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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 Fulfillment, Mail Stop 127, Washington, DC 20551. It is also available on the
Board’s web site, at
Letter of Transmittal

Board of Governors of the

Federal Reserve System
Washington, D.C., April 2003

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-ninth annual report of the Board of Governors

of the Federal Reserve System.

This report covers operations of the Board during calendar year 2002.


Monetary Policy and Economic Developments

4 Monetary Policy, Financial Markets, and the Economy over 2002 and Early 2003

8 Economic Projections for 2003


12 The Household Sector

14 The Business Sector

20 The Government Sector

21 The External Sector

23 The Labor Market

25 Prices

27 U.S. Financial Markets

34 International Developments


41 Monetary Policy and the Economic Outlook

45 Economic and Financial Developments in 2002

Federal Reserve Operations

69 Supervision for Compliance with Consumer Protection and
Community Reinvestment Laws
79 Implementation of Statutes Designed to Inform and Protect Consumers

82 Consumer Complaints

84 Advice from the Consumer Advisory Council

86 Promotion of Community Development in Historically Underserved Markets


94 Scope of Responsibilities for Supervision and Regulation

95 Supervision for Safety and Soundness

105 Supervisory Policy

114 Supervisory Information Technology

115 Staff Development

115 Regulation of the U.S. Banking Structure

121 Enforcement of Other Laws and Regulations

123 Federal Reserve Membership


125 Major Initiatives

126 Developments in Federal Reserve Priced Services

131 Developments in Currency and Coin

131 Developments in Fiscal Agency and Government Depository Services

134 Electronic Access

134 Information Technology

134 Examinations of the Federal Reserve Banks

135 Income and Expenses

136 Holdings of Securities and Loans

136 Volume of Operations

136 Federal Reserve Bank Premises

138 Pro Forma Financial Statements for Federal Reserve Priced Services


143 Strategic and Performance Plans and Performance Report
143 Mission
143 Goals and Objectives
144 Interagency Coordination


151 Regulation A (Extensions of Credit by Federal Reserve Banks) and
Regulation D (Reserve Requirements of Depository Institutions)
151 Regulation C (Home Mortgage Disclosure)
153 Regulation D
154 Regulation H (Membership of State Banking Institutions
in the Federal Reserve System)
154 Regulation H and Regulation Y (Bank Holding Companies
and Change in Bank Control)
155 Regulation K (International Banking Operations)
155 Regulation W (Transactions between Member Banks and Their Affiliates)
156 Policy Statements and Other Actions
157 Discount Rates in 2002
161 Authorization for Domestic Open Market Operations
163 Guidelines for the Conduct of System Open Market Operations
in Federal Agency Issues
163 Domestic Policy Directive

163 Authorization for Foreign Currency Operations

165 Foreign Currency Directive

165 Procedural Instructions with Respect to Foreign Currency Operations

166 Meeting Held on January 29–30, 2002

180 Meeting Held on March 19, 2002

189 Meeting Held on May 7, 2002

197 Meeting Held on June 25–26, 2002

205 Meeting Held on August 13, 2002

213 Meeting Held on September 24, 2002

220 Meeting Held on November 6, 2002

229 Meeting Held on December 10, 2002


237 Litigation under the Gramm–Leach–Bliley Act

237 Other Actions

Federal Reserve System Organization




245 Federal Advisory Council

246 Consumer Advisory Council

247 Thrift Institutions Advisory Council


248 Officers of the Banks and Branches

249 Conference of Chairmen

249 Conference of Presidents

250 Conference of First Vice Presidents

250 Directors of the Banks and Branches


Statistical Tables
272 1.€ Statement of Condition of the Federal Reserve Banks, by Bank,
December 31, 2002 and 2001
276 2. Federal Reserve Open Market Transactions, 2002
280 3.€ Federal Reserve Bank Holdings of U.S. Treasury and Federal Agency Securities,
December 31, 2000–02
281 4.€ Number and Annual Salaries of Officers and Employees of the Federal Reserve
Banks, December 31, 2002
282 5. Income and Expenses of the Federal Reserve Banks, by Bank, 2002
286 6. Income and Expenses of the Federal Reserve Banks, 1914–2002
290 7.€ Acquisition Costs and Net Book Value of Premises of the Federal Reserve
Banks and Branches, December 31, 2002
291 8. Operations in Principal Departments of the Federal Reserve Banks, 1999–2002
292 9.€ Federal Reserve Bank Interest Rates on Loans to Depository Institutions,
December 31, 2002
293 10. Reserve Requirements of Depository Institutions, December 31, 2002
294 11. Initial Margin Requirements under Regulations T, U, and X
295 12.€ Principal Assets and Liabilities and Number of Insured Commercial Banks
in the United States, by Class of Bank, June 30, 2002 and 2001
296 13.€ Reserves of Depository Institutions, Federal Reserve Bank Credit,
and Related Items, Year-End 1918–2002 and Month-End 2002
302 14.€ Banking Offices and Banks Affiliated with Bank Holding Companies
in the United States, December 31, 2001 and 2002

Federal Reserve System Audits



Monetary Policy and
Economic Developments

Monetary Policy and the Economic Outlook€

The economy of the United States has housing remained solid and was sup-
suffered a series of blows in the past few ported by another installment of tax
years, including the fall in equity market reductions, widespread price discount­
values that began in 2000, cutbacks in ing, and low mortgage interest rates.
capital spending in 2001, the horrific By midyear, the cutbacks in employ­
terrorist attacks of September 11, the ment came to an end, and private pay-
emergence of disturbing evidence of rolls started to edge higher.
corporate malfeasance, and an esca­ Although economic performance
lation of geopolitical risks. Despite appeared to be gradually improving, the
these adversities, the nation’s economy tentative nature of this improvement
emerged from its downturn in 2001 to warranted the continuation of a highly
post moderate economic growth last accommodative stance of monetary pol-
year. The recovery was supported by icy. Accordingly, the Federal Open Mar­
accommodative monetary and fiscal ket Committee (FOMC) held the federal
policies and undergirded by unusually funds rate at 13⁄4 percent through the
rapid productivity growth that boosted first part of the year. In March, however,
household incomes and held down busi­ the FOMC shifted from an assessment
ness costs. The productivity perfor­ that the risks over the foreseeable future
mance was also associated with a rapid to its goals of maximum sustainable
expansion of the economy’s potential, growth and price stability were tilted
and economic slack increased over the toward economic weakness to an assess­
year despite the growth in aggregate ment that the risks were balanced.
demand. Around midyear, the economy began
After turning up in late 2001, activity to struggle again. Concerns about cor­
began to strengthen more noticeably porate governance came to weigh
early last year. Sharp inventory cutbacks heavily on investors’ confidence, and
in 2001 had brought stocks into better geopolitical tensions, especially the
alignment with gradually rising final situation in Iraq, elevated uncertainties
sales, and firms began to increase pro­ about the future economic climate.
duction in the first quarter of 2002 to Equity prices fell during the summer,
curtail further inventory runoffs. More- liquidity eroded in corporate debt mar­
over, businesses slowed their contrac­ kets, and risk spreads widened. Busi­
tion of investment spending and began nesses once again became hesitant to
to increase outlays for some types of spend and to hire, and both manufac­
capital equipment. Household spending turing output and private payrolls began
on both personal consumption items and to decline. State and local governments
struggled to cope with deteriorating
Note. The discussion here and in the next fiscal positions, and the economies
section (‘‘Economic and Financial Developments of some of our major trading partners
in 2002 and Early 2003’’) consists of the text, remained weak. Although the already
tables, and selected charts from the Monetary Pol-
icy Report submitted to the Congress on Febru­
accommodative stance of monetary pol-
ary 11, 2003, pursuant to section 2B of the Federal icy and strong upward trend of produc­
Reserve Act. tivity were providing important support
4 89th Annual Report, 2002

to spending, the Committee perceived a Business caution is anticipated to give

risk that the near-term weakening could way over the course of the year to
become entrenched. In August, the clearer signs of improving sales. Inven­
FOMC adjusted its weighting of risks tories are lean relative to sales at
toward economic weakness, and in present, and restocking is likely to pro-
November, it reduced the targeted vide an additional impetus to production
federal funds rate 50 basis points, to in the period ahead. The rapid expansion
11⁄4 percent. The policy easing allowed of productivity, the waning effects of
the Committee to return to an assess­ earlier declines in household wealth, and
ment that the risks to its goals were the highly accommodative stance of
balanced. With inflation expectations monetary policy should also continue to
well contained, this additional monetary boost activity. Although state and local
stimulus seemed to offer worthwhile governments face budgetary problems,
insurance against the threat of persistent their restraint is likely to offset only a
economic weakness and substantial part of the stimulus from past and pro­
declines in inflation from already low spective fiscal policy actions at the fed­
levels. eral level. In addition, the strengthening
On net, the economy remained slug­ economies of our major trading partners
gish at the end of 2002 and early this along with the improving competitive­
year. The household sector continued ness of U.S. products ought to support
to be a solid source of demand. Motor demand for our exports. Taken together,
vehicle sales surged at year-end on the these factors are expected to lead to
tide of another round of aggressive dis­ a faster pace of economic expansion,
counting by the manufacturers, other while inflation pressures are anticipated
consumer outlays trended higher, and to remain well contained.
activity in housing markets remained
exceptionally strong. Concerns about
corporate governance appeared to
Monetary Policy, Financial
recede somewhat late last year, in part
Markets, and the Economy
because no new revelations of major
over 2002 and Early 2003
wrongdoing had emerged. However, the As economic growth picked up during
ongoing situation in Iraq, civil strife in the early months of 2002, the FOMC
Venezuela that has curtailed oil produc­ maintained its target for the federal
tion, and tensions on the Korean penin­ funds rate at 13⁄4 percent. A sharply
sula have sustained investors’ uncer­ reduced pace of inventory liquidation
tainty about economic prospects and accounted for a significant portion of
have pushed prices higher on world oil the step-up in real GDP growth, but
markets. Faced with this uncertainty, other indicators also suggested that
businesses have been cautious in spend­ the economy was gaining momentum.
ing and changed payrolls little, on net, Reductions in business outlays on equip­
over December and January. ment and software had moderated sig­
Mindful of the especially high degree nificantly after dropping precipitously
of uncertainty attending the economic in 2001, and consumer spending was
outlook in the current geopolitical well maintained by sizable gains in real
environment, the members of the disposable personal income. Residential
FOMC believe the most likely outcome construction activity was spurred by
to be that fundamentals will support low home mortgage interest rates. The
a strengthening of economic growth. improvement in economic conditions
Monetary Policy and the Economic Outlook 5

Selected Interest Rates


Ten-year Treasury 6

Two-year Treasury
Discount rate
(primary credit) 3

Intended federal funds rate 2

Discount rate 1
(adjustment credit)

1/3 1/31 3/20 4/18 5/15 6/27 8/21 9/17 10/2 11/6 12/11 1/30 3/19 5/7 6/26 8/13 9/24 11/6 12/10 1/29
2001 2002 2003
NOTE. The data are daily and extend through Federal Reserve changed the main credit program
February 5, 2003. The dates on the horizontal axis are offered at the discount window by terminating the
those of scheduled FOMC meetings and of any adjustment credit program and beginning the primary
intermeeting policy actions. On January 9, 2003, the credit program.

sparked a rally in equity markets late in Although the decline in investment

the first quarter and pushed up yields spending during the first quarter of
on longer-term Treasury instruments 2002 was the smallest in a year,
and investment-grade corporate bonds; gloomy business sentiment and large
yields on speculative-grade bonds margins of excess capacity in numer­
declined in reaction to brighter eco­ ous industries were likely to hamper
nomic prospects and the perceived capital expenditures. According to
reduction in credit risk. Meanwhile, anecdotal reports, many firms were
surging energy prices exerted upward unwilling to expand capacity until they
pressure on overall inflation, but still- saw more conclusive evidence of grow­
appreciable slack in resource utilization ing sales and profits. At the same time,
and a strong upward trend in private- however, the FOMC noted that, with
sector productivity were holding down the federal funds rate unusually low
core price inflation. on an inflation-adjusted basis and
At both its March and May meetings, considerable fiscal stimulus in train,
the FOMC noted that the apparent vigor macroeconomic policies would pro-
of the economy was importantly attrib­ vide strong support to further economic
utable to a slowdown in the pace of expansion. Against this backdrop, the
inventory liquidation and that con­ Committee at the March 19 meeting
siderable uncertainty surrounded the judged the accommodative stance of
outlook for final sales over the next monetary policy to be appropriate and
several quarters. The Committee was announced that it considered the risks
especially concerned about prospects to achieving its long-run objectives
for a rebound in business fixed invest­ as being balanced over the foreseeable
ment, which it viewed as key to ensur­ future, judgments it retained at its meet­
ing sustainable economic expansion. ing in early May.
6 89th Annual Report, 2002

The information reviewed at the earlier momentum. Turbulence in finan­

June 25–26 FOMC meeting confirmed cial markets appeared to be holding back
that the economy was expanding but at the pace of the economic expansion.
a slower pace than earlier in the year. Market participants focused their atten­
As expected, the degree of impetus tion on the lack of convincing evidence
to economic activity from decelerating that the recovery was gaining traction
inventory liquidation had moderated. and the possibility that more news of
Residential investment and consumer corporate misdeeds would surface in the
spending also had slowed appreciably run-up to the Securities and Exchange
after surging earlier in the year. The Commission’s August 14 deadline for
most recent data on orders and ship­ the certification of financial statements
ments suggested a small upturn in by corporate executives. Although the
business spending on equipment and cumulative losses in financial wealth
software, but the improvement in capi­ since 2000 were restraining expendi­
tal spending appeared to be limited, tures by households, very low mortgage
unevenly distributed across industries, interest rates were helping to sustain
and not yet firmly indicative of sus­ robust demand for housing. Moreover,
tained advance. Industrial production the financial resources made available
continued to increase, and the unem­ by a rapid pace of mortgage refinancing
ployment rate declined somewhat. activity, in combination with attractive
In financial markets, investors and incentives offered by auto manufactur­
lenders had apparently become more ers, supported other consumer spending.
risk averse in reaction to the mixed The Committee continued to judge the
tone of economic data releases, grow­ prevailing degree of monetary accom­
ing geopolitical tensions, further warn­ modation as appropriate to foster a solid
ings about terrorist attacks, and addi­ expansion that would bring the econ­
tional revelations of dubious corporate omy to fuller resource utilization. At the
accounting practices. In concert, these same time, the Committee recognized
developments pushed down yields on the considerable risks to that outlook
longer-term Treasury securities, while and the potential adverse consequences
interest rates on lower-quality corporate for economic prospects from possible
bonds rose notably, and equity prices additional deterioration of financial con­
dropped sharply. Although the economy ditions. The members noted, however,
continued to expand and the prospects that a further easing of monetary policy,
for accelerating aggregate demand if it came to be viewed as appropriate,
remained favorable, downbeat business could be accomplished in a timely man­
sentiment and skittish financial markets ner. In light of these considerations, the
rendered the timing and extent of the FOMC opted to retain a target rate of
expected strengthening of the expansion 13⁄4 percent for the federal funds rate,
subject to considerable uncertainty. In but it viewed the risks to the economy as
these circumstances, the FOMC left the having shifted from balanced to being
federal funds rate unchanged to keep tilted toward economic weakness.
monetary policy very accommodative When the FOMC met on Septem­
and once again assessed the risks to the ber 24, data indicated that economic
outlook as being balanced. growth had picked up in the third quar­
By the time of the August 13 FOMC ter, on average, buoyed in part by a
meeting, it had become apparent that surge in motor vehicle production. The
economic activity had lost some of its uneventful passing of the mid-August
Monetary Policy and the Economic Outlook 7

deadline for recertification of corporate major trading partners spelled difficul­

financial statements briefly alleviated ties for U.S. exports, and a rebound in
investors’ skittishness in debt and equity foreign output seemed more likely to
markets. However, the most timely follow than to lead a rebound at home.
information suggested that some soften­ Moreover, economic slack that was
ing in economic activity had occurred larger and more persistent than previ­
late in the summer. Those economic ously anticipated ran the risk of reduc­
reports, along with a darker outlook for ing core inflation appreciably further
corporate profits and escalating fears of from already low levels. Given these
a possible war against Iraq, led market considerations, the Committee lowered
participants to revise down their expec­ its target for the federal funds rate
tations for the economy. Equity prices 1⁄2 percentage point, to 11⁄4 percent. The

and yields on both longer-term Treasury relatively aggressive adjustment in the

and private securities moved sharply stance of monetary policy was deemed
lower in early autumn. In the Commit- to offset the potential for greater eco­
tee’s view, heightened geopolitical ten­ nomic weakness, and the Committee
sions constituted a significant additional accordingly announced that it judged
source of uncertainty clouding the eco­ risks to the outlook as balanced with
nomic outlook. Still, fundamentals sug­ respect to its long-run goals of price
gested reasonable prospects for contin­ stability and sustainable economic
ued expansion. Accordingly, the FOMC growth.
left the federal funds rate unchanged at When the FOMC met on Decem­
the close of the September meeting but ber 10, overall conditions in financial
also reiterated its view that the risks to markets had calmed considerably. Indi­
the outlook were weighted toward eco­ cators of production and spending, how-
nomic weakness. ever, remained mixed. The manufactur­
The information reviewed at the ing sector registered large job losses in
November 6 meeting indicated a more the autumn, and industrial production
persistent spell of below-par economic continued its slide, which had begun
performance than the FOMC had antici­ around midyear. A more vigorous
pated earlier. With home mortgage rates rebound in business fixed investment
at very low levels, residential con­ was not evident, and indeed the recent
struction activity remained high. But data on orders and shipments and anec­
consumer spending had decelerated dotal reports from business contacts
noticeably since midsummer under the generally signaled continued softness in
combined weight of stagnant employ­ capital spending. Very low home mort­
ment and declining household wealth gage interest rates were supporting resi­
resulting from further decreases in dential construction activity, but con­
equity prices. Worries about the poten­ sumption expenditures were sluggish.
tial for war against Iraq, as well as On balance, the Committee’s view was
persistent concerns about the course of that in the absence of major shocks
economic activity and corporate earn­ to consumer and business confidence,
ings, were apparently engendering a a gradual strengthening of the economic
high degree of risk aversion among busi­ expansion was likely over the com­
ness executives that was constraining ing quarters, especially given the very
capital spending and hiring. Despite a accommodative stance of monetary pol-
weakening in the exchange value of the icy and probable further fiscal stimulus.
dollar, sluggish economic growth among The FOMC left the federal funds rate
8 89th Annual Report, 2002

unchanged and indicated that it contin­ 31⁄2 percent, measured as the change
ued to view the risks to the outlook as between the final quarter of 2002 and
balanced over the foreseeable future. the final quarter of this year. The full
By the time of the FOMC meeting on range of these forecasts is 3 percent to
January 28–29, 2003, it had become 33⁄4 percent. Of course, neither the cen­
apparent that the economy had grown tral tendency nor the range is intended
only slowly in the fourth quarter of last to convey the uncertainties surrounding
year, but little evidence of cumulating the individual forecasts of the members.
weakness appeared in the most recent The civilian unemployment rate is
data, and final demand had held up rea­ expected to end the year in the 53⁄4 per-
sonably well. The escalation of global cent to 6 percent range.
tensions weighed heavily on business Apart from the geopolitical and other
and investor sentiment. Firms appar­ uncertainties, the forces affecting
ently were remaining very cautious in demand this year appear, on balance,
their hiring and capital spending, and conducive to a strengthening of the
equity prices had declined on balance economic expansion. Monetary policy
since the December meeting. But yield remains highly accommodative, and
spreads on corporate debt—especially federal fiscal policy is and likely will
for riskier credits—narrowed further, be stimulative. However, spending by
and longer-term Treasury yields many state and local governments will
declined slightly. Although the funda­ continue to be restrained by consider-
mentals still pointed to favorable pros­ able budget difficulties. Activity abroad
pects for economic growth beyond the is expected to improve this year, even if
near term, geopolitical developments at a less robust pace than in the United
were making it especially difficult to States; such growth together with the
gauge the underlying strength of the improving competitiveness of U.S. prod­
economy, and uncertainties about the ucts should generate stronger demand
economic outlook remained substantial. for our exports. Furthermore, robust
Against this background, the Committee gains in productivity, though unlikely to
decided to leave the federal funds rate be as large as in 2002, ought to continue
unchanged and stated that it continued to promote both household and business
to judge the risks to the outlook as spending. Household purchasing power
balanced. should be supported as well by a retreat
in the price of imported energy products
that is suggested by the oil futures mar­
Economic Projections for 2003 ket. And the adverse effects on house-
An unusual degree of uncertainty hold spending from past declines in
attends the economic outlook at present, equity wealth probably will begin to
in large measure, but not exclusively, wane.
because of potential geopolitical devel­ A reduction of businesses’ hesitancy
opments. But Federal Reserve policy- to expand investment and hiring is
makers believe the most probable out- critical to the durability of the expan­
come for this year to be a pickup in the sion, and such a reduction should occur
pace of economic expansion. The cen­ gradually if geopolitical risks ease and
tral tendency of the real GDP forecasts profitability improves. Inventories are
made by the members of the Board relatively lean, and some restocking
of Governors and the Federal Reserve ought to help boost production this year,
Bank presidents is 31⁄4 percent to albeit to a much smaller extent than did
Monetary Policy and the Economic Outlook 9

Economic Projections for 2003


Federal Reserve Governors

and Reserve Bank presidents
Indicator 2002 actual
Range tendency

Change, fourth quarter to fourth quarter 1

Nominal GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.1 41⁄2–51⁄2 43⁄4–5
Real GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.8 3–33⁄4 31⁄4–31⁄2
PCE chain-type price index . . . . . . . . . . . . . . . . . . 1.9 11⁄4–13⁄4 11⁄4–11⁄2
Average level, fourth quarter
Civilian unemployment rate . . . . . . . . . . . . . . . . . 5.9 53⁄4–6 53⁄4–6

1. Change from average for fourth quarter of previous

year to average for fourth quarter of year indicated.

last year’s cessation of sharp inventory Federal Reserve policymakers believe

liquidations. In addition, the continued that consumer prices will increase less
growth of final sales, the tax law provi­ this year than in 2002, especially if
sion for partial expensing of equipment energy prices partly reverse last year’s
purchases, replacement demand, and a sharp rise. In addition, resource utiliza­
more hospitable financial environment tion likely will remain sufficiently slack
should induce many firms to increase to exert further downward pressure
their capital spending. The growth of on underlying inflation. The central ten­
investment likely will be tempered, dency of FOMC members’ projections
however, by the persistence of excess for increases in the chain-type price
capital in some areas, notably the tele­ index for personal consumption expen­
communications sector, and reductions ditures (PCE) is 11⁄4 percent to 11⁄2 per-
in business spending on many types of cent this year, lower than the actual
new structures may continue this year. increase of about 2 percent in 2002.

Economic and Financial Developments€

in 2002 and Early 2003
In 2002, the United States economy cial markets and geopolitical devel­
extended the upturn in activity that opments boosted oil prices and added
began in late 2001. Real GDP increased to the uncertainty already faced by
23⁄4 percent over the four quarters of last businesses about the economic outlook.
year, according to the advance estimate In the summer, equity prices fell, risk
from the Commerce Department. How- spreads widened, and liquidity eroded in
ever, the pace of activity was uneven corporate debt markets. Businesses’ cau­
over the course of the year, as concerns tion was reflected in their reluctance to
about emerging economic and political substantially boost investment, restock
developments at times weighed heav­ inventories, or add to payrolls. Respond­
ily on an economy already adjusting to ing to these developments, as well
a succession of shocks from previous as some weakening in demand from
years. abroad, manufacturers trimmed produc­
Economic conditions improved tion during the fall. Employment at pri­
through the first part of the year. House- vate businesses declined again, and the
hold spending on both personal con­ unemployment rate rose to 6 percent in
sumption items and housing remained December. However, despite the modest
solid, businesses curtailed their inven­ pace of last year’s overall recovery,
tory liquidation and began to increase output per hour in the nonfarm busi­
their outlays for some types of capi­ ness sector grew 33⁄4 percent over the
tal equipment, and private employment year—an extraordinary increase even by
started to edge higher. But the forward the standards of the past half decade or
momentum diminished noticeably later so.
in the year when concerns about corpo­ Signals on the trajectory of the econ­
rate governance put a damper on finan- omy as we enter 2003 remain mixed.
Some of the factors that had noticeably
Change in Real GDP restrained the growth of real GDP in the
fourth quarter of last year—most espe­
Percent, annual rate
cially a sharp decline in motor vehicle
production—are not on track to be
6 repeated. Moreover, employment lev­
eled off on average in December and
January, and readings on industrial pro­
2 duction have had a somewhat firmer
+ tone of late. Nevertheless, the few data
_ in hand suggest that the economy has
not yet broken out of the pattern of
1996 1998 2000 2002
subpar performance experienced over
NOTE. Here and in subsequent charts, except as noted, the past year.
annual changes are measured from Q4 to Q4, and
change for a half-year is measured between its final Consumer price inflation moved up a
quarter and the final quarter of the preceding period. bit last year, reflecting sharply higher
12 89th Annual Report, 2002

Change in PCE Chain-Type Price Index often seen early in an economic recov­
ery; in contrast to the situation in many
Percent, annual rate
previous cycles, spending on durable
Total goods did not decline sharply during
Excluding food and energy 3 the recession and so had less cause to
rebound as the recovery got under way.
2 Apart from outlays on durable goods,
spending for most categories of con­
1 sumer goods and services increased at a
moderate rate last year.
That moderate rate of aggregate con­
1996 1998 2000 2002
sumption growth was the product of
NOTE. The data are for personal consumption various crosscurrents. On the positive
expenditures (PCE).
side, real disposable personal income
rose nearly 6 percent last year, the
energy prices. Excluding the prices of fastest increase in many years. Strong
food and energy items, the price index productivity growth partially offset
for personal consumption expenditures the effects of stagnant employment in
increased 13⁄4 percent, about 1⁄4 per­ restricting the growth of household
centage point less than in 2001; this income, and the phase-in of additional
deceleration most likely resulted from tax reductions from the Economic
continued slack in labor and product Growth and Tax Relief Reconciliation
markets, robust gains in productivity, Act of 2001 boosted household purchas­
and somewhat lower expectations of ing power appreciably. In addition, high
future inflation. levels of mortgage refinancing allowed
homeowners to reduce their monthly
payments, pay down more costly con­
The Household Sector sumer credit, and, in many cases, extract
equity that could be used to support
Consumer Spending other spending. On the negative side,
Consumer spending grew at a moderate household wealth again moved lower
pace last year and, on the whole, contin­ last year, as continued reductions in
ued to be an important source of support equity values outweighed further appre­
for overall demand. Personal consump­ ciation of house prices. By the end of
tion expenditures rose 21⁄2 percent in
real terms, near the 23⁄4 percent increase
in 2001 and down from the more than Change in Real Income and Consumption
4 percent average growth over the
Percent, annual rate
preceding several years. Sales of new
motor vehicles fell only a little from Disposable personal income 10
the extremely high levels of late 2001; Personal consumption
expenditures 8
outlays were especially strong during
the summer and late in the year, when
manufacturers were offering aggressive 4
price and financing incentives. Growth 2
of spending on other durable goods 0
was well maintained last year as well,
1996 1998 2000 2002
although the gains were smaller than is
Economic and Financial Developments in 2002 and Early 2003 13

the third quarter, according to the Fed­ cent in the first months of the year, fell
eral Reserve’s flow-of-funds accounts, to around 6 percent by the autumn and
the ratio of household net worth to dis­ dipped below that level early this year—
posable income had reversed nearly all the lowest in thirty-five years. Not sur­
of its run-up since the mid-1990s. prisingly, attitudes toward homebuying,
Consumer confidence, which had as measured by the Michigan SRC,
declined during most of 2001 and espe­ remained quite favorable.
cially after the September 11 attacks, Starts of new single-family homes
picked up in the first half of last year, were at 1.36 million units last year,
according to both the Michigan Survey 7 percent above the already solid pace
Research Center (SRC) and Conference for 2001. Sales of both new and existing
Board surveys. However, confidence homes were brisk as well. Home prices
retreated over the summer along with continued to rise but at a slower rate
the drop in equity prices, and by early than in 2001, at least according to some
this year, consumer confidence again measures. The repeat-sales price index
stood close to the levels of late 2001. for existing homes rose 51⁄2 percent over
These levels of consumer confidence, the four quarters ended in 2002:Q3, a
though at the bottom of readings of the slowing from the 83⁄4 percent increase
past several years, are nevertheless over the comparable year-earlier period.
above levels normally associated with The constant-quality price index for new
recession. homes rose 41⁄2 percent last year, but
The personal saving rate, which has this increase was close to the average
trended notably lower since the early pace over the past few years. At the
1980s, moved above 4 percent by late same time, measures of house prices
last year after having averaged 21⁄4 per- that do not control for the mix of homes
cent in 2001. The saving rate has been sold rose considerably more last year
buffeted during the past two years by than in 2001, a difference indicating that
surges in income induced by tax cuts a larger share of transactions were in
and by spikes in spending associated relatively expensive homes.
with variations in motor vehicle incen­ In the multifamily sector, starts aver-
tives. But, on balance, the extent of aged a solid 345,000 units last year,
the increase in the saving rate has an amount in line with that of the pre-
been roughly consistent with a gradual ceding several years. However, the pace
response of consumption to the reduc­ of building slowed a little in the fall.
tion in the ratio of household wealth to Apartment vacancy rates moved notably
disposable income. higher last year and rent and property
values declined; these changes suggest
that the strong demand for single-family
Residential Investment homes may be eroding demand for
Real expenditures on residential invest­ apartment space.
ment increased 6 percent in 2002—the
largest gain in several years. Demand
for housing was influenced by the same
Household Finance
factors affecting household spending Households continued to borrow at a
more generally, but it was especially rapid pace last year; the 91⁄4 percent
supported by low interest rates on mort­ increase in their debt outstanding was
gages. Rates on thirty-year fixed-rate the largest since 1989. Low mortgage
mortgages, which stood at around 7 per- interest rates helped spur both very
14 89th Annual Report, 2002

strong home purchases and refinanc­ ment credit, and auto leases—relative to
ing of existing loans, which together their incomes below previous peaks.
increased home mortgage debt 111⁄2 per- Against this backdrop, broad measures
cent. Refinancing activity was especially of household credit quality deteriorated
elevated in the fourth quarter, when very little last year, and signs of finan­
fixed mortgage interest rates dipped cial stress were confined mainly to the
to around 6 percent. Torrid refinancing subprime segment of the market. Delin­
activity helps explain last year’s slow- quency rates on home mortgages inched
down of consumer credit, which is up, while those on auto loans at finance
household borrowing not secured by real companies were flat. Delinquency rates
estate: A significant number of house- on credit cards bundled into securitized
holds reportedly extracted some of the asset pools remained close to those of
equity from their homes at the time of recent experience.
refinancing and used the proceeds to
repay other debt as well as to finance
home improvements and other expendi­
The Business Sector
tures. According to banks that partici­ Overall business fixed investment
pated in the Federal Reserve’s Senior moved lower last year, although the
Loan Officer Opinion Survey on Bank decline was not nearly so precipitous as
Lending Practices in October, the fre­ in 2001. Outlays for equipment and soft-
quency and size of cash-out refinanc­ ware edged up, but spending on struc­
ings were substantially greater than had tures fell sharply. Financing conditions
been reported in the January 2002 sur­ worsened over the summer, with equity
vey. Although automakers’ financing prices declining, initial public offerings
incentives and attractive cash rebates (IPOs) drying up, credit market spreads
stimulated a substantial amount of con­ widening, and banks tightening up
sumer borrowing, the growth rate of somewhat on credit standards in the
consumer credit in 2002, at 41⁄4 percent, wake of increased reports of corporate
was more than 21⁄2 percentage points malfeasance. In addition, geopolitical
below the pace in 2001. concerns increased firms’ already
Even though households took on a heightened uncertainty about the eco­
large amount of mortgage debt last year, nomic outlook. These factors contrib­
extraordinarily low mortgage rates kept uted to an apparent deterioration in busi­
the servicing requirement for that debt ness confidence, and businesses still
(measured as a share of homeowners’ have not felt any great urgency to boost
disposable income) well below its pre­ investment appreciably. For similar rea­
vious peak levels. Moreover, reflect­ sons, although firms slowed their rate of
ing large gains in residential real estate inventory liquidation last year, they have
values, equity in homes has continued yet to undertake a sustained restocking.
to increase despite sizable debt-financed
extractions. The combined influence
of low interest rates and the sizable
Fixed Investment
gain in disposable personal income also After dropping sharply in 2001, real
kept the total servicing costs faced by spending on equipment and software
households—which in addition to home rose 3 percent last year. Spending on
mortgage payments include costs of high-technology equipment, one of the
other financial obligations such as rental hardest-hit sectors in 2001, showed
payments of tenants, consumer install­ signs of uneven improvement. The
Economic and Financial Developments in 2002 and Early 2003 15

