-
Banks and through a committee struc- plished to make the NED system avail-
ture that ensures that key staff members able over the web and to add functional-
throughout the Federal Reserve System ity to further support the supervision of
participate in identifying requirements banking institutions. Implementation of
and setting priorities for IT initiatives. this new version of NED is planned for
SIT also houses the management of the the second quarter of 2002.
National Information Center, a compre- In September, new structure report
hensive repository for vital supervision forms were put into use to capture
information. changes in the organizational structure
of bank holding companies (FR Y–10)
SIT Activities and foreign banking organizations
(FR Y–10F). Also, extensive revisions
In 2001 SIT revised and updated the were made to NIC to support the collec-
operating plan for the ongoing approval tion of data and the quality of reports. In
and reassessment of IT projects, which addition, an Internet-based reporting
was prepared in 2000. It is developing a mechanism was implemented to allow
capital planning and information tech- bank holding companies to submit
nology investment guide to ensure that reports electronically. During the year,
IT investments in proposed projects and progress was made on enhancements
products support the function’s strategic to the CDTR so that it will be able to
goals. SIT is undertaking an enterprise handle more documents, accept docu-
document management project to iden- ments from other agencies, and permit
Banking Supervision and Regulation 163

web-based access. Implementation is disciplines of bank supervision: bank

planned for June 2002. examinations, bank holding company
inspections, surveillance and monitor-
ing, and applications analysis. Classes
Staff Training are conducted in Washington, D.C.,
The System Staff Development Program as well as at other locations and are
trains staff members at the Board of sometimes held jointly with other
Governors, the Reserve Banks, and state regulators.
banking departments who have supervi- The Federal Reserve System also
sory and regulatory responsibilities; stu- participates in training offered by the
dents from foreign supervisory authori- FFIEC and by certain other regulatory
ties attend training sessions on a space- agencies. The System’s involvement
available basis. The program’s goal is, includes developing and implementing
in part, to provide greater cross-training. basic and advanced training in relation
Training is offered at the basic, interme- to various emerging issues as well as in
diate, and advanced levels in the four specialized areas such as trust activities,

Training Programs for Banking Supervision and Regulation, 2001

Number of sessions conducted

Total Regional

Schools or seminars conducted by the Federal Reserve

Core schools
Banking and supervision elements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 8
Operations and analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 5
Bank management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 1
Report writing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 20
Management skills . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 9
Conducting meetings with management . . . . . . . . . . . . . . . . . . . . . . . . . . 16 16

Other schools
Loan analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 5
Examination management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 3
Real estate lending seminar . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 2
Specialized lending seminar . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 1
Senior forum for current banking and regulatory issues . . . . . . . . . . . . 4 4
Banking applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 . . .

Principles of fiduciary supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 1

Commercial lending essentials for consumer affairs . . . . . . . . . . . . . . . 3 3
Consumer compliance examinations I . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 1
Consumer compliance examinations II . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 1
CRA examination techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 1
Fair lending examination techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 2

Foreign banking organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 5

Information systems continuing education . . . . . . . . . . . . . . . . . . . . . . . . 2 . . .
Capital markets seminars . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 8
Technology risk integration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 24
Leadership dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 4
Seminar for senior supervisors of foreign central banks 1 . . . . . . . . . . . . . . . . .

Other agencies conducting courses 2

Federal Financial Institutions Examination Council . . . . . . . . . . . . . . . . . . 37 3
The Options Institute . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1

1. Conducted jointly with the World Bank. . . . Not applicable.

2. Open to Federal Reserve employees.
164 88th Annual Report, 2001

Student Examination Results, First Track, 2001

Result proficiency Consumer Information
Safety and Trust
soundness affairs technology

Passed . . . . . . . . . . . . . . . . . . . . . . . . 35 25 8 3 1
Failed . . . . . . . . . . . . . . . . . . . . . . . . . 19 4 9 1 3

Total . . . . . . . . . . . . . . . . . . . . . . . . . . 54 29 17 4 4

Note. These examinations are for examiners hired before February 28, 1998.

international banking, information tech- A staff member seeking an examin-

nology, municipal securities dealing, er’s commission follows one of two
capital markets, payment systems risk, training tracks. One track, for staff mem-
white collar crime, and real estate lend- bers hired before February 28, 1998,
ing. In addition, the System co-hosts the involves a ‘‘core proficiency examina-
World Bank Seminar for students from tion’’ as well as a specialty examination
developing countries. in an area of the student’s choice—
In 2001 the Federal Reserve trained safety and soundness, consumer affairs,
2,832 students in System schools, 645 in trust, or information technology. Stu-
schools sponsored by the FFIEC, and 15 dents on this track had to complete the
in other schools, for a total of 3,492, commissioning requirements by Decem-
including 234 representatives of foreign ber 31, 2001. In 2001, 35 examiners
central banks (see accompanying table). passed the core proficiency examination
The number of training days in 2001 (see table).
totaled 18,483. The other track, for staff members
The System gave scholarship assis- hired after February 27, 1998, involves
tance to the states for training their a ‘‘first proficiency examination’’ as
examiners in Federal Reserve and well as a ‘‘second proficiency examina-
FFIEC schools. Through this program, tion’’ in one of the four specialty areas.
445 state examiners were trained— The table below reflects 2001 pass rates
277 in Federal Reserve courses, 166 for the second track. At the end of 2001,
in FFIEC programs, and 2 in other the System had 1,242 field examiners,
courses. of which 861 were commissioned.

Student Examination Results, Second Track, 2001

Second proficiency
Result proficiency Consumer Information
Safety and Trust
soundness affairs technology

Passed . . . . . . . . . . . . . . . . . . . . . . . . 199 49 17 5 3
Failed . . . . . . . . . . . . . . . . . . . . . . . . . 3 11 4 0 0

Total . . . . . . . . . . . . . . . . . . . . . . . . . . 202 60 21 5 3

Note. These examinations are for examiners hired after February 27, 1998.
Banking Supervision and Regulation 165

Regulation of the of one or more banks in the United

U.S. Banking Structure States. Once formed, a bank holding
company must receive Federal Reserve
The Board of Governors administers the approval before acquiring or estab-
Bank Holding Company Act, the Bank lishing additional banks. The act also
Merger Act, the Change in Bank Con- identifies other activities permissible
trol Act, and the International Banking for bank holding companies; depend-
Act, each in relation to bank holding ing on the circumstances, these activi-
companies, financial holding compa- ties may or may not require Federal
nies, member banks, and foreign bank- Reserve approval in advance of their
ing organizations, as appropriate. In commencement.
doing so, the Federal Reserve acts on a Bank holding companies generally
variety of proposals that directly or indi- may engage in only those activities that
rectly affect the structure of U.S. bank- the Board has previously determined to
ing at the local, regional, and national be closely related to banking under sec-
levels; the international operations of tion 4(c)(8) of the act. Since 1996, the
domestic banking organizations; and act has provided an expedited prior-
the U.S. banking operations of foreign notice procedure for certain permissible
banks. nonbank activities and for acquisitions
In November 2001, revisions to of small banks and nonbank entities.
Regulation K—which governs the for- Since that time the act has also permit-
eign operations of U.S. banking orga- ted well-run bank holding companies
nizations and the U.S. operations of that satisfy certain criteria to commence
foreign banking organizations—were certain other nonbank activities on a
implemented. In general, the revisions de novo basis without first obtaining
streamlined foreign branching proce- Federal Reserve approval.
dures for U.S. banking organizations, When reviewing a bank holding com-
authorized expanded activities at for- pany application or notice to engage in
eign branches of U.S. banks, and imple- an activity that requires prior approval,
mented recent statutory changes. the Federal Reserve considers the
Changes were also made to the pro- financial and managerial resources of
visions governing permissible foreign the applicant, the future prospects of
activities of U.S. banking organiza- both the applicant and the firm being
tions, including securities activities, and acquired, the convenience and needs of
investments made under general consent the community to be served, the poten-
procedures. In addition, the revisions tial public benefits, the competitive
streamlined the application procedures effects of the proposal, and the appli-
applicable to foreign banks seeking to cant’s ability to make available to the
expand their operations in the United Board information deemed necessary
States. to ensure compliance with applicable
law. In the case of a foreign banking
Bank Holding Company Act organization seeking to acquire control
of a U.S. bank, the Federal Reserve
Under the Bank Holding Company Act, also considers whether the foreign
a corporation or similar organization bank is subject to comprehensive super-
must obtain the Federal Reserve’s vision or regulation on a consoli-
approval before forming a bank hold- dated basis by its home country
ing company through the acquisition supervisor. Data on decisions regard-
166 88th Annual Report, 2001

Decisions by the Federal Reserve on Domestic and International Applications, 2001

Action under authority delegated

by the Board of Governors
Direct action
by the Director of the
Board of Governors Office
Proposal Division of Banking of the Federal Total
Supervision and Secretary Reserve Banks

Approved Denied Permitted Approved Denied Approved Approved Permitted

Formation of bank
company . . . . . . . 28 0 0 0 0 3 170 59 260
Merger of bank
company . . . . . . . 8 0 0 0 0 6 40 22 76
Acquisition or
retention of
bank . . . . . . . . . . . . 19 0 0 0 0 6 86 39 150
Acquisition of
nonbank . . . . . . . . 0 0 62 0 0 7 0 124 193
Merger of bank . . . . . . 10 0 0 0 0 9 106 0 125
Change in control . . . . 0 0 0 0 0 3 0 111 114
Establishment of a
branch, agency,
or representative
office by a
foreign bank . . . . 12 0 4 3 0 0 9 0 28
Other . . . . . . . . . . . . . . . 360 0 29 56 0 69 1,081 155 1,750

Total . . . . . . . . . . . . . . . . 437 0 95 59 0 103 1,492 510 2,696

ing domestic and international applica- company declarations and 3 foreign

tions in 2001 are shown in the accompa- bank declarations were approved.
nying table. Financial holding companies do not
Since 2000, the Bank Holding Com- have to obtain the Board’s prior
pany Act has permitted the creation of approval to engage in or acquire a com-
a special type of bank holding com- pany engaged in new financial activities
pany called a financial holding com- under GLBA. Instead, the financial
pany. Financial holding companies are holding company must notify the Board
allowed to engage in a broader range of within thirty days after commencing a
nonbank activities than are traditional new activity or acquiring a company
bank holding companies: Among other engaged in a new activity. A financial
things, they may affiliate with securi- holding company also may engage in
ties firms and insurance companies and certain other activities that have been
engage in certain merchant banking determined to be financial in nature or
activities. Bank holding companies incidental to a financial activity or that
seeking financial holding company sta- are determined to be complementary to
tus must file a written declaration with a financial activity.
the Federal Reserve System; most decla-
rations are acted on by one of the
Reserve Banks under authority dele-
Bank Merger Act
gated by the Board of Governors. In The Bank Merger Act requires that all
2001, 135 domestic financial holding proposals involving the merger of
Banking Supervision and Regulation 167