Change in Real Business Fixed Investment by rental companies weakened sharply

along with the drop in air traffic that
Percent, annual rate occurred after September 11 but recov­
Structures ered gradually over the course of last
Equipment and software 20 year. Purchases of medium and heavy
trucks fell off overall, despite the fact
0 that demand for heavy (class 8) trucks
was boosted by spending in advance of
20 the implementation of more-stringent
environmental regulations.
Investment in equipment other than
high-tech and transportation goods
High-tech equipment moved modestly higher through most
and software 40
Other equipment of last year, as real outlays for indus­
trial machinery and a wide range of
20 other equipment gradually strengthened
+ through the summer. Although spending
_ edged lower again in the fourth quarter,
investment in non-high-tech, nontrans­
1996 1997 1998 1999 2000 2001 2002 portation equipment increased 31⁄2 per-
cent for the year as a whole.
NOTE. High-tech equipment consists of computers
and peripheral equipment and communications Spending on equipment and software
equipment. was supported last year by low inter­
est rates, which helped hold down the
clearest rebound was in computing cost of capital, as did the tax provi­
equipment, for which spending rose sion enacted in March 2002 that allows
25 percent in real terms; this gain fell partial expensing of new equipment
short of the increases posted in the late and software purchased before Sep­
1990s but far more than reversed the tember 11, 2004. Moreover, modest
previous year’s decline. Software invest­ increases in final sales together with
ment also turned positive, rising 6 per- replacement demand no doubt spurred
cent after declining about 3 percent in many firms to make new capital outlays.
2001. By contrast, real outlays for com­ Nevertheless, some sectors, most nota­
munications equipment were reported bly telecommunications, probably still
to be up only slightly in 2002 after had excess holdings of some forms
plummeting 30 percent in 2001. of capital. Concerns about corporate
Business spending on aircraft fell malfeasance, which had become more
sharply last year. Airlines were hit espe­ intense over the spring and summer,
cially hard by the economic downturn weighed heavily on financial markets
and by the reduction in air travel after and raised the cost of capital through
the September 11 attacks; although reduced share prices and higher yields
expenditures for new aircraft held up on the bonds of lower-rated firms. In
through the end of 2001 because of addition, uncertainty about the geopo­
the very long lags involved in producing litical situation, including the possible
planes, shipments of planes slowed consequences for oil prices of an out-
greatly thereafter. Meanwhile, business break of war with Iraq, likely made
outlays on motor vehicles edged up last many firms reluctant to commit them-
year. Demand for autos and light trucks selves to new expenditures. In all, busi-
16 89th Annual Report, 2002

nesses have been, and appear to remain, over production and inventories; with
quite cautious about undertaking new prospects for the strength of the recov­
capital spending projects. ery having diminished in the second
Real business spending for nonresi­ half of the year, businesses quickly cut
dential structures declined sharply for production, and inventories only edged
a second year in 2002. Outlays for up in the fourth quarter, according to
the construction of office buildings incomplete and preliminary data. In all,
and industrial buildings were especially total inventories were about unchanged
weak. Vacancy rates for such buildings last year compared with a liquidation
increased throughout the year, and prop­ of more than $60 billion in 2001, and
erty values and rents moved lower. Con­ this turnaround contributed 1 percent-
struction of new hotels and motels also age point to the growth of real GDP
fell considerably, reflecting the weak­ over the year. At year-end, inventory-to-
ness in the travel industry. By contrast, sales ratios in most sectors stood near
spending on other commercial build­ the low end of their recent ranges.
ings, such as those for retail, wholesale, In the motor vehicle industry, last
and warehouse space, moved only a year’s very strong sales were matched
little lower last year. by high levels of production, and the
A number of factors likely account stock of inventories, especially for light
for investment in structures having been trucks, appeared at times to be higher
much weaker than investment in equip­ than the industry’s desired levels. Nev­
ment. Structures depreciate very slowly, ertheless, the surge in sales late in the
so businesses can defer new outlays year helped to pare stocks, and dealers
without incurring much additional ended the year with inventories of light
deterioration of their capital stock. And vehicles at a comfortable level.
unlike investment in equipment, spend­
ing on structures is not eligible for par­
tial expensing. According to some ana­
Corporate Profits and
lysts, concerns about additional acts of
Business Finance
terrorism (and, until late in the year, the The profitability of the U.S. nonfinan­
lack of insurance to cover such events) cial corporate sector improved from its
may also have had a damping effect on lows of 2001 but relative to sector out-
some types of construction, particularly put remained at the low end of the
large ‘‘trophy’’ projects. range experienced over the past thirty
years. Economic profits of nonfinan­
cial corporations—that is, book prof-
Inventory Investment its adjusted for inventory valuations
The sharp inventory runoffs that charac­ and capital consumption allowances—
terized the economic downturn, together rebounded in late 2001 and were little
with gradually rising final sales, implied changed through the third quarter of last
that, by early last year, stocks were year. The sluggish expansion of aggre­
in much better alignment with sales than gate demand and the lack of pricing
had been the case during 2001. Accord­ power associated with intense competi­
ingly, businesses lessened the pace of tive pressures were the main factors that
inventory liquidation early in the year held down profits in 2002. Also playing
and by summer had turned to some a role, especially in the manufacturing
modest restocking. However, firms sector, were costs arising from under-
appeared to have exerted tight control funded defined-benefit pension plans.
Economic and Financial Developments in 2002 and Early 2003 17

Reflecting the pause in economic such as bank loans and commercial

growth, earnings reports for the fourth paper. Buoyed by declining yields, gross
quarter indicate that profits may have issuance of below-investment-grade
dropped some late in the year. bonds for the most part also held up well
A dearth of expenditures on fixed during the first half, although this seg­
capital and moribund merger and acqui­ ment of the market was hit hard after
sition activity were the chief culprits revelations of corporate malfeasance, as
behind the sluggish pace of nonfinan­ investors shunned some of the riskiest
cial corporate borrowing last year. Also issues; issuance was especially weak in
important was the propensity of some the beleaguered telecom and energy sec­
firms to draw on liquid assets—which tors, which continue to be saddled with
began the year at high levels—rather overcapacity and excessive leverage.
than to seek external financing. Conse­ Despite falling share prices, seasoned
quently, debt of the nonfinancial corpo­ equity offerings were also well main­
rate sector expanded only 11⁄2 percent, tained over the first half of the year, in
a rate slower than the already subdued part because of the decision of some
pace in 2001. The composition of busi­ firms—especially in the telecom and
ness borrowing was dominated last energy sectors—to reduce leverage.
year, as it was in 2001, by longer-term IPOs, by contrast, were sparse. The
sources of funds. Robust demand for evaporation of cash-financed mergers
higher-quality corporate debt on the part and acquisitions and desire by firms to
of investors, combined with the desire conserve cash kept equity retirements at
of firms to lock in low interest rates, their slowest pace since 1994.
prompted investment-grade corporations Over the summer, investors grew
to issue a large volume of bonds dur­ more reluctant to buy corporate bonds
ing the first half of 2002. With funding because of concerns about the reliabil­
needs limited, investment-grade issu­ ity of financial statements, deteriorat­
ers continued to use the proceeds to ing credit quality, and historically low
strengthen their balance sheets by refi­ recovery rates on defaulted speculative-
nancing higher-coupon bonds and by grade debt. Macroeconomic data sug­
paying down short-term obligations gesting that the economic recovery was

Major Components of Net Business Spreads of Corporate Bond Yields over

Financing the Ten-Year Treasury Yield

Billions of dollars Percentage points

Commercial paper 800 10

Bonds High yield
Bank loans Sum of major 600 8
components 400 6
200 4
_ AA 2
200 0

2000 2001 2002 2001 2002 2003

NOTE. Seasonally adjusted annual rate for nonfarm NOTE. The data are daily and extend through
nonfinancial corporate business. The data for the sum of February 5, 2003. The spreads compare the yields on the
major components are quarterly. The data for 2002:Q4 Merrill Lynch AA, BBB, and 175 indexes with the yield
are estimated. on the ten-year off-the-run Treasury note.
18 89th Annual Report, 2002

losing momentum and widespread com­ caused a rebound in gross bond issu­
pany warnings about near-term prof- ance, with firms continuing to use bond
its pushed yields on speculative-grade proceeds to refinance long-term debt
debt sharply higher. Risk spreads on and to pay down short-term debt. Rising
investment-grade bonds also widened stock prices and reduced volatility also
appreciably in the third quarter, as yields allowed seasoned equity issuance to
in that segment of the corporate bond regain some ground in the fourth quar­
market declined less than those on Trea­ ter. The improved tone in corporate debt
sury securities of comparable matu­ markets carried over into early 2003.
rity. Investors’ aversion to risk was also Gross corporate bond issuance contin­
heightened by mounting tensions with ued at a moderate pace, and despite the
Iraq; by early autumn, risk spreads on drop in stock prices in the latter half
junk-rated bonds reached their high­ of January, seasoned equity issuance has
est levels in more than a decade. Gross been reasonably well maintained. IPO
bond issuance both by investment- activity and venture capital financing,
grade and below-investment-grade firms however, remained depressed.
fell off markedly, and the amount of The heavy pace of bond issuance,
redemptions was large. By the third sagging capital expenditures, and dimin­
quarter, net issuance of bonds by non- ished merger and acquisition activ­
financial corporations had turned nega­ ity allowed firms to pay down large
tive for the first time since the early amounts of both business loans at banks
1950s. Trading conditions in the corpo­ and commercial paper last year. The
rate bond market deteriorated during this runoff in business loans that started
period, as bid–asked spreads reportedly in early 2001 intensified in the first half
widened in all sectors. With share prices of 2002. At the same time, commercial
dropping and stock market volatility paper issuers that were perceived as hav­
increasing, issuance of seasoned equity ing questionable accounting practices
nearly stalled in the summer and early encountered significant investor resis­
autumn. IPOs were virtually nonexistent tance, and most of these issuers discon­
amid widely publicized investigations tinued their programs. Bond rating agen­
into the IPO allocation process at large cies stepped up the pressure on firms to
investment banks. substitute longer-term debt for shorter-
A smattering of more upbeat news term debt and thereby reduce rollover
about the economy in mid-autumn and risk. In addition, banks raised the total
the absence of major revelations of cor­ cost of issuing commercial paper by
porate wrongdoing sparked a rally in tightening underwriting standards and
equity prices and rekindled investors’ boosting fees and spreads on the associ­
appetite for corporate debt. Over the ated backup lines of credit—especially
remainder of the year and during early for lower-rated issuers. In doing so,
2003, risk spreads narrowed consid­ respondents to the April Senior Loan
erably on investment-grade corporate Officer Opinion Survey on Bank Lend­
bonds—especially for the lowest rated ing Practices cited heightened concerns
of these issues—and even more on about the deterioration of issuers’ credit
speculative-grade bonds, although they quality and a higher probability of lines
remained high by historical standards. being drawn. Many commercial paper
In the meantime, liquidity in the corpo­ issuers either turned to longer-term
rate bond market generally improved. financing or dropped out of the credit
A brightening of investor sentiment markets altogether, and the volume
Economic and Financial Developments in 2002 and Early 2003 19

of nonfinancial commercial paper out- flow in the nonfinancial corporate sector

standing shrank about one-fourth during last year. Even so, many firms struggled
the first six months of the year after to service their debt, and corporate
having dropped one-third in 2001. credit quality deteriorated markedly. The
The volatility that gripped equity and trailing average default rate on corpo­
bond markets around midyear, how- rate bonds, looking back over the pre-
ever, did not spill over to the commer­ ceding twelve months, was already ele­
cial paper market. Quality spreads in the vated and climbing when WorldCom’s
commercial paper market were largely $26 billion default in July propelled
unaffected, in part because many of the the average rate to a record level. The
riskiest issuers had already exited the amount of nonfinancial corporate debt
market, while others had strengthened downgraded by Moody’s Investors Ser­
their cash positions and significantly vice last year was more than fourteen
reduced rollover risk earlier in the year. times the amount upgraded. At less than
Indeed, because of difficulties in the cor­ 25 percent, the average recovery rate in
porate bond market, some nonfinancial 2002 on all defaulted bonds—as mea­
firms turned temporarily to the commer­ sured by the price of bonds at default—
cial paper market to obtain financing, was at the low end of recovery rates
and the volume of outstanding paper over the past decade. Delinquency rates
rose in July after a lengthy period of on business loans at commercial banks
declines. Over the remainder of the year, rose noticeably before stabilizing in the
business loans at banks and commer­ second half of the year, and charge-off
cial paper outstanding contracted rap- rates remained quite high throughout
idly, as inventory investment remained 2002.
negligible, and firms continued to take After expanding rapidly in 2001,
advantage of relatively low longer-term commercial mortgage debt grew much
interest rates by issuing bonds. more slowly during the first quarter of
A decline in market interest rates and last year, as business spending on non-
improved profitability helped reduce the residential structures fell. Despite the
ratio of net interest payments to cash continued contraction in outlays on non-
residential structures, commercial mort-
Default Rate on Outstanding Bonds
Ratings Changes of Nonfinancial

3.5 Percent
3.0 Upgrades
1992 1994 1996 1998 2000 2002 40

NOTE. The default rate is monthly and extends 1996 1998 2000 2002
through December 2002. The rate for a given month is
the face value of bonds that defaulted in the twelve NOTE. Data are at an annual rate. Debt upgrades
months ending in that month divided by the face value (downgrades) are expressed as a percentage of par value
of all bonds outstanding at the end of the calendar of all bonds outstanding.
quarter immediately preceding the twelve-month period. SOURCE. Moody’s Investors Service.
20 89th Annual Report, 2002

gage debt accelerated over the remain­ realizations and to lower tax rates that
der of the year, apparently because of were enacted in the 2001 tax bill.
refinancing to extract a significant por­ Meanwhile, federal outlays increased
tion of equity from existing properties. nearly 8 percent in fiscal 2002 and
The issuance of commercial-mortgage- 11 percent excluding a decline in net
backed securities (CMBS), a key source interest expenses. Spending increased
of commercial real estate financing in notably in many categories, including
recent years, was well maintained in defense, homeland security, Medicaid,
2002. Even as office vacancy rates rose, and income security (which includes
the quality of commercial real estate the temporary extended unemployment
credit remained stable last year. Com­ compensation program). Federal gov­
mercial banks firmed standards on com­ ernment consumption and investment—
mercial real estate loans in 2002, on net, the part of spending that is counted in
and delinquency rates on commercial GDP—rose more than 7 percent in real
real estate loans at banks stayed at his­ terms in 2002. (Government spending
torically low levels. Delinquency rates on items such as interest payments
on CMBS leveled off after increasing and transfers are not counted in GDP
appreciably in late 2001, and forward- because they do not constitute a direct
looking indicators also do not suggest purchase of final production.)
elevated concerns about prospective The turn to deficit in the unified bud-
defaults: Yield spreads on CMBS over get means that the federal government,
swap rates remained in the fairly narrow which had been contributing to national
range that has prevailed over the past saving since 1997, began to reduce
several years. national saving last year. The reversal
more than offset an increase in saving
by households and businesses, and gross
The Government Sector national saving declined to 15 percent of
GDP by the third quarter of last year—
Federal Government the lowest national saving rate since the
Despite modest economic growth, the 1940s.
federal budget position deteriorated After it reentered the credit markets
sharply in 2002. After running a unified as a significant borrower of net new
budget surplus of $127 billion in fiscal funds in the second half of 2001, the
2001, the federal government posted a Treasury continued to tap markets in
deficit of $158 billion in fiscal 2002— volume last year. Federal net borrowing
and that deficit would have been was especially brisk over the first half
$23 billion larger if not for the shifting of the year. With federal debt rapidly
of some corporate tax payments from approaching its statutory borrowing
fiscal 2001 to fiscal 2002. After adjust­ limit, the Secretary of the Treasury
ment for that tax shifting, receipts declared a debt ceiling emergency on
declined 9 percent in fiscal 2002: A May 16 and identified about $80 billion
$50 billion drop in corporate payments worth of accounting measures that could
stemmed largely from tax provisions be used to create financing room within
enacted in the 2002 stimulus bill (espe­ the existing $5.95 trillion limit. The Sec­
cially the partial-expensing provision on retary’s announcement and subsequent
investment), and a decline in individual employment of one of these devices—in
tax payments of $136 billion was largely which Treasury securities held in gov­
attributable to a drop in capital gains ernment trust funds were temporarily
Economic and Financial Developments in 2002 and Early 2003 21

Federal Government Debt Held ing to the capital markets, many states
by the Public will be forced to boost revenues and
hold the line on spending.
Percent of nominal GDP
Real expenditures for consumption
and gross investment by state and local
45 governments rose less than 2 percent
in 2002—the smallest increase in ten
35 years. The slowdown in spending
growth was widespread across expen­
25 diture categories and included notably
smaller increases in outlays for con­
struction. Employment in the state and
1962 1972 1982 1992 2002
local sector continued to rise in 2002,
NOTE. Through 2001, the data for debt are year-end but at a slower rate than in recent years.
figures and the corresponding value for GDP is for Q4
at an annual rate; the final observation is for 2002:Q3. Debt of the state and local govern­
Excludes securities held as investments of federal gov­ ment sector expanded last year at the
ernment accounts. fastest pace since 1987. Governments
used the proceeds to finance capital
replaced by Treasury IOUs not subject spending and to refund existing debt
to the debt ceiling—had little effect in advance. Net issuance of short-term
on Treasury yields, as market partici­ municipal bonds was also well main­
pants were apparently confident that tained, as California and some other
the ceiling would be raised in time to states facing fiscal difficulties turned to
avoid default. And indeed, the Congress shorter-term borrowing while fashion­
approved legislation raising the statu­ ing more permanent solutions to their
tory borrowing limit to $6.4 trillion on budget problems. Worsening budget
June 27. With its credit needs remaining situations contributed to some deteri­
substantial, the Treasury continued to oration in municipal credit quality last
borrow heavily over the second half of year. Credit-rating downgrades outpaced
2002. The increase in the Treasury’s net upgrades by a significant margin, and
borrowing last year caused the ratio of the yield spread of BBB-rated over
publicly held debt to nominal GDP to insured AAA-rated municipal bonds
rise for the first time since 1993. rose significantly over the second half
of 2002.
State and Local Governments
State and local governments have con­
The External Sector
tinued to struggle in response to slug­ The U.S. current account deficit wid­
gish growth of receipts. In the current ened again in 2002 after a brief respite
fiscal year (which ends June 30 for most during the cyclical slowdown in 2001.
states), most state governments are Two-thirds of the expansion of the defi­
reported to be facing significant short- cit last year was attributable to a decline
falls. Although a variety of strategies in the balance on goods and services,
may be available for the purpose of although net investment income also fell
technically complying with balanced- sharply as receipts from abroad declined
budget requirements, including tapping more than payments to foreign inves­
nearly $20 billion in combined rainy- tors in the United States. The broad
day and general fund balances and turn­ exchange value of the dollar peaked
22 89th Annual Report, 2002

around February 2002 after appreciating strongest—Canada, Mexico, and several

about 13 percent in real terms from developing Asian economies. A gain of
January 2000; in early February 2003 it 12 percent in real exports of services
was down about 5 percent from the Feb­ in 2002 more than reversed the pre­
ruary 2002 level. vious year’s decline and reflected both
a pickup in tourism and an increase in
other private services. Export prices
Trade and the Current Account turned up in the second quarter after a
Both exports and imports rebounded in year of decline and continued to rise at a
2002 as the cyclical downturn of the moderate pace in the second half.
previous year was reversed and spend­ The very rapid growth of real imports
ing on travel recovered from the post- of goods in the first half of last year was
September 11 slump. As is often the a reaction to the revival of U.S. activity,
case, the amplitude of the recent cycle and they gained about 9 percent over
in trade has been greater than that of real the year. The particularly large gains
GDP. In 2001, stagnant real GDP in the in imports of consumer goods and auto-
United States and abroad was coupled motive products reflected the buoy­
with declines of 111⁄2 percent in real ancy of U.S. consumption expenditures.
exports and 8 percent in real imports. Imports of most major categories of
Last year, moderate growth of both capital goods also increased on bal­
foreign and domestic real GDP was ance over the year. However, as with
exceeded by gains of 5 percent and exports, import growth was consider-
9 percent, respectively, in our real ably stronger in the first half of the year
exports and imports. The faster growth than in the second. This pattern likely
of imports relative to exports over the reflected the deceleration in U.S. GDP,
past two years was consistent with the along with the effects of some depre­
historical pattern in which the respon­ ciation of the dollar. In addition, there
siveness of imports to income is greater may have been some shifting of import
in the United States than in the rest of demand from later in the year to the
the world. Although the dollar depreci­ earlier months as it began to appear
ated on balance last year, the lagged more likely that labor contract nego­
effects of its prior appreciation over the tiations at West Coast ports would not
two previous years contributed to the go smoothly.1 Imports of services more
faster growth in imports relative to than reversed their 2001 decline over
exports in 2002. the course of the year, and gains were
Real exports of goods posted a strong recorded for both travel and other pri­
gain in the second quarter of 2002 after vate services. Prices of non-oil imports
six consecutive quarters of decline. turned up in the second quarter after
However, as output growth slowed declining over the preceding four quar-
abroad, exports decelerated in the third
quarter and then fell in the fourth
1. The dispute between the Pacific Maritime
quarter. On balance, exports of goods Association and the International Longshore and
rose about 2 percent over the course Warehouse Union eventually led to an eleven-day
of the year, reversing only a small port closure in late September and early October
portion of the previous year’s decline. that ended when President Bush invoked the Taft–
Hartley Act. Although the monthly pattern of trade
Not surprisingly, the increase in goods was influenced by the closure, the overall level of
exports in 2002 was concentrated in the imports for the year does not appear to have been
destinations where GDP growth was much affected.
Economic and Financial Developments in 2002 and Early 2003 23

ters, as a result of the weaker exchange from equities and toward Treasury secu­
rate and a turnaround in prices of inter- rities. This shift may have reflected the
nationally traded commodities. damping of equity demand caused by
The spot price of West Texas interme­ slower economic growth and continued
diate crude oil climbed above $35 per concern about corporate governance and
barrel in early 2003, its highest level accounting. Over the same period, pur­
since the beginning of 2000. Oil prices chases by private U.S. investors of for­
had fallen to around $20 per barrel dur­ eign securities declined nearly $100 bil­
ing 2001 amid general economic weak­ lion. Accordingly, the net balance of
ness, but they began rising in Febru­ private securities trading recorded a
ary and March of last year in response sharp increase in net inflows.
to both improving global economic ac­ In contrast, net foreign direct invest­
tivity as well as a production-limiting ment inflows fell about $70 billion
agreement between OPEC and several between 2001 and 2002. Foreign invest­
major non-OPEC producers. Even ment in the United States and invest­
though production in a number of OPEC ment abroad by U.S. residents both
and non-OPEC countries in fact declined, but the decline in flows into
exceeded the agreed limits last year, the United States was considerably
heightened tensions in the Middle East larger, as merger activity slowed and
along with severe political turmoil in corporate profits showed little vigor.
Venezuela continued to put upward U.S. direct investment abroad held up
pressure on prices. The pressure inten­ fairly well in 2002, a result largely
sified late in the year as a strike in reflecting retained earnings.
Venezuela that began on December 2
virtually shut down that country’s oil
industry, and Venezuelan oil production The Labor Market
was still well below pre-strike levels in
early 2003. Concern over a possible war Employment and Unemployment
with Iraq, along with a very low level
of crude oil inventories in the United Labor markets appeared to stabilize last
States, has helped to keep spot prices spring after the sharp deterioration of
high. Also in response to the heightened 2001 and early 2002. Employment on
tensions, the price of gold shot up about private payrolls, which had declined an
30 percent over the past year. average of 160,000 per month in 2001,
leveled off in the spring and moved
slightly higher over the summer. But
The Financial Account labor demand weakened again as the
The increase in the current account defi­ economy softened later in the summer,
cit in 2002 was about equal on balance and private employment declined about
to the stepped-up foreign official pur­ 80,000 per month on average in the last
chases of U.S. assets, as changes in four months of the year. Private pay-
the components of private capital flows rolls rebounded nearly 150,000 in Janu­
were offsetting. Private foreign pur­ ary, though the magnitude of both the
chases of U.S. securities were about especially sharp decline in December
$360 billion at an annual rate through and the rebound in January likely was
November, a volume similar to last exaggerated by difficulties in adjusting
year’s total. However, there was some for the normal seasonal movements in
shift in the composition of flows away employment during these months.
24 89th Annual Report, 2002

The manufacturing sector continued Measures of Labor Utilization

to be the weakest segment of the labor
market; even during the spring and early
summer, when the overall labor market Augmented unemployment
rate 15
seemed to be improving, factory pay-
rolls contracted on average. Declines 12
in factory employment were more 9
pronounced—at about 50,000 per 6
month—toward the end of the year. Civilian unemployment
rate 3
Employment at help-supply firms and in
wholesale trade—two sectors in which
1973 1983 1993 2003
activity closely tracks that of manufac­
turing proper—rose over the summer NOTE. The data extend through January 2003. The
civilian rate is the number of civilian unemployed
but also turned down again later in the divided by the civilian labor force. The augmented rate
year. And employment in retail trade, adds to the numerator and the denominator of the
civilian rate the number of those who are not in the labor
though quite erratic, leveled off over the force but want a job. The small break in the augmented
summer before declining further in the rate in January 1994 arises from the introduction of a
fall. However, employment in services redesigned survey. For the civilian rate, the data are
monthly; for the augmented rate, the data are quarterly
other than help supply grew reasonably through December 1993 and monthly thereafter.
steadily throughout the year and rose
nearly 50,000 per month after March;
health services and education services fits have expired to be more selective in
contributed more than half of those job accepting job offers and provides them
gains. The finance and real estate sec­ with an incentive not to withdraw from
tors also added jobs last year, probably the labor force. In addition, as would be
because of the surge in mortgage refi­ expected in a still-weak labor market,
nancings and high levels of activity in the labor force participation rate moved
housing markets. Last year’s job losses lower last year.
in the private sector were partially offset
by an increase in government employ­ Productivity and Labor Costs
ment that averaged about 20,000 per
month; the increase resulted mostly Labor productivity rose impressively in
from hiring by states and munici­ 2002. Output per hour in the nonfarm
palities, but it also reflected hiring in business sector increased an estimated
the fall by the Transportation Security
Administration. Change in Output Per Hour
Overall employment moved lower,
on net, and the unemployment rate Percent, annual rate

increased a little less than 1⁄2 percentage

point over the year, to 6 percent, before
dropping back to 5.7 percent in Janu­ 6
ary 2003. The unemployment rate 4
probably has been boosted slightly by
the federal temporary extended unem­ +
ployment compensation program. By 0
extending benefits for an additional
three months, the program allows unem­ 1992 1994 1996 1998 2000 2002

ployed individuals whose regular bene- NOTE. Nonfarm business sector.

Economic and Financial Developments in 2002 and Early 2003 25

33⁄4 percent from the fourth quarter component of the ECI both posted
of 2001 to the fourth quarter of 2002. smaller increases last year. The decele­
Labor productivity typically suffers in ration was less pronounced for the
an economic downturn as businesses benefits component, however, which
reduce hours worked by proportionally was boosted by further large increases
less than the decline in output; con­ in employers’ health insurance costs.
versely, productivity typically rebounds According to the ECI, health insurance
early in an expansion as labor is brought costs, which constitute about 6 percent
back toward fuller utilization. During of overall compensation, rose 10 percent
the most recent downturn, however, last year after having risen about 9 per-
productivity held up comparatively well, cent in each of the preceding two years.
a performance that makes last year’s An alternative measure of compen­
surge all the more impressive. Indeed, sation costs is compensation per hour
productivity rose at an average annual in the nonfarm business sector, which is
rate of nearly 3 percent over the past derived from information in the national
two years, faster than the average pace income and product accounts. Accord­
of increase during the late 1990s. ing to this measure, hourly compensa­
Very likely, the rapid pace of last tion rose 41⁄4 percent last year—a little
year’s productivity growth was due more than the increase in the ECI and up
in part to the special circumstances from a much smaller increase in 2001.
that developed after the September 11 One important difference between these
attacks. Businesses cut labor substan­ two measures of compensation is that
tially in late 2001 and early 2002 amid the ECI omits stock options, while non-
widespread fear of a sharp decline in farm compensation per hour captures
demand; when demand held up better the value of these options upon exercise.
than expected, businesses proved able to The very small increase in the latter
operate satisfactorily with their existing measure in 2001 likely reflects, in part,
workforces. Moreover, the fact that this a drop in option exercises in that year,
step-up in productivity was not reversed and the larger increase in 2002 may
later in the year suggests that at least a point to a firming, or at least to a smaller
portion of it is sustainable. The recent rate of decline, of these exercises.
rapid growth in productivity may derive
in part from ongoing improvements
in the use of the vast amount of capital
installed in earlier years, and it may also The chain-type price index for personal
stem from organizational innovations consumption expenditures (PCE) rose
induced by the weak profit environment. about 2 percent last year, compared with
Indicators of hourly compensation an increase of 11⁄2 percent in 2001. This
sent mixed signals last year. The rise step-up in consumer price inflation
in the employment cost index (ECI) for resulted from a jump in energy prices.
hourly compensation in private nonfarm Outside of the energy sector, consumer
businesses, 31⁄4 percent, was 1 percent- price inflation was pushed lower last
age point lower than the increase in year by continued slack in labor and
2001. Compensation increases likely product markets as well as by expecta­
were damped last year by the soft labor tions of future inflation that appeared to
market and expectations of lower con­ be lower in 2002 than in most of 2001.
sumer price inflation. The wages and The increase in PCE prices excluding
salaries component and the benefits food and energy, which was just 13⁄4 per-
26 89th Annual Report, 2002

Alternative Measures of Price Change The PCE price index for food and
Percent beverages increased only 11⁄2 percent
last year; the increase followed a 3 per-
Price measure 2001 2002 cent rise in 2001 that reflected supply-
related price increases for many live-
Gross domestic product . . . . . . . . 2.0 1.3 stock products including beef, poultry,
Gross domestic purchases . . . . . . 1.3 1.6 and dairy products. But livestock sup-
Personal consumption
expenditures . . . . . . . . . . . . . . 1.5 1.9 plies had recovered by early last year,
Excluding food and energy . . . 1.9 1.7
Chained CPI . . . . . . . . . . . . . . . . . . . 1.2 1.9 and a drought-induced selloff of cattle
Excluding food and energy . . . 1.8 1.6 herds last summer pushed prices still
Fixed-weight lower.
Consumer price index . . . . . . . . . . 1.9 2.3 The prices of goods other than food
Excluding food and energy . . . 2.7 2.1
and energy items decelerated sharply
Note. Changes are based on quarterly averages and last year. Prices for apparel, new and
are measured to the fourth quarter of the year indicated used motor vehicles, and a wide range
from the fourth quarter of the preceding year.
of other durable goods all declined
cent, was about 1⁄4 percentage point less noticeably and, on average, at a faster
than in 2001. The price index for GDP pace than in 2001. Price increases
was less affected by last year’s rise in for services were much larger than for
energy prices than was the PCE mea­ goods and slowed less from the pre­
sure; much of the energy price increase vious year. Both tenants’ rent and
was attributable to higher prices of the imputed rent of owner-occupied
imported oil, which are not included housing—categories that account for a
in GDP because they are not part sizable share of services—rose signifi­
of domestic production. On net, GDP cantly less last year than they did in
prices rose only 11⁄4 percent last year, 2001. But many other services prices
a deceleration of 3⁄4 percentage point posted increases in 2002 that were about
that reflected not just the deceleration the same as in 2001. Information on
in core consumer prices but also con­ medical prices was mixed. According to
siderably smaller increases for prices of the CPI, the price of medical services
construction. continued to accelerate, rising 51⁄2 per-
The upturn in consumer energy prices cent last year. But the increase in
in 2002 was driven by a jump in crude the PCE measure of medical services
oil prices. Gasoline prices increased prices was less than 3 percent, a smaller
some 25 percent from December 2001 increase than in 2001. One reason for
to December 2002; prices of fuel oil this difference is that the prices of ser­
increased considerably as well. By con­ vices paid for by Medicare and Medi­
trast, consumer prices of natural gas caid are included in the PCE index but
posted only a modest rise after declining not in the CPI (because services pro­
sharply in 2001, and electricity prices vided by Medicare and Medicaid do not
moved lower. More recently, the rise represent out-of-pocket costs to con­
in crude oil prices since mid-December, sumers and so are outside of the CPI’s
together with cold weather, has scope), and Medicare reimbursement
increased the demand for natural gas rates for physicians were reduced last
and has led to higher spot gas prices; year.
the higher spot prices for both oil and Despite the acceleration in medical
gas are likely to be boosting consumer prices in the CPI but not in the PCE
energy prices early this year. price index, the CPI excluding food and
Economic and Financial Developments in 2002 and Early 2003 27

energy decelerated notably more than 23⁄4 percent during 2002, a rate a little
did the core PCE price index between lower than the 3 percent inflation expec­
2001 and 2002. The two price measures tations that had prevailed through most
differ in a number of respects, but much of 2001.
of last year’s greater deceleration in the
CPI can be traced to the fact that the
CPI suffers from a form of ‘‘substitution
U.S. Financial Markets
bias’’ that is not present in the PCE Developments in financial markets last
index. The CPI, being a fixed-weight year were shaped importantly by sharp
price index, overstates increases in the declines, on net, in equity prices and
cost of living because it does not ade­ most long-term interest rates and by
quately take into account the fact that periods of heightened market volatility.
consumers tend to substitute away from In contrast to 2001, when the Federal
goods that are rising in relative price; by Reserve eased the stance of monetary
contrast, the PCE price index does a policy eleven times, last year saw one
better job of taking this substitution into reduction in the intended federal funds
account. Last year, the Bureau of Labor rate—in early November—and interest
Statistics began to publish a new index rates on short-term Treasury securities
called the chained CPI; like the PCE had moved little until then. Longer-term
price index, the chained CPI does a interest rates, by contrast, were more
more complete job of taking consumer volatile. Investors’ optimism about
substitution into account, but it is other- future economic prospects pressured
wise identical to the official CPI. In longer-term Treasury bond yields higher
2001, an unusually large gap between early in 2002. But as the year pro­
increases in the official CPI and the gressed, that optimism faded when
chained CPI arose, pointing to very the economy failed to gather much
large substitution bias in the official CPI momentum, and longer-term Treasury
in that year. This gap narrowed in 2002, yields ended the year appreciably lower.
indicating that substitution bias declined Softer-than-expected readings of the
between the two years. (Final estimates economic expansion, a marked deterio­
of the chained CPI are not yet available; ration in corporate credit quality, con­
the currently available data for both cerns about corporate governance, and
2001 and 2002 are preliminary and sub­ heightened geopolitical tensions made
ject to revision.) investors especially wary about risk.
Survey measures of expected infla­ Lower-rated firms found credit substan­
tion generally ran a little lower in 2002 tially more expensive, as risk spreads on
than in 2001. According to the Michigan speculative-grade debt soared for most
SRC, median one-year inflation expecta­ of the year before narrowing somewhat
tions plummeted after the September 11 over the last few months. Even for
attacks, but by early 2002, expecta­ higher-quality firms, risk spreads wid­
tions returned to the 23⁄4 percent range ened temporarily during the tumultuous
that had prevailed during the previous conditions that prevailed in financial
summer. These expectations gradually markets over the summer. In addition,
moved lower over the course of last commercial banks tightened standards
year and now stand around 21⁄2 per- and terms for business borrowers, on
cent. Meanwhile, the Michigan SRC’s net, in 2002, and risk spreads on busi­
measure of five- to ten-year inflation ness loans remained in an elevated range
expectations remained steady at about throughout the year. Increased caution
28 89th Annual Report, 2002

on the part of investors was particularly as much as 11⁄2 percentage points, on

acute in the commercial paper market, net, in 2002. Longer-term interest rates
where the riskiest issuers discontinued began last year under upward pressure,
their programs. as signs that the economy had bottomed
Federal borrowing surged last year, out started to nudge rates higher in the
while private borrowing was held down final weeks of 2001. Positive economic
by the significantly reduced credit needs news pushed interest rates up appre­
of business borrowers. Declines in ciably further during the first quarter of
longer-term interest rates during the 2002. The increase in longer-term inter­
first half of the year created incentives est rates was consistent with the sharp
for both businesses and households to upward tilt of money market futures
lock in lower debt-service obligations rates, which suggested that market par­
by heavily tapping corporate bond and ticipants expected that the FOMC would
home mortgage markets, respectively. almost double the intended level of the
While mortgage borrowing remained funds rate by year’s end. However, as
strong, businesses sharply curtailed their readings on the strength of the economic
issuance of longer-term debt during the expansion came in on the soft side,
second half of 2002 amid the nervous­ investors substantially trimmed their
ness then prevailing in the financial expectations for policy tightening, and
markets. yields on longer-term Treasury securi­
ties turned down in the spring.
The slide in longer-term Treasury
Interest Rates yields intensified over the summer amid
Reflecting an unchanged stance of weaker-than-expected economic data,
monetary policy over most of last year, heightened geopolitical tensions, fresh
short-term market interest rates moved revelations of corporate malfeasance,
little until early November, when the and disappointing news about near-term
FOMC lowered the target federal funds corporate profits. In concert, these
rate 1⁄2 percentage point, and other short- developments prompted investors to
term interest rates followed suit. Yields mark down their expectations for eco­
on intermediate- and long-term Trea­ nomic growth and, consequently, their
sury securities, by contrast, declined anticipated path for monetary policy. A
widespread retrenchment in risk-taking
sent yields on speculative-grade corpo­
Interest Rates on Selected Treasury
rate bonds sharply higher and kept those
on the lower rungs of investment grade
Percent from declining, even as longer-term
nominal Treasury yields fell to very low
7 levels by the end of July.
Ten-year 6
The uneventful passing of the Secu­
rities and Exchange Commission’s
August 14 deadline for officers of large
Two-year companies to certify corporate financial
statements somewhat assuaged inves­
Three-month 1
tors’ anxieties about corporate gover­
2001 2002 2003 nance problems. But subsequent news
NOTE. The data are daily and extend through suggesting that the economy was los­
February 5, 2003. ing momentum and a flare-up in ten-
Economic and Financial Developments in 2002 and Early 2003 29

sions with Iraq further boosted demand ened bid–asked spreads in the corporate
for Treasury securities. The FOMC’s bond market enough to impair trad­
decision at the August meeting—to ing. Risk spreads on speculative-grade
leave the intended federal funds rate bonds narrowed considerably over the
unchanged but to judge the balance year’s final quarter and in early 2003,
of risks to the outlook as weighted though they remain elevated by his­
toward economic weakness—pulled the torical standards; risk spreads for the
expected path of the funds rate lower, weaker speculative-grade credits remain
and longer-term Treasury yields sank to exceptionally wide, as investors evi­
forty-year lows in early autumn. A high dently anticipate a continued high level
degree of investor uncertainty about the of defaults and low recovery rates.
future path of monetary policy was evi­
denced by implied volatilities of short-
term interest rates derived from option
Equity Markets
prices, which soared to record levels in Equity prices were buffeted last year by
early autumn. The size of the FOMC’s considerable fluctuations in investors’
November cut in the target federal funds assessments of the outlook for the
rate and the shift to balance in its assess­ economy and corporate earnings and
ment of risks surprised market partici­ by doubts about the quality and trans­
pants, but the policy easing appeared to parency of corporate balance sheets.
lead investors to raise the odds that the Net declines in stock prices in 2002
economy would pick up from its slug­ exceeded those posted during either of
gish pace. Generally positive economic the preceding two years. Worries about
news and rising equity prices over the the pervasiveness of questionable corpo­
remainder of the year also bolstered con­ rate governance and a deterioration in
fidence and prompted market partici­ the earnings outlook—especially in the
pants to mark up the expected path for technology sector—depressed equity
monetary policy and push up longer- prices in early 2002. The positive tenor
term Treasury yields. of economic data, however, managed
Yields on higher-quality investment- to outweigh those concerns, and stock
grade corporate bonds generally tracked prices staged a rally halfway through the
those on Treasuries of comparable matu­ first quarter, with the gains tilted toward
rity last year, although risk spreads on ‘‘old economy’’ firms. But the rebound
these instruments widened moderately
over the summer and early autumn
Major Stock Price Indexes
before narrowing over the remainder
of the year. Interest rates on below- January 2, 2001 = 100
investment-grade corporate debt, by
contrast, increased for much of last year, 125
as spreads over Treasuries ballooned in
response to mounting concerns about Wilshire 5000 100
corporate credit quality, historically low 75
recovery rates on defaulted bonds, and
S&P 500
revelations of improper corporate gover­ 50
nance; credit risk spreads widened in all
speculative sectors but especially in tele­ 2001 2002 2003
com and energy. By the summer, inves­ NOTE. The data are daily and extend through
tors’ retreat from risk-taking had wid­ February 5, 2003.
30 89th Annual Report, 2002

was short lived. Share prices started to Implied S&P 100 Volatility
tumble in early spring across all sectors
as weaker-than-expected economic data
eroded investors’ confidence in the
strength of the economic expansion.
These developments were reinforced by 40
first-quarter corporate earnings reports 30
that, though mostly matching or exceed­ 20
ing investors’ expectations, painted a
bleak picture of prospective sales and 10

1997 1999 2001 2003
Over the spring and summer, account­
ing scandals, widespread warnings NOTE. The data are daily and extend through
February 5, 2003. The series shown is the implied
about near-term corporate profitability, volatility of the S&P 100 stock price index as calculated
and heightened geopolitical tensions from the prices of options that expire over the next
several months.
intensified the slide in stock prices. Par­ SOURCE. Chicago Board Options Exchange.
ticularly large declines in share prices
were posted for technology firms, whose
prospects for sales and earnings were of economic data. Greater confidence
especially gloomy. Equity prices were among investors in the economic out-
boosted briefly by the uneventful pass­ look also helped bring down the implied
ing of the August 14 deadline to certify volatility on the S&P 100 significantly
financial statements, but they quickly by year-end, although it remains at
reversed course on continued concerns an elevated level by historical standards.
about the pace of economic growth and Despite the fourth-quarter rebound,
corporate earnings and the escalat­ broad equity indexes were down, on net,
ing possibility of military action against about 20percent in 2002, while the tech-
Iraq. By early October, equity indexes heavy Nasdaq lost more than 30 percent.
sank to their lowest levels since the The decline in equity prices dur­
spring of 1997, and implied stock price ing the first three quarters of 2002 is
volatility on the S&P 100 surged to its estimated to have erased more than
highest reading since the stock market $31⁄2 trillion in household wealth, a loss
crash of 1987. The drop in stock prices of nearly 9 percent of total household
widened the gap between the expected net worth, although the fourth-quarter
year-ahead earnings–price ratio for the rise in stock prices restored about
S&P 500 and the real ten-year Treasury $600 billion. Still, the level of house-
yield—one simple measure of the equity hold net worth at the end of last year
premium—to levels not seen since the was more than 40 percent higher than it
mid-1990s. was at the start of the bull market in
Share prices turned around in late 1995. Equity prices maintained their
October, as the third-quarter corporate upward momentum during the first half
earnings reports were not as weak as of January 2003 but then fell sharply
investors had originally feared. Equity amid the looming prospects of military
prices were also given a boost in early action against Iraq and a still-gloomy
November by the larger-than-expected outlook for corporate earnings. Broad
monetary policy easing, and the rally stock price indexes have lost almost
was sustained over the remainder of the 5 percent this year; however, solid
year by the generally encouraging tone fourth-quarter earnings from many
Economic and Financial Developments in 2002 and Early 2003 31

prominent technology companies helped pickup was driven by large acquisi­

brighten investors’ sentiment regarding tions of securities, especially mortgage-
that sector, and the Nasdaq is down backed securities, as well as a surge in
about 3 percent this year. home equity and residential real estate
By contrast, business lending at com­
Debt and Financial Intermediation mercial banks dropped 7 percent last
A deceleration of business borrowing year after falling almost 4 percent in
slowed growth of the debt of nonfed­ 2001; last year’s decline kept overall
eral sectors about 1 percentage point in loan growth for 2002 to about 5 percent.
2002, to 61⁄2 percent. By contrast, the In the October Senior Loan Officer
decline in interest rates last year kept Opinion Survey on Bank Lending Prac­
borrowing by households and state and tices, respondents noted that the decline
local governments brisk. At the federal in commercial and industrial (C&I)
level, weak tax receipts and an accelera­ lending since the beginning of the year
tion in spending pushed debt growth to reflected not only the limited funding
71⁄2 percent last year after a slight con- needs of creditworthy borrowers that
traction in 2001. found bond financing or a runoff of
For the year as a whole, corporate liquid assets more attractive, but also a
borrowing was quite weak, mainly reduction in the pool of creditworthy
because of sagging capital expenditures, borrowers. Over the course of last year,
a drying up of merger and acquisition banks reported some additional net
activity, and a reliance on liquid assets. tightening of standards and terms on
Although businesses tapped bond mar­ C&I loans, mainly in response to greater
kets in volume over the first half of the uncertainty about the economic outlook
year, subsequent concerns about the and rising corporate bond defaults,
reliability of financial statements and although the proportions of banks that
the quality of corporate governance and reported doing so declined noticeably.
deteriorating creditworthiness ruined Direct measures of loan pricing condi­
investors’ appetite for corporate debt in tions from the Federal Reserve’s quar­
the summer and early autumn. House- terly Survey of Terms of Business Lend­
holds, by contrast, flocked to the mort­ ing also indicated that banks were
gage markets to take advantage of low cautious lenders last year, as the average
mortgage rates throughout the year, and spread of C&I loan rates over market
strong motor vehicle sales supported interest rates on instruments of com­
the expansion of consumer credit. For parable maturity remained wide, and
depository institutions, the net effect of spreads on new higher-risk loans
these developments was an accelera­ declined only slightly from the lofty lev­
tion of credit to 61⁄2 percent last year, els that prevailed over the first half of
2 percentage points above the pace the year. Although bank lenders were
of 2001. The growth of credit at thrift wary about business borrowers, espe­
institutions moderated, though the slow- cially toward lower-rated credits, they
down can be attributed for the most did not significantly constrict the supply
part to a large thrift institution’s conver­ of loans: Most small firms surveyed by
sion to a bank charter. The growth of the National Federation of Independent
credit at commercial banks accelerated Businesses in 2002 reported that they
to 63⁄4 percent—a significant increase experienced little or no difficulty satisfy­
from the anemic pace in 2001; the ing their borrowing needs.
32 89th Annual Report, 2002

Loan quality at commercial banks deterioration in corporate credit quality.

improved overall last year. Loan delin­ However, these negative pressures were
quency rates edged down through the offset somewhat by the continued strong
third quarter of 2002—the latest growth of insurance premiums, and both
period for which Call Report data are sectors of the insurance industry stayed
available—in response to better perfor­ fairly well capitalized in 2002.
mance of residential real estate and con­
sumer loans and a stable delinquency
rate on C&I loans. Despite the improve­
Monetary Aggregates
ment in consumer loan quality, domestic The broad monetary aggregates deceler­
banks imposed somewhat more strin­ ated noticeably last year after surging in
gent credit conditions when lending 2001. Short-term market interest rates,
to households, according to the survey which had declined swiftly during 2001,
on bank lending practices. Moderate net were stable over the first half of the
proportions of surveyed institutions year; deposit rates, in a typical pattern
tightened credit standards and terms for of lagged adjustment, continued to fall.
credit card and other consumer loans Consequently, the opportunity cost of
throughout last year. The net fraction of holding M2 assets increased, especially
banks that tightened standards on resi­ for its liquid deposit (checking and sav­
dential mortgage loans rose late in the ings accounts) and retail money fund
year to the highest share in the past components, thereby restraining the
decade, but nonetheless remained quite demand for such assets. After decele­
low. Commercial banks generally reg­ rating in the first half of the year, M2
istered strong profit gains last year, rebounded significantly in the second
although steep losses on loans to energy half, because of a surge in liquid depos­
and telecommunications firms signifi­ its and retail money market mutual
cantly depressed profits at several large funds. The strength in both components
bank holding companies. Despite the partly reflected elevated volatility in
increased rate of provisioning for loan equity markets against the backdrop of
losses, the banking sector’s profitability a still-low opportunity cost of holding
stayed in the elevated range recorded such deposits. In addition, another wave
for the past several years, as a result of
the robust fee income from mortgage M2 Growth Rate
and credit card lending, effective cost
controls, and the relatively inexpen­ Percent, annual rate
sive funding offered by inflows of core
deposits. As of the third quarter of last 10
year, virtually all assets in the banking 8
sector were at well-capitalized insti­ 6
tutions, and the substitution of securi­
ties for loans on banks’ balance sheets 4
helped edge up risk-based capital ratios. 2
The financial condition of insurance
companies, by contrast, worsened nota­ 1990 1994 1998 2002
bly last year. Both property and casualty NOTE. M2 consists of currency, travelers checks,
insurers and life and health insurers demand deposits, other checkable deposits, savings
deposits (including money market deposit accounts),
sustained significant investment losses small-denomination time deposits, and balances in retail
from the decline in equity prices and the money market funds.
Economic and Financial Developments in 2002 and Early 2003 33

of mortgage refinancing boosted M2 since the late 1960s had usually been set
growth during this period. (Refinanc­ below market interest rates. The sub­
ings cause prepayments to accumu­ sidy required Federal Reserve Banks to
late temporarily in deposit accounts administer credit extensions heavily in
before being distributed to investors order to ensure that borrowing institu­
in mortgage-backed securities.) All tions used credit only in appropriate
told, over the four quarters of the year, circumstances—specifically, when they
M2 increased 7 percent, a pace that had exhausted other reasonably avail-
exceeded the expansion of nominal able funding sources. That administra­
income. As a result, M2 velocity—the tion was necessarily somewhat subjec­
ratio of nominal GDP to M2—declined tive and consequently difficult to apply
for the fifth year in a row, roughly in consistently across Reserve Banks. In
line with the drop in the opportunity addition, the heavy administration was
cost of M2 over this period. one factor that caused depository insti­
Reflecting in part the slowing of tutions to become reluctant to use the
its M2 component, M3—the broadest window even in appropriate conditions.
money aggregate—expanded 61⁄2 per- Also, depository institutions were con­
cent in 2002, a pace well below the cerned at times about being marked with
123⁄4 percent advance posted in 2001. a ‘‘stigma’’ if market analysts and coun­
Growth in M3 was also held down terparties inferred that the institution
by a sharp deceleration of institutional was borrowing from the window and
money funds, as their yields dropped to suspected that the borrowing signaled
close alignment with short-term market that the institution was having financial
interest rates. This effect was only partly difficulties. The resulting reluctance to
offset by the pickup in needs to fund use the window reduced its usefulness
bank credit, which resulted in an accele­ in buffering shocks to the reserve mar­
ration in the issuance of managed lia­ ket and in serving as a backup source
bilities, including large time deposits. of liquidity to depository institutions,
M3 velocity continued to decline in and thus undermined its performance as
2002. a monetary policy tool.
To address these issues, the Board of
Governors specified that primary credit
New Discount Window Programs may be made available at an above-
On October 31, 2002, following a three- market interest rate to depository insti­
month public comment period, the tutions in generally sound financial con­
Board of Governors approved changes dition. The above-market interest rate
to its Regulation A that established eliminates the implicit subsidy. Also,
two new types of loans to depository restricting eligibility for the program
institutions—primary and secondary to generally sound institutions should
credit—and discontinued the adjustment reduce institutions’ concerns that their
and extended credit programs. The new borrowing could signal financial
programs were implemented on Janu­ weakness.
ary 9, 2003. The seasonal credit pro- The Federal Reserve set the initial
gram was not altered. primary credit rate at 2.25 percent,
The primary reason for adopting the 100 basis points above the FOMC’s tar-
new programs was to eliminate the sub­ get federal funds rate as of January 9,
sidy to borrowing institutions that was 2003. The target federal funds rate
implicit in the basic discount rate, which remained unchanged, and thus the adop-
34 89th Annual Report, 2002

tion of the new programs did not repre­ rapid pace of recovery slowed in devel­
sent a change in the stance of monetary oping Asia and in Canada, while perfor­
policy. In the future, the primary credit mance remained lackluster in much of
rate will be adjusted from time to time the rest of the world.
as appropriate, using the same discre­ Monetary policy actions abroad also
tionary procedure that was used in the diverged across countries in 2002 as
past to set the adjustment credit rate. authorities reacted to differing economic
The Federal Reserve also established conditions. In Canada, official interest
procedures to reduce the primary credit rates were raised in three steps by July
rate to the target federal funds rate in a amid concerns that buoyant domestic
national emergency, even if key policy- demand and sharply rising employ­
makers are unavailable. ment would ignite inflationary pres­
Institutions that do not qualify for sures. Monetary authorities in Australia
primary credit may obtain secondary and Sweden also increased policy rates
credit when the borrowing is consistent in the first half of the year. However, as
with a prompt return to market sources economic conditions weakened around
of funds or is necessary to resolve severe the world in the second half, official
financial difficulties. The interest rate interest rates were held constant in Can­
on secondary credit is set by for­ ada and Australia and were lowered
mula 50 basis points above the pri­ in Sweden. Monetary policy was held
mary credit rate. The rate was set steady throughout 2002 in the United
initially at 2.75 percent. Because sec­ Kingdom, where growth was moderate
ondary credit borrowers are not in and inflation subdued, but official inter­
sound financial condition, extensions of est rates were lowered 25 basis points,
secondary credit usually involve some to 3.75 percent, in early February 2003
administration. in response to concerns about the pros­
pects for global and domestic demand.
The European Central Bank (ECB) held
International Developments rates constant through most of the year,
The international economy rebounded as inflation remained above the ECB’s
in 2002 after a stagnant performance in 2 percent target ceiling, but rates were
2001, but recovery was uneven in both lowered 50 basis points in December as
timing and geographical distribution. the euro area’s already weak recovery
Growth abroad picked up sharply in the appeared to be stalling. Japanese short-
first half of last year, as a strong rally term interest rates remained near zero,
in the high-tech exporting economies in while authorities took some limited fur­
developing Asia was joined by robust ther steps to stimulate demand through
growth in Canada and, to a lesser extent, nontraditional channels. Monetary pol-
Mexico. Japan also posted respectable icy was tightened in both Mexico and
growth in the first half, largely as a Brazil in response to concerns about
result of a surge of exports. However, the inflationary effects of past currency
performance in the euro area remained depreciation.
sluggish, and several South American Yield curves in the major foreign
economies experienced difficulties, with industrial countries steepened and
full-fledged crises in Argentina and shifted up in the first quarter of 2002
Venezuela and mounting concerns about in response to generally favorable eco­
prospects for Brazil. As the U.S. econ­ nomic news, but later they flattened out
omy decelerated in the second half, the and moved back down as the outlook
Economic and Financial Developments in 2002 and Early 2003 35

Equity Indexes in Selected mies; equity prices began to decline

Foreign Industrial Countries around midyear as global demand soft­
ened but posted modest rebounds late in
Week ending January 5, 2001 = 100
the year.
The foreign exchange value of the
Japan 100 dollar continued its mild upward trend
into the early part of 2002, as it appeared
Canada 80 that the United States was poised to lead
a global economic recovery. However,
Euro area 60 the dollar weakened sharply in the late
United Kingdom spring and early summer amid deep­
ening concerns about U.S. corporate
2001 2002 2003
governance and profitability. Around
NOTE. The data are weekly. The last observations are that time market analysts also appeared
the average of trading days through February 5, 2003.
to become more worried about the
growing U.S. current account deficit and
deteriorated. Similarly, equity prices in its potential negative influence on the
the major foreign industrial economies future value of the dollar. The dollar
held up well early in the year but then rebounded somewhat around midyear as
declined along with the U.S. stock mar­ growth prospects for other major econ­
ket and ended the year down sharply omies, particularly in the euro area,
from the previous year. The perfor­ appeared to dim; the dollar dropped
mance of the stock markets in the back again late in the year, as geopoliti­
emerging-market economies was mixed. cal tensions intensified, and continued
Share prices in Brazil and Mexico fell to depreciate in early 2003. In nominal
sharply in the second and third quarters terms the dollar has declined about
but then showed some improvement 5 percent on balance over the past year,
toward the end of the year. In the Asian with depreciations against the curren­
emerging-market economies, equity cies of the major industrial countries
prices rose in the first half of 2002 on and several of the developing Asian
a general wave of optimism, especially economies partly offset by appreciation
in the high-technology producing econo- against the currencies of several Latin
American countries.
Equity Indexes in Selected
Emerging Markets Industrial Economies
Week ending January 5, 2001 = 100 The Canadian economy recorded the
Developing Asia strongest performance among the major
Mexico 120 foreign industrial countries last year
despite some slowing in the second half.
100 The strength, which was largely home-
80 grown, reflected robust growth of con­
sumption and residential construction
Argentina Brazil 60 as well as an end to inventory runoffs
early in the year. The expansion was
2001 2002 2003 accompanied by very rapid increases in
NOTE. The data are weekly. The last observations are employment and utilization of capacity,
the average of trading days through February 5, 2003. and the core inflation rate breached the
36 89th Annual Report, 2002

upper end of the government’s 1 percent announced in the fall, but the details
to 3 percent target range near the end of of this plan are still not fully specified.
the year. The Canadian dollar appreci­ In September, the Bank of Japan
ated against the U.S. dollar in the first announced a plan to buy shares from
half of the year, but it dropped back banks with excessive holdings of equity,
somewhat in the second half as the which would help to reduce bank
economy slowed; by the end of the year exposure to stock market fluctuations.
it was up only slightly on balance. The Because the transactions are to occur at
Canadian dollar has moved up some- market prices, there would be no net
what more so far this year. financial transfer to the banks. Near the
The Japanese economy recorded posi­ end of last year the Bank of Japan (BOJ)
tive growth during 2002, although it was raised its target range for bank reserves
not enough to fully reverse the decline at the BOJ from ¥10–15 trillion to
in output that occurred in 2001. Despite ¥15–20 trillion, increased the monthly
about 10 percent appreciation of the yen amount of its outright purchases of long-
against the dollar in 2002, Japanese term government bonds, and broad­
growth was driven largely by exports, ened the range of collateral that can be
with smaller contributions from both used for market operations. In Decem­
increased consumption and a slower ber the monetary base was up about
pace of inventory reduction. In contrast, 20 percent from a year earlier, a rise
private investment continued to decline, partially reflecting the increased level
although not as sharply as in 2001. of bank reserves at the BOJ. However,
Labor market conditions remained quite the twelve-month rate of base money
depressed, and consumer prices contin­ growth was considerably below the
ued to fall. Little progress was made on 36 percent pace registered in April.
the serious structural problems that have Broad money growth remains subdued.
plagued the Japanese economy, includ­ Economic performance in the euro
ing the massive and growing amount area was quite sluggish last year.
of bad loans on the books of Japanese Although exports were up sharply,
banks. A new set of official measures growth in consumption was modest,
that aims at halving the value of bad and private investment declined. The
loans within two and a half years was area’s lackluster economic performance
pushed the unemployment rate up by
U.S. Dollar Exchange Rate against several tenths of a percentage point by
Selected Major Currencies the end of the year. Economic weakness
Week ending January 5, 2001 = 100
was particularly pronounced in some of
the larger countries—Germany, Italy,
Japanese yen the Netherlands, and, to a lesser extent,
110 France. In contrast, growth in Spain
and some of the smaller euro-area
Canadian pound 100 countries—Ireland, Portugal, Finland,
and Greece—was much more robust.
90 Headline inflation jumped to a bit above
Euro 21⁄2 percent early in the year, owing to
2001 2002 2003 higher food and energy prices and in
small part to the introduction of euro
NOTE. The data are weekly. Exchange rates are in
foreign currency units per dollar. Last observations are notes and coins. Increased slack in the
the average of trading days through February 5, 2003. economy, however, together with the
Economic and Financial Developments in 2002 and Early 2003 37

15 percent appreciation of the euro by approved in September 2002, $6 billion

the end of the year, helped to mitigate of which was disbursed by the end of
inflation concerns, and the ECB low­ the year. However, financial conditions
ered its policy interest rate in Decem­ improved markedly after Lula won the
ber. The euro continued to appreciate in election in late October and appointed
early 2003. a cabinet perceived to be supportive of
Economic growth in the United King­ orthodox fiscal and monetary policies,
dom held up better than in the other including greater central bank indepen­
major European countries last year, and dence. By January 2003 the real had
sterling strengthened about 10 percent reversed about one-fourth of its previ­
versus the dollar. However, the expan­ ous decline against the dollar, and bond
sion remained uneven, with the services spreads had fallen sharply. However,
sector continuing to grow more rapidly the new administration still faces some
than the smaller manufacturing sec­ major challenges. In particular, serious
tor. Despite tight labor markets, infla­ concerns remain over the very large
tion remained a bit below the Bank of quantity and relatively short maturity
England’s target of 21⁄2 percent for most of the outstanding government debt. In
of the past year. A sharp rise in housing addition, last year’s currency deprecia­
prices has, however, raised some con­ tion fueled a rise in inflation that has
cern about the possibility of a real estate
price bubble. The British government
announced its intention to complete a U.S. Dollar Exchange Rates and Bond
rigorous assessment of its criteria for Spreads for Selected Emerging Markets
joining the European Monetary Union January 5, 2001 = 100 January 5, 2001 = 100
(EMU) by the middle of this year and, if
they are met, to hold a referendum on Exchange rates
360 180
entry. Brazilian real
280 Mexican 140
Emerging-Market Economies 200 100
Korean won
The Brazilian economy posted a surpris­ 120 Argentine peso 60
ingly strong rebound in 2002 despite a
major political transition and accompa­
Percentage points Percentage points
nying turbulence in financial markets.
The Brazilian real depreciated sharply Bond spreads
80 20
between May and October, and sover­
eign bond spreads climbed to 2,400 60 Argentina 15
basis points as it became increasingly
likely that Luiz Inácio Lula da Silva 40 10
(Lula), the Workers’ Party candidate, Mexico
20 5
would win the presidential election.
Given some of the past stances of the 2001 2002 2003
party, this possibility fueled concerns
NOTE. The data are weekly averages that are indexed
among foreign investors about a poten­ to the week ending January 5, 2001. Exchange rates (top
tial erosion of fiscal and monetary dis­ panel) are in foreign currency units per dollar. Bond
cipline. In response to the sharp dete­ spreads (bottom panel) are the J.P. Morgan Emerging
Market Bond Index (EMBI+) spreads over U.S.
rioration in financial conditions facing Treasuries. Last observations are the average of trading
Brazil, a $30 billion IMF program was days through February 5, 2003.
38 89th Annual Report, 2002

prompted several increases in the mone­ the dollar, and the bolivar depreciated
tary policy interest rate. In January the sharply. Opponents of President Hugo
government raised the upper bound of Chavez mounted a short-lived coup in
its inflation target range for this year to April and declared a national strike in
8.5 percent from 6.5 percent, although early December. The strike brought the
the target for next year was lowered already-weak economy to a standstill,
at the same time to 5.5 percent from and output in the key oil industry plum-
6.25 percent. meted. The strike abated in early Febru­
Argentine GDP contracted further in ary in all sectors but oil. In response to
2002 after declining 10 percent in 2001. the strike, Chavez increased his control
The currency board arrangement that of the state-owned oil company and oil
had pegged the peso at a one-to-one rate production began rising in early 2003,
with the dollar collapsed early last year; but it was still well below pre-strike
the peso lost nearly three-fourths of its levels. With the exchange rate plunging
value by late June, and sovereign bond in late January, the government sus­
spreads spiked to more than 7,000 basis pended currency trading for two weeks
points. By early 2002, the banking sys­ before establishing a fixed exchange rate
tem had become effectively insolvent as regime and some restrictions on foreign
a result of the plunging peso, the weak currency transactions.
economy, and the government’s default One of the few bright spots in Latin
on debt that the banks held mostly invol­ America last year was the Mexican
untarily. Confronted with this situation, economy. Boosted by the U.S. recovery,
the government forced the conversion growth was moderate for the year as a
of the banks’ dollar-denominated assets whole despite some late slowing. How-
and liabilities to pesos and also man- ever, financial conditions deteriorated
dated the rescheduling of a large share somewhat after midyear as market
of deposits. As a result of these and participants reevaluated the strength of
other measures, confidence in the bank­ the North American recovery. Mexican
ing system, already shaken, was further stock prices slid about 25 percent
impaired. Financial and economic con­ between April and September, and sov­
ditions eventually stabilized in the sec­ ereign bond spreads widened nearly
ond half of the year, but there are no 200 basis points to around 430 basis
signs yet of a sustained recovery. The points over the same period. Never­
government also defaulted on obliga­ theless, the Mexican economy did not
tions to multilateral creditors in late appear to be much affected by spillovers
2002 and early 2003. In January, Argen­ from the problems elsewhere in Latin
tina and the International Monetary America; bond spreads dropped sharply
Fund reached agreement on a $6.6 bil­ between October and the end of the
lion short-term program that will go year to around 300 basis points, a level
to meeting Argentina’s payments to considerably lower than elsewhere in
the IMF at least through the elections the region. The peso depreciated about
expected in the spring and also to clear­ 12 percent against the dollar over the
ing its overdue obligations to the multi- course of last year. The decline fueled
lateral development banks. an increase in twelve-month inflation to
Venezuela experienced extreme eco­ more than 51⁄2 percent by year-end. The
nomic and political turmoil over the past acceleration put inflation above the gov­
year. In February 2002 the central bank ernment target rate of 41⁄2 percent and
abandoned the bolivar’s crawling peg to well above the ambitious 3 percent tar-
Economic and Financial Developments in 2002 and Early 2003 39

get set for 2003. In response to increas­ The performance of the ASEAN-5
ing inflation, the Bank of Mexico has economies—Indonesia, Malaysia, the
tightened monetary policy four times Philippines, Singapore, and Thailand—
since September 2002. The peso has also was generally robust in 2002,
continued to depreciate in early 2003, although the overall softening in global
and bond spreads have moved back up a demand in the second half of the year
bit. was evident there as well. The second-
The Asian emerging-market econo­ half slowing in production was particu­
mies generally performed well in 2002, larly pronounced in Singapore, which is
although there were significant dif­ heavily dependent on exports of high-
ferences within the region. Outside technology products. Taiwan, another
of China, the strongest growth was high-technology producer, also showed
recorded in South Korea, which bene­ a significant deceleration in output
fited in the first half of the year from between the first and second halves of
both an upturn in global demand for the year. Both of these economies expe­
high-tech products and a surge in rienced some mild deflation in 2002,
domestic demand, particularly consump­ although prices turned up toward the
tion. However, consumer confidence end of the year.
deteriorated at the end of the year as ten­ Although the Hong Kong economy
sions over North Korea intensified; the did not show as much improvement as
uneasy situation, as well as the substan­ most other emerging Asian economies
tial existing consumer debt burden, pose in the first half of last year, it recorded
significant risks to growth in consump­ very strong growth in the third quarter.
tion this year. The Korean won appreci­ Nevertheless, prices continued to fall for
ated sharply against the dollar between the fourth consecutive year. The main-
April and midyear in response to land Chinese economy, which again out-
improving economic conditions; it then performed the rest of the region in 2002,
dropped back in late summer and early enjoyed surging investment by the gov­
fall as perceptions about the strength of ernment and by foreign investors as well
the global recovery were adjusted down- as robust export growth. The Chinese
ward. However, the won turned back up economy continued to experience mild
against the dollar late last year. deflation last year.