insured depository institutions be acted tition in any relevant market; the com-
on by the appropriate federal banking pleteness of information submitted by
agency. If the institution surviving the the acquiring person; and whether the
merger is a state member bank, the Fed- proposed change would have an adverse
eral Reserve has primary jurisdiction. effect on the federal deposit insur-
Before acting on a merger proposal, the ance funds. As part of the process, the
Federal Reserve considers the financial Federal Reserve may contact other
and managerial resources of the appli- regulatory or law enforcement agencies
cant, the future prospects of the existing for information about each acquiring
and combined institutions, the conve- person.
nience and needs of the community to The appropriate federal banking agen-
be served, and the competitive effects cies are required to publish notice of
of the proposed merger. It also con- each proposed change in control and to
siders the views of certain other agen- invite public comment, particularly from
cies regarding the competitive factors persons located in the markets served by
involved in the transaction. During the institution being acquired.
2001 the Federal Reserve approved In 2001 the Federal Reserve approved
125 merger applications. 114 proposed changes in control of
When the FDIC, the OCC, or the state member banks and bank holding
OTS has jurisdiction over a merger, the companies.
Federal Reserve is asked to comment on
the competitive factors; by using stan-
dard terminology in assessing competi-
International Banking Act
tive factors in merger cases, the four The International Banking Act, as
agencies have sought to ensure consis- amended by the Foreign Bank Supervi-
tency in administering the act. The Fed- sion Enhancement Act of 1991, requires
eral Reserve submitted 653 reports on foreign banks to obtain Federal Reserve
competitive factors to the other agencies approval before establishing branches,
in 2001. agencies, commercial lending company
subsidiaries, or representative offices in
the United States.
Change in Bank Control Act In reviewing proposals, the Federal
The Change in Bank Control Act Reserve generally considers whether
requires persons seeking control of a the foreign bank is subject to compre-
U.S. bank or bank holding company to hensive supervision or regulation on a
obtain approval from the appropriate consolidated basis by its home country
federal banking agency before complet- supervisor. It also considers whether the
ing the transaction. The Federal Reserve home country supervisor has consented
is responsible for reviewing changes in to the establishment of the U.S. office;
the control of state member banks and the financial condition and resources
bank holding companies. In its review, of the foreign bank and its existing U.S.
the Federal Reserve considers the finan- operations; the managerial resources
cial position, competence, experience, of the foreign bank; whether the home
and integrity of the acquiring person; country supervisor shares information
the effect of the proposed change on the regarding the operations of the foreign
financial condition of the bank or bank bank with other supervisory authorities;
holding company being acquired; the whether the foreign bank has provided
effect of the proposed change on compe- adequate assurances that information
168 88th Annual Report, 2001

concerning its operations and activities domestic branches, and all member
will be made available to the Board, banks (including national banks) must
if deemed necessary to determine and obtain Federal Reserve approval to
enforce compliance with applicable law; establish foreign branches. When
whether the foreign bank has adopted reviewing proposals to establish domes-
and implemented procedures to combat tic branches, the Federal Reserve con-
money laundering and whether the home siders the scope and character of the
country of the foreign bank is develop- proposed banking activities to be con-
ing a legal regime to address money ducted. When reviewing proposals for
laundering or is participating in multilat- foreign branches, the Federal Reserve
eral efforts to combat money launder- considers, among other things, the con-
ing; and the record of the foreign bank dition of the bank and the bank’s experi-
with respect to compliance with U.S. law. ence in international banking. Once a
In 2001 the Federal Reserve approved member bank has received authority to
28 applications by foreign banks to open a branch in a particular foreign
establish branches, agencies, and repre- country, that bank may open additional
sentative offices in the United States. branches in that country without prior
approval from the Federal Reserve.
Excluding proposals related to recent
Overseas Investments by large domestic mergers, the Federal
U.S. Banking Organizations Reserve in 2001 acted on proposals
U.S. banking organizations may engage involving 1,399 new or merger-related
in a broad range of activities overseas. domestic branches and granted prior
Many of the activities are conducted approval for the establishment of 13 for-
indirectly through Edge Act and agree- eign branches.
ment corporation subsidiaries. Although State member banks also must obtain
most foreign investments are made Federal Reserve approval to establish
under general consent procedures that financial subsidiaries. These subsidiaries
involve only an after-the-fact notifica- may engage in activities that are finan-
tion to the Board, large and other signi- cial in nature or incidental to financial
ficant investments require the prior activities, including certain securities-
approval of the Board. Excluding pro- and insurance-related activities that the
posals relating to recent large domestic parent bank may not conduct directly. In
mergers, the Federal Reserve in 2001 2001, 6 applications for financial sub-
approved 26 proposals for significant sidiaries were approved.
overseas investments by U.S. banking
organizations. The Federal Reserve also
approved 1 application to acquire an
Stock Repurchases by
Edge Act corporation, 3 to extend the
Bank Holding Companies
corporate existence of an established A bank holding company may repur-
Edge Act corporation, and 12 to estab- chase its own shares from its share-
lish or acquire a new agreement holders. When the company borrows
corporation. money to buy the shares, the trans-
action increases the company’s debt
and decreases its equity. The Federal
Applications by Member Banks Reserve may object to stock repurchases
State member banks must obtain Fed- by holding companies that fail to meet
eral Reserve approval to establish certain standards, including the Board’s
Banking Supervision and Regulation 169

capital adequacy guidelines. In 2001 Delegation of Applications

the Federal Reserve reviewed 20 stock
repurchase proposals by bank holding Historically, the Board of Governors has
companies; all were approved by a delegated certain regulatory functions,
Reserve Bank under delegated authority. including the authority to approve, but
not to deny, certain types of applica-
tions, to the Reserve Banks, to the
Public Notice of Director of the Board’s Division of
Federal Reserve Decisions Banking Supervision and Regulation,
and to the Secretary of the Board. In
Most decisions by the Federal Reserve 2001, 80 percent of the applications pro-
that involve a bank holding company, a cessed were handled under delegated
bank merger, a change in control, or the authority.
establishment of a new U.S. banking
presence by a foreign bank are effected
by an order or an announcement. Orders Enforcement of
state the decision, the essential facts Other Laws and Regulations
of the application or notice, and the The Board’s enforcement responsibili-
basis for the decision; announcements ties also extend to financial disclosures
state only the decision. All orders and by state member banks; securities credit;
announcements are made public imme- and efforts, under the Bank Secrecy Act,
diately; they are subsequently reported to counter money laundering.
in the Board’s weekly H.2 statistical
release and in the monthly Federal
Reserve Bulletin. The H.2 release also Financial Disclosures by
includes announcements of applications State Member Banks
and notices received by the Federal
State member banks that issue securities
Reserve but not yet acted on. For each
registered under the Securities Exchange
pending application and notice, the
Act of 1934 must disclose certain infor-
related H.2A states the deadline for
mation of interest to investors, including
comments. The Board’s public web site
annual and quarterly financial reports
( contin-
and proxy statements. By statute, the
ues to provide information relevant to
Board’s financial disclosure rules must
the applications process.
be substantially similar to those of the
Securities and Exchange Commission.
Timely Processing of Applications At the end of 2001, twenty-three state
member banks were registered with the
The Federal Reserve sets internal target Board under the Securities Exchange
time frames for the processing of appli- Act.
cations. The setting of targets promotes
efficiency at the Board and the Reserve Securities Credit
Banks and reduces the burden on appli-
cants. Generally, the length of the target Under the Securities Exchange Act, the
period ranges from twelve to sixty days, Board is responsible for regulating
depending on the type of application credit in certain transactions involving
or notice filed. In 2001, 92 percent of the purchase or carrying of securities.
applications were processed within the The Board’s Regulation T limits the
established time period. amount of credit that may be provided
170 88th Annual Report, 2001

by securities brokers and dealers when tain records. These documents record
the credit is used to trade debt and information on persons involved in large
equity securities. The Board’s Regula- currency transactions and on suspicious
tion U limits the amount of credit that activity related to possible violations of
may be provided by lenders other than federal law, including money laundering
brokers and dealers when the credit is and other financial crimes. The act is a
used to purchase or carry publicly held primary tool in the fight against money
equity securities if the loan is secured by laundering; its requirements inhibit
those or other publicly held equity secu- money laundering by creating a paper
rities. The Board’s Regulation X applies trail of financial transactions that helps
these credit limitations, or margin law enforcement and regulators identify
requirements, to certain borrowers and and trace the proceeds of illegal activity.
to certain credit extensions, such as In addition to the specific require-
credit obtained from foreign lenders by ments of the Bank Secrecy Act (BSA),
U.S. citizens. the Board’s Regulation H (12 CFR
Several regulatory agencies enforce 208.63) requires each banking organiza-
the Board’s securities credit regulations. tion supervised by the Federal Reserve
The SEC, the National Association of to develop a written program for BSA
Securities Dealers, and the national compliance that is formally approved
securities exchanges examine brokers by the institution’s board of directors.
and dealers for compliance with Regula- The compliance program must (1) estab-
tion T. The federal banking agencies lish a system of internal controls to
examine banks under their respective ensure compliance with the act, (2) pro-
jurisdictions for compliance with Regu- vide for independent compliance test-
lation U; the Farm Credit Administra- ing, (3) identify individuals responsible
tion, the National Credit Union Admin- for coordinating and monitoring day-to-
istration, and the Office of Thrift day compliance, and (4) provide train-
Supervision examine lenders under their ing for personnel as appropriate. To
respective jurisdictions for compliance monitor compliance, each Reserve Bank
with Regulation U, and the Federal has designated a senior, experienced
Reserve examines other Regulation U examiner as the Bank Secrecy Act and
lenders. anti-money-laundering contact. During
Since 1990 the Board has published a examinations of state member banks and
list of foreign stocks that are eligible for U.S. branches and agencies of for-
margin treatment at broker–dealers on eign banks, specially trained examiners
the same basis as domestic margin secu- review the institution’s compliance with
rities. In 2001 the foreign list was the act.
revised in March and September. The Board has a special investiga-
tions section in the Division of Banking
Supervision and Regulation that con-
Anti–Money Laundering ducts financial investigations, provides
The Department of the Treasury’s regu- expertise to the U.S. law enforcement
lation (31 CFR 103) implementing the community for investigation and train-
Currency and Foreign Transactions ing initiatives, and offers training to
Reporting Act (commonly referred to as various foreign central banks and gov-
the Bank Secrecy Act) requires banks ernment agencies; section staff speak at
and other types of financial institutions banking conferences to promote best
to file certain reports and maintain cer- practices in the industry. Internationally,
Banking Supervision and Regulation 171

the section has provided anti-money- sory letter in November to all domestic
laundering training and technical assis- and foreign banking organizations under
tance to countries in Asia; in Eastern its supervision. The letter described the
Europe, including the newly indepen- act’s provisions, highlighted those pro-
dent states; in South and Central visions needing immediate attention by
America; and in the Caribbean. Staff financial institutions and supervisory
members have also participated in staff, and described the new rules that
numerous multilateral anti-money- would be issued under the act.
laundering initiatives such as the Finan- At the request of Treasury staff and
cial Action Task Force and the Basel consistent with statutory requirements
Committee on Banking Supervision. for consultation, the Federal Reserve has
In 2001, the Federal Reserve contin- been actively assisting in the develop-
ued to provide expertise and guidance to ment of these new rules. Of the twenty
the Bank Secrecy Act Advisory Group, working groups established by the Trea-
a committee established by the Con- sury Department to carry out the differ-
gress at the Department of the Treasury ent regulatory projects required by the
to seek measures to reduce unneces- act, Federal Reserve staff are involved
sary burdens created by the act and to in fifteen. The Federal Reserve also
increase the utility of data gathered established a PATRIOT Act Work-
under the act to aid regulators and law ing Group composed of senior, experi-
enforcement. The Federal Reserve also enced Bank Secrecy Act/anti-money-
assisted the Treasury Department in pro- laundering examiners from throughout
viding feedback to financial institutions the System. This group, which is
on the reporting of suspicious activity. charged with overseeing the System’s
Since the terrorist attacks of Septem- implementation of the new law, worked
ber 11, the Federal Reserve has played on drafting new examination procedures
an important role in many joint activi- and developing a new training curricu-
ties with bank supervisory and law lum for examiners who conduct Bank
enforcement authorities and the bank- Secrecy Act and anti-money-laundering
ing community, both domestically and examinations.
abroad, to combat money laundering
and terrorist financing. In addressing the
mandates of the anti-money-laundering
Loans to Executive Officers
provisions of the USA PATRIOT Act, Under section 22(g) of the Federal
the Federal Reserve issued a supervi- Reserve Act, a state member bank must

Loans by State Member Banks to their Executive Officers, 2000 and 2001

Range of interest
Period Number Amount (dollars) rates charged

October 1–December 31 . . . . . . . . . . . . . . . . 702 59,232,000 5.5–20.8

January 1–March 31 . . . . . . . . . . . . . . . . . . . 633 65,663,000 2.0–21.0
April 1–June 30 . . . . . . . . . . . . . . . . . . . . . . . . 710 51,109,000 3.9–18.0
July 1–September 30 . . . . . . . . . . . . . . . . . . . 665 56,830,000 4.6–19.5

Source. Call Reports.