Monetary Policy Report of July 2002

Monetary Policy and the ity to provide growth over the longer
Economic Outlook haul.
The Federal Reserve had moved
The pace of economic activity in the
aggressively in 2001 to counter the
United States picked up noticeably in
weakness that had emerged in aggregate
the first half of 2002 as some of the
demand; by the end of the year, it had
powerful forces that had been restrain­
lowered the federal funds rate to
ing spending for the preceding year and
13⁄4 percent, the lowest level in forty
a half abated. With inventories in many years. With only tentative signs that
industries having been brought into activity was picking up, the Federal
more comfortable alignment with sales, Open Market Committee (FOMC)
firms began boosting production around decided to retain that unusual degree
the turn of the year to stem further run­ of monetary accommodation by leav­
offs of their stocks. And while capital ing the federal funds rate unchanged at
spending by businesses has yet to show its January meeting. Confirmation of an
any real vigor, the steep contraction of improvement in activity was evident by
the past year or so appears to have come the time of the March meeting, and the
to an end. Household spending, as it has FOMC moved toward an assessment
throughout this cyclical episode, contin­ that the risks to the outlook were bal­
ued to trend up in the first half. With anced between its long-run goals of
employment stabilizing, the increases price stability and maximum sustain-
in real wages made possible by gains able economic growth, a view main­
in labor productivity and the effects of a tained through its June meeting. The
variety of fiscal actions have provided durability and strength of the expansion
noticeable support to disposable in- were recognized to depend on the tra­
comes. At the same time, low interest jectory of final sales. The extent of a
rates have buoyed the purchase of dura­ prospective strengthening of final sales
ble goods and the demand for housing. was—and still is—uncertain, however,
Growth was not strong enough to fore- and with inflation likely to remain con­
stall a rise in the unemployment rate, tained, the Committee has chosen to
and slack in product and labor markets, maintain an accommodative stance of
along with declining unit costs as pro­ policy, leaving the federal funds rate at
ductivity has soared, has helped to keep its level at the end of last year.
core inflation low. The exceptionally
The economy expanded especially
strong performance of productivity over
rapidly early in the year. As had been
the past year provides further evidence
anticipated, much of the first quarter’s
of the U.S. economy’s expanded capac-
strength in production resulted from the
efforts of firms to limit a further draw-
Note. The discussion in this section consists down of inventories after the enormous
of the text and tables from the Monetary Policy liquidation in the fourth quarter of 2001.
Report submitted to the Congress on July 16,
2002; the charts from this report (as well as earlier
With respect to first-quarter sales, pur­
reports) are available on the Board’s web site, at chases of light motor vehicles dropped back from their extraordinary fourth-
42 89th Annual Report, 2002

quarter level, but other consumer spend• cial market conditions could reinforce
ing increased substantially. Housing business caution.
starts, too, jumped early in the year— Nevertheless, a number of factors are
albeit with the help of weather condi• likely to boost activity as the economy
tions favorable for building in many moves into the second half of 2002.
parts of the country—and spending on With the inflation-adjusted federal funds
national defense moved sharply higher. rate barely positive, monetary policy
All told, real GDP is now estimated to should continue to provide substantial
have increased at an annual rate in support to the growth of interest-
excess of 6 percent in the first quarter. sensitive spending. Low interest rates
Economic activity appears to have also have allowed businesses and house-
moved up further in recent months but holds to strengthen balance sheets by
at a slower pace than earlier in the year. refinancing debt on more favorable
Industrial production has continued to terms. Fiscal policy actions in the form
post moderate gains, and nonfarm pay- of lower taxes, investment incentives,
rolls edged up in the second quarter and higher spending are providing con•
after a year of nearly steady declines. siderable stimulus to aggregate demand
However, several factors that had con• this year. Foreign economic growth
tributed importantly to the outsized gain has strengthened and, together with a
of real output in the first quarter appear decline in the foreign exchange value
to have made more modest contribu• of the dollar, should bolster U.S. exports.
tions to growth in the second quarter. Finally, the exceptional performance of
Available data suggest that the swing in productivity has supported household
inventory investment was considerably and business incomes while relieving
smaller in the second quarter than in the pressures on price inflation, a combina•
first. Consumer spending has advanced tion that augurs well for the future.
more slowly of late, and while the con•
struction of new homes has expanded
further, its contribution to the growth of
Monetary Policy, Financial
real output has not matched that of ear•
Markets, and the Economy
lier in the year.
over the First Half of 2002
Notable crosscurrents remain at work The information reviewed by the FOMC
in the outlook for economic activity. at its meeting of January 29 and 30
Although some of the most recent indi• seemed on the whole to indicate that
cators have been encouraging, busi• economic activity was bottoming out
nesses still appear to be reluctant to add and that a recovery might already be
appreciably to workforces or to boost under way. Consumer spending had held
capital spending, presumably until they up remarkably well, and the rates of
see clearer signs of improving prospects decline in manufacturing production and
for sales and profits. These concerns, as business purchases of durable equip•
well as ongoing disclosures of corporate ment and software had apparently mod•
accounting irregularities and lapses in erated toward the end of 2001. In addi•
corporate governance, have pulled down tion, the expectation that the pace of
equity prices appreciably on balance inventory runoff would slow after sev•
this year. The accompanying decline eral quarters of substantial and growing
in net worth is likely to continue to liquidation constituted another reason
restrain household spending in the for anticipating that economic activity
period ahead, and less favorable finan• would improve in the period imme-
Monetary Policy Report of July 2002 43

diately ahead. Nonetheless, looking hold led to noticeable increases in broad

beyond the near term, the FOMC faced stock indexes and in long-term interest
considerable uncertainty about the rates. But the strength of the recovery
strength of final demand. Because remained unclear. The outlook for busi•
household spending had not softened to ness fixed investment—which would
the usual extent during the recession, be one key to the strength of economic
it appeared likely to have only limited activity once the thrust from inventory
room to pick up over coming quarters. restocking came to an end—was espe•
Intense competitive pressures were cially uncertain, with anecdotal reports
thought to be constraining the growth of indicating that businesses remained
profits, which could damp investment hesitant to enter into major long-term
and equity prices. At the same time, the commitments. While the FOMC be•
outlook for continued subdued inflation lieved that the fiscal and monetary poli•
remained favorable given the reduced cies already in place would continue to
utilization of resources and the fur• stimulate economic activity, it consid•
ther pass-through of earlier declines in ered the questions surrounding the out-
energy prices. Taken together, these con• look for final demand over the quarters
ditions led the FOMC to leave the stance ahead still substantial enough to justify
of monetary policy unchanged, keeping the retention of the current accommoda•
its target for the federal funds rate at tive stance of monetary policy, particu•
13⁄4 percent. In light of the tentative larly in light of the relatively high unem•
nature of the evidence suggesting that ployment rate and the prospect that
the upturn in final demand would be the lack of price pressures would persist.
sustained, the FOMC decided to retain Given the positive tone of the avail-
its assessment that the more important able economic indicators, the FOMC
risk to achieving its long-run objectives announced that it considered the risks to
remained economic weakness—the pos• achieving its long-run objectives as now
sibility that growth would fall short of being balanced over the foreseeable
the rate of increase in the economy’s future.
potential and that resource utilization By the time of the May 7 FOMC
would fall further. meeting, it had become evident that eco•
When the FOMC met on March 19, nomic activity had expanded rapidly
economic indicators had turned even early in 2002. But the latest statistical
more positive, providing encouraging data and anecdotal reports suggested
evidence that the economy was recov• that the expansion was moderating con•
ering from last year’s recession. Con• siderably in the second quarter and that
sumer spending had remained brisk in the extent to which final demand would
the early part of the year, the decline in strengthen was still unresolved. Busi•
business expenditures on equipment and ness sentiment remained gloomy as
software appeared to have about run its many firms had significantly marked
course, and housing starts had turned down their own forecasts of growth in
back up. Industrial production, which sales and profits over coming quarters.
had been falling for nearly a year and a These revised projections, along with
half, increased in January and February the uncertainty surrounding the robust•
as businesses began to meet more of the ness of the overall economic recov•
rise in sales from current production and ery, had contributed to sizable declines
less from drawing down inventories. in market interest rates and weighed
Indications that an expansion had taken heavily on equity prices, which had
44 89th Annual Report, 2002

dropped substantially between the that the risks to the economic outlook
March and May meetings. The outlook remained balanced.
for inflation had remained benign
despite some firming in energy prices,
as excess capacity in labor and product Economic Projections
markets held the pricing power of many for 2002 and 2003
firms in check, and the apparent strong
The members of the Board of Governors
uptrend in productivity reduced cost
and the Federal Reserve Bank presi-
pressures. In these circumstances, the
dents, all of whom participate in the
FOMC decided to keep the federal funds
deliberations of the FOMC, expect the
rate at its accommodative level of
economy to expand rapidly enough over
13⁄4 percent and maintained its view that,
against the background of its long-run the next six quarters to erode current
goals of price stability and sustainable margins of underutilized capital and
economic growth, the risks to the out- labor resources. The central tendency of
look remained balanced. the forecasts for the increase in real
Over the next seven weeks, news on GDP over the four quarters of 2002 is
the economy did little to clarify ques-
tions regarding the vigor of the ongoing
recovery. The information received in Economic Projections for 2002 and 2003
advance of the June 25–26 meeting of Percent
the FOMC continued to suggest that
Federal Reserve Governors
economic activity had expanded in the and
second quarter, but both the upward Indicator
Reserve Bank presidents
impetus from the swing in inventory Central
investment and the growth in final Range tendency
demand appeared to have diminished. In
financial markets, heightened concerns 2002

about accounting irregularities at promi-

Change, fourth quarter
nent corporations and about the outlook to fourth quarter 1
for profits had contributed to a substan- Nominal GDP . . . . . . . . . . . . 41⁄2–51⁄2 43⁄4–51⁄4
Real GDP . . . . . . . . . . . . . . . . 3–4 31⁄2–33⁄4
tial decline in equity prices and corre- PCE chain-type price
spondingly to a further erosion in house- index . . . . . . . . . . . . . . . . 11⁄4–2 11⁄2–13⁄4

hold wealth. But some cushion to the Average level,

fourth quarter
effects on aggregate demand of the Civilian unemployment
decline in share prices had been pro- rate . . . . . . . . . . . . . . . . . . 51⁄2–61⁄4 53⁄4–6
vided by the fall in the foreign exchange
value of the dollar and the drop in long-
term interest rates. Although the FOMC Change, fourth quarter
believed that robust underlying growth to fourth quarter 1
Nominal GDP . . . . . . . . . . . . 41⁄2–6 5–53⁄4
in productivity, as well as accommoda- Real GDP . . . . . . . . . . . . . . . . 31⁄4–41⁄4 31⁄2–4
tive fiscal and monetary policies, would PCE chain-type price
index . . . . . . . . . . . . . . . . 1–21⁄4 11⁄2–13⁄4
continue to support a pickup in the rate
of increase of final demand over com- Average level,
fourth quarter
ing quarters, the likely degree of the Civilian unemployment
strengthening remained uncertain. The rate . . . . . . . . . . . . . . . . . . 5–6 51⁄4–51⁄2

FOMC decided to keep unchanged 1. Change from average for fourth quarter of previous
its monetary policy stance and its view year to average for fourth quarter of year indicated.
Monetary Policy Report of July 2002 45

31⁄2 percent to 33⁄4 percent, and the cen• Economic and Financial
tral tendency for real GDP growth in Developments in 2002
2003 is 31⁄2 percent to 4 percent. The
central tendency of the projections of The pace of economic activity picked
the civilian unemployment rate, which up considerably in the first half of 2002
averaged just under 6 percent in the after being about unchanged, on bal•
second quarter of 2002, is that it stays ance, in the second half of 2001. Final
close to this figure for the remainder sales advanced modestly as substantial
of the year and then moves down to gains in household and government
between 51⁄4 percent and 51⁄2 percent by spending were partly off-set by weak
the end of 2003. business fixed investment and a widen•
Support from monetary and fiscal ing gap between imports and exports.
policies, as well as other factors, should In addition, inventory liquidation slowed
lead to a strengthening in final demand sharply as businesses stepped up pro•
over coming quarters. Business spend• duction to bring it more closely in line
ing on equipment and software will with the pace of final sales. The increase
likely be boosted by rising sales, in real GDP was particularly rapid early
improving profitability, tax incentives, in the year, with the first-quarter gain
and by the desire to acquire new capi• elevated by a steep reduction in the
tal embodying ongoing technological pace of the inventory run-off, a surge
advances. Improving labor market con• in defense spending, and a weather-
ditions and a robust underlying trend in induced spurt in construction. Real GDP
productivity growth should further bol• is currently estimated to have risen at an
ster household income and contribute to annual rate of just over 6 percent in the
an uptrend in spending. In addition, the first quarter and appears to have posted
liquidation of last year’s inventory over- a more moderate gain in the second
hangs has left businesses in a position to quarter.
begin rebuilding stocks as they become Private payroll employment declined
more persuaded that the recovery in through April, and at midyear the unem•
final sales will be sustained. ployment rate stood somewhat above
Most FOMC participants expect its average in the fourth quarter of 2001.
underlying inflation to remain close to Core inflation—which excludes the
recent levels through the end of 2003. direct influences of the food and energy
Core inflation should be held in check sectors—remained subdued through
by productivity gains that hold down May, held down by slack in resource
cost increases, a lack of pressure on utilization and continued sizable
resources, and well-anchored inflation advances in labor productivity. Overall
expectations. Overall inflation, which inflation was boosted by a surge in
was depressed last year by a notable energy prices in March and April, but
decline in energy prices, is likely to run energy prices have since retreated a bit.
slightly higher this year. In particular, Inflation expectations remained in check
the central tendency of the projections in the first half of this year.
of the increase in the chain-type index As judged by declines in most interest
for personal consumption expenditures rates over the first half of the year, finan•
over the four quarters of both 2002 cial market participants have marked
and 2003 is 11⁄2 percent to 13⁄4 percent, down their expectation of the vigor of
compared with last year’s pace of the economic expansion. Interest rates,
11⁄4 percent. along with most equity indexes, rose
46 89th Annual Report, 2002

noticeably toward the end of the first posable income have supported a solid
quarter in reaction to generally stronger- underlying pace of spending. The
than-expected economic data. But Trea• decline in stock prices in the first half of
sury yields and equity prices more than 2002 reduced household wealth, and the
rolled back those increases on renewed debt-service burden remained high, but
questions about the strength of the financial stress among households to
rebound in the economy, including date has been limited.
growing uncertainty regarding prospec•
tive corporate profits and concerns about Consumer Spending
escalating geopolitical tensions and
about the governance and transparency Real consumer expenditures increased
of U.S. corporations. Private demands at an annual rate of 31⁄4 percent in the
on credit markets moderated in the first first quarter. Demand for motor vehicles
half of the year, as businesses substan• dropped from an extraordinary fourth-
tially curbed their net borrowing. For quarter pace, but purchases remained
the most part, this reduction reflected supported in part by continued large
further declines in business investment, incentive packages. Outlays for other
a pickup in operating profits, and a goods and services advanced smartly in
return to net equity issuance. But, in the first quarter. In the second quarter,
addition, lenders became more cautious the rate of increase in consumer spend•
and selective, especially for borrowers ing looks to have eased somewhat.
of marginal credit quality. Motor vehicle purchases were little
Market perceptions that the recov• changed, and most other major catego•
ery in the United States might turn out ries of consumer spending likely posted
to be less robust than anticipated also smaller gains than earlier in the year.
put downward pressure on the foreign Real disposable personal income
exchange value of the dollar as mea• moved sharply higher in the first quarter
sured against the currencies of our major and appears to have risen a little further
trading partners, especially during the in the second quarter. Wages and sala•
second quarter of 2002. Central banks in ries have increased only moderately this
some foreign countries, including Can• year. But tax payments have fallen
ada, tightened policy as growth firmed. markedly; last year’s legislation low•
The euro-area economy recovered mod• ered withheld tax payments again this
estly during the first half, and some year, and final payments this spring on
brighter signs were evident in Japan. In tax obligations for 2001 were substan•
contrast, the dollar strengthened on bal• tially below last year’s level (likely
ance against the currencies of our other related at least in part to a decline in
important trading partners; in particular, capital gains realized last year). All told,
the Mexican peso lost ground, and real disposable income increased at an
financial markets reacted to political and annual rate of 8 percent between the
economic problems in several South fourth quarter of last year and May.
American countries. However, household net worth has
likely fallen further because the nega•
tive effect of the decline in stock prices
The Household Sector has been only partly offset by an appar•
Household spending began the year on a ent continued appreciation in the value
strong note and continued to rise in the of residential real estate. According to
second quarter. Further gains in dis• the flow of funds accounts, by the end
Monetary Policy Report of July 2002 47

of the first quarter, the ratio of house- ing homes jumped in early 2002 after
hold net worth to disposable income had moving sideways during the preceding
reversed close to two-thirds of its run-up three years; sales of new homes have
in the second half of the 1990s; this ratio also been running quite high in recent
has undoubtedly registered additional months.
declines since the end of March. Con• Home prices have continued to move
sumer sentiment improved over the first up strongly. For example, over the year
several months of the year, with indexes ending in the first quarter, the constant-
from both the Conference Board and quality price index for new homes
the Michigan Survey Research Center rose 51⁄4 percent, and the repeat-sales
reversing last fall’s sharp deterioration. price index for existing homes was up
However, both indexes have given up 61⁄4 percent. Despite these increases,
some of those gains more recently. low mortgage rates have kept housing
The personal saving rate increased in affordable. Rates on thirty-year conven•
the first half of this year, as the decline tional fixed-rate loans averaged less than
in wealth over the past two years likely 7 percent in the first half of this year,
held down consumer spending relative and rates on adjustable-rate loans con•
to disposable personal income. In May, tinued the downtrend that began in early
the saving rate stood at 3 percent of 2001. The share of median household
disposable income, up from an average income required to finance the purchase
of 11⁄2 percent over 2001. Movements of a median-price house is close to its
in the saving rate have been very erratic average for the past ten years and well
over the past year, reflecting cyclical below the levels that prevailed in the
factors, the timing of tax cuts, and 1970s and 1980s.
adjustments in incentives to purchase In the multifamily sector, housing
motor vehicles. starts averaged 340,000 units at an
annual rate over the first five months of
Residential Investment the year, a pace close to the average of
the previous five years. However, condi•
Real residential investment increased tions in this market have deteriorated
at an annual rate of about 15 percent somewhat during the past year. In the
in the first quarter, and the level of activ• first quarter, the vacancy rate for apart•
ity appears to have remained robust ments spiked to the highest level since
in the second quarter. The first-quarter the late 1980s, and rents and property
surge was spurred partly by unseason• values were below year-earlier readings.
ably warm and dry winter weather,
which apparently encouraged builders
Household Finance
to move forward some of their planned
construction. At the same time, under- As it did last year, household debt
lying housing activity has been sup- appears to have expanded at more than
ported by the gains in income and confi• an 8 percent annual rate during the first
dence noted above, and, importantly, by half of 2002. Although consumer credit
low interest rates on mortgages. In the (debt not secured by real estate) has
single-family sector, starts averaged an increased, the bulk of the expansion in
annual rate of 1.35 million units over household debt has come from a sizable
the first five months of the year—up buildup of home mortgage debt. Refi•
61⁄2 percent from the already buoyant nancing activity has fallen below last
pace registered in 2001. Sales of exist• year’s record pace, but it has remained
48 89th Annual Report, 2002

strong as households have continued to sion are likely still restraining equip•
extract a portion of the accumulated ment demand, but rising output, improv•
equity in their homes. ing corporate profits, and continuing
The aggregate household debt-service technological advances appear to be
burden—the ratio of estimated mini- working in the opposite direction. Many
mum scheduled payments on mortgage businesses have worked off their excess
and consumer debt to disposable per• stocks, and the substantial inventory
sonal income—although still elevated, runoff that began in the first quarter of
has moved little this year. The effect of last year seems to be drawing to a close.
the fast pace of household borrowing on The combination of higher profits and
the debt burden has been offset by lower weak investment spending has led to a
interest rates and the brisk growth in drop in borrowing by the nonfinancial
disposable income. On balance, indi• business sector thus far this year.
cators of credit quality do not suggest
much further deterioration in the finan• Fixed Investment
cial condition of households. While
delinquency rates for subprime borrow• Real business spending on equipment
ers have risen further for auto loan pools and software (E&S) was little changed
and have stayed high for mortgages, in the first quarter after having dropped
mortgage delinquencies for all borrow• sharply last year. In the high-tech cate•
ers have changed little, and delinquen• gory, real expenditures moved up in the
cies on credit card accounts at banks first quarter after a double-digit decline
have not risen significantly since the in 2001. Outlays for computers posted
mid-1990s. The number of personal large gains in inflation-adjusted terms in
bankruptcy filings also has essentially both the fourth and first quarters; many
moved sideways this year, albeit at a businesses apparently postponed com•
historically high rate. Lenders have puter replacement over much of last year
apparently reacted to these indicators but now seem to be taking advantage
of household credit quality by tighten• of ongoing technological progress and
ing standards for consumer loans, as the associated large declines in prices.
reported on the Federal Reserve’s Senior In contrast, real expenditures for
Loan Officer Opinion Surveys. Stan• communications equipment were little
dards for mortgage loans, however, have changed in the first quarter after hav•
changed little, and, on the whole, credit ing plunged by one-third during 2001.
appears to have remained readily avail- Excess capacity in the provision of tele•
able to the household sector. com services is continuing to weigh
heavily on the demand for communi•
cations equipment. Business outlays for
The Business Sector software edged down in real terms in the
Spending in the business sector appears first quarter.
to have bottomed out recently, but a Real spending on transportation
strong recovery has not yet taken hold. equipment dropped in the first quarter.
Real business fixed investment, which Outlays for aircraft shrank dramatically
declined sharply last year, fell again in as the reduction in orders after last
the first quarter, but seems to have year’s terrorist attacks began to show
firmed in the second quarter. Excess through to spending. Outlays for motor
capacity in some sectors and uncertainty vehicles fell sharply early in the year
about the pace of the economic expan• owing to weakness in the market for
Monetary Policy Report of July 2002 49

heavy trucks and a reported reduction in began in the middle of last year in the
fleet sales to rental companies related to wake of the decline in the prices of oil
the downturn in air travel. Real E&S and natural gas from their peaks a few
spending outside of the high-tech and quarters earlier. Incoming data point to
transportation categories moved up in further declines in spending for nonresi•
the first quarter after sizable declines in dential structures in the second quarter.
the three preceding quarters. This pat-
tern probably reflects the deceleration
Inventory Investment
and subsequent acceleration in business
output, which is an important determi• Businesses ran off inventories at an
nant of spending in this category. annual rate of nearly $30 billion in the
In the second quarter, real E&S first quarter. This drawdown followed a
spending likely rose, borne along by much larger liquidation—at an annual
increases in sales and a rebound in rate of roughly $120 billion—in the
profits. Incoming data on orders and fourth quarter, and the associated
shipments suggest that real outlays for step-up in production contributed almost
high-tech equipment advanced and that 31⁄2 percentage points to the first-quarter
expenditures for other nontransportation increase in real GDP. Book-value data
equipment also rose. Spending on air- on inventories outside of the motor vehi•
craft probably contracted further, but cle sector point to a further slackening
orders for heavy trucks surged this of the drawdown more recently. Since
spring, as some companies reportedly last fall, inventory–sales ratios have
shifted purchases forward in anticipa• more than reversed the run-up that
tion of stricter emissions requirements occurred as the economy softened. Cur•
that are scheduled to take effect in the rently, inventories do not appear to be
fall. Because of lags in the ordering and excessive for the economy as a whole,
building of new equipment, the provi• although industry reports suggest that
sion for partial expensing in the Job overhangs persist in a few areas. In con•
Creation and Worker Assistance Act trast to inventories in other sectors,
passed by the Congress in early March motor vehicle stocks increased in the
will likely bolster investment spending first half of this year, as automakers
gradually. boosted production in order to rebuild
Real outlays for nonresidential struc• stocks that had been depleted by the
tures registered a very large decline in robust pace of sales in late 2001. Motor
the first quarter after having slipped vehicle inventories were no longer lean
appreciably in 2001. Outlays for office as of the middle of this year.
and industrial structures, lodging facili•
ties, and public utilities dropped sub• Corporate Profits and Business
stantially. Vacancy rates for offices Finance
jumped in the first quarter to their high•
est level since the mid-1990s; in addi• The economic profits of the U.S. nonfi•
tion, rents and property values were nancial corporate sector grew 5 percent
noticeably below their levels one year at a quarterly rate in the first quarter of
earlier. Vacancy rates have risen dra• this year after a surge of 133⁄4 percent
matically in the industrial sector as well. in the fourth quarter of 2001. The corre•
Construction of drilling structures also sponding ratio of profits to sector GDP
contracted sharply in the first quarter, has edged up to 83⁄4 percent, reversing a
thereby continuing the downtrend that portion of the steep decline registered
50 89th Annual Report, 2002

over the preceding few years but continued to weigh on issuance this
remaining well below its peak in the year.
mid-1990s. Early indicators point to fur• Although many businesses have
ther profit gains in the second quarter. apparently substituted bond debt for
The rise in profits since late 2001, shorter-term financing by choice, oth•
combined with weak capital expendi• ers, especially investment-grade firms
tures and low share repurchase and cash- in the telecommunications sector, have
financed merger activities, have helped done so by necessity: They were pushed
keep nonfinancial corporations’ need for out of the commercial paper market or
external funds (the financing gap) below otherwise encouraged by investors and
the average of last year. In addition, credit-rating agencies to curb their reli•
corporations have turned to the equity ance on short-term sources of financing
markets to raise a portion of their to limit the associated rollover risk.
needed external funds: Corporations Indeed, commercial paper outstanding
have sold more new equity than they ran off sharply in February and early
have retired this year—the first period March, when several companies that
of net equity issuance in nearly a were perceived as having questionable
decade. They have used much of these accounting practices were forced to tap
funds to repay debt. As a result, the bank lines to pay off maturing commer•
growth of nonfinancial business debt cial paper. With lower-quality borrow•
appears to have slowed considerably in ers leaving the market in the face of
the first half of 2002 after rapid gains in elevated risk spreads, commercial paper
preceding years. outstanding shrank nearly 30 percent in
Much of the growth in nonfinancial the first half of the year after a sizable
business debt this year has been concen• decline in 2001.
trated in the corporate bond market Some firms that exited the commer•
(though issuance has not been quite so cial paper market turned, at least tem•
strong as in 2001), as firms have taken porarily, to banks as an alternative.
advantage of historically attractive Nonetheless, on net, commercial and
yields. Many corporations have used the industrial loans at banks have declined
proceeds of their bond offerings to pay this year, reflecting borrowers’ prefer•
down commercial and industrial (C&I) ence for lengthening the maturity of
loans at banks and commercial paper. In their liabilities and the overall reduction
recent months, however, net corporate in the demand for external financing,
bond issuance has slowed, and the con- noted earlier. To a more limited extent, a
traction in short-term funding appears to somewhat less receptive lending envi•
have moderated. ronment probably also weighed on busi•
About one fifth of total bond offer• ness borrowing at banks. In particular,
ings over the first half of 2002 have banks continued to tighten terms and
been in the speculative-grade market. standards on C&I loans on net over
This fraction is about unchanged from the first half of this year, although the
last year but still well below the propor• fraction of banks that reported having
tions seen in the latter half of the 1990s, done so fell noticeably in the Federal
and speculative-grade bond offerings Reserve’s Senior Loan Officer Opinion
have been concentrated in the higher Survey in April. Banks have also
quality end of that market. Troubles in imposed stricter underwriting standards
the two largest sectors of the market— and higher fees and spreads on backup
telecommunications and energy—have lines of credit for commercial paper over
Monetary Policy Report of July 2002 51

most of 2001 and early 2002; banks Nonetheless, investor appetite for
cited increased concerns about the credit- CMBS has apparently been strong, as
worthiness of issuers and a higher likeli• yield spreads have narrowed this year.
hood of lines being drawn down. Delinquency rates on CMBS pools,
Indicators of credit quality still point which had been rising during the early
to some trouble spots in the nonfinancial part of the year, seem to have stabilized
business sector. The ratio of net interest in recent months, and delinquency rates
payments to cash flow has trended up on commercial mortgages held by banks
since the mid-1990s for the nonfinan• and insurance companies have remained
cial corporate sector as a whole, with near their historical lows.
increases most pronounced for weaker The low level of risk spreads for
speculative-grade firms. The default rate CMBS suggests that concerns about ter•
on outstanding corporate bonds has rorism insurance have not been wide-
remained quite elevated by historical spread in the market for commercial
standards. By contrast, although the mortgages, and responses to the Federal
delinquency rate on C&I loans at banks Reserve’s Senior Loan Officer Opinion
has risen a bit further this year, it has Survey in April indicate that most
stayed well below rates observed in the domestic banks required insurance on
early 1990s. In part, however, this per• less than 10 percent of the loans being
formance may be attributable to more used to finance high-profile or heavy-
aggressive loan sales and charge-offs traffic properties. Nonetheless, that
than in the past. It may be that problems fraction was much higher at a few
have risen more for large firms than banks, and some credit-rating agencies
for smaller ones, as the increase in C&I have placed certain CMBS issues—
loan delinquencies over recent quarters mainly those backed by high-profile
was limited to large banks, where loans properties—on watch for possible
to larger firms are more likely to be downgrade because of insufficient ter•
held. Credit rating downgrades contin• rorism insurance.
ued to outpace upgrades by a substantial
margin, as was the case in the last quar•
ter of 2001. Spreads of corporate bond
The Government Sector
yields over those on comparable Trea• The federal unified budget moved into
suries have remained high by historical deficit in fiscal 2002 after having posted
standards and have risen considerably a substantial surplus in fiscal 2001. The
across the credit-quality spectrum for deterioration reflects a sharp drop in tax
telecom firms. Corporate bond spreads collections (resulting in part from the
also widened, though to a much smaller effects of the economic downturn, the
extent, for a few highly rated firms in decline in stock prices, and legislated
other industries owing to concerns about tax cuts) and unusually large supple-
their accounting practices. mental spending measures. As a conse•
After having surged late last year, quence, federal debt held by the public
growth in commercial mortgage debt increased in the first half of the year
dropped back in the first half of this year after rapid declines during the previous
amid a sharp decline in construction several years. The budgets of states and
activity. Issuance of commercial mort• localities have also been strained by eco•
gage backed securities (CMBS), a major nomic events, and many state and local
component of commercial mortgage governments have taken steps to relieve
finance, has been especially weak. these pressures.
52 89th Annual Report, 2002