172 88th Annual Report, 2001

include in its quarterly Call Report and were operating 49,102 branches.
information on all extensions of credit These banks accounted for 38 percent of
by the bank to its executive officers all commercial banks in the United
since the date of the preceding report. States and for 74 percent of all commer-
The accompanying table summarizes cial banking offices.
this information for 2001.

Federal Reserve Membership

At the end of 2001, 3,058 banks were
members of the Federal Reserve System

Federal Reserve Banks

The Federal Reserve Banks devoted cost effective while continuing to pro-
considerable attention in 2001 to vide high-quality, reliable services.
improving security, operational effi- Another cost-reduction project begun
ciency, and service quality. This chapter during the year was a concentrated multi-
describes those efforts as well as other year effort to reduce employee benefit
activities affecting the Reserve Banks. costs by consolidating health and wel-
fare plans and their administration, by
outsourcing, and by implementing cost-
Major Initiatives effective benefit-plan design strategies.
Since the terrorist attacks on Septem- The savings from these efforts are
ber 11, the Federal Reserve has reevalu- expected to fully offset enhancements
ated its contingency and business conti- of employee benefits that are intended
nuity plans and operations and is taking to make employment at the Federal
steps to enhance them. All information Reserve more attractive and thus
technology infrastructures—both within improve the institution’s ability to com-
and outside the Federal Reserve’s pete for and retain the skilled profes-
control—that support critical operations sionals, technical staff, and key execu-
are being reexamined to ensure that they tives needed to carry out the Federal
have appropriate security, redundancy, Reserve’s mission.
and diversity. Experience gained from
preparing for the century date change and Developments in
in the aftermath of the attacks is being Federal Reserve Priced Services
applied to strengthen further the Federal
Reserve’s national incident-response pro- The Monetary Control Act of 1980
cedures and communications. requires that the Federal Reserve set fees
In 2001, the Federal Reserve Banks for providing ‘‘priced services’’ to
made an ambitious commitment to depository institutions that, over the
reduce System costs in certain areas sig- long run, recover all the direct and indi-
nificantly over the next three years. To rect costs of providing the services as
achieve this objective, they initiated sev- well as the imputed costs, such as the
eral cost-reduction projects in the infor- taxes that would have been paid and the
mation technology, accounting, and return on equity that would have been
human resources functions. earned had the services been provided
Among the cost-reduction projects are by a private firm. The imputed costs and
several to centralize or standardize com- imputed profit are collectively referred
mon information technology utilities to as the private-sector adjustment fac-
and resources. The Reserve Banks are tor (PSAF).1 Over the past ten years, the
also collaborating on several projects to
eliminate duplication of efforts in appli- 1. Along with income taxes and the return on
cation development and to identify com- equity, the PSAF is made up of three additional
imputed costs: interest on debt, sales taxes, and
mercially available alternatives to soft- assessments for deposit insurance from the Fed-
ware planned for development. These eral Deposit Insurance Corporation. Also allocated
efforts will enable the Banks to be more to priced services are assets and personnel costs of
174 88th Annual Report, 2001

September 11 and the Payments System

We are blessed with a financial system that is creative, that is flexible, that
is innovative. Banks—including the central bank—were there when they were
needed and did what was required with dispatch. We should be proud of the
banking system’s role in minimizing the economic fallout of that tragic day.
Alan Greenspan, Chairman, Board of Governors

For several days after the terrorist attacks Reserve accounts averaged ten times their
on September 11, 2001, communications usual level, with more than 70 percent of
and connectivity problems disrupted por- those balances held by just six institutions,
tions of the nation’s payments system compared with the 20 percent this group
infrastructure, requiring many banks, secu- normally holds. Disruptions in large pay-
rities dealers, and settlement utilities in ment flows also resulted from problems
lower Manhattan to relocate their opera- in the clearance and settlement of U.S. gov-
tions to contingency sites. Although most ernment securities transactions and the
backup procedures worked as planned, redemption of maturing commercial paper
telecommunications problems impaired transactions.
some firms’ ability to communicate with Although electronic funds transfer sys-
counterparties and employees and to trans- tems, such as Fedwire, CHIPS, the auto-
mit payment and settlement instructions. mated clearinghouse (ACH), and credit and
Transportation problems in the Manhattan debit card networks, were not directly
area also made it difficult to move employ- affected by the attacks, some participants
ees to contingency sites. experienced connectivity problems, result-
Disruptions to the payments system due ing in a decline in payments activity. The
to telecommunications and transportation value of aggregate daily payments over
problems resulted in payment delays and CHIPS, for example, was lower than
liquidity dislocations among financial mar- normal through September 14 but recov-
ket participants for several days. As one ered the following week, while the value
indication of liquidity dislocations, from of government securities transfers over
September 12 to 14, the balances that the Fedwire securities transfer system
depository institutions held in their Federal remained low through the week of Septem-

Federal Reserve Banks have recovered priced services was $926.5 million,
99.8 percent of their priced services other income related to priced services
costs, including the PSAF (table). was $33.9 million, and costs related to
Overall, fees charged in 2001 for priced services were $901.9 million,
priced services increased approximately resulting in net revenue of $58.5 million
5.2 percent from 2000.2 Revenue from and a recovery rate of 95.0 percent of
costs, including the PSAF.3

the Board of Governors that are related to priced

services; in the pro forma statements at the end of 3. Financial data reported throughout this
the chapter, Board expenses are included in operat- chapter—revenue, other income, cost, net reve-
ing expenses, and Board assets are part of long- nue, and income before taxes—can be linked to
term assets. the pro forma statements at the end of the chapter.
2. Based on a chained Fisher Ideal price index Other income is revenue from investment of clear-
not adjusted for quality changes. ing balances, net of earnings credits, an amount
Federal Reserve Banks 175

ber 17. Although the value of Fedwire The Federal Reserve also worked closely
funds transfers initially declined on Sep- with the financial industry to restore con-
tember 11, the value of transfers increased nectivity and the normal flow of payments.
materially starting on September 12 and The Board used its authority under the
remained high throughout the month. Telecommunications Service Priority pro-
The Federal Reserve responded to these gram to expedite emergency provision
disruptions in a variety of ways. On the of telecommunications circuits for the
morning of September 11, the Federal Reserve Banks and several key payment
Reserve announced, ‘‘The Federal Reserve providers and market utilities in the New
System is open and operating. The dis- York City area. In addition, the Federal
count window is available to meet liquidity Reserve extended the operating hours of
needs.’’ Depository institutions affected by the Fedwire funds and securities transfer
the disruptions to the payments system bor- systems to give financial institutions and
rowed heavily from the window for several their customers more time to process each
days. In addition, the Federal Reserve pro- day’s intended payments. The Federal
vided a large volume of reserves through Reserve also executed a significant number
open market operations. Daylight and over- of off-line Fedwire funds payment orders
night overdrafts also increased dramati- on behalf of institutions that were experi-
cally, reflecting the difficulties that account encing connectivity problems. Finally, the
holders experienced in managing their Fed- Reserve Banks continued to credit the
eral Reserve accounts as a result of pay- value of all check deposits to depositing
ments system disruptions. In view of these institutions’ accounts, even if the Reserve
difficulties, the Reserve Banks waived day- Banks could not present the checks to
light overdraft fees and overnight overdraft (and debit the accounts of) paying banks
penalty fees from September 11 through 21 because airplanes were grounded. As a
for all account holders. To support the result of the decision to credit these depos-
direct provision of U.S. dollar liquidity to its, daily check float, which normally is
foreign-based entities, the Federal Reserve less than $1 billion, peaked at $47.4 billion
arranged currency swaps with the Bank of on September 13, providing an additional
Canada, the Bank of England, and the significant source of liquidity to the bank-
European Central Bank. ing system.

Check Collection operations totaled $764.7 million, and

other income amounted to $28.5 mil-
Federal Reserve Bank operating ex-
lion. Net income from check services
penses and imputed costs for commer-
was $38.9 million, a $44.4 million, or
cial check services in 2001 totaled
53.3 percent, decrease compared with
$754.4 million, compared with $680.1
2000 net income.
million in 2000. Revenue from check The Reserve Banks handled 16.9 bil-
lion checks in 2001, a decrease of
termed net income on clearing balances. Total cost 0.5 percent from 2000 (see table). The
is the sum of operating expenses, imputed costs volume of checks deposited that
(interest on debt, interest on float, sales taxes, and required processing by the Reserve
the Federal Deposit Insurance Corporation assess-
ment), imputed income taxes, and the targeted
Banks increased 0.8 percent, a slightly
return on equity. Net revenue is revenue plus net slower rate than the 1.1 percent increase
income on clearing balances minus total cost. in 2000. The volume of fine-sort checks,
176 88th Annual Report, 2001

Priced Services Cost Recovery, 1992–2001

Millions of dollars except as noted

Revenue from Targeted return Total Cost recovery
Year expenses and
services 1 on equity costs (percent) 3
imputed costs 2

1992 ...................... 760.8 710.7 24.9 735.6 103.4

1993 ...................... 774.5 820.4 17.5 837.9 92.4
1994 ...................... 767.2 760.2 21.0 781.2 98.2
1995 ...................... 765.2 752.7 31.5 784.2 97.6

1996 . . . . . . . . . . . . . . . . . . . . . . 815.9 746.4 42.9 789.3 103.4

1997 . . . . . . . . . . . . . . . . . . . . . . 818.8 752.8 54.3 807.1 101.5
1998 . . . . . . . . . . . . . . . . . . . . . . 839.8 743.2 66.8 809.9 103.7
1999 . . . . . . . . . . . . . . . . . . . . . . 867.6 775.7 57.2 833.0 104.2
2000 . . . . . . . . . . . . . . . . . . . . . . 922.8 818.2 98.4 916.6 100.7
2001. . . . . . . . . . . . . . . . . . . . . . . 960.4 901.9 109.2 1,011.1 95.0

1992–2001 . . . . . . . . . . . . . . . . 8,293.0 7,782.2 523.7 8,305.9 99.8

Note. In this and the following tables, components 2. Includes operating expenses of $6,861.3 million,
may not sum to totals or yield percentages shown because imputed costs of $552.4 million, and imputed income
of rounding. Amounts in bold are restatements due to taxes of $275.0 million for the ten-year period. Also,
errors in previously reported data. the effect of one-time accounting changes net of taxes of
1. Includes revenue from services of $8,025.2 million $74.1 million and $19.4 million is included for 1993 and
and other income and expense (net) of $267.8 million for 1995 respectively.
the ten-year period. 3. Revenue from services divided by total costs.

which are presorted by the depositing expedite check returns; lessons learned
banks according to paying bank, during the project are being incorpo-
declined 10.4 percent, compared with a rated into new proposals to exploit tech-
10.7 percent decrease in 2000. nology and reduce transportation costs
The Reserve Banks continued to in check clearing.
encourage the use of electronic check During 2001, the Federal Reserve
products to make the collection system Banks continued a five-year check mod-
more efficient. In 2001, the percentage ernization project to install uniform
of all checks presented electronically by software and hardware for check pro-
the Reserve Banks to paying banks was cessing, check imaging, and check
21.7 percent (approximately 3.7 billion adjustments in forty-five Reserve Bank
checks), compared with 20.4 percent offices and to give depository institu-
in 2000. The Reserve Banks captured tions web-based access to check ser-
images of 8.1 percent of the checks they vices. The project costs are expected to
collected, compared with 7.2 percent in be recovered over the long run because
2000. the modernization effort will increase
To assess the potential benefits, in operating efficiency and make it pos-
terms of error corrections and opera- sible to offer additional services to
tional processes, of keeping image depository institutions.
copies of all checks processed, the New
York Reserve Bank’s Utica office con-
tinued a pilot project to capture images
Automated Clearinghouse
of the checks processed on all its high- Reserve Bank operating expenses and
speed check sorters. The Minneapolis imputed costs for commercial automated
Bank’s Helena Branch concluded its clearinghouse (ACH) services totaled
pilot project to use check images to $67.7 million in 2001. Revenue from
Federal Reserve Banks 177