Federal Government ment increased further in the second

Over the first eight months of fiscal year Federal saving, which equals the uni•
2002 (October through May) the unified fied budget surplus adjusted to conform
budget recorded a deficit of $147 bil• to the accounting practices followed
lion, compared with a surplus of in the national income and product
$137 billion over the same period of accounts, has fallen considerably since
fiscal year 2001. Nominal receipts were the middle of last year. Net federal sav•
12 percent lower than during the same ing, which accounts for the depreciation
period of fiscal 2001, and daily Treasury of government capital, turned negative
data since May suggest that receipts in the first quarter of this year. At the
have remained subdued. Individual tax same time, the net saving of households,
payments are running well below last businesses, and state and local govern•
year’s pace; this weakness reflects gen• ments has moved up from its trough of
eral macroeconomic conditions, the leg• last year. On balance, net national sav•
islated changes in tax policy, and the ing as a share of GDP has held roughly
decline in stock prices and consequent steady in the past several quarters after
reduction in capital gains realizations in having moved down sharply since 1999.
2001. The extent of the weakness was Federal debt held by the public, which
not widely anticipated—this spring’s had been declining rapidly over the past
nonwithheld tax payments, which few years, grew at a 31⁄4 percent annual
largely pertain to last year’s liabilities, rate in the first quarter of 2002 and is
generated the first substantial negative estimated to have increased consider-
April surprise in revenue collections in ably more in the second quarter. The
a number of years. Corporate tax pay• ratio of federal government debt held
ments have also dropped from last by the public to nominal GDP fell only
year’s level because of weak profits and slightly in the first quarter following
the business tax provisions included in several years of steep declines. In
the Job Creation and Worker Assistance response to the changing budget out-
Act of 2002. look, the Treasury suspended its buy-
Nominal federal outlays during the back operations through mid-August
first eight months of fiscal 2002 were and increased the number of auctions
10 percent higher than during the same of new five-year notes and ten-year
period last year; excluding a drop in net indexed securities.
interest payments owing to the current During the second quarter, the Trea•
low level of interest rates, outlays were sury took unusual steps to avoid breach•
up 14 percent. The rate of increase was ing its statutory borrowing limit
especially large for expenditures on of $5.95 trillion. In early April, it
income security, health, and national and temporarily suspended investments in
homeland defense. Real federal expendi• the Government Securities Investment
tures for consumption and gross invest• Fund—the so-called G-fund of the Fed•
ment, the part of government spending eral Employees’ Retirement System.
that is a component of real GDP, rose at Incoming individual nonwithheld tax
an annual rate of roughly 111⁄2 percent receipts later that month allowed the
in the first calendar quarter of 2002 as Treasury to reinvest the G-fund assets
defense spending surged. The available with an adjustment for interest. Late
data suggest that real federal expendi• in May, the Treasury declared a debt
tures for consumption and gross invest• ceiling emergency, which allowed it to
Monetary Policy Report of July 2002 53

disinvest a portion of the Civil Service to borrow heavily in bond markets to

Retirement and Disability Fund, in addi• finance capital expenditures and to
tion to the G-fund, to keep its debt from refund existing obligations, including
breaching the statutory limit. At the time short-term debt issued last year. The
of the declaration, the Treasury indi• overall credit quality of the sector has
cated that disinvestments from these two remained high despite the fiscal stresses
funds, combined with other stopgap associated with the recent economic
measures, would be sufficient to keep slowdown, and yield ratios relative to
it from breaching the debt ceiling only Treasuries have changed little this year,
through late June. The Congress on net.
approved legislation raising the statu•
tory borrowing limit to $6.4 trillion on
June 27. The External Sector
Stronger growth in the United States
State and Local Governments contributed to a widening of U.S. exter•
nal deficits in the first quarter of this
Slow growth of revenue resulting from year. The United States has continued
the economic downturn has also gener• to receive large net private financial
ated a notable deterioration in the fiscal inflows in 2002, but both inflows and
position of many state and local govern• outflows have been at lower levels than
ments over the past year. In response, in recent years.
many states and localities have been
trimming spending plans and, in some Trade and the Current Account
cases, raising taxes and fees. In addition,
many states have been dipping into The U.S. deficit on trade in goods and
rainy-day and other reserve funds. services widened about $27 billion in
Together, these actions are helping to the first quarter, to nearly $380 billion
move operating budgets toward balance. at an annual rate, as a surge in imports
Real consumption and investment overwhelmed a slower expansion of
spending by state and local governments exports. U.S. net investment income
rose at an annual rate of 41⁄4 percent in decreased $33 billion to a slight deficit
the first quarter, but available data sug• position after recording modest sur•
gest that outlays were little changed pluses in all four quarters last year. The
in the second quarter. Outlays for con• U.S. deficit on other income and trans•
sumption items seem to have held to fers widened about $9 billion, to nearly
only moderate increases in the first half $70 billion at an annual rate. The U.S.
of this year, a step-down from last year’s current account, which is the sum of the
more robust gains. Investment spending above, recorded a deficit in the first
rose briskly in the first quarter and quarter of $450 billion at an annual rate,
retreated in the second quarter; this 4.3 percent of GDP and nearly $70 bil•
pattern largely reflects the contour of lion larger than the deficit in the fourth
construction expenditures, which were quarter of 2001.
boosted early in the year by unseason• Real exports of goods and services
ably warm and dry weather. increased 3 percent at an annual rate in
Debt growth in the state and local the first quarter, after five quarters of
government sector has slowed so far in decline. This improvement resulted from
2002 from last year’s very rapid pace. a very large step-up in service receipts,
States and localities have continued as payments by foreign travelers moved
54 89th Annual Report, 2002

back up to near pre-September 11 levels helped keep the value of oil imports
and other private service receipts at a very low level in the first quarter.
increased as well. The real value of But oil prices began to rise in February
exported goods contracted in the first and March as global economic activity
quarter, but at only a 31⁄2 percent annual picked up and as OPEC reduced its
rate. Goods exports had declined much production targets in an agreement
more steeply in the previous three quar• with five major non-OPEC producers
ters under the effects of slower output (Angola, Mexico, Norway, Oman, and
growth abroad, continued appreciation Russia). Oil prices remained firm in the
of the dollar, and plunging global second quarter around $26 per barrel
demand for high-tech products. The amid turmoil in the Middle East, a one-
better performance in the first quarter of month suspension of oil exports by Iraq,
2002 included a markedly slower rate disruption of supply from Venezuela,
of decline of machinery exports and a and increasing global demand. The price
small increase in exported aircraft. of gold also has reacted to heightened
While exports of computers continued geopolitical tensions and moved up
to fall, exports of semiconductors rose more than 13 percent over the first half
for the first time in nearly two years. of 2002.
Export prices continued to edge down in
the first quarter.
The Financial Account
U.S. real imports of goods and ser•
vices expanded in the first quarter at an The shift in the pattern of U.S. interna•
8 percent annual rate. As was the case tional financial flows observed in the
with exports, a substantial part of the second half of 2001 continued into the
increase came from larger service first quarter of this year. Influenced
payments related to increased travel by increased economic uncertainty,
abroad by U.S. residents. Reflecting the questions about corporate governance
rebound in U.S. economic activity, and accounting, and sagging share
imports of real goods rose at about a prices, foreign demand for U.S. equities
4 percent pace in the first quarter of remained weak. Foreign net purchases
2002, the first increase in four quarters, of U.S. bonds slowed; although pur•
as a decline in oil imports was more chases of corporate bonds continued
than offset by a substantial increase in to be robust, demand for agency and
imports of other goods. Growth of non- Treasury bonds slackened. Nonetheless,
oil imports was led by increased imports because U.S. net purchases of foreign
of computers, autos, and consumer securities also fell off, the contribution
goods. The price of imported non-oil of net inflows through private securities
goods declined at about a 21⁄4 percent transactions to financing the U.S. cur-
annual rate, in line with its trend in rent account deficit remained at a high
2001; prices fell for a wide range of level. Preliminary and incomplete data
capital goods and industrial supplies. for the second quarter of 2002 suggest a
Declining demand during the second continuation of this pattern.
half of last year put the price of West Slower economic activity, both in the
Texas intermediate (WTI) crude oil in United States and abroad, and reduced
December 2001 at around $19 per bar• merger activity caused direct investment
rel, its lowest level since mid-1999. inflows and outflows to drop sharply
Unusually warm winter weather in the late last year. Direct investment inflows,
United States—along with low prices— which were strong through the first half
Monetary Policy Report of July 2002 55

of 2001, plummeted in the second half. month in the first quarter and declined
U.S. direct investment abroad stayed at 8,000 per month in the second quarter.
a high level through the third quarter In the second quarter, hiring in con•
but then fell sharply. Both inflows and struction fell by the same amount as in
outflows remained weak in the first the first quarter. Retail employment
quarter of 2002. Available data point to declined somewhat after rising a bit in
a pickup of capital inflows from official the first quarter, and the employment
sources during the first half of 2002, as gain in services other than help supply
the recent weakening of the foreign was slightly smaller than in the first
exchange value of the dollar prompted quarter. However, employment losses in
some official purchases. several other categories abated in the
second quarter.
The unemployment rate in the second
The Labor Market quarter averaged 5.9 percent, up from a
Labor markets weakened further in the reading of 5.6 percent in both the fourth
first few months of the year; they now quarter of last year and the first quarter
appear to have stabilized but have yet to of this year. The higher unemployment
show signs of a sustained and substan• rate in recent months is consistent with
tial pickup. Growth of nominal compen• weak employment gains, and it probably
sation slowed further in the first part was boosted a bit by the federal tempo•
of the year after having decelerated rary extended unemployment compensa•
in 2001. With productivity soaring in tion program. Because this program pro•
recent quarters, unit labor costs have vides additional benefits to individuals
fallen sharply. who have exhausted their regular state
benefits, it encourages unemployed indi•
Employment and Unemployment viduals to be more selective about tak•
ing a job offer and likely draws some
After having fallen an average of nearly people into the labor force to become
160,000 per month in 2001, private pay- eligible for these benefits.
roll employment declined at an average
monthly rate of 88,000 in the first quar•
Productivity and Labor Costs
ter and was about unchanged in the sec•
ond quarter. Employment losses in the Labor productivity has increased rapidly
manufacturing sector have moderated in in recent quarters. After rising at an
recent months, and employment in the average annual rate of around 1 percent
help supply services industry—which in the first three quarters of last year,
provides many of its workers to the output per hour in the nonfarm business
manufacturing sector—has increased. sector jumped at an annual rate of
These two categories, which were a 51⁄2 percent in the fourth quarter of last
major locus of weakness last year, year and 81⁄2 percent in the first quarter
gained an average of 11,000 jobs per of this year. Productivity likely contin•
month over the past three months, com• ued to rise in the second quarter, albeit
pared with an average loss of 76,000 at a slower pace. Labor productivity
jobs per month in the first quarter of the often rises briskly in the early stages of
year and 163,000 jobs per month over economic recoveries, but what makes
2001. the recent surge unusual is that it fol•
Apart from manufacturing and help lowed a period of modest increases,
supply, private payrolls fell 12,000 per rather than declines. In earlier postwar
56 89th Annual Report, 2002

recessions, productivity deteriorated as their value when exercised. The decele•

firms retained more workers than may ration in this measure of compensation
have been required to meet reduced is much more dramatic than in the ECI
production needs. The strength in pro• because the ECI does not include stock
ductivity growth around the beginning options. The moderate increase in nomi•
of this year suggests that employers nal compensation combined with the
may have doubted the durability of the spike in productivity growth led unit
pickup in sales and, therefore, deferred labor costs to drop at an annual rate in
new hiring until they became more con• excess of 5 percent in the first quarter,
vinced of the vigor of the expansion. after a decline of 3 percent in the fourth
Smoothing through the recent cyclical quarter.
fluctuations, productivity advanced at an Information about the behavior of
average annual rate of close to 31⁄2 per- compensation in more recent months
cent between the fourth quarter of 2000 is limited. Readings on average hourly
and the first quarter of this year. earnings of production or nonsupervi•
Although this pace is unlikely to be sory workers suggest a further decelera•
sustained, it further bolsters the view tion in wages: The twelve-month change
that the underlying trend in productivity in this series was 31⁄4 percent in June,
has moved up since the first half of the 3⁄4 percentage point below the change

1990s. for the preceding twelve months.

The employment cost index (ECI) for
private nonfarm businesses increased
just under 4 percent during the twelve
months ended in March of this year, A jump in energy prices in the spring
after rising about 41⁄4 percent in the pre- pushed up overall inflation in the first
ceding twelve-month period. The recent part of 2002, but core inflation remained
small step-down likely reflects the subdued. The chain-type price index
lagged effects of the greater slack in for personal consumption expenditures
labor markets and lower consumer price (PCE) increased at an annual rate of
inflation. The wages and salaries com• 21⁄4 percent over the first five months
ponent and the benefits component of of the year, compared with a rise of just
the ECI both decelerated by 1⁄4 percent- over 1 percent for the twelve months of
age point relative to the preceding year. 2001. Core PCE prices rose at an annual
The slowing in benefits costs occurred rate of just over 11⁄2 percent during the
despite a 21⁄2 percentage point pickup first five months of this year, which was
in health insurance cost inflation, to a the pace recorded for 2001.
101⁄2 percent rate of increase. Energy prices rose sharply in March
Nominal compensation per hour in and April but have turned down more
the nonfarm business sector—an alter- recently. Gasoline prices spiked in those
native measure of compensation based two months, as crude oil costs moved
on the national income and product higher and retail gasoline margins
accounts—rose 31⁄2 percent during the surged. Since April, gasoline prices
year ending in the first quarter. This rate have, on balance, reversed a small part
represented a sharp slowing from the of this rise. Natural gas prices stayed
71⁄4 percent pace recorded four quarters low in early 2002 against a backdrop of
earlier, which likely had been boosted very high inventories; however, these
significantly by stock options; stock prices have, on average, moved higher
options are included in this measure at in more recent months. Electricity prices
Monetary Policy Report of July 2002 57

have dropped this year, a move reflect• However, the levels of inflation corre•
ing deregulation of residential prices in sponding to these two alternative mea•
Texas as well as lower prices for coal sures of consumer prices are markedly
and natural gas, which are used as inputs different: Core PCE inflation was about
in electricity generation. All told, energy 11⁄2 percent over the twelve months
prices increased at an annual rate of ended in May, while core CPI inflation
20 percent over the first five months of was about 21⁄2 percent. This gap is more
the year, reversing a little more than half than 1⁄2 percentage point larger than the
of last year’s decline. average difference between these infla•
Consumer food prices increased at tion measures during the 1990s (based
an annual rate of 11⁄2 percent between on the current methods used to construct
December and May. A poor winter crop the CPI instead of the official published
of vegetables pushed up prices early CPI). The larger differential arises from
this year, but supplies subsequently several factors. First, the PCE price
increased and prices came down. In index (unlike the CPI) includes several
addition, consumer prices for meats and components for which market-based
poultry, which began to weaken late last prices are not available, such as check•
year, remained subdued this spring. ing services provided by banks without
Core inflation was held down over explicit charges; the imputed prices for
the first five months of the year by con• these components have increased con•
tinued softness in goods prices, includ• siderably less rapidly in the past couple
ing a significant decline in motor vehi• of years than previously. Second, the
cle prices. Non-energy services prices substantial acceleration in shelter costs
continued to move up at a faster pace since the late 1990s has provided a
than core goods prices, although the larger boost to the CPI than to the PCE
very sizable increases in residential rent price index because housing services
and the imputed rent of owner-occupied have a much larger weight in the CPI.
housing have eased off in recent months. Third, PCE medical services prices—
The rate of increase in core consumer which are largely based on producer
prices has been damped by several price indexes rather than information
forces. One is the lower level of from the CPI—have increased more
resource utilization that has prevailed
over the past year. Core price increases
were also held down by declines in non- Alternative Measures of Price Change
oil import prices and the lagged effects Percent
of last year’s decline in energy prices on
firms’ costs. In addition, inflation expec• 2000 2001
Price measure to to
tations have stayed in check: The Michi• 2001 2002
gan Survey Research Center index of
median expected inflation over the sub- Chain-type
Gross domestic product . . . . . . . . 2.3 1.4
sequent year has rebounded from last Gross domestic purchases . . . . . . 2.2 .7
fall’s highly unusual tumble, but its Personal consumption
expenditures . . . . . . . . . . . . . . 2.4 .7
average in recent months of 23⁄4 percent Excluding food and energy . . . 1.9 1.3
is below the average reading of 3 per- Fixed-weight
cent in 2000. Consumer price index . . . . . . . . . . 3.4 1.2
Excluding food and energy . . . 2.7 2.5
Like core PCE inflation, inflation
measured by the core consumer price Note. Changes are based on quarterly averages and
index (CPI) has remained subdued. are measured from Q1 to Q1.
58 89th Annual Report, 2002

slowly than CPI medical services prices early in 2002, as evidenced by strong
over the past couple of years. flows into both equity and bond mutual
The chain-type price index for gross funds. Equity fund inflows lessened in
domestic purchases—which captures May and turned into outflows in June,
prices paid for consumption, investment, however, as concerns about the strength
and government purchases—rose at an and accuracy of corporate earnings
annual rate of roughly 1 percent in the reports mounted. But the net shift
first quarter of 2002, putting the four- toward longer-term assets this year
quarter change at 3⁄4 percent. This pace appears to have contributed to a signifi•
represents a marked slowing relative to cant deceleration in M2, which has also
the 21⁄4 percent rise in the year-earlier been slowed by reduced mortgage refi•
period, owing to both a drop in energy nancing activity and a leveling out of the
prices (as the decline in the second half opportunity cost of holding M2 assets.
of 2001 was only partly offset by the
increase this spring) and more rapid
Interest Rates
declines in the prices of investment
goods such as computers. The GDP Uncertain about the robustness of the
price index rose at an annual rate of economic recovery, the FOMC opted to
11⁄4 percent in the first quarter and was retain its accommodative policy stance
up almost 11⁄2 percent relative to the over the first half of 2002, leaving
first quarter of last year. The GDP price its target for the federal funds rate at
index decelerated somewhat less than 13⁄4 percent. Market participants, too,
the index for gross domestic purchases, have apparently been unsure about the
in part because declining oil prices strength of the recovery, and shifts in
receive a smaller weight in U.S. produc• their views of the economic outlook
tion than in U.S. purchases. have played a significant role in move•
ments in market interest rates so far this
year. During the first quarter of the year,
U.S. Financial Markets news on aggregate spending and output
Market interest rates have moved lower, came in well above expectations, and
on net, since the end of 2001, as market Treasury coupon yields rose between
participants apparently viewed the ongo• 35 and 65 basis points. The second quar•
ing recovery as likely to be less robust ter, however, brought renewed concerns
than they had been expecting late last about the economic outlook, com•
year. Such a reassessment of the strength pounded by sharp declines in equity
of economic activity and associated prices. In recent months, Treasury cou•
business earnings, along with worries pon yields have more than reversed their
about the accuracy of published cor• earlier increases and are now 40 to
porate financial statements, weighed 50 basis points below their levels at the
heavily on major equity indexes, which end of 2001.
dropped 12 to 31 percent. The debt Survey measures of long-term infla•
of the nonfinancial sectors expanded tion expectations have been quite stable
at a moderate pace, but lenders have this year, implying that real rates
imposed somewhat firmer financing changed about as much as nominal
terms, especially on marginal borrowers. rates. The spread between nominal
Households’ preferences for safer and inflation-indexed Treasury yields,
assets, which had intensified following another gauge of investors’ expectations
last year’s terrorist attacks, diminished about inflation, has moved over a rela-
Monetary Policy Report of July 2002 59

tively wide range since the end of 2001, banks have moved a bit higher this year,
but, on net, it has edged up only slightly. as banks have raised the spread of the
Even the small widening of this spread average interest rate on business loans
likely overstates a shift in sentiment over the target federal funds rate. The
regarding future price pressures in the wider spread reflects higher risk premi•
economy. In mid-February, the Trea• ums on C&I loans to lower-quality bor•
sury reassured investors that it would rowers; spreads for higher-quality bor•
continue to issue indexed debt, an rowers have changed little on net.
announcement that was reinforced in
May when the Treasury made public its
Equity Markets
decision to add one more auction of
ten-year indexed notes to its annual After falling in January in reaction
schedule of offerings. This reaffirmation to pessimistic assessments of expected
of the Treasury’s commitment to issue business conditions over the coming
indexed securities may have pulled year—especially in the tech sector—
indexed yields down by bolstering the stock prices rebounded smartly toward
actual and expected liquidity of the the end of the first quarter on stronger-
market. than-expected macroeconomic data.
Yields on longer-maturity bonds is- Most first-quarter corporate earnings
sued by investment-grade corporations releases met or even exceeded market
have stayed close to their lows of the participants’ expectations, but many
past ten years, but speculative-grade firms included sobering guidance on
yields remained near the high end of sales and earnings prospects in those
their range since the mid-1990s. Spreads announcements. These warnings, com•
relative to Treasury yields have widened bined with mounting questions about
most recently for both investment- and corporate accounting practices, worries
speculative-grade bonds as concerns about threats of domestic terrorism, and
about corporate earnings reporting escalating geopolitical tensions, have
intensified. Such concerns have also taken a considerable toll on equity prices
played a prominent role in the commer• since the end of March. On net, all
cial paper market, especially early this major equity indexes are down sub•
year, when investors, who had become stantially so far this year. Share prices
increasingly worried about accounting in the telecom and technology sectors
scandals, imposed high premiums on have performed particularly poorly, and,
lower-quality borrowers. Subsequently, on July 10, the Nasdaq was 31 percent
however, many such borrowers either lower than at the end of 2001. The
left the commercial paper market or Wilshire 5000, a broad measure of
reduced their reliance on commer• equity prices, fell 181⁄2 percent over the
cial paper financing, and the average same period, returning to a level 40 per-
yield spread on second-tier commercial cent below its historical peak reached in
paper over top-tier paper has narrowed March 2000.
considerably. Declining share prices pulled down
Interest rates on car loans have the price–earnings ratio for the S&P 500
changed little, on net, this year, and index (calculated using operating profits
mortgage rates have moved lower. How- expected over the coming year). None•
ever, according to the Federal Reserve’s theless, the ratio remained elevated
Survey of Terms of Business Lending, relative to its typical values before the
interest rates on C&I loans at domestic mid-1990s, suggesting that investors
60 89th Annual Report, 2002

continued to anticipate rapid long-term The Federal Reserve also addressed

growth in corporate profits. possible changes to the structure of its
discount window facility. On May 17,
Monetary Policy Instruments 2002, the Federal Reserve Board
released for public comment a proposed
At its March 19 meeting, the FOMC amendment to the Board’s Regulation A
assessed the priorities, given limited that would substantially revise its
resources, it should attach to further discount window lending procedures.
studies of the feasibility of outright pur• Regulation A currently authorizes the
chases for the System Open Market Federal Reserve Banks to operate
Account (SOMA) of mortgage-backed three main discount window programs:
securities guaranteed by the Govern• adjustment credit, extended credit, and
ment National Mortgage Association seasonal credit. The proposed amend•
(GNMA-MBS) and the addition of for• ment would establish two new discount
eign sovereign debt securities to the window programs called primary credit
list of collateral eligible for U.S. dollar and secondary credit as replacements
repurchase agreements by the System. for adjustment and extended credit. The
As noted in the February and July 2001 Board also requested comment on the
Monetary Policy Reports to the Con• continued need for the seasonal program
gress, such alternatives could prove but did not propose any substantive
useful if outstanding Treasury debt obli• changes to the program.
gations were to become increasingly The proposal envisions that primary
scarce relative to the necessary growth credit would be available for very short
in the System’s portfolio, and the terms, ordinarily overnight, to deposi•
FOMC had requested that the staff tory institutions that are in generally
explore these options. Noting that many sound financial condition at an interest
of the staff engaged in these studies rate that would usually be above short-
were also involved in contingency plan• term market interest rates, including
ning, which had been intensified after the federal funds rate; currently, the dis•
the September 11 attacks, the FOMC count rate is typically below money
decided to give the highest priority market interest rates. The requirement
to such planning. Federal budgetary that only financially sound institutions
developments over the past year meant should have access to primary credit
that constraints on Treasury debt sup- should help reduce the stigma currently
ply would not become as pressing associated with discount window bor•
an issue as soon as the FOMC had rowings. In addition, because the pro-
previously thought. Still, given the posed discount rate structure will elimi•
inherent uncertainty of budget fore- nate the incentive that currently exists
casts, the likely significant needs for depository institutions to borrow to
for large SOMA operations in com• exploit a positive spread between short-
ing years, and the lead times required term money market rates and the dis•
to implement new procedures, the count rate, the Federal Reserve will be
FOMC decided that the exploratory able to reduce the administrative burden
work on the possible addition of out- on borrowing banks. As a result, deposi•
right purchases of GNMA-MBS should tory institutions should be more likely
go forward once it was possible to do so to turn to the discount window when
without impeding contingency planning money markets tighten significantly,
efforts. enhancing the window’s ability to serve
Monetary Policy Report of July 2002 61

as a marginal source of reserves for the The proportion of total credit sup-
overall banking system and as a backup plied by depository institutions over
source of liquidity for individual deposi• the first half of the year is estimated to
tory institutions. Secondary credit would have been near its lowest value since
be available, subject to Reserve Bank 1993. Although banks have continued
approval and monitoring, for depository to acquire securities at about the same
institutions that do not qualify for pri• rapid pace observed in 2001, the shift
mary credit. in household and business preferences
The proposed amendment is intended toward longer-term sources of credit
to improve the functioning of the dis• greatly reduced the demand for bank
count window and the money market loans. As noted, banks’ loans to busi•
more generally. Adoption of the pro• nesses ran off considerably, as corporate
posal would not entail a change in the borrowers turned to the bond market in
stance of monetary policy. It would not volume to take advantage of favorable
require a change in the FOMC’s target long-term interest rates. Growth of real
for the federal funds rate and would not estate loans slowed markedly this year,
affect the overall level of market interest partly as outlays for nonresidential
rates. The comment period on the pro• structures declined, but growth of con•
posal ends August 22, 2002. If the sumer loans was fairly well maintained.
Board then votes to revise its lending With some measures of credit quality in
programs, the changes likely would take the business and household sectors still
place several months later. pointing to pockets of potential strain,
loan-loss provisions remained high at
banks and weighed on profits. Nonethe•
Debt and Financial Intermediation
less, bank profits in the first quarter
Growth of the debt of domestic nonfi• stayed in the elevated range observed
nancial sectors other than the federal over the past several years, and virtually
government is estimated to have slowed all banks—98 percent by assets—
during the first half of 2002, as busi• remained well capitalized.
nesses’ needs for external funds Among nondepository financial inter•
declined further owing to weak capital mediaries, government-sponsored enter•
spending, continuing inventory liqui• prises (GSEs) curtailed their net lending
dation, and rising profits. In addition, (net acquisition of credit market instru•
growth in consumer credit moderated ments) during the first quarter of the
following a surge in auto financing late year, but available data suggest that
last year. On balance, nonfederal debt insurance companies more than made
expanded at a 51⁄2 percent annual rate in up for the shortfall. The GSEs appeared
the first quarter of the year after grow• to continue to restrain their net lending
ing 71⁄2 percent in 2001. In contrast, the in the second quarter, in part as yields
stock of federal debt held by the public, on mortgage-backed securities, which
which had contracted slightly in 2001, are a major component of their holdings
grew 31⁄4 percent at an annual rate in the of financial assets, compared less favor-
first quarter and expanded further in the ably to yields on the debt they issue.
second quarter, as federal tax revenues Net lending by insurance providers in
fell short of expectations and govern• the first quarter was especially strong
ment spending increased substantially. among life insurance companies, which
The sharp rise in federal debt outstand• experienced a surge in sales late last
ing followed a few years of declines. year in the aftermath of the Septem-
62 89th Annual Report, 2002

ber 11 terrorist attacks. Net lending by large declines registered throughout

the GSEs amounted to 14 percent of the 2001.
net funds raised by both the financial M3—the broadest monetary
and nonfinancial sectors in the credit aggregate—grew 31⁄2 percent at an
markets in the first quarter of 2002, and annual rate through the first six months
the figure for insurance companies was of the year after rising 123⁄4 percent in
10 percent; depository credit accounted 2001. Most of this deceleration, apart
for 13 percent of all net borrowing over from that accounted for by M2, resulted
the same period. from the weakness of institutional
money market funds, which declined
slightly, after having surged about
Monetary Aggregates
50 percent last year. Yields on these
The broad monetary aggregates deceler• funds tend to lag market yields some-
ated considerably during the first half what, and so the returns on the funds,
of this year. M2 rose 41⁄2 percent at an like those on many M2 assets, became
annual rate after having grown 101⁄4 per- less attractive as their yields caught up
cent in 2001. Several factors contributed with market rates.
to the slowing in M2. Mortgage refi•
nancing activity, which results in pre-
payments that temporarily accumulate
International Developments
in deposit accounts before being distrib• Signs that economic activity abroad had
uted to investors in mortgage-backed reached a turning point became clearer
securities, moderated over the first half during the first half of 2002, but recov•
of this year. In addition, the opportunity ery has been uneven and somewhat tepid
cost of holding M2 assets has leveled on average in the major foreign indus•
out in recent months, so the increase in trial countries. Improving conditions in
this aggregate has been more in line the high-tech sector have given a boost
with income. Because the rates of return to some emerging-market economies,
provided by many components of M2 especially in Asia, but several Latin
move sluggishly, the rapid declines in American economies have been troubled
short-term market interest rates last by a variety of adverse domestic devel•
year temporarily boosted the attractive• opments. Foreign financial markets
ness of M2 assets. In recent months, became increasingly skittish during the
however, yields on M2 components first half of the year amid worries about
have fallen to more typical levels global political and economic develop•
relative to short-term market interest ments, including concerns about cor•
rates. Lastly, precautionary demand for porate governance and accounting trig•
M2, which was high in the aftermath of gered by U.S. events. Oil prices reversed
last year’s terrorist attacks, seems to a large part of their 2001 decline.
have unwound in 2002, with investors During the first half, monetary
shifting their portfolios back toward authorities in some foreign countries
longer-term assets such as equity and where signs of recovery were most
bond mutual funds. With growth in evident and possible future inflation
nominal GDP picking up significantly pressures were becoming a concern—
this year, M2 velocity—the ratio of Canada, Australia, New Zealand, and
nominal GDP to M2—rose about Sweden, among others—began to roll
11⁄2 percent at an annual rate in the first back a portion of last year’s easing, rais•
quarter of 2002, in sharp contrast to the ing expectations that policy tightening
Monetary Policy Report of July 2002 63

might become more widespread. How- the consequences of global geopolitical

ever, policy was held steady at the Euro• developments. With U.S. investments
pean Central Bank (ECB) and the Bank perceived as becoming less attractive,
of England. The Bank of Japan (BOJ) the financing requirements of a large
maintained short-term interest rates near and growing U.S. current account deficit
zero and kept balances of bank deposits also seemed to emerge as a more promi•
at the BOJ at elevated levels. Yield nent negative factor. The dollar has lost
curves in most foreign industrial coun• more than 9 percent against the major
tries became a bit steeper during the first currencies since the end of March and is
quarter as long-term rates rose in reac• down, on balance, more than 8 percent
tion to news suggesting stronger U.S. so far in 2002. In contrast, the dollar has
growth and improving prospects for glo• gained about 2 percent this year, on a
bal recovery. Since then, long-term rates weighted-average basis, against the cur•
have edged lower, on balance, in part as rencies of our other important trading
investors shifted out of equity invest• partners.
ments. Foreign equities performed The dollar’s exchange rate against the
well in most countries early in the year, Japanese yen was quite volatile in the
but share prices in many countries first half and, on balance, the dollar has
have fallen since early in the second fallen more than 10 percent since the
quarter—in some cases more steeply beginning of the year. Although Japan’s
than in the United States. The broad domestic economy continued to struggle
stock indexes for the major industrial with deflation and severe structural
countries are down since the beginning problems, including mounting bad loans
of the year, except in Japan, where stock in the financial sector and growing
prices, on balance, are about unchanged. bankruptcies, some indicators (includ•
High-tech stocks have been hit espe• ing strong reported first-quarter GDP, a
cially hard. firming of industrial production, and a
During the first quarter of 2002, the somewhat better reading on business
foreign exchange value of the dollar sentiment in the BOJ’s second-quarter
(measured by a trade-weighted index Tankan survey) suggested that a cycli•
against the currencies of major indus• cal recovery has begun. The yen’s
trial countries) appeared to react prima• rise occurred despite downgradings of
rily to shifting market views about the Japan’s government debt by leading
relative strength of the U.S. recovery rating services in April and May and
and its implications for the timing and several episodes of intervention sales of
extent of future monetary tightening. yen in foreign exchange markets by
Despite some fluctuations in this period, Japanese authorities in May and June.
the dollar stayed fairly close to the more Japanese stock prices, which had fallen
than sixteen-year high reached in Janu• to eighteen-year lows in early February,
ary. In the second quarter, however, turned up later as economic prospects
the dollar trended downward as earlier became less gloomy. At midyear, the
market enthusiasm about U.S. recovery TOPIX index was about where it was at
dimmed. Concerns about profitability, the start of the calendar year.
corporate governance, and disclosure After declining in the final quarter of
at U.S. corporations appeared to dampen 2001, euro-area GDP appears to have
the attraction of U.S. securities to inves• increased in the first half, though at only
tors, as did worries that the United a modest rate. Exports firmed and inven•
States was particularly vulnerable to tory de-stocking appeared to be winding
64 89th Annual Report, 2002

down, but consumption remained weak. the exchange value of the Swiss franc
The pace of activity varied across has been driven up by flows into Swiss
countries, with growth in Germany—the assets prompted in part by uncertainties
euro area’s largest economy—lagging about global political developments. The
behind. Despite lackluster area-wide Swiss National Bank eased its official
growth, concerns about inflation became rates in May to counteract this pres•
increasingly prominent. For most of the sure and provide support for the Swiss
first half, euro-area headline inflation economy.
persisted at or above the ECB’s 2 per- Economic recovery appears to be
cent target limit, partly on higher energy well under way in Canada. Real GDP
and food price inflation; even excluding increased 6 percent at an annual rate in
the effects of those two components, the first quarter, and other indicators
inflation picked up somewhat during the point to continued strong perfor•
period. Inflation concerns also were mance in the second quarter. Cana•
fanned by difficult labor market negotia• dian exports—particularly automotive
tions this spring, but the strength of the exports—benefited early in the year
euro may blunt inflationary pressures from the firming of U.S. demand, but
to some extent. The new euro notes and the expansion has become more wide-
coins were introduced with no notice- spread, and employment growth has
able difficulties at the beginning of the been strong. Although headline con•
year, but the euro drifted down against sumer price inflation has remained in
the dollar for several weeks thereafter. the bottom half of the Bank of Canada’s
Since then, however, the euro has target range of 1 percent to 3 percent,
reversed direction and moved steadily core inflation has crept up this year.
higher. On balance, the dollar has lost In April, the Bank of Canada increased
nearly 11 percent against the euro so far its overnight rate 25 basis points, citing
in 2002. stronger-than-expected growth in both
The United Kingdom seemed to the United States and Canada, and it
weather last year’s slump better than increased that rate again by the same
most industrial countries, as strength amount in June. The Canadian dollar,
in consumption counteracted weakness which had been at a historically low
in investment and net exports, though level against the U.S. dollar in January,
growth did weaken in the last quarter of moved up quite steeply in the second
2001 and into the first quarter of 2002. quarter and has gained about 5 percent
Notable increases in industrial produc• for the year so far.
tion and continued strength in the ser• The Mexican economy was hit hard
vice sector indicate that growth picked by the global slump in 2001 and espe•
up in the second quarter. Household bor• cially by the weaker performance of the
rowing has increased briskly, supported U.S. economy. Mexican exports stabi•
by rapid increases in housing prices, and lized early this year as U.S. activity
unemployment rates remain near record picked up, and other indicators also now
lows. At the same time, retail price suggest that the Mexican economy is
inflation has remained below the Bank beginning to recover. In February,
of England’s 21⁄2 percent target. Sterling despite the weak level of activity at the
has fallen nearly 5 percent against the time, the Bank of Mexico tightened
euro since the beginning of the year, monetary policy to keep inflation on
while it has gained more than 6 percent track to meet its 41⁄2 percent target for
against the dollar. Elsewhere in Europe, 2002, and the Mexican peso moved up a
Monetary Policy Report of July 2002 65

bit against the dollar during February more volatile. Brazilian markets have
and March. In April, with inflation been roiled by political uncertainties
apparently under control, the central related to national elections coming
bank eased policy, and since then the in the fall. Attention has focused on
peso has moved down substantially. vulnerabilities associated with Brazil’s
Against the dollar, the decline since the large outstanding stock of debt, much
beginning of the year has amounted to of which is short-term. Since April, the
almost 7 percent. After rising through value of the real against the dollar has
April, Mexican share prices also fell fallen nearly 20 percent, and Brazilian
sharply, leaving them at midyear about spreads have widened substantially. Sev•
unchanged from their end-2001 levels. eral other South American countries,
Financial and economic conditions including Uruguay and Venezuela, also
deteriorated significantly in Argentina have been beset by growing financial
this year. The Argentine peso was deval• and economic problems.
ued in January and then allowed to float Asian economies that rely importantly
in early February; since then, it has lost on exports of computers and semicon•
more than 70 percent of its value versus ductors (Korea, Singapore, Malaysia,
the dollar. The peso’s fall severely and Taiwan) have grown quite vig•
strained balance sheets of Argentine orously so far this year, a buoyancy
issuers of dollar-based obligations. Vari• reflecting in part the recent turnaround
ous stop-gap measures intended to of conditions in the technology sector
restrict withdrawals from bank accounts and stronger U.S. growth. The curren•
and to force conversion of dollar- cies of several countries of this group
denominated loans and deposits into have moved up against the dollar. In
peso-denominated form put banks and Korea, the expansion has been more
depositors under further stress. Mean- broad-based, as domestic demand was
while, economic activity has continued fairly resilient during the recent global
to plummet, and the government has downturn and has remained firm. China,
struggled to gain support for reforms which is less dependent on technology
that would address chronic fiscal imbal• exports, has continued to record strong
ances. Since late 2001, the government growth as well. Other countries in the
has been servicing its obligations only region also have started to recover from
to its multilateral creditors, and spreads steep slowdowns or contractions in
on Argentina’s international debt have 2001, although Hong Kong has contin•
soared to more than 65 percentage ued to be troubled by the collapse of
points. property prices. Most stock markets in
In recent months financial markets the region have recorded gains so far
elsewhere in the region have become this year.
Federal Reserve Operations


Consumer and Community Affairs

Among the Federal Reserve’s responsi­ • Analyzes applications for mergers and
bilities in the areas of consumer and acquisitions by state member banks
community affairs are and bank holding companies in rela­
tion to CRA performance
• Supervising banks to ensure their
compliance with the regulations • Disseminates information on commu­
nity development techniques to bank­
• Writing and interpreting regulations ers and the public through Commu­
to implement federal laws intended to nity Affairs Offices at the Reserve
protect and inform consumers Banks.