Activity in Federal Reserve Priced Services, 2001, 2000, and 1999

Thousands of items

Percent change
Service 2001 2000 1999
2000 to 2001 1999 to 2000

Commercial checks . . . . . . . . . . . . . . . . 16,905,016 16,993,800 17,075,008 −.5 −.5

Funds transfers . . . . . . . . . . . . . . . . . . . . 115,308 111,175 105,408 3.7 5.5
Securities transfers . . . . . . . . . . . . . . . . . 6,708 5,666 5,147 18.4 10.1
Commercial ACH . . . . . . . . . . . . . . . . . 4,448,361 3,812,191 3,343,615 16.7 14.0
Noncash services . . . . . . . . . . . . . . . . . . 412 519 613 −20.7 −15.3
Cash transportation . . . . . . . . . . . . . . . . 18 19 18 −5.3 5.6

Note. Activity in commercial checks is the total num- items processed; in noncash services, the number of items
ber of commercial checks collected, including processed on which fees are assessed; and in cash transportation,
and fine-sort items; in funds transfers and securities trans- the number of registered mail shipments and FRB-
fers, the number of transactions originated on line and off arranged armored carrier stops.
line; in commercial ACH, the total number of commercial

ACH operations and other income Reserve Bank offices the support for
totaled $79.4 million, resulting in net ACH operations once provided by each
income of $11.9 million. The Reserve of the twelve Federal Reserve Banks.
Banks processed 4.4 billion commercial Support activities being consolidated
ACH transactions (worth $12.7 trillion), include ensuring the timely and accurate
an increase of 16.7 percent from 2000. processing of payments, maintaining the
In 2000, the Board approved a new integrity of the ACH application, moni-
approach to pricing ACH transactions toring file processing, and responding
that the Reserve Banks deliver through to customers’ questions. The consolida-
and receive from private-sector ACH tion, which is expected to reduce ACH
operators (PSOs). Among other things, costs while maintaining service quality,
the Board authorized the Reserve Banks is scheduled to be complete by the end
to initiate discussions with the PSOs to of the first quarter of 2002.
negotiate the structure and level of fees
that the Reserve Banks charge the PSOs
for processing inter-operator transac- Fedwire Funds Transfer and
tions as well as the fees that the Reserve Net Settlement
Banks pay the PSOs. Negotiations con-
tinued into 2001, and a new inter- Reserve Bank operating expenses and
operator fee structure became effective imputed costs for Fedwire funds trans-
on October 1. On that same date, the fer and net settlement services totaled
Reserve Banks also implemented a new $56.7 million in 2001. Revenue from
pricing method for their depository insti- these operations totaled $61.8 mil-
tution ACH customers. Monthly fixed lion, and other income amounted to
fees were increased, and per-item fees $2.0 million, resulting in net income of
were decreased. The new method better $7.1 million.
corresponds to the Reserve Banks’ ACH
cost structure, which is characterized by
Funds Transfer
high fixed and low variable costs.
In August, the Reserve Banks began The Fedwire funds transfer system
the process of consolidating at two allows depository institutions to draw
178 88th Annual Report, 2001

Fees Paid by Depository Institutions for transfer surcharge also remained

Selected Federal Reserve Priced Services, unchanged.4
2000 and 2001
In September, the Reserve Banks
began the final phase of consolidating
Item 2000 2001 the operations of the Fedwire funds
transfer service.5 The consolidation is
Fedwire Funds Transfers, expected to reduce operating costs upon
by Volume Tier1
its completion in August 2002.
(number of transfers per month) 2
1 (1 to 2,500) . . . . . . . . . . . . . . . . .33 .33 Net Settlement
2 (2,501 to 80,000) . . . . . . . . . . . .24 .24
3 (80,001 and more) . . . . . . . . . . .17 .16
Off-line surcharge . . . . . . . . . . . . . . . 15.00 15.00 Private clearing arrangements that
Net Settlement,
exchange and settle transactions may
by type of Service use the Reserve Banks’ net settlement
Net settlement sheet service to settle their transactions. The
Entries, each . . . . . . . . . . . . . . . . . . . . .95 .95
Files, each . . . . . . . . . . . . . . . . . . . . . . 12.00 12.00 Reserve Banks provide settlement ser-
Minimum per month . . . . . . . . . . . . 60–175 60–100 vices to approximately 70 local and
Fedwire Securities national private arrangements, including
Account maintenance local check clearinghouse associations,
Per issue . . . . . . . . . . . . . . . . . . . . . .45 .45 automated clearinghouse networks, and
Per account . . . . . . . . . . . . . . . . . . 15.00 15.00
credit card processors. In 2001, the
Transfers, each 2 . . . . . . . . . . . . . . . . .70 .70 Reserve Banks processed more than
Off-line surcharge . . . . . . . . . . . . . . . 18.00 25.00
417,000 settlement entries for these
Noncash Collection
arrangements, and fees remained at their
Bonds, each . . . . . . . . . . . . . . . . . . . . 40.00 40.00
Deposit envelopes 2000 levels.
(per envelope of coupons) 3
1–5 . . . . . . . . . . . . . . . . . . . . . . . . . . 4.75 4.75
6–50 . . . . . . . . . . . . . . . . . . . . . . . . . 2.50 2.50
Fedwire Securities Service
Cash letters
(flat fee, by number of The Fedwire securities service allows
envelopes of coupons) 3 depository institutions to transfer securi-
1–5 . . . . . . . . . . . . . . . . . . . . . . . . . . 7.50 7.50
6–50 . . . . . . . . . . . . . . . . . . . . . . . . . 15.00 15.00 ties issued by the U.S. Treasury, federal
Return items, each . . . . . . . . . . . . . . 15.00 20.00 government agencies, and other entities
electronically to other institutions in the
Note. Rates for 2000 are as of April 3. United States. Reserve Bank operating
1. Rates apply only to their specified volume tiers.
2. Originated and received. expenses and imputed costs for provid-
3. Deposits and cash letters may contain no more than ing this service totaled $19.5 million
50 envelopes of coupons. in 2001. Revenue totaled $19.0 mil-
lion, and other income amounted to
$0.7 million, resulting in net income of
on their reserve or clearing balances at
$0.2 million. Approximately 6,708 mil-
the Reserve Banks and transfer funds
lion transfers were processed on the
to other institutions. The number of
Fedwire funds transfers originated
by depository institutions increased 4. Depository institutions that do not have an
3.7 percent in 2001, to 115,308 mil- electronic connection to the Fedwire funds trans-
lion. In August, the Reserve Banks fer system can originate transfers via ‘‘off-line’’
telephone instructions.
reduced the transfer fee for the highest- 5. The first phase of this and the Fedwire secu-
volume tier while keeping other fees rities service consolidation was completed in
unchanged (table). The off-line funds March 1999.
Federal Reserve Banks 179

system during the year, an increase of item fee was increased from $15 to $20,
18.4 percent from 2000.6 The basic per- and the other collection fees remained
transfer fee for transfers originated and the same.
received by depository institutions and
the monthly account maintenance fees
were unchanged in 2001, while the off-
Special Cash Services
line securities transaction surcharge was The Reserve Banks charge fees for
increased from $18.00 to $25.00. providing special cash-related services,
In September, the Reserve Banks such as currency packaged in a non-
began the final phase of consolidation standard way. These services—
of the Fedwire securities service in an collectively referred to as ‘‘special cash
effort to reduce costs. The consolidation services’’—account for a very small
is expected to be complete in August proportion (less than 1 percent) of the
2002. total cost of cash services provided by
The Government National Mortgage the Reserve Banks to depository institu-
Association (Ginnie Mae) announced tions. Operating expenses and imputed
plans in 2001 to have its securities clear costs for special cash services totaled
and settle on the Fedwire securities $2.1 million in 2001. Revenue and other
transfer system. The conversion is income totaled $2.3 million, resulting in
expected to be complete by March 2002. net income of $0.2 million.

Noncash Services Float

The Federal Reserve provides a service Federal Reserve float decreased in 2001
to collect and process municipal bearer to a daily average of $604.6 million,
bonds and coupons issued by state and from a daily average of $774.2 million
local governments (referred to as ‘‘non- in 2000. The Federal Reserve recovers
cash’’ items). The service, which has the cost of float associated with priced
been centralized at one Federal Reserve services as part of the fees for those
office, processed 412,000 noncash trans- services.
actions in 2001.
Operating expenses and imputed costs
for noncash services totaled $1.6 million
Developments in
in 2001. Revenue from noncash opera-
Currency and Coin
tions totaled $2.0 million, resulting in Currency volume in the Federal Reserve
net income of $0.4 million. The return- System continued to be high in 2001.
Reserve Banks received 33.5 billion
6. The expenses, revenues, and volumes notes from circulation in 2001, a slight
reported here are for transfers of securities issued increase from the 33.3 billion notes
by federal government agencies, government- received in 2000, the Y2K flowback
sponsored enterprises, and international institu- year (when depository institutions
tions such as the World Bank. The Fedwire securi-
ties service also provides account maintenance, returned the extra vault cash they had
transfer, and settlement services for U.S. Treasury held in anticipation of the century date
securities. When the Reserve Banks provide these change). Reserve Banks also made pay-
services, they act as fiscal agents of the United ments of 34.3 billion notes to circulation
States. The Treasury Department assesses fees on
depository institutions for some of these services.
in 2001, a 7 percent increase from 2000.
For details, see the section ‘‘Fiscal Agency Ser- The Federal Reserve Bank of San
vices’’ later in this chapter. Francisco officially opened the Phoenix
180 88th Annual Report, 2001

cash-processing center on September 4. and depository expenses, a decrease of

The center will operate as a satellite $16.6 million from 2000.
office of the Los Angeles Branch.
Fiscal Agency Services
Developments in
Fiscal Agency and As fiscal agents, Reserve Banks provide
Government Depository Services to the Treasury services related to the
federal debt. For example, they issue,
The total cost of providing fiscal agency transfer, reissue, exchange, and redeem
and depository services to the Treasury marketable Treasury securities and sav-
in 2001 amounted to $246.5 million, ings bonds; they also process secondary
compared with $262.5 million in 2000 market transfers initiated by depository
(table). The cost of providing services institutions.
to other government agencies was
$38.9 million, compared with $39.4 mil-
Marketable Treasury Securities
lion in 2000. In 2001, the Reserve Banks
requested reimbursement by the Trea- Reserve Bank operating expenses for
sury and other government agencies activities related to marketable Treasury
of $285.4 million for fiscal agency securities in 2001 (Treasury Direct,

Expenses of Federal Reserve Banks for Fiscal Agency and Depository Services,
2001, 2000, and 1999
Thousands of dollars

Agency and service 2001 2000 1999

Department of the Treasury

Bureau of the Public Debt
Savings bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69,569.8 70,786.7 70,285.8
Treasury Direct . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,326.6 41,259.3 40,446.2
Commercial book entry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,998.1 13,924.6 15,744.2
Marketable Treasury issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,366.8 14,224.3 13,715.1
Definitive securities and Treasury coupons . . . . . . . . . . . . . . 610.9 1,069.3 4,886.7
Other services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150.7 132.5 100.4
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129,022.9 141,404.7 145,178.4

Financial Management Service

Treasury tax and loan and Treasury general account . . . . . 31,106.0 38,649.0 34,971.0
Government check processing . . . . . . . . . . . . . . . . . . . . . . . . . . 30,310.2 31,866.9 33,365.4
Automated clearinghouse . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,665.2 10,799.1 11,263.4
Government agency check deposits . . . . . . . . . . . . . . . . . . . . . 2,272.9 2,218.8 2,422.7
Fedwire funds transfers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199.2 182.9 187.7
Other services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,771.5 27,015.4 20,423.5
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104,324.9 110,732.2 102,633.7

Other Treasury
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,149.8 10,362.8 7,786.8
Total, Treasury . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246,497.5 262,499.7 255,598.9
Other Federal Agencies
Department of Agriculture
Food coupons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,197.2 16,463.7 18,643.9
U.S. Postal Service
Postal money orders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,255.0 9,213.5 6,623.3
Miscellaneous agencies
Other services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,434.0 13,747.1 13,983.0
Total, other agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38,886.2 39,424.3 39,250.2

Total reimbursable expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 285,383.7 301,924.0 294,849.1

Federal Reserve Banks 181

Fedwire book-entry system, marketable printed and mailed 37.8 million savings
issues, definitive securities, and Trea- bonds on behalf of the Treasury’s
sury coupons) totaled $59.3 million, Bureau of the Public Debt, a 3.3 percent
a 15.9 percent decrease from 2000. increase from 2000. They also processed
The Reserve Banks processed nearly nearly 5.5 million original-issue trans-
258,000 tenders for Treasury securities, actions for the Series I (inflation-
compared with 220,000 in 2000, and indexed) savings bond and 26.2 mil-
handled 2.8 million reinvestment lion original-issue transactions for the
requests, compared with 2.0 million in Series EE savings bond. In addition, the
2000. Banks processed approximately 563,000
The Reserve Banks operate two book- redemption, reissue, and exchange trans-
entry securities systems for Treasury actions, a 1.0 percent decrease from
securities: the Fedwire system, which 2000. Reserve Bank staff responded to
provides custody and transfer, and Trea- 1.6 million service calls from owners of
sury Direct, which provides custody ser- savings bonds, a 4.4 percent increase
vices only.7 Almost all book-entry Trea- from 2000.
sury securities, 97.5 percent of the
total par value outstanding at year-end Depository Services
2001, were maintained on Fedwire; the
remainder were maintained on Treasury The Reserve Banks maintain the Trea-
Direct. The Reserve Banks in 2001 sury’s funds account, accept deposits of
originated 7.8 million Fedwire transfers federal taxes and fees, pay checks drawn
of Treasury securities, a 1.9 percent on the Treasury’s account, and make
increase from 2000. electronic payments on behalf of the
On behalf of Treasury Direct custom- Treasury.
ers, the Reserve Bank designated to
handle sales sold nearly 15,000 securi- Federal Tax Payments
ties worth $699.9 million, compared Reserve Bank operating expenses
with more than 16,000 securities worth related to federal tax payments in 2001
$581.2 million in 2000, collecting totaled $31.1 million. The Federal
almost $510,000 in fees on behalf of the Reserve enhanced the Treasury tax and
Treasury, a decrease of 8.4 percent from loan program at midyear 2001 by
the almost $557,000 in fees collected in enabling the Treasury to invest funds
2000. with eligible depository institutions
throughout the afternoon rather than just
Savings Bonds in the morning, adding approximately
Reserve Bank operating expenses $3.0 million to Treasury’s investment
for savings bond activities totaled income. It also worked with the Trea-
$69.6 million in 2001, a decrease of sury to develop a pilot program whereby
1.7 percent from 2000. The Banks the Treasury could place investments
with depository institutions for a set
term, the interest rate being determined
7. The Fedwire book-entry securities mecha- by auction.
nism is also used for safekeeping and transfer of
securities issued by federal government agencies,
government-sponsored enterprises, or interna- Payments Processed for the Treasury
tional institutions. For details, see the section
‘‘Fedwire Securities Service’’ earlier in this Reserve Bank operating expenses
chapter. related to government payments in 2001
182 88th Annual Report, 2001

amounted to $42.4 million. The Banks Information Technology

processed 900.4 million ACH trans-
actions for the Treasury, an increase of The Federal Reserve continued in 2001
7.4 percent from 2000. They also pro- to provide highly reliable and secure
cessed 345.8 million paper government electronic services and expanded its
checks, an increase of 32.0 percent from electronic access options to depository
2000. In addition, the Banks issued institutions. Significant progress was
nearly 435,000 paper fiscal agency made on the System’s project to imple-
checks, a decrease of 17.4 percent from ment frame relay technology on Fednet,
2000. the telecommunications network that
During the year, a Reserve Bank supports both external electronic con-
assisted Treasury’s efforts to facilitate nections between the Federal Reserve
electronic payments to the federal gov- and depository institutions and internal
ernment. The Bank began sending ACH communications among Reserve Banks.
debits and making related accounting The improvements will improve the
entries for Treasury’s web site speed, reliability, and performance of
and began converting checks received the depository institutions’ electronic
by the Treasury at the point of sale at connections during contingencies and
four overseas military bases. will also increase the capacity and flex-
ibility to support new electronic services
using web-based technologies. The
Reserve Banks continued to improve
Services Provided to Other Entities electronic access options for depository
The Reserve Banks provide fiscal institutions and to offer web-based
agency and depository services to other applications for check imaging, cash
domestic and international agencies ordering, and savings bonds processing.
when they are required to do so by the The Banks plan to offer other new web-
Secretary of the Treasury or when they based services over the next several
are required or permitted to do so by years.
federal statute. One such service is the
provision of food coupon services for Examinations of
the Department of Agriculture. Reserve Federal Reserve Banks
Bank operating expenses for food cou-
pon services in 2001 totaled $13.2 mil- Section 21 of the Federal Reserve Act
lion, 19.8 percent lower than in 2000. requires the Board of Governors to order
The Banks redeemed 587 million food an examination of each Federal Reserve
coupons, a decrease of 14.5 percent Bank at least once a year. The Board
from 2000. The Federal Reserve System engages a public accounting firm to per-
is consolidating food coupon processing form an annual audit of the combined
and expects 2001 consolidations to save financial statements of the Reserve
more than $500,000 per year. Banks (see the section ‘‘Federal Reserve
As fiscal agents of the United States, Bank Combined Financial Statements’’).
the Reserve Banks also process all The public accounting firm also audits
postal money orders deposited by banks the annual financial statements of each
for collection. In 2001, they processed of the twelve Banks. The Reserve Banks
229.4 million postal money orders, use the framework established by the
approximately the same number as in Committee of Sponsoring Organizations
2000. of the Treadway Commission (COSO)
Federal Reserve Banks 183

in assessing their internal controls over tion at each Reserve Bank includes an
financial reporting, including the safe- assessment of the effectiveness of the
guarding of assets. Within this frame- Bank’s internal audit function.
work, each Reserve Bank provides an Each year, to assess compliance with
assertion letter to its board of directors the policies established by the Federal
annually confirming adherence to the Reserve’s Federal Open Market Com-
COSO standards, and a public account- mittee (FOMC), the division also exam-
ing firm certifies management’s asser- ines the accounts and holdings of the
tion and issues an attestation report to System Open Market Account at the
the Bank’s board of directors and to the Federal Reserve Bank of New York and
Board of Governors. the foreign currency operations con-
The firm engaged for the audits of ducted by that Bank. In addition, a pub-
the individual and combined financial lic accounting firm certifies the sched-
statements of the Reserve Banks for ule of participated asset and liability
2001 was PricewaterhouseCoopers LLP accounts and the related schedule of
(PwC). Fees for these services totaled participated income accounts at year-
$1.3 million. In order to ensure auditor end. Division personnel follow up on
independence, the Board requires that the results of these audits. The FOMC
PwC be independent in all matters relat- receives the external audit reports and
ing to the audit. Specifically, PwC may the report on the division’s follow-up.
not perform services for the Reserve
Bank or others that would place it in a
position of auditing its own work, mak-
Income and Expenses
ing management decisions on behalf The accompanying table summarizes the
of the Reserve Banks, or in any other income, expenses, and distributions of
way impairing its audit independence. net earnings of the Federal Reserve
In 2001 the Reserve Banks engaged Banks for 2000 and 2001.
PwC for advisory services totaling Income in 2001 was $31,871 million,
$0.9 million, $0.7 million of which was compared with $33,964 million in 2000.
for project management advisory ser- Total expenses were $2,718 million
vices related to the System’s check mod- ($1,834 million in operating expenses,
ernization project. The Board believes $250 million in earnings credits granted
that these advisory services do not to depository institutions, and $295 mil-
directly affect the preparation of the lion in assessments for expenditures
financial statements audited by PwC and by the Board of Governors). The cost
are not incompatible with the services of new currency was $339 million.
provided by PwC as an independent Revenue from priced services was
auditor. $926.5 million.
In 2001, the examinations by the The profit and loss account showed a
Board’s Division of Reserve Bank net loss of $1,117 million. The loss was
Operations and Payment Systems of the due primarily to unrealized losses on
Reserve Banks, using a format consis- assets denominated in foreign curren-
tent with the integrated COSO frame- cies revalued to reflect current market
work, assessed the efficiency and effec- exchange rates. Statutory dividends paid
tiveness of operations, the reliability to member banks totaled $428 million,
of financial reporting, compliance with $18 million more than in 2000; the rise
applicable laws and regulations, and the reflects an increase in the capital and
safeguarding of assets. The annual atten- surplus of member banks and a conse-
184 88th Annual Report, 2001

Income, Expenses, and Distribution of Net Earnings

of Federal Reserve Banks, 2001 and 2000
Millions of dollars

Item 2001 2000

Current income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,871 33,964

Current expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,085 1,972
Operating expenses 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,834 1,586
Earnings credits granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 385

Current net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29,786 31,992

Net additions to (deductions from, − ) current net income . . . . . . . . . . . . . . . −1,117 −1,492
Cost of unreimbursed services to Treasury . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 8
Assessments by the Board of Governors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 634 624
For expenditures of Board . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295 188
For cost of currency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339 436

Net income before payments to Treasury . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,035 29,868

Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 428 410
Transferred to surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518 4,115

Payments to Treasury 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,089 25,344

1. Includes a net periodic credit for pension costs of 2. Interest on Federal Reserve notes.
$331 million in 2001 and $393 million in 2000.

quent increase in the paid-in capital (see table). Holdings of U.S. govern-
stock of the Reserve Banks. ment securities increased $31,152 mil-
Payments to the Treasury in the form lion, and holdings of loans increased
of interest on Federal Reserve notes $32 million.
totaled $27,089 million in 2001, up from The average rate of interest earned
$25,344 million in 2000; the payments on the Reserve Banks’ holdings of gov-
equal net income after the deduction of ernment securities declined to 5.46 per-
dividends paid and of the amount neces- cent, from 6.20 percent in 2000, and
sary to bring the surplus of the Reserve the average rate of interest earned on
Banks to the level of capital paid in. loans declined to 3.18 percent, from
In the ‘‘Statistical Tables’’ section of 6.27 percent.
this volume, table 5 details the income
and expenses of each Federal Reserve
Bank for 2001, and table 6 shows a Volume of Operations
condensed statement for each Bank for Table 8 in the ‘‘Statistical Tables’’ sec-
the years 1914 through 2001. A detailed tion shows the volume of operations in
account of the assessments and expendi- the principal departments of the Federal
tures of the Board of Governors appears Reserve Banks for the years 1996
in the section ‘‘Board of Governors through 2001.
Financial Statements.’’