• Investigating complaints from the Examination for

public about bank compliance with Compliance with the CRA
the regulations
The Federal Reserve assesses the CRA
• Promoting community development in performance of state member banks dur­
historically underserved markets. ing examinations for compliance with
consumer protection regulations. By
These responsibilities are carried out statute, banks with assets of less then
by members of the Board of Governors, $250 million that were rated ‘‘satisfac­
the Board’s Division of Consumer and tory’’ for CRA performance in their
Community Affairs, and the consumer most recent examination are examined
and community affairs staffs at the Fed­ not more than once every forty-eight
eral Reserve Banks. months, and those that were rated ‘‘out-
standing’’ for CRA purposes in their
most recent examination are examined
Supervision for Compliance not more than once every sixty months.
with Consumer Protection and Banks with assets of $250 million
Community Reinvestment Laws or more that were rated ‘‘satisfactory’’
or ‘‘outstanding’’ in their most recent
Activities Related to the examination are examined not more than
Community Reinvestment Act once every twenty-four months. During
The Community Reinvestment Act the 2002 reporting period, the Federal
(CRA) requires that the Board and other Reserve conducted 312 CRA examina­
banking agencies encourage financial tions. Of the banks examined, 40 were
institutions to help meet the credit needs rated ‘‘outstanding’’ in meeting commu­
of the local communities in which they nity credit needs, 270 were rated ‘‘sat­
do business, consistent with safe and isfactory,’’ 1 was rated ‘‘needs to
sound business practices. To carry out improve,’’ and 1 was rated as being in
this mandate, the Federal Reserve ‘‘substantial noncompliance.’’ 1

• Examines state member banks to 1. The 2002 reporting period was from July 1,
assess compliance with the CRA 2001, through June 30, 2002.
70 89th Annual Report, 2002

Analysis of Applications for Bank, had received a CRA rating in

Mergers and Acquisitions in 2001 of ‘‘needs to improve’’ from its
Relation to the CRA primary supervisor, the Office of Thrift
Supervision. The Board considered
During 2002, the Board of Governors
information indicating that Tucker Fed­
considered applications for several sig­
eral Bank’s CRA performance had
nificant banking mergers:
improved since then and noted that
Tucker would be merged into RBC Cen­
• In June, the Board approved an appli­ tura Bank (which had a CRA rating of
cation by Royal Bank of Canada ‘‘satisfactory’’) upon consummation of
(Montreal, Canada) and RBC Centura the merger of the holding company.
Bank, Inc. (Rocky Mount, North In the Citigroup case, many of the
Carolina), to acquire Eagle Banc­ public commenters’ concerns related to
shares, Inc., and its subsidiary, the activities of Citigroup’s subprime
Tucker Federal Bank (both in Tucker, lending subsidiaries. A special examina­
Georgia). tion of those activities, by the Federal
Reserve Bank of New York, was still
• In October, the Board approved an under way at the time. In acting on the
application by Citigroup, Inc. (New application, the Board noted that a care­
York, New York), to acquire Golden ful review of the record indicated that
State Bancorp, Inc. (San Francisco, Citigroup, on balance, had a satisfac­
California). tory record of compliance and con­
cluded that the ongoing examination
• In December, the Board approved of the subprime subsidiaries did not
an application by Cooperatieve Cen­ warrant delay or denial. The Board indi­
trale Raiffeisen–Boerenleenbank B.A. cated that many of the issues raised by
(Rabobank Nederland Utrecht, The commenters could be more adequately
Netherlands) to acquire VIB Corp. addressed through the special examina­
and its subsidiary, Valley Independent tion. The Board noted, moreover, that if
Bank (both in El Centro, California). violations or other concerns were identi­
fied during the special examination, the
Comments were received from the Board has broad authority to enforce
public on each of these applications. compliance with fair lending and other
Many commenters expressed concern applicable laws through the supervisory
that the proposed merger or acquisition process.
could lead to decreased lending levels In the third application, the Board
in low-income communities, includ­ found that the CRA record of the
ing mortgage, small-business, and com­ depository institution was consistent
munity development lending; abusive with approval.
lending practices; the provision of costly The Board acted on other bank and
and inadequate banking services to bank holding company applications that
low-income consumers; and the clo­ involved protests by members of the
sure of branch offices in low-income public concerning CRA performance;
communities. one also involved a bank having a
In the case of the Royal Bank of CRA rating lower than ‘‘satisfactory.’’
Canada application, the bank subsidiary Another thirty-three applications raised
of Eagle Bancshares, Tucker Federal other issues related to CRA, fair lend-
Consumer and Community Affairs 71

ing, or compliance with consumer credit the Reserve Banks’ consumer compli­
protection laws and regulations.2 ance supervision program, Division staff
visited each Reserve Bank during the
year to review documents developed
Other Consumer Compliance by Reserve Bank consumer compliance
Activities examiners during bank examinations
The Division of Consumer and Com­ and other supervisory activities.
munity Affairs’ Compliance Oversight Also during 2002, the Board issued
Section supports and oversees the super­ guidance for Reserve Bank examiners
visory efforts of the Federal Reserve on consumer protection laws and regula­
Banks to ensure that consumer protec­ tions. For example, the Board clarified
tion laws and regulations are fully and the signature provisions of Regula­
fairly enforced. Section staff provide tion B, which implements the Equal
guidance and expertise to the Reserve Credit Opportunity Act, and provided
Banks on consumer protection regu­ supplemental guidance to assist examin­
lations, enforcement techniques, exam­ ers in writing CRA performance evalua­
iner training, and emerging issues. They tions for large banks.
develop, update, and revise examination
policies, procedures, and guidelines Fair Lending
and review Reserve Bank supervisory
reports and work products. Section staff Under the Equal Credit Opportunity
also participate in interagency activities Act, the Board refers any violation that
designed to promote uniformity in it has reason to believe constitutes
examination principles and standards. a ‘‘pattern or practice’’ of discrimination
Examinations are the Federal Re- to the Department of Justice. During
serve’s primary means of enforcing 2002 the Board made six such referrals.
bank compliance with consumer pro­ Two involved violations of the prohibi­
tection laws. During the reporting tion against requiring an applicant’s
period, the Reserve Banks con­ spouse to sign a credit obligation (unless
ducted 387 consumer compliance the spouse is a co-applicant or the
examinations—316 of state member spouse’s signature is necessary under
banks and 71 of foreign banking organi- state law to permit the creditor to take
zations.3 To assess the effectiveness of possession of the property in case of
default). Two other referrals involved
2. In addition, nine applications involving other discrimination on the basis of marital
CRA issues, fair lending issues, or compliance
with consumer credit protection laws and regula­
status by lenders that combined the
tions were withdrawn in 2002. Other applications income of married joint applicants but
were handled by the Reserve Banks under author­ not the income of unmarried joint appli­
ity delegated to them by the Board. cants. One of the two lenders was also
3. The foreign banking organizations examined found to have priced loans on the basis
by the Federal Reserve are organizations operating
under section 25 or 25(a) of the Federal Reserve of marital status. A fifth referral resulted
Act (Edge Act and agreement corporations) and from a lender’s practice of failing to
state-chartered commercial lending companies consider child support a source of
owned or controlled by foreign banks. These insti­ income and imposing a minimum
tutions are not subject to the Community Reinvest­
ment Act and typically engage in relatively few
income requirement, which had a dis­
activities that are covered by consumer protection parate impact on the basis of sex. The
laws. sixth referral involved a lender that
72 89th Annual Report, 2002

engaged in a pattern or practice of two state member banks for violations

redlining (discouraging loan applica­ of the Board’s Regulation H, which
tions from consumers living in minority implements the National Flood Insur­
neighborhoods) in a major city. ance Act: In October 2001, a consent
In 2001 the Board supplemented order assessing penalties of $10,500 was
interagency procedures for fair lend­ issued against McIlroy Bank and Trust
ing examinations with alternative (Fayetteville, Arkansas), and in April
procedures for banks having low- 2002, a consent order assessing penal-
discrimination-risk profiles. Typically, ties of $10,000 was issued against Com­
such banks are stable community banks, munity Bank of Granbury (Granbury,
commonly specializing in commercial Texas).
or agricultural lending, that are located
in suburban or rural markets having a Coordination with

low percentage of minority residents. Other Federal Banking Agencies

The alternative procedures facilitate

the allocation of resources for more- Member agencies of the Federal Finan­
intensive analysis of institutions that cial Institutions Examination Council
have higher-risk profiles. During 2002, (FFIEC) develop uniform examination
roughly 25 percent of all fair lending principles, standards, procedures, and
examinations were conducted using the report formats.4 In 2002, the FFIEC
issued examiner guidance under the
alternative procedures.
Real Estate Settlement Procedures Act
regarding settlement service mark-ups
Flood Insurance and unearned fees. The FFIEC is in the
process of revising examination proce­
The National Flood Insurance Reform
dures related to the Truth in Lending
Act of 1994 substantially amended the
Act, the Home Ownership and Equity
National Flood Insurance Act of 1968,
Protection Act, the Home Ownership
which created the National Flood Insur­
Counseling Act, and the Homeowners
ance Program (NFIP). The amendments
Protection Act.
sought to increase compliance with
In 2001, the Federal Reserve joined
federal flood insurance requirements,
with the Federal Deposit Insurance
increase participation in the NFIP,
Corporation (FDIC), the Office of the
increase income to the National Flood
Comptroller of the Currency (OCC), and
Insurance Fund, and decrease the finan­
the Office of Thrift Supervision (OTS)
cial burden on the federal government,
to publish an advance notice of pro-
taxpayers, and victims resulting from
posed rulemaking, seeking public com­
floods. Under the amendments, the Fed­
ment on a wide range of questions
eral Reserve Board and the other federal
related to revising the Community Rein-
financial institution supervisory agen­
vestment Act. In 2002, the agencies
cies are required to impose civil money
reviewed the comments and weighed
penalties when they find a pattern or
various possible amendments to the
practice of violations of the NFIP. Any
such civil money penalties are remitted
to the Federal Emergency Management 4. The FFIEC member agencies are the Board
Agency for deposit in the National of Governors of the Federal Reserve System, the
Federal Deposit Insurance Corporation, the Office
Flood Mitigation Fund. of the Comptroller of the Currency, the Office of
During the 2002 reporting period, the Thrift Supervision, and the National Credit Union
Board imposed civil money penalties on Administration.
Consumer and Community Affairs 73

regulations. At year-end 2002, they were thinking, and decisionmaking skills.

reaching a final decision about whether Commissioned examiners serve as
to issue a proposed rule and, if so, what ‘‘examiners in charge’’ of bank exam­
changes to propose. They were weigh­ inations.
ing whether any change with the To help ensure that supervision staff
potential for substantial benefits would have the knowledge and skills needed to
be justified in light of the burdens of be successful in an evolving financial
implementation. industry, the System must continually
Also in 2002, the Board, the OCC, identify, develop, coordinate, and review
and the FDIC conducted the annual training and development opportunities.
update for the host-state loan-to-deposit At least every three years, Board and
ratios used to determine compliance Reserve Bank staff review the core con­
with section 109 of the Riegle–Neal sumer affairs curriculum, updating sub­
Interstate Banking and Branching Effi­ ject matter and adding new elements
ciency Act of 1994. as appropriate. Each course is updated
periodically to take account of major
technical changes as well as changes
Consumer and CRA Training in instructional delivery techniques. The
for Bank Examiners staff also look for opportunities to
Ensuring that financial institutions com­ deliver courses via alternative channels
ply with laws and regulations that pro­ such as the Internet or other distance-
tect consumers and encourage commu­ learning technologies.
nity reinvestment is an important part of The core consumer affairs curriculum
the bank examination and supervision comprises five courses focused on vari­
process. As the number and complexity ous consumer laws, regulations, and
of consumer financial transactions grow, examining concepts. In 2002, these
training for examiners of the state mem­ courses were offered in twelve sessions
ber banks under the Federal Reserve’s to more than 200 consumer compliance
supervisory responsibility becomes even examiners:
more important.
Federal Reserve bank examiners are • Consumer Compliance Examina­
employees of the Federal Reserve tions I. Emphasizes examination pro­
Banks, which carry out compliance cedures and the practical application
supervision under authority delegated by of banking regulations; focuses on the
the Board. Their training, however, is a consumer laws and regulations that
shared responsibility of the Board and govern financial institution opera­
the Reserve Banks. Individuals seeking tional procedures and non-real-estate
to become commissioned examiners for lending. The course is geared toward
the Federal Reserve must complete a assistant examiners with three to six
formal course of training. Assistant months of examination experience.
examiners complete three levels of
course work, with attention to internal • Consumer Compliance Examina­
controls, information technology, risk tions II. Equips assistant examiners
management, risk-focused examination with the fundamental skills needed to
techniques, and integrated supervision determine compliance with the basic
concepts. In addition to passing two elements of consumer laws and regu­
proficiency examinations, examiners lations governing real estate trans-
must exhibit strong analytical, critical- actions; also covers System policies
74 89th Annual Report, 2002

on all major aspects of the consumer public certain data about their home pur­
compliance risk-focused examination chase, home improvement, and refinanc­
process. Assistant examiners have six ing loan transactions. Depository institu­
to twelve months of examination tions generally are covered if (1) they
experience when they complete the are located in metropolitan areas,
course. (2) they met the asset threshold at the
end of the preceding calendar year (for
• Fair Lending Examination Tech­ 2001, assets of more than $31 million;
niques. Provides assistant examiners for 2002, more than $32 million), and
with the skills and knowledge needed (3) they originated at least one home
to plan and conduct a risk-focused fair purchase loan (or refinancing) in the
lending examination. Assistant exam­ preceding calendar year. For-profit
iners generally have eighteen months mortgage companies are covered if
of examination experience when they (1) they are located in metropolitan
complete the course. areas, (2) they had assets of more than
$10 million (when combined with the
• Community Reinvestment Act Exami­ assets of any parent company) at the end
nation Techniques. Prepares assistant of the preceding calendar year or origi­
examiners to write performance eval­ nated 100 or more home purchase loans
uations for the CRA portion of con­ and refinancings in the preceding
sumer compliance examinations. Stu­ calendar year, and (3) their home pur­
dents must be familiar with the CRA chase loan originations and refinancings
regulation and CRA examination accounted for 10 percent or more of
procedures. their total loans by dollar volume in the
preceding calendar year.
• Commercial Lending Essentials for In 2002, a total of 6,659 depository
Consumer Affairs. Optional training institutions and affiliated mortgage com­
opportunity. Familiarizes assistant panies and 972 independent mortgage
examiners with basic techniques for companies reported HMDA data for
underwriting and pricing commercial calendar year 2001. Lenders submitted
loans, including identifying the bank’s information about the disposition of loan
credit culture and risk profile. applications, the geographic location of
the properties related to loan applica­
In addition to providing core training, tions and loans, and, in most cases, the
the training program emphasizes the race or national origin, income, and sex
importance of continuing professional of applicants and borrowers. The FFIEC
development. Opportunities for continu­ processed the data and produced disclo­
ing development might include special sure statements on behalf of the FFIEC
projects and assignments, self-study pro- member agencies and the Department
grams, rotational assignments, instruct­ of Housing and Urban Development
ing at System schools, or mentoring. (HUD).
The FFIEC prepared individual dis­
closure statements for each lender that
Reporting on Home Mortgage reported data—one statement for each
Disclosure Act Data metropolitan area in which the lender
The Home Mortgage Disclosure Act had offices and reported loan activity.
(HMDA) requires that mortgage lenders In 2002, the FFIEC prepared more than
covered by the act collect and make 53,000 disclosure statements, reporting
Consumer and Community Affairs 75

data for calendar year 2001.5 Each insti­ was higher in 2001 than in 2000; the
tution made its disclosure statement increase was 2 percent for lower-income
public in July, and reports contain­ and higher-income applicants and 4 per-
ing aggregate data for all mortgage cent for middle-income applicants. From
and home improvement loans in each 1993 through 2001, the number of home
of 330 metropolitan areas were made purchase loans to lower-, middle-, and
available at central depositories.6 FFIEC upper-income applicants increased
member agencies, the reporting institu­ 82 percent, 50 percent, and 60 percent
tions, HUD, the Department of Justice respectively.
(DOJ), and members of the public use In 2001, 32 percent of Hispanic appli­
these data. The data also assist HUD, cants and 29 percent of black applicants
the DOJ, and state and local agencies in for home purchase loans reported
responding to allegations of lending dis­ under HMDA sought government-
crimination and in targeting lenders for backed mortgages; the comparable fig­
further inquiry. ures were 16 percent for white and for
The HMDA data reported for 2001 Native American applicants and 8 per-
covered 27.6 million loans and applica­ cent for Asian applicants. Twenty-seven
tions, about 44 percent more than in percent of lower-income applicants for
2000. The greater volume was due pri­ home purchase loans, compared with
marily to an increase of about 120 per- 9 percent of higher-income applicants,
cent in refinancing activity. The number applied for government-backed mort­
of home purchase loans covered by gages in 2001.
HMDA and extended in 2001, com­ Overall, the denial rate for conven­
pared with 2000, increased 8 percent tional home purchase loans (that is,
for Hispanics, 4 percent for Asians, and loans that are not government-backed)
1 percent for whites but fell 7 percent was 21 percent in 2001. The rate rose
for blacks. The precise change for steadily from 1993 through 1998 but has
Native Americans could not be deter- fallen since then. In 2001, denial rates
mined because of reporting errors in the for conventional home purchase loans
2000 data. Over the period 1993 through reported under HMDA were 36 percent
2001, the number of home purchase for black applicants, 35 percent for
loans extended increased 158 percent Native American applicants, 23 percent
for Hispanics, 92 percent for Asians, for Hispanic applicants, 16 percent for
76 percent for blacks, 28 percent for white applicants, and 11 percent for
Native Americans, and 26 percent for Asian applicants. Each of these rates
whites. was lower than the comparable rate for
For each income category, the num­ 2000.
ber of home purchase loans reported
Agency Reports on Compliance
5. The FFIEC also compiles information on with Consumer Protection Laws
applications for private mortgage insurance (PMI) and Regulations
similar to the information on home mortgage lend­
ing collected under HMDA. Lenders typically The Board is required to report annually
require PMI for conventional mortgages that on compliance with consumer protec­
involve small down payments. tion laws by entities supervised by the
6. Central depository sites include libraries,
universities, and city planning offices. A list of
various federal agencies. This section
the sites can be found at summarizes data collected from the
centdep/default2.cfm. twelve Federal Reserve Banks, the
76 89th Annual Report, 2002

FFIEC member agencies, and other fed­ reporting period—two by the OTS and
eral enforcement agencies.7 one by the OCC. The Federal Trade
Commission settled one action and con­
Regulation B
tinued its litigation against a mortgage
(Equal Credit Opportunity)
lender for alleged violations of the Equal
Credit Opportunity Act (ECOA) and
The FFIEC agencies reported that
Regulation B. The alleged violations
83 percent of the institutions examined
include failing to take written applica­
during the 2002 reporting period were in
tions for mortgage loans, failing to pro-
compliance with Regulation B, the same
vide rejected applicants with written
percentage as for the 2001 reporting
notice of adverse action, failing to col­
period. Of the institutions not in full
lect required information about the race
compliance, 81 percent had five or
or national origin and sex of applicants
fewer violations. The most frequent vio­
for mortgage loans; and, when provid­
lations involved failure to take one or
ing notice of adverse action, failing to
more of the following actions:
give the name and address of the federal
agency that administers compliance with
• Provide a written notice of credit
the ECOA.
denial or other adverse action contain­
The other agencies that enforce the
ing a statement of the action taken,
ECOA—the Farm Credit Admin­
the name and address of the creditor,
istration (FCA), the Department of
a notice of rights, and the name and
Transportation, the Securities and
address of the federal agency that
Exchange Commission, the Small
enforces compliance
Business Administration, and the Grain
Inspection, Packers and Stockyards
• Provide a statement of reasons for
Administration of the Department of
credit denial or other adverse action
Agriculture—reported substantial com­
that is specific and indicates the prin­
pliance among the entities they super-
cipal reasons for the adverse action
vise. The FCA’s examination and
enforcement activities revealed viola­
• Collect information for monitoring
tions of the ECOA mostly related to
purposes about the race or national
creditors’ failure to collect information
origin and sex of the applicants seek­
in mortgage applications for monitoring
ing credit primarily for the purchase
purposes and failure to comply with
or refinancing of a principal residence
rules regarding adverse action notices.
No formal enforcement actions relating
• Notify the credit applicant of the
to Regulation B were initiated by these
action taken within the time frames
specified in the regulation.

Three formal enforcement actions Regulation E

containing provisions relating to Regu­ (Electronic Fund Transfers)

lation B were issued during the 2002

The FFIEC agencies reported that
approximately 92 percent of the institu­
7. Because the agencies use different methods tions examined during the 2002 report­
to compile the data, the information presented
here supports only general conclusions. The 2002
ing period were in compliance with
reporting period was from July 1, 2001, through Regulation E, compared with 95 per-
June 30, 2002. cent for the 2001 reporting period.
Consumer and Community Affairs 77

The most frequent violations involved Regulation Z

failure to comply with the following (Truth in Lending)
The FFIEC agencies reported that
77 percent of the institutions examined
• Determine whether an error occurred, during the 2002 reporting period were
and transmit the results of the inves­ in compliance with Regulation Z, com­
tigation to the consumer within ten pared with 79 percent for the 2001
business days reporting period. Of the institutions not
in full compliance, 73 percent had five
• Credit the customer’s account in the or fewer violations, compared with
amount of the alleged error within ten 75 percent for the 2001 reporting period.
business days of receiving the error The most frequent violations involved
notice, if more time is needed to con- failure to take one or more of the follow­
duct the investigation ing actions:

• Report the results of the investigation • Accurately disclose the finance

to the consumer within three business charge, taking any prepaid finance
days after its completion. charges into account

The agencies did not issue any formal • Accurately disclose the number,
enforcement actions relating to Regula­ amounts, and timing of payments
tion E during the reporting period. scheduled to repay the obligation

Regulation M • Ensure that if the disclosed finance

(Consumer Leasing) charge (which affects other disclo­
sures) is understated, the amount dis­
The FFIEC agencies reported that more
closed is understated by no more than
than 99 percent of the institutions exam­
ined during the 2002 reporting period
were in compliance with Regulation M,
which is comparable to the level of com­ • Ensure that disclosures reflect the
pliance for the 2001 reporting period. terms of the legal obligation between
The few violations noted involved fail­ the parties
ure to adhere to specific disclosure
requirements. The agencies did not issue • Provide the index value for the peri­
any formal enforcement actions relating odic adjustments to variable-rate
to Regulation M during the reporting loans.
Three formal enforcement actions
Regulation P
containing provisions relating to Regu­
(Privacy of
lation Z were issued during the 2002
Consumer Financial Information)
reporting period—two by the OTS and
one by the OCC. In addition, 174 insti­
July 2001 through June 2002 marked tutions supervised by the Federal
the first full year of implementation of Reserve, the FDIC, or the OTS were
Regulation P. Examinations found few required, under the Interagency Enforce­
violations, and no formal enforcement ment Policy on Regulation Z, to refund
actions were issued. a total of approximately $1.2 million
78 89th Annual Report, 2002

to consumers for the 2002 reporting tutions examined during the 2002
period. During the reporting period, the reporting period were in compliance, the
FTC continued its efforts to curb abu­ same proportion as for the 2001 report­
sive practices by some subprime mort­ ing period. Among the institutions not
gage lenders, entering into three set­ in full compliance, the most frequently
tlements, initiating three legal actions, cited violations involved
and pursuing litigation against one
creditor for alleged violations of the • Failing to provide a clear, conspicuous
Truth and Lending Act (TILA) and the disclosure regarding a cosigner’s lia­
Home Ownership and Equity Protection bility for a debt
The Department of Transportation • Entering into a consumer credit con-
(DOT) concluded its investigation of tract containing a nonpossessory secu­
five cases involving air carriers for pos­ rity interest in household goods, a
sible violations of the TILA. All five practice barred by Regulation AA.
cases involved the timeliness of process­
ing requests for credit card refunds. Four No formal enforcement actions relat­
of the cases were closed with warning ing to Regulation AA were issued dur­
letters; in the fifth case, DOT entered ing the reporting period.
into a consent order that directed the
carrier to cease and desist from further
violations of the refund provisions of Regulation CC
the TILA and assessed a civil penalty of (Availability of Funds and
$25,000. In addition, the DOT contin­ Collection of Checks)
ued to prosecute a cease-and-desist con-
sent order issued in 1993 against a travel The FFIEC agencies reported that
agency and a charter operator. The com­ 90 percent of institutions examined dur­
plaint alleged that the two organizations ing the 2002 reporting period were in
had violated Regulation Z by routinely compliance with Regulation CC, com­
failing to send credit statements for pared with 91 percent for the 2001
refund requests to credit card issuers reporting period. Among the institutions
within seven days of receiving fully not in full compliance, the most fre­
documented credit refund requests from quently cited violations involved the
customers. The case remained pending failure to take one or more of the follow­
because the principal of the company ing actions:
was serving a prison sentence for
an unrelated airline bankruptcy fraud • Make funds from certain checks, both
conviction. local and nonlocal, available for with­
drawal within the times prescribed by
the regulation
Regulation AA

(Unfair or Deceptive Acts

• Provide a written notice explaining
or Practices)
why an exception to the institution’s
The three banking regulators with availability policy was invoked
responsibility for enforcing Regula­
tion AA’s Credit Practices Rule—the • Provide a written notice when the
Federal Reserve, the OCC, and the depository bank extended the time for
FDIC—reported that 99 percent of insti­ making funds available for withdrawal
Consumer and Community Affairs 79

• Follow special procedures when technology and information-processing

invoking the exception for large-dollar capabilities. Prominent among these
deposits. developments have been the movement
to risk-based pricing of mortgage credit
No formal enforcement actions relat­ and the growth of new channels for
ing to Regulation CC were issued dur­ loan applications, funding, and origina­
ing the reporting period. tion. In 2002, the Board took note of
these changes in carrying out a review
Regulation DD of Regulation C, which implements
(Truth in Savings) the Home Mortgage Disclosure Act
The FFIEC agencies reported that The express purposes of HMDA are
87 percent of institutions examined dur­ to
ing the 2002 reporting period were in
compliance with Regulation DD, com­ • Provide the public and government
pared with 88 percent for the 2001 officials with data that will help show
reporting period. Among the institutions whether lenders are serving the home-
not in full compliance, the most fre­ lending needs of the neighborhoods
quently cited violations involved and communities in which they are
• Advertisements that were inaccurate
or misleading (or both) • Help government officials target
public investment to promote private
• Use of the phrase ‘‘annual percentage investment where it is needed
yield’’ in an advertisement without
disclosing additional terms and condi­ • Provide data that assist in identifying
tions of customer accounts possible discriminatory lending pat-
terns and enforcing antidiscrimination
• Failure to provide notice before matu­ statutes.
rity for automatically renewing time
accounts having a term of more than Regulation C requires lenders to
one month. report data about each mortgage loan
application or origination (including
No formal enforcement actions relat­ loan amount, type, and purpose), each
ing to Regulation DD were issued dur­ applicant or borrower (including race
ing the reporting period. or ethnicity, sex, and income), and each
property (including location and occu­
pancy status). These data are made
Implementation of
available to the public after identifying
Statutes Designed to
information is removed to protect con­
Inform and Protect Consumers
sumers’ privacy.
In 2002, the Board concluded that
Changes in the Collection of significant changes to Regulation C
Data on Home Mortgage Loans were needed to keep pace with develop­
ments in the mortgage-lending market.
The past decade has witnessed impor­ One change was to broaden the types of
tant developments in mortgage markets, data collected to include data on loan
spurred in part by improvements in pricing. This change will aid both in
80 89th Annual Report, 2002

deterring discrimination and in help­ requests that are approved and result in
ing data users better understand the loan originations as well as requests that
mortgage market, particularly the are denied. Lenders may, but will not be
subprime market. Over the years, the required to, report preapproval requests
focus of concerns about discrimination that are approved but not accepted by
has shifted from lenders’ decisions to the applicant.
approve or deny applications to lenders’ In addition, the Board revised the
loan-pricing practices. The widespread categories for identifying the race and
adoption of risk-based pricing has national origin of applicants and bor­
focused attention on the fairness of lend­ rowers to conform to categories used by
ers’ pricing decisions. Obtaining infor­ the Bureau of the Census and other fed­
mation about loan pricing is critical to eral agencies. Following guidance pro­
ensuring the continued utility of the vided by the Office of Management and
HMDA data. Budget, the Board will permit an appli­
Beginning January 1, 2004, lenders cant to select more than one race and
will report rate spreads for loans that will distinguish between race and His-
exceed a certain price threshold (for first panic ethnicity; these changes take effect
lien loans, prices must be reported if the January 1, 2004.
difference between the loan’s annual In response to the growing num­
percentage rate and the yield on Trea­ ber of telephone applications and the
sury securities with comparable maturi­ increasing proportion of loan applica­
ties is 3 percentage points or more; for tions for which information on applicant
subordinate lien loans, if the difference race, ethnicity, or sex is missing, the
is 5 percentage points or more). Lenders Board mandated collection of such data
will also report whether a loan meets the on telephone applications; this rule,
price-based triggers of the Home Own­ which parallels the rule for mail and
ership and Equity Protection Act, which Internet applications, took effect Janu­
requires that borrowers of high-priced ary 1, 2003.
loans be given special disclosures and Finally, the Board made several
other protections. changes to improve the consistency
The Board also revised Regulation C and utility of the HMDA data. These
to reflect another major change in the changes include simplifying the defini­
mortgage market—the increasing avail- tions of loan types and distinguishing
ability of preapproval programs. Preap­ loans for manufactured homes from
proval programs offer the possibility of loans for site-built homes.
conditional approval of a mortgage loan
before a borrower has chosen a prop­
erty, enabling the borrower to demon­
Revisions to

strate to potential home sellers that

Truth in Lending Regulations

the borrower will likely be able to obtain In April 2002, the Board revised the
a loan. Regulation C will require lend­ official staff commentary to Regula­
ers to report preapproval requests that tion Z (Truth in Lending) to clarify how
are evaluated under programs in which creditors that place Truth in Lending
the lender gives approved applicants Act disclosures in the same document
a written commitment letter, good for as the credit contract can satisfy the
a set period and for up to a fixed dollar requirement to provide the disclo­
amount. Beginning January 1, 2004, sures before consummation and in a
lenders will identify preapproval form the consumer can keep. The revi-
Consumer and Community Affairs 81

sions also provide guidance on disclos­ ATM card. In 2002, the number of ATM
ing costs for certain credit insurance transactions per month averaged almost
policies. 1.2 billion, an increase of nearly 3 per-
The Board also took the following cent from 2001. The number of installed
regulatory actions during the year: ATMs rose nearly 9 percent, to about
• Raised from $480 to $488 the total Direct deposit is also widely used.
dollar amount of points and fees that About 60 percent of U.S. households
triggers additional requirements for have funds deposited directly into their
certain mortgage loans under the checking or savings accounts. Use of the
Home Ownership and Equity Protec­ service is particularly common in the
tion Act, effective in January 2003, to public sector: Approximately 72 percent
reflect changes in the consumer price of all government payments in fiscal
index, as prescribed by the statute. year 2002 were made using electronic
funds transfer, including 79 percent of
• Maintained at $32 million the exemp­ social security payments, 98 percent of
tion threshold for depository institu­ federal salary and retirement payments,
tions required to collect data in 2003 and 39 percent of federal income tax
under the Home Mortgage Disclosure refunds.
Act, in keeping with the consumer Direct bill payment is a less widely
price index for urban wage earners used EFT payment mechanism. About
and clerical workers (CPI–W), as pre- 36 percent of U.S. households have pay­
scribed by the statute. ments automatically deducted from their
About one-third of U.S. households
Economic Effects of the use debit cards, which consumers use at
Electronic Fund Transfer Act merchant terminals to debit their check­
As required by the Electronic Fund ing or savings accounts. These point-of-
Transfer Act (EFTA), the Board moni­ sale (POS) systems account for a fairly
tors the effects of the act on institutions’ small share of electronic transactions,
compliance costs and the benefits of the but their use has continued to grow
act to consumers. rapidly. The average number of POS
Approximately 85 percent of U.S. transactions per month rose almost
households have or use one or more 39 percent, from 304.0 million in 2001
electronic fund transfer (EFT) service— (revised from previously reported data)
for example, an ATM card, a debit card, to 421.7 million in 2002, though the
or direct deposit. The proportion of number of POS terminals fell, to
households using EFT services has 3.5 million.
grown over the past ten years at an Electronic check conversion is a
annual rate of 2 percent to 3 percent, variation of electronic funds transfer
according to data from the Board’s whereby a check is used as the source
Survey of Consumer Finances (the most of information for a one-time electronic
recent data available were from 1998; payment from the consumer’s checking
data from the 2001 survey are to be account via EFT. During 2002, Board
released in 2003). staff helped develop and distribute
Automated teller machines remain the consumer information to explain the
most widely used EFT service. About process (
two-thirds of U.S. households have an checkconv/default.htm).
82 89th Annual Report, 2002