Federal Reserve Bank Premises

Holdings of Securities and Loans
In 2001, construction of the Atlanta
The Reserve Banks’ average daily hold- Reserve Bank’s new headquarters build-
ings of securities and loans during ing and the San Francisco Bank’s new
2001 amounted to $559,323 million, an cash-processing center in Phoenix was
increase of $31,184 million from 2000 completed.
Federal Reserve Banks 185

Securities and Loans of Federal Reserve Banks, 1999–2001

Millions of dollars except as noted

Item and year Total government Loans 2
securities 1

Average daily holdings 3

1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495,606 495,384 221
2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 528,139 527,774 365
2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 559,323 558,926 397

1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,227 28,216 11
2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,760 32,737 23
2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,536 30,523 13
Average interest rate (percent)
1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.70 5.70 5.02
2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.20 6.20 6.27
2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.46 5.46 3.18

1. Includes federal agency obligations. 3. Based on holdings at opening of business.

2. Does not include indebtedness assumed by the Fed-
eral Deposit Insurance Corporation.

The Board approved a new building and planning options for its Seattle
program for the Chicago Bank’s Detroit and Portland Branches. The lease on
Branch. The Bank relocated its check- the
processing function from its head-
quarters building to leased space near was renewed.
Midway Airport in Chicago and sold The multiyear renovation program
its Westgate warehouse in suburban and the cleaning and repair of the exte-
Chicago. rior stonework continued at the New
Design work for the Dallas Bank’s York Bank’s headquarters building.
new Houston Branch building contin- An improvement program for the main
ued. The Kansas City Bank continued to chiller plant in the headquarters building
analyze the long-term planning options continued. Also, the improvements to
for its headquarters facility, and the the New York Bank’s leased office facil-
St. Louis Bank initiated a similar analy- ity in New York City were completed.
sis of its headquarters facility. At all facilities, security enhancement
The San Francisco Bank began a programs were undertaken as a result of
study of the long-term business needs the events of September 11.
186 88th Annual Report, 2001

Pro Forma Financial Statements for Federal Reserve Priced Services

Pro Forma Balance Sheet for Priced Services, December 31, 2001 and 2000
Millions of dollars

Item 2001 2000

Short-term assets (Note 1)

Imputed reserve requirements
on clearing balances . . . . . . . . . . . . 860.8 667.0
Investment in marketable securities . . . 7,747.3 6,002.6
Receivables . . . . . . . . . . . . . . . . . . . . . . . . . 76.5 74.9
Materials and supplies . . . . . . . . . . . . . . . 3.1 3.2
Prepaid expenses . . . . . . . . . . . . . . . . . . . . 30.5 35.2
Items in process of collection . . . . . . . . 1,772.1 4,094.6
Total short-term assets . . . . . . . . 10,490.3 10,877.4

Long-term assets (Note 2)

Premises . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473.0 471.9
Furniture and equipment . . . . . . . . . . . . . 176.1 171.2
Leases and leasehold improvements . . 88.1 65.3
Prepaid pension costs . . . . . . . . . . . . . . . . 760.8 659.9
Total long-term assets . . . . . . . . . 1,498.0 1,368.3
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . 11,988.3 12,245.7

Short-term liabilities
Clearing balances and balances
arising from early credit
of uncollected items . . . . . . . . . . . . . 8,524.5 6,886.1
Deferred-availability items . . . . . . . . . . . 1,855.7 3,878.1
Short-term debt . . . . . . . . . . . . . . . . . . . . . . 20.8 113.2
Short-term payables . . . . . . . . . . . . . . . . . . 89.2 .0
Total short-term liabilities . . . . . 10,490.3 10,877.4

Long-term liabilities
Long-term debt . . . . . . . . . . . . . . . . . . . . . . 519.7 443.0
benefits obligation . . . . . . . . . . . . . . 257.8 243.9
Total long-term liabilities . . . . . 777.4 686.9
Total liabilities . . . . . . . . . . . . . . . . . . . . . . 11,267.7 11,564.3

Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720.6 681.4

Total liabilities and equity (Note 3) . . . 11,988.3 12,245.7

Note. Components may not sum to totals because of The accompanying notes are an integral part of these
rounding. Amounts in bold are restatements due to errors pro forma priced services financial statements.
in previously reported data.
Federal Reserve Banks 187

Pro Forma Income Statement for Federal Reserve Priced Services, 2001 and 2000
Millions of dollars

Item 2001 2000

Revenue from services provided

to depository institutions (Note 4) . . . . . . 926.5 881.5
Operating expenses (Note 5) . . . . . . . . . . . . . . . . 814.9 716.5
Income from operations . . . . . . . . . . . . . . . . . . . . 111.7 165.1
Imputed costs (Note 6)
Interest on float . . . . . . . . . . . . . . . . . . . . . . . . . . 15.5 12.8
Interest on debt . . . . . . . . . . . . . . . . . . . . . . . . . . 32.0 31.5
Sales taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12.6 9.3
FDIC insurance . . . . . . . . . . . . . . . . . . . . . . . . . . .0 60.1 .0 53.6
Income from operations after
imputed costs . . . . . . . . . . . . . . . . . . . . . . . . . 51.6 111.4
Other income and expenses (Note 7)
Investment income . . . . . . . . . . . . . . . . . . . . . . . 273.3 411.8
Earnings credits . . . . . . . . . . . . . . . . . . . . . . . . . −239.4 33.9 −370.5 41.3
Income before income taxes . . . . . . . . . . . . . . . . 85.4 152.7
Imputed income taxes (Note 8) . . . . . . . . . . . . . . 26.9 48.1
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58.5 104.6
Memo: Targeted return on equity (Note 9) . . . 109.2 98.4

Note. Components may not sum to totals because of The accompanying notes are an integral part of these
rounding. Amounts in bold are restatements due to errors pro forma priced services financial statements.
in previously reported data.

Pro Forma Income Statement for Federal Reserve Priced Services, by Service, 2001
Millions of dollars

Com- Funds Com-

mercial transfer Fedwire Noncash Cash
Item Total mercial
check and net securities services services
collection settlement

Revenue from services

(Note 4) . . . . . . . . . . . . . . . . 926.5 764.7 61.8 19.0 76.9 2.0 2.2

Operating expenses
(Note 5) . . . . . . . . . . . . . . . . 814.9 684.3 50.3 18.4 58.5 1.3 2.0
Income from operations . . . . . . 111.7 80.4 11.4 .6 18.4 .7 .2

Imputed costs (Note 6) . . . . . . . 60.1 52.2 3.1 1.0 3.8 .1 .0

Income from operations

after imputed costs . . . . . . 51.6 28.2 8.4 −.4 14.6 .6 .2
Other income and expenses,
net (Note 7) . . . . . . . . . . . . 33.9 28.5 2.0 .7 2.5 .0 .1
Income before income taxes . . 85.4 56.7 10.4 .3 17.2 .6 .2

Imputed income taxes

(Note 8) . . . . . . . . . . . . . . . . 26.9 17.9 3.3 .1 5.4 .2 .1
Net income . . . . . . . . . . . . . . . . . . 58.5 38.9 7.1 .2 11.8 .4 .2

Memo: Targeted return on

equity (Note 9) . . . . . . . . . 109.2 90.2 7.4 2.3 8.9 .2 .1

Note. Components may not sum to totals because of The accompanying notes are an integral part of these
rounding. pro forma priced services financial statements.
188 88th Annual Report, 2001

Pro Forma Income Statement for Federal Reserve Priced Services, by Service, 2000
Millions of dollars

Com- Funds Com-

mercial transfer Fedwire Noncash Cash
Item Total mercial
check and net securities services services
collection settlement

Revenue from services

(Note 4) . . . . . . . . . . . . . . . . 881.5 728.6 61.9 17.8 68.8 2.3 2.1

Operating expenses
(Note 5) . . . . . . . . . . . . . . . . 716.5 595.5 49.5 14.0 53.6 1.7 2.1
Income from operations . . . . . . 165.1 133.1 12.4 3.8 15.2 .6 .0

Imputed costs (Note 6) . . . . . . . 53.6 46.3 3.1 .8 3.3 .1 .0

Income from operations
after imputed costs . . . . . . 111.4 86.8 9.3 3.0 11.9 .4 .0
Other income and expenses,
net (Note 7) . . . . . . . . . . . . 41.3 34.7 2.7 .8 2.9 .1 .1
Income before income taxes . . 152.7 121.5 12.0 3.8 14.8 .6 .1

Imputed income taxes

(Note 8) . . . . . . . . . . . . . . . . 48.1 38.3 3.8 1.2 4.7 .2 .0

Net income . . . . . . . . . . . . . . . . . . 104.6 83.2 8.2 2.6 10.1 .4 .1

Memo: Targeted return on

equity (Note 9) . . . . . . . . . 98.4 80.8 7.5 1.9 8.0 .2 .1

Note. Components may not sum to totals because of The accompanying notes are an integral part of these
rounding. Amounts in bold are restatements due to errors pro forma priced services financial statements.
in previously reported data.


Notes to Pro Forma Financial Statements for Priced Services
(1) Short-Term Assets be double-counted on a consolidated Federal Reserve
balance sheet; adjustments for items associated with non-
The imputed reserve requirement on clearing balances
priced items, such as those collected for government
held at Reserve Banks by depository institutions reflects a
agencies; and adjustments for items associated with
treatment comparable to that of compensating balances
providing fixed availability or credit before items are
held at correspondent banks by respondent institutions.
received and processed. Among the costs to be recovered
The reserve requirement imposed on respondent balances
under the Monetary Control Act is the cost of float, or net
must be held as vault cash or as non-earning balances
CIPC during the period (the difference between gross
maintained at a Reserve Bank; thus, a portion of priced
CIPC and deferred-availability items, which is the portion
services clearing balances held with the Federal Reserve
of gross CIPC that involves a financing cost), valued at
is shown as required reserves on the asset side of the
the federal funds rate.
balance sheet. The remainder of clearing balances is
assumed to be invested in three-month Treasury bills,
(2) Long-Term Assets
shown as investment in marketable securities.
Receivables are (1) amounts due the Reserve Banks for Consists of long-term assets used solely in priced ser-
priced services and (2) the share of suspense-account and vices, the priced-services portion of long-term assets
difference-account balances related to priced services. shared with nonpriced services, and an estimate of the
Materials and supplies are the inventory value of short- assets of the Board of Governors used in the development
term assets. of priced services. Effective Jan. 1, 1987, the Reserve
Prepaid expenses include salary advances and travel Banks implemented the Financial Accounting Standards
advances for priced-service personnel. Board’s Statement of Financial Accounting Standards
Items in process of collection is gross Federal Reserve No. 87, Employers’ Accounting for Pensions (SFAS 87).
cash items in process of collection (CIPC) stated on a Accordingly, the Reserve Banks recognized credits to
basis comparable to that of a commercial bank. It reflects expenses of $101.0 million in 2001 and $115.5 million in
adjustments for intra-System items that would otherwise 2000 and corresponding increases in this asset account.
Federal Reserve Banks 189

(3) Liabilities and Equity Interest is imputed on the debt assumed necessary to
finance priced-service assets. The sales taxes and FDIC
Under the matched-book capital structure for assets, assessment that the Federal Reserve would have paid had
short-term assets are financed with short-term payables it been a private-sector firm are among the components of
and short-term debt in 2001 and only short-term debt in the PSAF (see note 3).
2000. Long-term assets are financed with long-term debt Float costs are based on the actual float incurred for
and equity in a proportion equal to the ratio of long-term each priced service. Other imputed costs are allocated
debt to equity for the fifty largest bank holding compa- among priced services according to the ratio of operating
expenses less shipping expenses for each service to the
nies, which are used in the model for the private-sector total expenses for all services less the total shipping
adjustment factor (PSAF). The PSAF consists of the taxes expenses for all services.
that would have been paid and the return on capital that The following list shows the daily average recovery of
would have been provided had priced services been fur- actual float by the Reserve Banks for 2001 in millions of
nished by a private-sector firm. Other short-term liabili- dollars:
ties include clearing balances maintained at Reserve
Banks and deposit balances arising from float. Other Total float 1,056.3
long-term liabilities consist of accrued postemployment Unrecovered float 112.3
and postretirement benefits costs and obligations on capi- Float subject to recovery 944.0
tal leases. Sources of recovery of float
Income on clearing balances 94.4
As-of adjustments 451.7
(4) Revenue Direct charges 505.3
Per-item fees (107.4)
Revenue represents charges to depository institutions for
priced services and is realized from each institution Unrecovered float includes float generated by services
through one of two methods: direct charges to an institu- to government agencies and by other central bank ser-
tion’s account or charges against its accumulated earn- vices. Float recovered through income on clearing bal-
ings credits. ances is the result of the increase in investable clearing
balances; the increase is produced by a deduction for float
for cash items in process of collection, which reduces
(5) Operating Expenses imputed reserve requirements. The income on clearing
Operating expenses consist of the direct, indirect, and balances reduces the float to be recovered through other
other general administrative expenses of the Reserve means. As-of adjustments and direct charges refer to float
that is created by interterritory check transportation and
Banks for priced services plus the expenses for staff the observance of non-standard holidays by some deposi-
members of the Board of Governors working directly on tory institutions. Such float may be recovered from the
the development of priced services. The expenses for depository institutions through adjustments to institution
Board staff members were $4.9 million in 2001 and reserve or clearing balances or by billing institutions
$4.2 million in 2000. The credit to expenses under directly. Float recovered through direct charges and per-
SFAS 87 (see note 2) is reflected in operating expenses. item fees is valued at the federal funds rate; credit float
The income statement by service reflects revenue, op- recovered through per-item fees has been subtracted from
the cost base subject to recovery in 2001. The 2001 float
erating expenses, and imputed costs. Certain corporate levels were unusually high because of the effect of Sep-
overhead costs not closely related to any particular priced tember 11 events.
service are allocated to priced services in total based on
an expense-ratio method, but are allocated among priced
(7) Other Income and Expenses
services based on management decision. Corporate over-
head was allocated among the priced services during Consists of investment income on clearing balances and
2001 and 2000 as follows (in millions): the cost of earnings credits. Investment income on clear-
ing balances represents the average coupon-equivalent
yield on three-month Treasury bills applied to the total
2001 2000 clearing balance maintained, adjusted for the effect of
reserve requirements on clearing balances. Expenses for
Check . . . . . . . . . . . . . . . . . . . . . 43.5 40.3 earnings credits granted to depository institutions on their
ACH . . . . . . . . . . . . . . . . . . . . . . 4.4 3.7 clearing balances are derived by applying the average
Funds transfer . . . . . . . . . . . . . . 3.5 4.3 federal funds rate to the required portion of the clearing
Book entry . . . . . . . . . . . . . . . . . 1.9 1.1 balances, adjusted for the net effect of reserve require-
Noncash services . . . . . . . . . . . .1 .1 ments on clearing balances.
Special cash services . . . . . . . . .0 .1

Total . . . . . . . . . . . . . . . . . . . . . . 53.4 49.6 (8) Income Taxes

Imputed income taxes are calculated at the effective tax
rate derived from the PSAF model (see note 3).
(6) Imputed Costs
Imputed costs consist of interest on float, interest on debt, (9) Return on Equity
sales taxes, and the FDIC assessment. Interest on float is
derived from the value of float to be recovered, either The after-tax rate of return on equity that the Federal
explicitly or through per-item fees, during the period. Reserve would have earned had it been a private business
Float costs include costs for checks, book-entry securi- firm, as derived from the PSAF model (see note 3).
ties, noncash collection, ACH, and funds transfers.

The Board of Governors and the

Government Performance and Results Act
Under the Government Performance and of the performance measures identified
Results Act of 1993 (GPRA), federal in the strategic plan (except those asso-
agencies are required, in consultation ciated with the monetary policy func-
with the Congress and outside stake- tion). It also describes the operational
holders, to prepare a strategic plan cov- processes and resources needed to meet
ering a multiyear period and to submit those targets and discusses validation
annual performance plans and perfor- and verification of results.
mance reports. Although it is not cov- The strategic and performance plans
ered by the act, the Board of Governors are available on the Board’s public
has chosen to voluntarily comply with web site (
the act. boarddocs/rptcongress). The Board’s
mission statement and a summary of
the goals and objectives set forth in
Strategic and Performance Plans the strategic and performance plans are
The Board’s most recent strategic plan given below.
in the GPRA format, released in Decem-
ber 2001, covers the period 2001–05.
Like the earlier plan, which covered Mission
1997–2002, the most recent document The mission of the Board is to foster the
states the Board’s mission, articulates stability, integrity, and efficiency of the
major goals for the period, outlines strat- nation’s monetary, financial, and pay-
egies for achieving those goals, and dis- ment systems so as to promote optimal
cusses the environment and other fac- macroeconomic performance.
tors that could affect their achievement.
It also addresses issues that cut across
agency jurisdictional lines, identifies Goals and Objectives
key quantitative measures of perfor- The Federal Reserve has three primary
mance, and discusses the evaluation of goals with interrelated and mutually
performance. reinforcing elements:
The Board’s most recent performance
plan covers its 1998–99 budget.1 The
plan sets forth specific targets for some Goal
1. The Board’s budget covers two calendar To conduct monetary policy that pro-
years (making it slightly incongruent with the motes the achievement of maximum
act’s requirement that a performance plan be sub- sustainable long-term growth; price sta-
mitted for each fiscal year). Neither a performance bility fosters that goal.
plan for 2000–01 nor a performance report for
1998–99 was prepared, as staff attention was
diverted to matters associated with the century Objectives
date change and the Gramm–Leach–Bliley Act. A
performance plan for 2002–03 will be issued in • Stay abreast of recent developments
the second quarter of 2002. and prospects in the U.S. economy
192 88th Annual Report, 2001

and financial markets and in those relating to consumer financial trans-

abroad, so that monetary policy deci- actions (Truth in Lending, Truth in
sions will be well informed Savings, Consumer Leasing, and
• Enhance our knowledge of the struc- Electronic Funds Transfer) to carry
tural and behavioral relationships out congressional intent, striking the
in the macroeconomic and financial proper balance between protection of
markets and improve the quality of consumers and burden to the industry.
the data used to gauge economic
performance, through developmental
research activities Goal
• Implement monetary policy effec- To provide high-quality professional
tively in rapidly changing economic oversight of Reserve Bank operations
circumstances and in an evolving and to foster the integrity, efficiency,
financial market structure and accessibility of U.S. payment and
• Contribute to the development of U.S. settlement systems.
international policies and procedures,
in cooperation with the Department of Objectives
the Treasury and other agencies
• Promote understanding of Federal • Develop sound, effective policies and
Reserve policy among other govern- regulations that foster payment system
ment policy officials and the general integrity, efficiency, and accessibility
public. • Produce high-quality assessments of
Federal Reserve Bank operations,
projects, and initiatives that assist
Goal Federal Reserve management in fos-
tering and strengthening sound inter-
To promote a safe, sound, competitive, nal control systems and efficient and
and accessible banking system and effective performance
stable financial markets. • Conduct research and analysis that
contributes to policy development
Objectives and/or increases the Board’s and oth-
• Provide comprehensive and effective ers’ understanding of payment system
supervision of U.S. banks, bank and dynamics and risk.
financial holding companies, U.S.
operations of foreign banking organi-
Interagency Coordination
zations, and related entities
• Promote overall financial stability, Interagency coordination helps focus
manage and contain systemic risk, and efforts to eliminate redundancy and
ensure that emerging financial crises lower costs. As required by the Govern-
are identified early and successfully ment Performance and Results Act and
resolved in conformance with past practice, the
• Improve efficiency and effectiveness Board has worked closely with other
and reduce burden on supervised federal agencies to consider plans and
institutions strategies for programs, such as bank
• Promote equal access to banking supervision, that cross jurisdictional
services lines. In particular, coordination with the
• Administer and ensure compliance Department of the Treasury and other
with consumer protection statutes agencies is evident throughout both the
The Board of Governors and the Government Performance and Results Act 193

strategic and performance plans. Much the five agencies has been created to
of the Board’s formal effort to plan address and report on strategic planning
jointly has been made through the Fed- issues of mutual concern. This working
eral Financial Institutions Examination group has been meeting since June
Council (FFIEC), a group made up of 1997. These and similar planning efforts
the five federal agencies that regulate can significantly lower the govern-
depository institutions.2 In addition, a ment’s costs for data processing and
coordinating committee of representa- other activities as well as depository
tives of the chief financial officers of institutions’ costs for complying with
federal regulations.
2. The FFIEC consists of the Board of Gover-
nors of the Federal Reserve System, the Federal forms for the federal examination of financial
Deposit Insurance Corporation, the National institutions and to make recommendations to pro-
Credit Union Administration, the Office of the mote uniformity in the supervision of financial
Comptroller of the Currency, and the Office of institutions. The FFIEC also provides uniform
Thrift Supervision. It was established in 1979 pur- examiner training and has taken a lead in develop-
suant to title X of the Financial Institutions Regu- ing standardized software needed for major data
latory and Interest Rate Control Act of 1978. The collection programs to support the requirements of
FFIEC is a formal interagency body empowered to the Home Mortgage Disclosure Act and the Com-
prescribe uniform principles, standards, and report munity Reinvestment Act.

Federal Legislative Developments

One federal law was enacted during tions. The following discussion summa-
2001 that significantly affects the Fed- rizes title III and describes the portions
eral Reserve System and the institutions that bear significantly on the Federal
it supervises. In addition, legislation was Reserve System and the institutions it
proposed by the Board of Governors supervises.
that would, if enacted, facilitate check Title III requires a broad range of
truncation and enhance the efficiency financial institutions in the United States
of the nation’s payments system as a to establish anti-money-laundering pro-
whole. grams, including policies, procedures,
controls, and audit functions.1 Covered
financial institutions must establish con-
USA PATRIOT Act trols that are reasonably designed to
The Uniting and Strengthening Amer- detect instances of money laundering
ica by Providing Appropriate Tools through certain correspondent or priv-
Required to Intercept and Obstruct Ter- ate banking accounts. In addition, these
rorism Act of 2001 (USA PATRIOT institutions generally may not establish
Act), Public Law 107-56, enacted on or administer correspondent accounts
October 26, 2001, adds to and amends in the United States for, or on behalf of,
existing laws, including laws pertaining a foreign shell bank.
to financial institutions, to enhance Title III also directs the Secretary of
domestic security following the Septem- the Treasury (Secretary), in consultation
ber 11, 2001, attacks. Title III of the act with the Board of Governors and the
amends various federal banking laws Securities and Exchange Commission
and other laws related to financial insti- (SEC), to issue regulations that gener-
tutions or products, principally the Bank ally would require securities brokers and
Secrecy Act but also the Bank Holding dealers to submit suspicious activity
Company Act of 1956, the Fair Credit reports regarding suspected money-
Reporting Act, and the Right to Finan- laundering transactions. The Secretary
cial Privacy Act. In addition, the USA and the federal financial regulators must
PATRIOT Act amends the Federal also issue joint regulations for financial
Reserve Act to authorize certain System institutions regarding the verification
personnel to act as law enforcement offi- of customer identification upon account
cers and carry firearms to protect and opening.
safeguard System premises and staff. Under title III, the Secretary, in
Title III of the act directs certain consultation with certain other govern-
government agencies, principally the ment officials, including the Chairman
Department of the Treasury in consulta- of the Board of Governors, may impose
tion with the Board of Governors of the
Federal Reserve System, to take steps to
investigate and curtail money launder- 1. Financial institutions supervised by the
Board and other federal financial regulators are
ing and other activities that might be subject to existing regulations that direct the
undertaken to finance terrorist actions institutions to implement anti-money-laundering
or disrupt legitimate banking opera- programs.
196 88th Annual Report, 2001

special measures to address money- conducting certain actions at domestic

laundering problems associated with financial institutions.
specific foreign jurisdictions, foreign
financial institutions, and transactions
involving such jurisdictions or institu-
Proposed Check Truncation Act
tions. Title III also amends the Bank In December, the Board proposed that
Holding Company Act and the Bank Congress adopt legislation to facilitate
Merger Act to reflect the Board’s prac- check truncation.2 The proposed legisla-
tice of considering the effectiveness of tion, titled the Check Truncation Act, is
an institution’s anti-money-laundering designed to foster payment system inno-
activities when evaluating certain appli- vation and enhance payment system effi-
cations under these acts. ciency by reducing some of the legal
Title III directs the Secretary, in con- impediments to check truncation that
sultation with certain agencies and par- exist under current law. If enacted, the
ties, including the Chairman, to evaluate proposed legislation would enable banks
certain provisions of the USA PATRIOT to expand the use of electronics in the
Act and to report to the Congress on the collection and return of checks, reduc-
findings. The report must include rec- ing the industry’s reliance on transpor-
ommendations for any additional legis- tation to move checks across the nation.
lative action. Moreover, the Secretary, Details are available on the Board’s web
the SEC, and the Board must submit site at
joint recommendations to the Congress paymentsys.htm.
on regulations that would apply certain
provisions of the Bank Secrecy Act to
registered and unregistered investment 2. Check truncation refers to any of a number
of arrangements in which the original paper checks
companies and on whether personal are removed from the collection or return process
holding companies should be required before reaching either paying or depositary banks,
to disclose their beneficial owners when respectively, or reaching their customers.

Record of Policy Actions

of the Board of Governors

Regulation B sumer financial services transactions.