The incremental costs associated with The Board also established an advi­
the Electronic Fund Transfer Act are sory group to assess the Federal
difficult to quantify because no one Reserve’s complaints and inquiry
knows how industry practices would database—Complaints Analysis Evalu­
have evolved in the absence of statutory ation System and Reports (CAESAR).
requirements. The benefits of the EFTA The advisory group is organized into
are also difficult to measure because two subcommittees: one to develop and
they cannot be isolated from consumer implement improvements to data entry
protections that would have been pro­ and reporting processes, and the other to
vided in the absence of regulation. The analyze the adequacy of the complaint
available evidence suggests no serious and inquiry code structure. Enhance­
consumer problems with the EFTA (see ments to CAESAR will be implemented
the section ‘‘Agency Reports on Compli­ in the first quarter of 2003.
ance with Consumer Protection Laws
and Regulations’’).
Complaints against
State Member Banks
Consumer Complaints In 2002 the Federal Reserve received
The Federal Reserve investigates com­ just over 5,700 complaints from con­
plaints against state member banks and sumers. The majority (63 percent)
forwards to the appropriate enforcement related to practices that are not subject
agency complaints that involve other to federal regulation (see next sec­
creditors and businesses. Each Reserve tion, ‘‘Unregulated Practices’’). About
Bank investigates complaints against 48 percent of the complaints received
state member banks in its District. were against state member banks (see
The Board provides guidance to the tables). Of the complaints against state
Reserve Banks on complaint program member banks, 66 percent involved loan
policies and procedures through advi­ functions: 3 percent alleged discrim­
sory letters and periodic updates to the ination on a basis prohibited by law
Consumer Complaint Manual. In 2002, (race, color, religion, national origin,
the Board issued guidance and new sex, marital status, age, the fact that the
codes for identifying complaints and applicant’s income comes from a public
inquiries about electronic check conver­ assistance program, or the fact that the
sion transactions and the sale of insur­ applicant has exercised a right under
ance by state member banks. The Board the Consumer Credit Protection Act),
also clarified procedures for investigat­ and 63 percent concerned other credit-
ing complaints alleging unlawful credit related practices, such as the imposition
discrimination. In addition, the Board of annual membership fees, or credit
established supplemental procedures to denial on a basis not prohibited by law
help the Reserve Banks focus and expe­ (for example, credit history or length of
dite investigations. residence). Twenty-four percent of the
In 2002 the Board initiated a work- complaints against state member banks
flow study of the Federal Reserve’s involved disputes about interest on
complaint-handling process to identify deposits and general deposit account
ways to maximize efficiency and effec­ practices, and the remaining 10 percent
tiveness. The study is expected to be concerned disputes about electronic
completed by early spring 2003. fund transfers, trust services, or other
Consumer and Community Affairs 83

Consumer Complaints against State Member Banks and Other Institutions Received by the
Federal Reserve System, 2002

State member Other

Subject Total
banks institutions 1

Regulation B (Equal Credit Opportunity) . . . . . . . . . . . . . . . . . . . . . . . 66 36 102

Regulation C (Home Mortgage Disclosure Act) . . . . . . . . . . . . . . . . . 0 1 1
Regulation E (Electronic Fund Transfers) . . . . . . . . . . . . . . . . . . . . . . . 64 76 140
Regulation H (Bank Sales of Insurance) . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 0
Regulation M (Consumer Leasing) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 0
Regulation P (Privacy of Consumer Financial Information) . . . . . . . 12 4 16
Regulation Q (Payment of Interest) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 0

Regulation Z (Truth in Lending) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 617 374 991

Regulation BB (Community Reinvestment) . . . . . . . . . . . . . . . . . . . . . 2 1 3
Regulation CC (Expedited Funds Availability) . . . . . . . . . . . . . . . . . . 29 25 54
Regulation DD (Truth in Savings) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72 48 120
Fair Credit Reporting Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375 201 576
Fair Debt Collection Practices Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 17 81

Fair Housing Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 5 6

Flood insurance rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 10 13
Regulations T, U, and X . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 0
Real Estate Settlement Procedures Act . . . . . . . . . . . . . . . . . . . . . . . . . . 20 14 34
Unregulated practices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,440 2,128 3,568

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,765 2,940 5,705

1. Complaints against these institutions were referred

to the appropriate regulatory agencies.

practices. Information on the outcomes Unregulated Practices

of the investigations of these complaints
is provided in the table. As required by section 18(f ) of the Fed­
During 2002, the Federal Reserve eral Trade Commission Act, the Board
completed the investigation of 86 com­ monitors complaints about banking
plaints against state member banks that practices that are not subject to existing
were pending at year-end 2001 and regulations, focusing on those that con­
found four violations of regulations. cern possible unfair or deceptive prac­
In the vast majority of cases, the bank tices. In 2002 the Board received more
had correctly handled the customer’s than 1,400 complaints that involved
account; notwithstanding, the bank in unregulated practices. The categories
many cases chose to reimburse or other- that received the most complaints
wise accommodate the consumer. involved checking and credit card
Also during the year, the Federal accounts: Consumers alleged that unau­
Reserve handled more than 2,000 thorized withdrawals were made from
inquiries about consumer credit and their checking accounts (101), disputed
banking policies and practices. In amounts withdrawn (155), and com­
responding to these inquiries, the Board plained about insufficient-funds charges
and Reserve Banks gave specific expla­ and procedures (141); they also com­
nations of laws, regulations, and bank­ plained about fees associated with credit
ing practices and provided relevant card accounts (149) and about debt-
printed materials on consumer issues. collection tactics (109). The remainder
84 89th Annual Report, 2002

Consumer Complaints Received by the Federal Reserve System,

by Subject of Complaint, 2002

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 . . . . . . . . . . 19 1 2 1 6 0
Credit cards . . . . . . . . . . . . . . 20 1 8 1 8 2
Other loans . . . . . . . . . . . . . . . 27 1 0 2 12 0
Other type of complaint
Real estate loans . . . . . . . . . . 508 18 16 37 211 92
Credit cards . . . . . . . . . . . . . . 1,007 37 7 7 340 429
Other loans . . . . . . . . . . . . . . . 227 8 10 22 91 29

Deposits . . . . . . . . . . . . . . . . . . . . . . 658 24 21 83 272 112

Electronic fund transfers . . . . . . . 64 2 3 5 20 15
Trust services . . . . . . . . . . . . . . . . . 30 1 1 4 11 1
Other . . . . . . . . . . . . . . . . . . . . . . . . . 205 7 7 21 84 22

Total . . . . . . . . . . . . . . . . . . . . . . . . . 2,765 100 75 183 1,055 702

of the complaints concerned unregu­ adverse action notice, which the bank
lated practices in other areas: Consum­ subsequently corrected. The remaining
ers complained about credit denials seven cases are pending.
attributed to credit history, failure to
remove the lien on property for which
the mortgage had been paid off, and
Advice from the

poor customer service.

Consumer Advisory Council

The Board’s Consumer Advisory

Council—whose members are drawn
Complaint Referrals to HUD from consumer and community organi­
In accordance with a memorandum of zations, the financial services indus­
understanding between HUD and the try, academic institutions, and state
federal bank regulatory agencies, in agencies—advises the Board on matters
2002 the Federal Reserve referred to concerning laws administered by the
HUD ten complaints alleging state Board and other issues related to con­
member bank violations of the Fair sumer financial services. Council meet­
Housing Act. In two of the ten cases ings are open to the public.
the Federal Reserve’s investigations In 2002, the Council met in March,
revealed no evidence of illegal discrimi­ June, and October. The rules implement­
nation. In a third case the bank had ing the Community Reinvestment Act
made an error regarding the consumer’s (CRA) were a major topic at the March
Consumer and Community Affairs 85

Consumer Complaints Received—Continued

Complaints against state member banks


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

0 0 0 2 0 8 19 38
0 1 0 0 0 0 7 27
0 1 2 1 0 9 10 37

0 75 13 10 11 43 498 1,006
1 79 16 8 1 119 795 1,802
1 42 4 1 4 23 521 748
2 74 27 10 14 43 475 1,133
0 6 0 9 1 5 76 140
0 2 4 0 3 4 21 51
2 14 9 0 2 44 518 723

6 294 75 41 36 298 2,940 5,705

and June meetings. In March, Council text in evaluating a bank’s CRA per­
members commented on the investment formance and emphasized that bankers
test, data collection, and the small-bank should review the performance context
test. Some members considered the with regulators at the beginning of
existing investment test to be sufficient, examinations.
while others preferred that a separate In March, Council members dis­
community development test replace the cussed Regulation C, which implements
investment test. Regarding data collec­ the Home Mortgage Disclosure Act.
tion for small-business and small-farm They provided views on issues still
lending, some members emphasized under review after the Board’s January
that gathering quality data is a substan­ 2002 revisions to the regulation, includ­
tial burden for small banks and ques­ ing the appropriate threshold for collect­
tioned the overall benefits of collecting ing price data on higher cost loans; a
detailed data. Members also commented proposal to require lenders to ask tele­
on the appropriate size-definition of phone applicants their race, ethnicity,
‘‘small bank.’’ In June, Council mem­ and sex; and a proposal to report lien
bers considered the effectiveness of status for applications and originated
the evaluation criteria for community loans. A discussion of Regulation B,
development performance in terms of which implements the Equal Credit
changing community dynamics. Mem­ Opportunity Act, focused on proposed
bers also noted the importance of con- changes to the definition of ‘‘creditor’’
86 89th Annual Report, 2002

and the prohibition against data nota­ that limiting the use and display of per­
tion for non-mortgage credit. Members sonal identifiers (such as social security
provided both supporting and opposing numbers) and providing additional tools
views on removing the prohibition to identity-theft victims to clear their
against data notation. credit records would be beneficial. The
In June, Council members discussed discussion of access to credit cards
the rules implementing the privacy pro- focused on consumers who may not
visions of the Gramm–Leach–Bliley have the ability to repay their debt, par­
Act. Members commented on the effec­ ticularly students.
tiveness of the required privacy notices
in light of the notices’ length and com­
plexity. Other comments concerned the Promotion of Community
low rates of response to the notices. Development in Historically
Also in June, Council members dis­ Underserved Markets
cussed financial literacy and noted the
challenges of designing and delivering In 2002, the community affairs function
financial literacy training in an envi­ within the Federal Reserve System
ronment of technological advances and expanded its activities to promote eco­
expanding financial products. They nomic growth and financial literacy in
emphasized that no single solution or historically underserved markets. The
design works for all consumers and that structure and mission of the community
a broad approach to training and deliv­ affairs program was conceived to help
ery systems is necessary to reach those financial institutions meet their respon­
in need of training. sibilities under the Community Rein-
At the October meeting, the amend­ vestment Act, and Community Affairs
ments proposed by the Department of Offices around the System continued
Housing and Urban Development to its during the year to hold CRA round-
Regulation X, which implements the tables with bankers and community
Real Estate Settlement Procedures Act development organizations to increase
(RESPA), were a topic of discussion. understanding of CRA-related policy
Council members focused on whether issues and investment tools. However,
the proposed ‘‘guaranteed mortgage community affairs programs have broad­
package agreement’’ and the proposed ened to respond to the evolving finan­
revisions to the good-faith estimate cial and regulatory needs of diverse
would benefit financial institutions and groups and communities. Reserve Bank
consumers during the mortgage selec­ Community Affairs Offices focus on
tion process. Members also addressed providing information and investment
inconsistencies between the Board’s opportunities to low- and moderate-
Truth in Lending Act disclosure rules income communities within their Dis­
and HUD’s proposed RESPA rules. tricts, while the Board’s Community
The Council also discussed identity Affairs Office brings a national perspec­
theft and access to credit cards during tive, engaging in projects that have sig­
the October meeting. Regarding identity nificant implications for public policy.
theft, members considered the adequacy In 2002, System community affairs
of current laws and whether potential programs also addressed financial
legislative, regulatory, or industry solu­ education, financial services for Native
tions would be effective in combating Americans, banking for immigrant com­
identify theft. Many members agreed munities, emerging issues and opportu-
Consumer and Community Affairs 87

nities in community development, and ment for Financial Education in a

community development finance. national symposium on financial liter­
acy and provided training on consumer
credit management for Air Force Com­
Promotion of Financial Education mand financial specialists. Consumer
education materials on financial privacy,
Consumers who are well informed on developed in collaboration with other
financial matters are generally able to government agencies, were launched
make better decisions for their families, during National Consumer Protection
increasing their economic security and Week 2002 (
well-being. In turn, secure families are pubs/privacy/default.htm).
better able to contribute to vital, thriving Across the Federal Reserve System,
communities, further fostering commu­ Community Affairs Offices organized
nity economic development. As a conse­ programs to heighten employee aware­
quence, financial education has risen on ness of fundamental financial manage­
the agendas of educators, community ment concepts. At the Board, commu­
groups, businesses, government agen­ nity affairs staff organized lunch-and-
cies, and policymakers. learn sessions on savings and budgeting
The Board supported a wide range of and joined with staff of the Manage­
activities promoting financial education ment Division to identify best practices
in 2002, including conducting research, in employee financial education. The
sponsoring meetings, providing training, Federal Reserve Bank of St. Louis
and preparing educational materials. held information sessions focused on
Staff in the Board’s Division of Con­ employee housing and credit resources,
sumer and Community Affairs prepared and several Reserve Banks hosted Con­
articles for the Journal of Family and sumer Protection Week activities for
Consumer Sciences and the Federal their employees.
Reserve Bulletin (‘‘Financial Literacy: Reserve Banks in Atlanta, Boston,
An Overview of Practice, Research, and Chicago, Cleveland, Philadelphia, and
Policy,’’ San Francisco supported financial edu­
bulletin/2002/1102lead.pdf) summariz­ cation initiatives in their Districts. For
ing efforts in research, fieldwork, and example, the San Francisco Reserve
public policy that further the goal of Bank published a compendium of
creating financially literate consumers. financial literacy resources for bank­
Research initiated by Board staff ers interested in offering financial edu­
investigated consumers’ financial man­ cation programs that serve their local
agement practices and their engagement markets (
in the financial services marketplace, webresources/bankersguide.pdf). The
consumers’ choices of financial insti­ Chicago Reserve Bank coordinated
tutions for home-secured loans, con­ asset-building workshops in Illinois
sumers’ efforts at comparison shopping, and southeastern Wisconsin to provide
and consumers’ complaint actions with information on investment approaches
respect to problems with credit cards. for low- and moderate-income persons.
During the year, partnerships with And the Boston, Atlanta, and Chicago
other agencies and organizations were Reserve Banks hosted workshops in
formed to undertake a variety of finan­ their communities on the benefits of the
cial education initiatives. Board staff federal Earned Income Tax Credit and
collaborated with the National Endow­ Assets for Independence programs as
88 89th Annual Report, 2002

Lending in Indian Country

Overcoming challenges to development requires leadership, commitment, creativ­
ity, and flexibility. . . . [T]he vision of tribal leaders and the involvement of
partners have helped to bring the new ideas, as well as the capital and technical
assistance, necessary to create viable economies in Indian Country.
Mark W. Olson, Member, Board of Governors
November 18, 2002

Extension of economic development into sovereign nations, Native American com­

underserved communities often rests on munities have the right to self-govern and
gaining an understanding of local culture to adjudicate contractual disputes in their
and history. With such an understand­ own tribal courts. While the exercise of
ing, lenders, developers, and local lead­ sovereignty preserves the right of tribal
ers can bridge the information and credit self-governance, it also creates a complex
gaps to facilitate the flow of capital and legal environment that results in uncer­
other resources that support growth and tainty for lenders and investors, who seek
development. consistency in their evaluation of risk and
Understanding local culture and history the likely return on investment. At the
is especially critical to overcoming the same time, some tribal members are unfa­
challenges of lending on Indian reserva­ miliar with the requirements and expecta­
tions and tribal lands, collectively known tions of lenders and other private-sector
as Indian Country. In many Native Ameri­ investors. These competing forces—the
can communities, misunderstanding, mis­ business need for certainty and predictabil­
trust, and discrimination have histori­ ity on one hand and unfamiliarity with
cally hindered the development of the lender and investor needs on the other—
infrastructures—governmental, physical, can disrupt the flow of information
educational, and financial—needed to sup- between Native American communities
port market-based economies. Further, and the banking industry, impairing the
many tribal communities are underserved operation of an efficient market.
by financial institutions, a situation that
limits their access to the credit and capital
The Role of the Federal Reserve
vital to their growth and development. As
a result, many tribal communities struggle Staff of the Community Affairs Offices
with significant social and economic chal­ (CAOs) at the Board of Governors and
lenges, as seen in high rates of unemploy­ several Federal Reserve Banks have
ment, inadequate housing, and low educa­ worked with tribal leaders and bankers for
tional attainment. nearly a decade to address the factors that
Sovereignty is a central issue in eco­ hinder lending and discourage financial
nomic development in Indian Country. As investments in Indian Country. CAO staff

wealth-creation vehicles for low-income faced by Native American populations

families. through sponsorship of the Federal
Reserve System’s first national confer­
ence on banking opportunities on Indian
Programs in Cooperation reservations and tribal lands (see box
with Native Americans ‘‘Lending in Indian Country’’). System
In 2002, the community affairs function staff continued to facilitate meetings and
addressed credit and lending barriers workshops and to convene task forces to
Consumer and Community Affairs 89

have sought to increase communication of the Board and participating Reserve

and highlight opportunities for profitable Banks (the Reserve Banks of Chicago,
relationships and development in Indian Kansas City, Minneapolis, and San Fran­
Country by creating mutually benefi­ cisco). The committee helped ensure that
cial partnerships. They have fostered the agenda topics were culturally sensitive and
exchange of information through work- accurately portrayed the credit needs and
shops on sovereign lending, articles in concerns of Native American communities
Reserve Bank newsletters, assistance in and at the same time emphasized the criti­
designing a financial training curriculum cal role of banks in creating economic
for Native American students, and support opportunity in Indian Country. To promote
for the development of regulations and pro­ the partnerships between lenders and com­
cedures that govern secured credit trans- munities that are essential to the growth
actions. At the national level, CAO staff and stabilization of local economies, the
at the Board have served on federal task conference agenda was developed to high-
forces that helped develop policy to light ways in which creative economic
improve funding opportunities in Indian development efforts—financed by leverag­
Country. ing funds from government loan and guar­
Through ongoing relationships with antee programs with bank credit—can
tribal leaders and bankers, the Federal result in safe, sound lending transactions.
Reserve has gained valuable insight into The conference, held on November 18–
the cultural and legal issues and the con­ 20, 2002, in Scottsdale, Arizona, drew
cerns of all parties. This insight led to more than 400 participants. It provided a
recognition by the Federal Reserve and its forum for financiers, tribal leaders, and
Native American partners of a need for a economic developers to discuss innovative
national dialogue on lending in Indian development opportunities in Indian Coun­
Country. try. The conference format employed
‘‘talking circles,’’ a discussion method
unique to the Native American culture that
Pathway to a National Conference
invites tribal members to enter into dia­
To promote a national dialogue, the Fed­ logue following each plenary session.
eral Reserve and its tribal partners began Breakout sessions addressed related issues
planning a conference that could serve as integral to development in Indian Coun­
a catalyst, stimulating new partnerships try, including commercial codes, bank for­
and creative initiatives in Native American mation, regulatory matters, and wealth-
communities across the country. An advi­ building strategies. The breakout sessions
sory committee made up of tribal leaders, afforded an opportunity to explore more
lenders, community development practi­ fully the topics addressed in panel discus­
tioners, attorneys, and academics knowl­ sions, enabling the building of partnerships
edgeable about Indian Country issues was to effect sustainable economic revitaliza­
formed by the Community Affairs Officers tion in Indian Country.

discuss financing of housing and small Banking for

businesses on tribal lands and finan- Immigrant Communities

cial literacy within tribal communities.

Through a national interagency Native Major demographic changes and pop-

American task force, Board staff began ulation shifts have been the impetus

planning for a policy development for several Federal Reserve initiatives

forum on financial literacy in Indian involving immigrant banking markets.

Country scheduled for May 2003. Seven Reserve Banks—Atlanta, Boston,

90 89th Annual Report, 2002

Chicago, Dallas, Kansas City, New • Loss mitigation and foreclosure

York, and Richmond—sponsored pro- prevention
grams and outreach meetings during
2002 to heighten financial institutions’ • Sustaining and revitalizing communi­
awareness of the credit and financial ties affected by economic downturns.
service needs of Hispanic communities.
English and Spanish versions of materi­
als on Electronic Transfer Accounts (an
Community Development
account designed by the U.S. Treasury Federal Reserve outreach activities and
for recipients of federal benefits), the programs in rural markets continued in
matricula consular card for Mexican 2002. Initiatives included conferences
nationals seeking banking services, and on community development challenges
financial literacy (‘‘Building Wealth: A and opportunities for rural residents
Beginner’s Guide to Securing Your and business owners, rural policy, and
Financial Future’’) are available on the opportunities for public–private partner-
Dallas Reserve Bank’s web site (at ships to further economic development in rural communities. Board staff contin­
Through other activities, the Chicago ued to work with the Rural Home Loan
Reserve Bank addressed the needs of Partnership, an interagency group com­
the Asian-American community, and mitted to increasing affordable housing
the Minneapolis Reserve Bank, the in rural communities.
needs of Islamic and Hmong immigrant Small-business development is an
communities. important component of efforts to
rebuild and strengthen communities.
Several Reserve Banks held workshops
Emerging Issues and Opportunities to provide information on opportunities
for business development and part­
The Federal Reserve in 2002 conducted nerships with local community develop­
programs and held conferences on ment organizations. Reserve Banks also
emerging issues in community develop­ provided technical assistance and infor­
ment to encourage research and discus­ mation on the mechanics of accessing
sion among academics and practitioners. tax credits for small businesses and for
Among the topics discussed were commercial development. Board staff
participated on a task force sponsored
• Community development and smart by the Department of Commerce to
growth (affordable housing, brown- explore development and capital forma­
fields redevelopment, transit systems, tion for minority microentrepreneurs.
and urban revitalization) The community affairs function con­
tinued to expand its presence in the
• Microenterprise development in small international arena. Board staff partici­
cities and towns pated with the Organisation for Eco­
nomic Co-operation and Development
• Entry-level employment opportunities (OECD), a body of international groups
in technology for low- and moderate- working to build partnerships and iden­
income persons tify collaborative approaches to devel­
opment, and delivered remarks at an
• Financial innovation in community OECD conference in England on the use
development of private finance for community build-
Consumer and Community Affairs 91

ing. Board staff also held meetings with ple, Board staff served as the Federal
officials from Indonesia, Japan, Yugo­ Reserve liaison to the Local Initiatives
slavia, New Zealand, and Russia to dis­ Support Corporation advisory board’s
cuss community development policies Center for Home Ownership. Board
and strategies. staff also provided support to Governor
The preservation of affordable hous­ Edward Gramlich in his role as chair-
ing remains a central issue for the Fed­ man of the board of directors for the
eral Reserve. During 2002, Board staff Neighborhood Reinvestment Corpora­
served in various capacities to support tion, a national nonprofit organization
the housing activities of the Federal charged by Congress with revitalizing
Reserve’s external partners. For exam­ older, distressed communities.

Banking Supervision and Regulation

The U.S. banking system exhibited con­ Net interest margins widened moder­
siderable strength in 2002, producing ately for the year, a result of low interest
record earnings while absorbing sig­ rates and growth in low-cost core depos­
nificant deterioration in asset quality, its. Demand for business loans was
lackluster revenues from financial- weak, leading to a $70 billion (or 7 per-
market activities, and the effects of eco­ cent) decline in aggregate commercial
nomic weakness more generally. This and industrial loans outstanding. With
remarkable performance is attributable supply boosted by historically low mort­
in part to historically low interest gage rates, banks added significantly
rates; it also reflects the benefits of to their holdings of one- to four-family
fundamentally strong balance sheets mortgage loans and pass-through securi­
and prudent capitalization as well as ties. Loans outstanding under home
the industry’s continuing enhancements equity lines of credit grew nearly 40 per-
to risk-management processes and cent, the third consecutive year that
capabilities. these balances have risen by more than
Industry earnings rose 20 percent for 20 percent. Commercial real estate lend­
the year, supported by robust growth in ing, especially lending to finance non-
low-cost core deposits, continued profit- farm nonresidential properties, multi-
ability from consumer lending and mort­ family housing, and new construction,
gage banking operations, and improved also grew rapidly.
operating efficiency. Elevated credit The economic environment also
costs and reversals in market-sensitive affected the way in which banks funded
lines of business offset some of this their operations. During this period
improvement. of low interest rates and soft equity
Nonperforming assets rose over the prices, many households shifted funds
year, particularly at large, complex insti­ into interest-bearing bank transaction
tutions. The rise was fueled by a series accounts at the same time many banks
of high-profile bankruptcies and con­ undertook significant initiatives to bol­
tinuing weak economic growth. The ster core deposit growth. By the end of
effect on banks of these bankruptcies 2002, money market deposit accounts
was somewhat muted, however, as and savings deposits accounted for
bondholders rather than banks absorbed nearly 30 percent of the industry’s fund­
much of the credit costs associated with ing. Capital remains a key strength of
these high-profile borrowers. Credit- the industry, as the total risk-based capi­
protection instruments also played a tal ratio remained at about 12.7 percent.
role in reducing bank credit losses. Non-interest revenues from the origi­
Banks thus appear to have benefited nation of mortgages for sale to others
significantly from their ability to dis­ were a major positive for the industry,
perse risk through credit derivatives, as were service charges on rapidly grow­
the syndicated loan market, loan sales, ing deposit accounts. Market-sensitive
and securitization activities, combined revenues were again weak, consistent
with better risk-management and risk- with the overall softness in equity mar­
measurement systems. kets. Most banks supported their earn-
94 89th Annual Report, 2002

ings by taking significant securities Scope of Responsibilities for

gains, in some cases associated with Supervision and Regulation
adjustments to the institution’s interest
The Federal Reserve is the federal
rate risk profile.
supervisor and regulator of all U.S. bank
Banks also reported significant gains
holding companies (including financial
in operating efficiency, attributable in
holding companies formed under the
part to a change in accounting prac­
authority of the Gramm–Leach–Bliley
tice that reduced expenditures to amor­
Act) and of state-chartered commercial
tize goodwill. Special charges offset
banks that are members of the Federal
some of these gains at a small number
Reserve System. In overseeing these
of large institutions related to restruc­
organizations, the Federal Reserve seeks
turing and potential litigation-related
primarily to promote their safe and
sound operation and their compliance
Work continued toward finalizing
with laws and regulations, including the
a new international capital standard,
Bank Secrecy Act and consumer protec­
with approval of the new framework
tion and civil rights laws.1
expected in 2003 and implementation
The Federal Reserve also has respon­
of the new rules in 2007. This year’s
sibility for the supervision of all Edge
efforts included an unprecedented coor­
Act and agreement corporations; the
dinated effort among supervisors and
international operations of state member
bankers in the G–10 countries to
banks and U.S. bank holding companies;
assemble detailed information on the
and the operations of foreign banking
risk profiles of individual banks and the
companies in the United States.
measured risks associated with these
The Federal Reserve exercises impor­
tant regulatory influence over entry into
Bankers and supervisors enter 2003
the U.S. banking system and the struc­
in a strong position but with a cautious
ture of the system through its adminis­
outlook. Both the positive and negative
tration of the Bank Holding Company
influences seen in 2002 appear likely to
Act, the Bank Merger Act (with regard
subside. By year-end 2002, asset quality
to state member banks), the Change in
was showing signs of some improve­
Bank Control Act (with regard to bank
ment at most banks and possible signs
holding companies and state member
of economic improvement and some
banks), and the International Banking
recovery in equity markets were emerg­
ing. Charge-offs on consumer loans
remained generally stable, as available 1. The Board’s Division of Consumer and
Community Affairs is responsible for coordinating
evidence continued to suggest that the Federal Reserve’s supervisory activities with
household debt burdens were manage- regard to the compliance of banking organizations
able. Bankers expect credit quality to with consumer protection and civil rights laws. To
stabilize and ultimately to improve in carry out this responsibility, the Federal Reserve
the coming year, although an uncertain trains a number of its bank examiners in the evalu­
ation of institutions with regard to such compli­
economy and geopolitical concerns may ance. The chapter of this volume covering con­
continue to affect the activities and out- sumer and community affairs describes these
look of both households and businesses. regulatory responsibilities. Compliance with other
Despite these uncertainties, the funda­ banking statutes and regulations, which is treated
in this chapter, is the responsibility of the Board’s
mental strengths of the industry leave it Division of Banking Supervision and Regulation
well positioned to support, and benefit and the Federal Reserve Banks, whose examiners
from, an economic recovery. also check for safety and soundness.
Banking Supervision and Regulation 95

Act. The Federal Reserve is also respon­ tions. The table provides information on
sible for imposing margin requirements the examinations and inspections con­
on securities transactions. In carrying ducted by the Federal Reserve during
out these responsibilities, the Federal the past five years.
Reserve coordinates its supervisory
activities with other federal banking
State Member Banks
agencies, state agencies, functional
regulators, and the bank regulatory At the end of 2002, 949 state-chartered
agencies of other nations. banks (excluding nondepository trust
companies and private banks) were
members of the Federal Reserve Sys­
Supervision for tem. These banks represented approxi­
Safety and Soundness mately 12 percent of all insured U.S.
To ensure the safety and soundness commercial banks and held approxi­
of banking organizations, the Federal mately 27 percent of all insured com­
Reserve conducts on-site examinations mercial bank assets in the United States.
and inspections and off-site surveillance The guidelines for Federal Reserve
and monitoring. It also undertakes examinations of state member banks
enforcement and other supervisory are fully consistent with section 10 of
actions. the Federal Deposit Insurance Act, as
amended by section 111 of the Federal
Deposit Insurance Corporation Improve­
Examinations and Inspections ment Act of 1991 and by the Riegle
The Federal Reserve conducts examina­ Community Development and Regula­
tions of state member banks, the U.S. tory Improvement Act of 1994. A full-
branches and agencies of foreign banks, scope, on-site examination of these
and Edge Act and agreement cor­ banks is required at least once a year;
porations. In a process distinct from exceptions are certain well-capitalized,
examinations, it conducts inspections of well-managed institutions having assets
holding companies and their nonbank of less than $250 million, which may be
subsidiaries. Pre-examination planning examined once every eighteen months.
and on-site review of operations are
integral parts of the overall effort to
Bank Holding Companies
ensure the safety and soundness of
financial institutions. Whether it is an At year-end 2002, a total of 5,963 U.S.
examination or an inspection, the review bank holding companies were in opera­
entails (1) an assessment of the quality tion, of which 5,135 were top-tier bank
of the processes in place to identify, holding companies. These organizations
measure, monitor, and control risks, controlled 6,278 insured commercial
(2) an appraisal of the quality of the banks and held approximately 94 per-
institution’s assets, (3) an evaluation of cent of all insured commercial bank
management, including an assessment assets in the United States.
of internal policies, procedures, con­ Federal Reserve guidelines call for
trols, and operations, (4) an assessment annual inspections of large bank holding
of the key financial factors of capital, companies as well as smaller companies
earnings, liquidity, and sensitivity to that have significant nonbank assets.
market risk, and (5) a review for compli­ In judging the financial condition of
ance with applicable laws and regula­ the subsidiary banks owned by holding
96 89th Annual Report, 2002

State Member Banks and Holding Companies, 1998–2002

Entity/Item 2002 2001 2000 1999 1998

State member banks

Total number . . . . . . . . . . . . . . . . . . . . . . . . . . 949 970 991 1,010 994
Total assets (billions of dollars) . . . . . . . . . 1,863 1,823 1,645 1,423 1,312
Number of examinations . . . . . . . . . . . . . . . 814 816 899 858 820
By Federal Reserve System . . . . . . . . . . 550 561 610 551 511
By state banking agency . . . . . . . . . . . . . 264 255 289 307 309

Top-tier bank holding companies

Large (assets of more than $1 billion)
Total number . . . . . . . . . . . . . . . . . . . . . . . . 329 312 309 283 273
Total assets (billions of dollars) . . . . . . . 7,483 6,905 6,213 5,625 5,136
Number of inspections . . . . . . . . . . . . . . . 439 413 352 332 290
By Federal Reserve System 1 . . . . . . . 431 409 346 329 281
On site . . . . . . . . . . . . . . . . . . . . . . . . . 385 372 309 298 262
Off site . . . . . . . . . . . . . . . . . . . . . . . . . 46 37 37 31 19
By state banking agency . . . . . . . . . . . 8 4 6 3 9
Small (assets of $1 billion or less)
Total number . . . . . . . . . . . . . . . . . . . . . . . . 4,806 4,816 4,800 4,831 4,880
Total assets (billions of dollars) . . . . . . . 821 768 716 679 647
Number of inspections . . . . . . . . . . . . . . . 3,726 3,486 3,347 3,064 3,257
By Federal Reserve System . . . . . . . . 3,625 3,396 3,264 2,973 3,178
On site 2 . . . . . . . . . . . . . . . . . . . . . . . . 264 730 835 684 723
Off site . . . . . . . . . . . . . . . . . . . . . . . . . 3,361 2,666 2,429 2,289 2,455
By state banking agency . . . . . . . . . . . 101 90 83 91 79

Financial holding companies

Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 602 567 462 . . . . . .
Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 23 21 . . . . . .