Equal Credit Opportunity Under the Electronic Signatures in
Global and National Commerce Act
Regulation E (E–Sign Act), electronic documents and
Electronic Fund Transfers signatures have the same validity as
paper documents and handwritten signa-
Regulation M tures. In this light, the Board approved
Consumer Leasing interim amendments to Regulations B,
E, M, Z, and DD to accommodate elec-
Regulation Z tronic disclosures if the consumer has
Truth in Lending affirmatively consented in accordance
Regulation DD with the E–Sign Act. The amendments
Truth in Savings also provide guidance on complying
with the regulations’ timing and deliv-
March 19, 2001—Interim Rules ery requirements when electronic disclo-
sures are used, to ensure that consumers
The Board approved interim rules to have an adequate opportunity to access
provide uniform standards for the elec- and retain the information. In addition,
tronic delivery of disclosures required the Board requested public comment on
under Regulations B, E, M, Z, and DD, the interim rules.
effective March 30, 2001, with manda-
tory compliance by a date to be desig-
nated in the final rules.1 Regulation D
Reserve Requirements of
Votes for this action: Messrs. Greenspan, Depository Institutions
Ferguson, Kelley, Meyer, and Gramlich.
October 9, 2001—Amendments
Several federal statutes and the imple-
menting regulations administered by the The Board amended Regulation D to
Board require that written disclosures be decrease the amount of net transaction
provided in connection with certain con- accounts at depository institutions to
which a lower reserve requirement
applies (low reserve tranche) and to
Note. In voting records throughout this chap- increase the amount of reservable liabili-
ter, Board members, except Chairman Greenspan ties exempt from reserve requirements
and Vice Chairman Ferguson, are listed in order of (reserve exemption level) for 2002,
seniority. effective for the reserve computation
1. The interim rules originally required manda-
tory compliance by October 1, 2001. Because it is
period beginning November 27, 2001,
considering adjustments to the rules to provide for institutions reporting weekly.
additional flexibility, on August 1, 2001, the Board
lifted the mandatory compliance date for the Votes for this action: Messrs. Greenspan,
interim rules. Ferguson, Kelley, Meyer, and Gramlich.
200 88th Annual Report, 2001

Under the Monetary Control Act of must report weekly.2 To reflect increases
1980, depository institutions, Edge cor- in the rate of growth of total deposits at
porations, agreement corporations, and all depository institutions, the Board
U.S. agencies and branches of foreign increased the deposit cutoff levels used
banks are subject to reserve require- in determining the frequency and detail
ments set by the Board. The act directs of reporting from $101 million to
the Board to adjust annually the amount $106.9 million for nonexempt deposi-
of the low reserve tranche to reflect tory institutions, beginning in Septem-
changes in net transaction accounts at ber 2002.
depository institutions. Recent declines Exempt institutions (those with total
in net transaction accounts warranted a reservable liabilities not exceeding the
decrease in the low reserve tranche reserve exemption level of $5.7 mil-
from $42.8 million to $41.3 million, lion) that have at least $5.7 million in
and the Board amended Regulation D total deposits may report annually, and
accordingly. exempt institutions that have less than
The Garn–St Germain Depository $5.7 million in total deposits are not
Institutions Act of 1982 establishes a required to file deposit reports.
zero percent reserve requirement on the
first $2 million of an institution’s reserv-
able liabilities. The act also provides for
Regulation E
annual adjustments to that exemption
Electronic Fund Transfers
amount based on increases in reservable February 27, 2001—Amendments
liabilities at depository institutions.
Recent growth in reservable liabilities The Board amended Regulation E to
warranted an increase in the amount require disclosure of certain fees asso-
exempted from reserve requirements ciated with automated teller machine
from $5.5 million to $5.7 million, (ATM) transactions, effective March 9,
and the Board amended Regulation D 2001, with mandatory compliance by
accordingly. October 1, 2001.
For institutions reporting weekly, the
amendments are effective with the Votes for this action: Messrs. Greenspan,
Ferguson, Meyer, and Gramlich. Absent
reserve computation period beginning and not voting: Mr. Kelley.
November 27, 2001, and the corre-
sponding reserve maintenance period The Electronic Fund Transfer Act,
beginning December 27, 2001. For insti- which is implemented by Regulation E,
tutions reporting quarterly, the amend- was amended by the Gramm–Leach–
ments are effective with the reserve
computation period beginning Decem-
ber 18, 2001, and the corresponding 2. All U.S. branches and agencies of foreign
reserve maintenance period beginning banks and Edge and agreement corporations are
required to submit the Report of Transaction
January 17, 2002. Accounts, Other Deposits, and Vault Cash
To reduce the reporting burden on (FR 2900) weekly regardless of size. In addition,
small institutions, depository institutions depository institutions that obtain funds from non-
having total deposits below specified U.S. sources or that have foreign branches or inter-
national banking facilities continue to be required
levels are required to report their depos- to file the Report of Certain Eurocurrency Trans-
its and reservable liabilities quarterly or actions (FR 2950/FR 2951) at the same frequency
less frequently, while larger institutions as they file the FR 2900 report.
Board Policy Actions 201

Bliley Act to add certain requirements is among the 100 largest insured banks
for ATM transactions. The amendments may control or hold an interest in a
to Regulation E implement these provi- financial subsidiary if the bank has at
sions by requiring ATM operators that least one issue of outstanding eligible
impose a fee to post a notice to that debt that is rated in one of the three
effect on or at the ATM and to disclose highest rating categories by a nationally
the amount of the fee either on the recognized statistical rating organiza-
screen or on a paper notice before the tion. Banks among the second 50 largest
customer is committed to completing insured banks may also qualify under an
the transaction. Financial institutions are alternative standard that the Board and
also required to include in their initial the Secretary of the Treasury determine
disclosures to a customer contracting for by regulation to be comparable and con-
electronic fund transfer services a notice sistent with the debt-rating requirement.
that a fee may be imposed by an ATM The final rule, which for state mem-
operator not holding the customer’s ber banks is incorporated in Regula-
account or by any national, regional, tion H, provides that a bank qualifies
or local network used to complete the under the alternative standard if it has a
transaction. current long-term issuer credit rating
from a nationally recognized statistical
Regulation H rating organization that is within the
Membership of organization’s three highest investment-
State Banking Institutions grade rating categories. A long-term
in the Federal Reserve System credit rating is defined as a written
opinion that assesses the bank’s over-
January 17, 2001—Amendments all capacity and willingness to pay in a
timely manner its unsecured, dollar-
The Board approved a final rule that denominated financial obligations that
provides an alternative to the debt-rating mature in not less than one year.
requirement for certain large state mem-
ber banks that propose to own a finan-
cial subsidiary, effective March 5, 2001. March 7, 2001—Delay of
Votes for this action: Messrs. Greenspan,
Effective Date
Ferguson, Kelley, and Gramlich. Absent The Board extended, from April 1 to
and not voting: Mr. Meyer. October 1, 2001, the effective date for a
new rule that provides consumer protec-
The Board and the Department of tions in connection with insurance sales
the Treasury jointly approved a final by state member banks.
rule that establishes an alternative to
the debt-rating requirement that certain Votes for this action: Messrs. Greenspan,
large banks may meet when they seek Ferguson, Kelley, Meyer, and Gramlich.
to acquire a financial subsidiary and
thereby engage in expanded financial The Board, jointly with the Federal
activities. The final rule is substantially Deposit Insurance Corporation, the
similar to the interim rule adopted in Office of the Comptroller of the Cur-
March 2000. rency, and the Office of Thrift Super-
Under the Gramm–Leach–Bliley Act, vision, approved a six-month extension
a national or state member bank that of the effective date of a new inter-
202 88th Annual Report, 2001

agency final rule on the sale of insur- qualifying criteria for a state member
ance by depository institutions that had bank to own a financial subsidiary; and
been published on December 4, 2000. describes the procedures and restrictions
The new joint rule implements the con- that would apply if a state member bank
sumer protection provisions of the or an affiliate ceased to meet these cri-
Gramm–Leach–Bliley Act applicable to teria. It also provides guidance on how
the retail sale, solicitation, advertising, the act’s capital deduction and CRA
or offer of an insurance product or annu- requirements apply to a state member
ity by a depository institution or by a bank having a financial subsidiary.
person engaged in such activities at an
office of or on behalf of a depository
institution. The agencies provided the Regulation H
extension to give institutions sufficient Membership of
time to ensure implementation of the State Banking Institutions
new protections. in the Federal Reserve System
Regulation Y
August 8, 2001—Amendments Bank Holding Companies and
The Board approved a final rule amend- Change in Bank Control
ing Regulation H to permit qualify- October 15, 2001—Amendments
ing state member banks to engage in
expanded financial activities through The Board approved amendments to
financial subsidiaries, effective Septem- Regulations H and Y to revise the reg-
ber 17, 2001. ulatory capital treatment of securitiza-
tion transactions by state member banks
Votes for this action: Messrs. Greenspan, and bank holding companies, including
Ferguson, Kelley, Meyer, and Gramlich. financial holding companies, effective
January 1, 2002.
The Board approved a final rule
implementing the provisions of the Votes for this action: Messrs. Greenspan,
Gramm–Leach–Bliley Act that autho- Ferguson, Kelley, Meyer, and Gramlich.
rize qualifying state member banks to
control or hold an interest in a financial The Board, jointly with the Federal
subsidiary, which may engage in certain Deposit Insurance Corporation, the
activities that are financial in nature, Office of the Comptroller of the Cur-
or incidental thereto, but that the parent rency, and the Office of Thrift Super-
bank may not conduct directly. The vision, amended the regulatory capital
final rule is substantially similar to the standards to address the treatment of
interim rule approved by the Board in recourse obligations, residual interests,
March 2000 and to the rule adopted by and direct credit substitutes related to
the Office of the Comptroller of the securitization transactions that expose
Currency for financial subsidiaries of banking and thrift institutions to credit
national banks. risk. The amended standards better
The final rule provides a streamlined reflect the institutions’ relative exposure
prior-notice procedure for acquiring an to credit risks and provide a more con-
interest in a financial subsidiary; incor- sistent regulatory capital treatment for
porates the capital, managerial, Commu- certain transactions that involve simi-
nity Reinvestment Act (CRA), and other lar risk. They also increase consistency
Board Policy Actions 203

among the supervisory agencies in the tion 4(c)(6) or 4(c)(7) of the Bank Hold-
area of regulatory capital requirements. ing Company Act, the portfolio invest-
For transactions entered into before the ment authority under Regulation K
effective date, institutions may either (International Banking Operations), the
adopt any portion of the final rule that authority to make investments in small
would reduce their capital requirements business investment companies (SBICs)
or defer adoption until December 31, under the Small Business Investment
2002, if complying with the rule would Act, and the authority to make invest-
increase their capital requirements. ments under section 24 of the Federal
Deposit Insurance Act (other than
December 10, 2001—Amendments section 24(f)). The rule exempts from
the new capital charges any individual
The Board amended the capital guide- investment made by a bank or bank
lines in Regulations H and Y to estab- holding company before March 13,
lish minimum capital requirements for 2000. In addition, the new charges do
equity investments in nonfinancial com- not apply to investments made in or
panies by state member banks and bank through SBICs to the extent that such
holding companies, including financial investments, in the aggregate, represent
holding companies, effective April 1, 15 percent or less of the banking organi-
2002. zation’s tier 1 capital.
Votes for this action: Messrs. Greenspan,
Ferguson, Meyer, and Gramlich, Ms. Bies, Regulation K
and Mr. Olson. Absent and not voting: International Banking Operations
Mr. Kelley.
Rules Regarding
The Board, jointly with the Federal Delegation of Authority
Deposit Insurance Corporation and the
Office of the Comptroller of the Cur- October 10, 2001—Amendments
rency, adopted special minimum capi-
tal requirements for equity investments The Board approved amendments to
in nonfinancial companies by banks Regulation K to eliminate unnecessary
and bank holding companies, including regulatory burden, increase transpar-
financial holding companies. The final ency, and streamline the approval pro-
rule imposes a series of marginal capital cess fo