Note. Data for prior periods have been updated. inspections being performed off site versus on site.
1. For large bank holding companies subject to con­ See text section ‘‘Bank Holding Companies’’ for more
tinuous, risk-focused supervision, includes multiple tar­ information.
geted reviews. . . . Not applicable.
2. In 2002, the supervisory program for small bank
holding companies was revised, resulting in more

companies, Federal Reserve examiners of such companies. If all of a company’s

consult examination reports prepared subsidiary depository institutions have
by the federal and state banking authori­ composite and management ratings of
ties that have primary responsibility ‘‘satisfactory’’ or better, and if no mate-
for the supervision of those banks, rial outstanding issues at the holding
thereby minimizing duplication of effort company or consolidated level are other-
and reducing the burden on banking wise indicated, only a composite rating
organizations. and a management rating based on the
Small, noncomplex bank holding ratings of the lead subsidiary depository
companies—those that have consoli­ institution are assigned to the company.
dated assets of $1 billion or less—are In 2002, the Federal Reserve conducted
subject to a special supervisory pro- 3,361 reviews of such bank holding
gram that was implemented in 1997 and companies. If a company’s subsidiary
modified in 2002.2 The program permits depository institutions have ratings
a more flexible approach to supervision lower than ‘‘satisfactory’’ or other sig­
nificant supervisory issues, a more thor­
2. Refer to SR letter 02–01 for a discussion of ough off-site review of the organization
the factors considered in determining whether a is conducted using surveillance results
bank holding company is complex or noncomplex. and other information. If the informa-
Banking Supervision and Regulation 97

tion obtained off site from these sources lion and $15 billion; 85, between
is not sufficient to determine the overall $500 million and $1 billion; and 390,
financial condition of the holding com­ less than $500 million.
pany and to assign the composite and
management ratings, the holding com­
pany is subject to increased supervisory Specialized Examinations
review that may include an on-site The Federal Reserve conducts special­
review and off-site monitoring. ized examinations of banking organiza­
While the 2002 modifications to the tions in the areas of information technol­
special supervisory program principally ogy, fiduciary activities, transfer agent
affect the supervision of small holding activities, and government and munici­
companies, they also promote more- pal securities dealing and brokering. The
effective use of targeted on-site reviews Federal Reserve also conducts special­
to fulfill the requirements for, when ized examinations of certain entities,
necessary, the full-scope inspection of other than banks, brokers, or dealers,
larger holding companies—those with that extend credit subject to the Board’s
consolidated assets of $1 billion to margin regulations.
$5 billion. In general, the modifications With passage of the Gramm–Leach–
direct Reserve Banks to use surveillance Bliley Act in 1999, the Federal Reserve
results and other information to focus ceased conducting routine annual
attention and resources on holding com­ examinations of securities underwriting
panies that warrant increased scrutiny. and dealing activities through so-called
section 20 subsidiaries of bank holding
Financial Holding Companies companies. Under the act, the Federal
Reserve is generally required to rely on
Under the Gramm–Leach–Bliley Act, the supervisory activities of the func­
the Federal Reserve has supervisory tional regulator for broker–dealer sub­
oversight authority and responsibility sidiaries unless the Board has cause
for bank holding companies, includ­ to believe that a broker–dealer poses
ing those that operate as financial hold­ a material risk to an insured depository
ing companies. The statute streamlines affiliate. No such examinations for cause
the Federal Reserve’s supervision of all were conducted during 2002.
bank holding companies and sets forth
parameters for the relationship between Information Technology Activities
the Federal Reserve and other regula­
tors. The statute differentiates between In recognition of the importance of
the Federal Reserve’s relations with information technology to safe and
regulators of depository institutions and sound operations in the financial indus­
its relations with functional regulators try, the Federal Reserve reviews the
(that is, regulators for insurance, securi­ information technology activities of
ties, and commodities). supervised financial institutions as well
As of year-end 2002, 602 domestic as certain independent data centers that
bank holding companies and 30 foreign provide information technology services
banking organizations had financial to these institutions. Several years ago,
holding company status. Of the domes- the information technology reviews of
tic institutions, 37 financial holding banking institutions were integrated into
companies had consolidated assets of the overall supervisory process, and thus
$15 billion or more; 90, between $1 bil­ all safety and soundness examinations
98 89th Annual Report, 2002

Adoption of Rules Governing Transactions with Affiliates

In 2002, the Federal Reserve Board issued but emphasized, in the statutory and regula­
a new regulation that addresses transac­ tory frameworks it established, the impor­
tions between insured depository insti­ tance of limitations on affiliate transactions
tutions and their affiliates. The new as a means of protecting depository institu­
regulation—Regulation W (Transactions tions from losses in their transactions with
between Member Banks and Their affiliates.
Affiliates)—implements sections 23A and
23B of the Federal Reserve Act. It takes Key Provisions of Regulation W
effect April 1, 2003.
Key provisions of Regulation W, and some
of the important exemptions from the rule,
Background are described below.
Sections 23A and 23B of the Federal
Reserve Act are designed to protect deposi­ Derivatives Transactions and
tory institutions from losses in transactions Intraday Credit
with their affiliates. They also limit a
depository institution’s ability to transfer to Derivatives transactions between a deposi­
its affiliates the subsidy arising from the tory institution and its affiliates are not
institution’s access to the federal safety subject to the quantitative limitations and
net. Section 23A subjects covered trans- collateral requirements of section 23A.
actions between depository institutions and They are, however, subject to the market
their affiliates (for example, loans from a terms requirement of section 23B. In addi­
depository institution to or for the benefit tion, depository institutions are required to
of an affiliate, and purchases of assets by a adopt policies and procedures under sec­
depository institution from an affiliate) to tion 23A to manage the credit exposure
quantitative limits and collateral require­ arising from their derivatives transactions
ments. Section 23B requires that deposi­ with affiliates.
tory institutions conduct most transactions Intraday extensions of credit by deposi­
with affiliates on terms and under circum­ tory institutions to affiliates also are sub­
stances that are substantially the same as ject to the market terms requirement of
those granted to nonaffiliates—that is, a section 23B. However, such extensions
depository institution may not grant its of credit are exempt from the quantitative
affiliate more favorable terms and condi­ limits and collateral requirements of sec­
tions than it would grant a similarly situ­ tion 23A if the depository institution adopts
ated nonaffiliate in a comparable transac­ policies and procedures to manage its
tion. This provision is commonly referred credit exposure to affiliates in such trans-
to as the ‘‘market terms requirement.’’ actions and has no reason to believe that
Before adoption of Regulation W, the the affiliate receiving intraday credit would
statutory provisions of sections 23A and have difficulty repaying the loan.
23B of the Federal Reserve Act had been
implemented by means of Board interpreta­ Scope of Application—
tions and informal staff guidance. Having a Foreign Banking Organizations
comprehensive and consistent application
of the statutory provisions became espe­ To help ensure a competitive playing field
cially important with passage in 1999 of for U.S. depository institutions vis-à-vis
the Gramm–Leach–Bliley Act (GLBA). foreign banking organizations operating in
GLBA not only provided for broader affili­ the United States, Regulation W applies to
ations among financial services providers transactions between the U.S. branches and
Banking Supervision and Regulation 99

agencies of a foreign bank and the foreign was legally conducting before Regula­
bank’s affiliates engaged in the United tion W was issued.
States in securities underwriting and deal­
ing, insurance underwriting, merchant Loan Purchases
banking, and insurance company invest­ For some years, the Board has allowed a
ment. The issue of competitive equity depository institution to purchase a loan
arises most strongly in connection with from an affiliate if the institution makes an
these activities—activities that a U.S. bank independent evaluation of the borrower’s
cannot engage in directly or through an creditworthiness before the affiliate extends
operating subsidiary. the loan and if the institution commits to
purchasing the loan before the affiliate
Scope of Application— extends the loan. In 1995, Board staff
Financial Subsidiaries expressly limited the availability of this
Congress amended section 23A in 1982 to exemption to institutions whose loan pur­
provide that under the statute, subsidiaries chases from any one affiliate represented
of a depository institution generally are no more than 50 percent of the dollar
not affiliates of the institution. This provi­ amount of the loans made by that affiliate.
sion was based on the premise that subsidi­ This condition was designed to prevent
aries of a depository institution generally bank holding companies from using the
are consolidated with the depository insti­ exemption extensively to fund their non-
tution and are engaged only in activities bank lending affiliates.
that the depository institution may conduct Regulation W retains this 50 percent
directly. limitation but allows the institution’s pri­
In 1999, GLBA authorized depository mary federal regulator, on a case-by-case
institutions to own financial subsidiaries basis, to restrict loan purchases even more
that engage in activities that the parent if appropriate to protect the safety and
institution may not conduct directly. GLBA soundness of the institution.
also amended section 23A to define a At the time Regulation W was adopted,
financial subsidiary of a bank as an affiliate the Board sought comment on a proposed
of the bank—and thus subjected transac­ rule that would prevent a depository insti­
tions between the bank and its finan­ tution from using this exemption if its pur­
cial subsidiaries to the limitations of chases of loans from an affiliate under the
sections 23A and 23B. Section 23A, as exemption exceeded 100 percent of the
amended by GLBA, defines a financial institution’s capital stock and surplus.
subsidiary as a subsidiary of any state or
national bank that is engaged in an activity
that is not permissible for national banks A key premise of the Gramm–Leach–
(other than a subsidiary that federal law Bliley Act is that sections 23A and 23B of
specifically authorizes national banks to the Federal Reserve Act limit the risk to
control). A subsidiary of a financial subsid­ depository institutions of the broader affili­
iary is also a financial subsidiary. ations permitted by GLBA and make exten­
Exceptions to the definition of a finan­ sive prior-transaction review by the bank
cial subsidiary are included in Regula­ regulatory agencies unnecessary. In light
tion W for (1) insurance agency subsidi­ of the greater role of these statutory
aries of banks, (2) subsidiaries of state- provisions in risk management, Federal
chartered banks that engage in activities Reserve examiners and other supervisory
that the parent state bank may engage in staff have been directed to review inter-
directly under federal and state law, and company transactions for compliance with
(3) subsidiaries of state-chartered banks the statute and Regulation W frequently
that engage in activities that the subsidiary and rigorously.
100 89th Annual Report, 2002

are now expected to include a review the year the Federal Reserve examined
of information technology risks and 1 state member limited-purpose trust
activities. During 2002, the Federal company acting as a national securities
Reserve was the lead agency in two depository.
examinations of large, multiregional
data processing servicers examined in
Government and Municipal Securities
cooperation with the other federal bank­
Dealers and Brokers
ing agencies.
The Federal Reserve is responsible for
Fiduciary Activities examining state member banks and for­
eign banks for compliance with the Gov­
The Federal Reserve has supervi­ ernment Securities Act of 1986 and with
sory responsibility for institutions that Department of the Treasury regulations
together hold more than $15 trillion governing dealing and brokering in
of assets in various fiduciary capacities. government securities. Thirty-five state
During on-site examinations of fidu­ member banks and 10 state branches of
ciary activities, the institution’s compli­ foreign banks have notified the Board
ance with laws, regulations, and general that they are government securities deal­
fiduciary principles and potential con­ ers or brokers not exempt from Trea­
flicts of interest are reviewed; its man­ sury’s regulations. During 2002 the Fed­
agement and operations, including its eral Reserve conducted 9 examinations
asset- and account-management, risk- of broker–dealer activities in govern­
management, and audit and control pro­ ment securities at these institutions.
cedures, are also evaluated. In 2002, These examinations are generally con­
Federal Reserve examiners conducted ducted concurrently with the Federal
194 on-site fiduciary examinations. Reserve’s examination of the state mem­
ber bank or branch.
Transfer Agents and The Federal Reserve is also respon­
Securities Clearing Agencies sible for ensuring compliance with the
Securities Act Amendments of 1975 by
As directed by the Securities Exchange state member banks and bank holding
Act of 1934, the Federal Reserve con- companies that act as municipal securi­
ducts specialized examinations of those ties dealers, which are examined pursu­
state member banks and bank holding ant to the Municipal Securities Rule-
companies that are registered with the making Board’s rule G-16 at least once
Board as transfer agents. Among other each two calendar years. Of the 27 enti­
things, transfer agents countersign and ties that dealt in municipal securities
monitor the issuance of securities, reg­ during 2002, 8 were examined during
ister the transfer of securities, and the year.
exchange or convert securities. On-site
examinations focus on the effective­
Securities Credit Lenders
ness of the institution’s operations and
its compliance with relevant securities Under the Securities Exchange Act of
regulations. During 2002, the Federal 1934, the Federal Reserve Board is
Reserve conducted on-site examinations responsible for regulating credit in cer­
at 30 of the 98 state member banks and tain transactions involving the purchase
bank holding companies that were reg­ or carrying of securities. In addition to
istered as transfer agents. Also during examining banks under its jurisdiction
Banking Supervision and Regulation 101

for compliance with the Board’s margin enforcement). In addition to formal

regulations as part of its general exami­ enforcement actions, the Reserve
nation program, the Federal Reserve Banks in 2002 completed 116 informal
maintains a registry of persons other enforcement actions, such as resolutions
than banks, brokers, and dealers who with boards of directors and memoran­
extend credit subject to those regula­ dums of understanding.
tions. The Federal Reserve may conduct
specialized examinations of these lend­
ers if they are not already subject to Risk-Focused Supervision
supervision by the Farm Credit Admin­ In recent years the Federal Reserve
istration, the National Credit Union has created several programs aimed at
Administration, or the Office of Thrift enhancing the effectiveness of the super­
Supervision. visory process. The main objective of
At the end of 2002, 795 lenders other these initiatives has been to sharpen the
than banks, brokers, or dealers were reg­ focus on (1) those business activities
istered with the Federal Reserve. Other posing the greatest risk to banking orga­
federal regulators supervised 166 of nizations and (2) the organizations’
these lenders, and the remaining 629 management processes for identifying,
were subject to limited Federal Reserve measuring, monitoring, and controlling
supervision. On the basis of regulatory risk.
requirements and annual reports, the
Federal Reserve exempted 281 lenders Regional Banking Organizations
from its on-site inspection program. The
securities credit activities of the remain­ The risk-focused supervision program
ing 348 lenders were subject to either for regional banking organizations
biennial or triennial inspection. One applies to institutions having a manage­
hundred twenty-seven inspections were ment structure organized by function or
conducted during the year, compared business line, a broad array of products,
with 65 in 2001. and operations that span multiple super­
visory jurisdictions. For smaller regional
banking organizations, the supervi­
Enforcement Actions sory program may be implemented with
and Civil Money Penalties a point-in-time inspection. For larger
In 2002 the Federal Reserve completed institutions, it may take the form of a
18 enforcement cases involving 32 sep­ series of targeted reviews. For the larg­
parate actions, such as cease-and-desist est, most complex institutions, the pro­
orders, written agreements, removal and cess is continuous, as described in the
prohibition orders, and civil money pen­ next section. To minimize burden on the
alties. The Board of Governors collected institution, work is performed off site to
$60,829 in civil money penalties. All the greatest extent possible. Addition-
funds collected were remitted to the ally, to minimize the number of requests
Department of the Treasury. for information from the institution,
All final enforcement orders issued examiners make use of public and reg­
by the Board and all written agreements ulatory financial reports, market data,
executed by the Reserve Banks in information from automated surveil-
2002 are available to the public and lance screening systems (see section
are posted on the Board’s web site ‘‘Surveillance and Risk Assessment’’), and internal management reports.
102 89th Annual Report, 2002

Large, Complex Banking Organizations During the year, the Federal Reserve,
the Office of the Comptroller of the
The Federal Reserve applies a risk-
Currency, and the Securities and
focused supervision program to
Exchange Commission formed an inter-
large, complex banking organizations
agency working group to assess
(LCBOs).3 The key features of the
whether, in light of the post-Septem­
LCBO supervision program are (1) iden­
ber 11 risk environment, additional
tifying those LCBOs that are judged, on
guidance on business resumption is
the basis of their shared risk character­
needed. The agencies held a series of
istics, to present the highest level of
meetings with financial institutions and
supervisory risk to the Federal Reserve
core clearing and settlement organiza­
System, (2) maintaining continual super-
tions to discuss lessons learned and the
vision of these institutions to keep
need for improving the resilience of the
current the Federal Reserve’s assess­
financial system after a wide-scale dis­
ment of each organization’s condition,
ruption. In September 2002, the work­
(3) assigning to each LCBO a supervi­
ing group published for comment a
sory team composed of Reserve Bank
Draft Interagency White Paper on Sound
staff members who have skills appro­
Practices to Strengthen the Resilience of
priate for the organization’s risk profile
the U.S. Financial System.4 The agen­
(the team leader is the central point of cies are continuing to work with repre­
contact, has responsibility for only one sentatives of the industry to identify
LCBO, and is supported by specialists sound practices and plan to issue a final
skilled in evaluating the risks of LCBO paper in 2003.
business activities and functions), and
(4) promoting Systemwide and inter-
agency information-sharing through an Community Banks
automated system. The risk-focused supervision program
Supporting the supervision process for community banks emphasizes the
is an automated application and review of activities having the high­
database—the Banking Organization est level of risk to an institution and
National Desktop (BOND)—that was provides a tiered approach to the exami­
developed to facilitate real-time, secure nation of these activities. Examination
information-sharing and collaboration procedures are tailored to the char­
across the Federal Reserve System and acteristics of the bank, keeping in
with certain other federal and state mind its size, complexity, and risk pro-
regulators. During 2002, BOND was file. The examination procedures entail
enhanced to include the capability of both off-site and on-site work, includ­
searching and accessing supervisory ing planning, completion of a pre-
documents using web-based technology. examination visit, preparation of a
BOND performance and functionality detailed scope-of-examination memo­
were also improved to promote analysis randum, thorough documentation of
across institutions. the work done, and preparation of an
examination report tailored to the
scope and findings of the examination.
3. For an overview of the Federal Reserve’s The framework for risk-focused super-
LCBO program, see Lisa M. DeFerrari and
David E. Palmer, ‘‘Supervision of Large Complex
Banking Organizations,’’ Federal Reserve Bulle­ 4. Federal Register, vol. 67, no. 172 (Sept. 5,
tin, vol. 87 (February 2001), pp. 47–57. 2002), pp. 56835–56842.
Banking Supervision and Regulation 103

vision of community banks was devel­ insurance activities collected via the
oped jointly with the Federal Deposit report.
Insurance Corporation and has been Historically, paper copies of the Bank
adopted by the Conference of State Holding Company Performance Reports
Bank Supervisors. have been provided to individual bank
holding companies and to state bank­
ing agencies. Effective with the March
Surveillance and Risk Assessment 2002 report, paper distribution was
The Federal Reserve uses automated replaced by electronic distribution of
screening systems to monitor the finan­ non-confidential information via the
cial condition and performance of state Board’s National Information Center
member banks and bank holding compa­ web site. The change was made to
nies between on-site examinations. The improve the efficiency and timeliness of
screening systems analyze supervisory distribution of the reports and to provide
data and regulatory financial reports broader access to the reports by public
to identify companies that appear to users.
be weak or deteriorating. This analysis The Federal Reserve works through
helps to direct examination resources to the Federal Financial Institutions
institutions that exhibit higher risk pro- Examination Council (FFIEC) Task
files. Screening systems also assist in Force on Surveillance Systems to coor­
the planning of examinations by identi­ dinate surveillance activities with the
fying companies that are engaging in other federal banking agencies.5 During
new or complex activities. the year, the task force added to the
In addition to using automated screen­ Uniform Bank Performance Report sev­
ing systems, the Federal Reserve pre- eral items on securitization activities
pares quarterly Bank Holding Com­ substantially similar to the items added
pany Performance Reports for use in to the Bank Holding Company Perfor­
monitoring and inspecting supervised mance Report. Also during the year, the
banking organizations. The reports con­ task force adopted a web-based distribu­
tain, for individual bank holding com­ tion system for the Uniform Bank Per­
panies, financial statistics and compari­ formance Report.
sons with peer companies. They are
compiled from data provided by large
bank holding companies in quarterly
International Activities
regulatory reports (FR Y–9C and The Federal Reserve supervises the for­
FR Y–9LP). During 2002, information eign branches of and overseas invest­
on securitization and asset sales activ­ ments by member banks, Edge Act and
ities was added to the report to help agreement corporations, and bank hold­
examiners and analysts evaluate the ing companies; and investments by bank
potential risks of these activities. holding companies in export trading
Among the new information collected companies. It also supervises the activi­
is detail on the volume and composi­ ties that foreign banking organizations
tion of securitization activities, the vol­
ume and composition of retained credit 5. The member agencies of the FFIEC are the
exposures, and delinquencies of and net Board of Governors, the Federal Deposit Insur­
ance Corporation (FDIC), the National Credit
losses on securitized assets. Also dur­ Union Administration (NCUA), the Office of the
ing the year the Federal Reserve sub­ Comptroller of the Currency (OCC), and the
stantially expanded the information on Office of Thrift Supervision (OTS).
104 89th Annual Report, 2002

conduct through entities in the United U.S. economy with a means of financ­
States, including branches, agencies, ing international business, especially
representative offices, and subsidiaries. exports. Agreement corporations are
similar organizations, state chartered or
Foreign Operations of
federally chartered, that enter into an
U.S. Banking Organizations
agreement with the Board to refrain
from exercising any power that is
The Federal Reserve examines the not permissible for an Edge Act
international operations of state member corporation.
banks, Edge Act corporations, and bank Under sections 25 and 25A of the
holding companies principally at the Federal Reserve Act, Edge Act and
U.S. head offices of these organizations, agreement corporations may engage in
where the ultimate responsibility for international banking and foreign finan­
their foreign offices lies. In 2002 the cial transactions. These corporations,
Federal Reserve examined 1 foreign most of which are subsidiaries of mem­
branch of a state member bank and ber banks, may (1) conduct a deposit
4 foreign subsidiaries of Edge Act cor­ and loan business in states other than
porations and bank holding companies. that of the parent, provided that the busi­
The examinations abroad were con­ ness is strictly related to international
ducted with the cooperation of the transactions, and (2) make foreign
supervisory authorities of the countries investments that are broader than those
in which they took place; when appro­ made by member banks because they
priate, the examinations were coordi­ may invest in foreign financial organi­
nated with the Office of the Comptroller zations, such as finance companies and
of the Currency. Examiners also make leasing companies, as well as in foreign
visits to the overseas offices of U.S. banks.
banks to obtain financial and operating Edge Act and agreement corpora­
information and, in some instances, tions numbered 80 and were operating
to evaluate their efforts to implement 12 branches at year-end 2002. These
corrective measures or to test their corporations are examined annually.
adherence to safe and sound banking
U.S. Activities of Foreign Banks
At the end of 2002, 61 member banks
were operating 855 branches in for­ The Federal Reserve has broad authority
eign countries and overseas areas of the to supervise and regulate the U.S. activ­
United States; 31 national banks were ities of foreign banks that engage in
operating 652 of these branches, and banking and related activities in the
30 state member banks were oper­ United States through branches, agen­
ating the remaining 203. In addition, cies, representative offices, commercial
16 nonmember banks were operating lending companies, Edge Act corpora­
17 branches in foreign countries and tions, commercial banks, and certain
overseas areas of the United States. nonbank companies. Foreign banks con­
tinue to be significant participants in the
Edge Act and Agreement Corporations U.S. banking system.
As of year-end 2002, 193 foreign
Edge Act corporations are international banks from 55 countries were operating
banking organizations chartered by the 253 state-licensed branches and agen­
Board to provide all segments of the cies (of which 10 were insured by the
Banking Supervision and Regulation 105

Federal Deposit Insurance Corporation) these two processes provide critical

as well as 52 branches licensed by the information to U.S. supervisors in a
Office of the Comptroller of the Cur­ logical, uniform, and timely manner.
rency (of which 6 had FDIC insurance). The Federal Reserve conducted or par­
These foreign banks also directly owned ticipated with state and federal regu­
16 Edge Act and agreement corpora­ latory authorities in 307 examinations
tions and 3 commercial lending compa­ during 2002.
nies; in addition, they held an equity
interest of at least 25 percent in 86 U.S.
commercial banks.
Technical Assistance
Altogether, the U.S. offices of these In 2002 the Federal Reserve System
foreign banks at the end of 2002 con- continued to provide technical assis­
trolled approximately 18 percent of tance on bank supervisory matters
U.S. commercial banking assets. These to foreign central banks and supervi­
foreign banks also operated 92 rep­ sory authorities. Technical assistance
resentative offices; an additional 57 for­ involves visits by System staff members
eign banks operated in the United to foreign authorities as well as consul­
States solely through a representative tations with foreign supervisors who
office. visit the Board or the Reserve Banks.
State-licensed and federally licensed Technical assistance in 2002 was con­
branches and agencies of foreign banks centrated in Latin America, Asia, and
are examined on site at least once every former Soviet bloc countries.
eighteen months, either by the Federal During the year, the Federal Reserve
Reserve or by a state or other federal offered supervision training courses in
regulator; in most cases, on-site exami­ Washington, D.C., and in a number of
nations are conducted at least once foreign jurisdictions exclusively for for­
every twelve months, but the period eign supervisory authorities. System
may be extended to eighteen months staff also took part in technical assis­
if the branch or agency meets certain tance and training missions led by the
criteria. International Monetary Fund, the World
The Federal Reserve conducts a joint Bank, the Inter-American Develop­
program for supervising the U.S. opera­ ment Bank, the Asian Development
tions of foreign banking organizations Bank, the Basel Committee on Banking
in cooperation with the other federal Supervision, and the Financial Stability
banking agencies and state banking Institute.
agencies. The program has two main
parts. One part focuses on the examina­
tion process for those foreign banking
Supervisory Policy
organizations that have multiple U.S. Within the supervisory policy function,
operations and is intended to improve the Federal Reserve develops guidance
coordination among the various U.S. for examiners and financial institutions
supervisory agencies. The other part as well as regulations for financial insti­
is a review of the financial and opera­ tutions under the supervision of the Fed­
tional profile of each organization to eral Reserve. Staff members also partici­
assess its general ability to support its pate in international supervisory forums
U.S. operations and to determine what and provide support for the work of the
risks, if any, the organization poses Federal Financial Institutions Examina­
through its U.S. operations. Together, tion Council.
106 89th Annual Report, 2002

Capital Adequacy Standards the new capital rule was published in

SR letter 02–4 on March 4, 2002.
During 2002, the Federal Reserve,
together with the other federal banking
agencies, issued two final rules amend­ Claims on Securities Firms
ing the agencies’ regulatory capital In April, the federal banking agencies
guidelines and issued guidance on a issued final rules amending the risk-
number of policy topics. One final rule based capital standards for banks, bank
established the regulatory capital treat­ holding companies, and savings associa­
ment of equity investments in nonfinan­ tions by reducing from 100 percent to
cial companies held by banking orga­ 20 percent the risk weight accorded to
nizations. The other final rule reduced certain claims on, and claims guaranteed
from 100 percent to 20 percent the risk by, qualifying securities firms having
weight applied, under the agencies’ high investment-grade ratings in coun­
risk-based capital guidelines, to certain tries that are members of the Organi­
claims on qualifying securities firms. sation for Economic Co-operation and
The Federal Reserve, together with the Development. The change brings the
other federal banking agencies, also risk weight in line with a 1998 revision
issued policy guidance on manage­ to the Basel Capital Accord. Qualifying
ment of country risk and asset securi­ U.S. securities firms are broker–dealers
tization and draft guidance on credit registered with the Securities and
card lending. The Federal Reserve also Exchange Commission (SEC) that are in
clarified that preferred stock covered compliance with the SEC’s net capital
by certain hedging arrangements is not rule. The Board’s final rule also applies
includable in regulatory capital. In addi­ a 20 percent risk weight to certain col­
tion, the Federal Reserve issued guid­ lateralized claims on qualifying securi­
ance introducing a new statistical loan- ties firms.
sampling methodology for community
Management of Country Risk

Capital for Nonfinancial In February, the Federal Reserve and

Equity Investments the other federal banking agencies pub­
lished guidance for banking organiza­
In January, the Federal Reserve, together tions concerning the elements of an
with the OCC and the FDIC, adopted a effective country risk management pro­
final rule governing the regulatory capi­ cess. The interagency guidance builds
tal treatment of equity investments in on the findings of a 1998 study by the
nonfinancial companies held by banks, Interagency Country Exposure Review
bank holding companies, and finan­ Committee on the country risk man­
cial holding companies. The final rule agement practices of U.S. banks, sup­
subjects covered equity investments to plementing and strengthening previous
a capital charge that increases in steps guidance and ensuring that banking
as the banking organization’s level of organizations’ management of risks
concentration in equity investments arising from their international activi­
increases. Agency monitoring also ties are appropriately and adequately
increases as the level of concentra­ addressed during the examination pro­
tion in equity investments increases. cess. The guidance was contained in
A summary of the key provisions of SR letter 02–5, issued March 8, 2002.
Banking Supervision and Regulation 107

Credit Card Lending hensiveness and effectiveness of credit

review in examinations of certain com­
In July, under the auspices of the Fed­
munity banks. In addition, the guidance
eral Financial Institutions Examination
clarified that loan reviews conducted
Council, the federal banking agencies
as part of full-scope Federal Reserve
issued draft guidance on account man­
examinations are expected to comply
agement and loss allowance for credit
with existing Federal Reserve guid­
card lending. The draft guidance
ance or with the new loan-sampling
describes the agencies’ expectations
regarding prudent risk-management
practices for credit card activities,
particularly with regard to credit-line
management, over-limit accounts, and
Securitization Guidance
workouts. It also addresses income rec­ In May 2002, the federal banking
ognition and loss-allowance practices in agencies released several policy state­
connection with credit card lending. ments on securitization-related issues.
The guidance builds on the agencies’
Hedging of Preferred Stock Issued final rules for ‘‘Capital Treatment of
through Special-Purpose Entities Recourse, Direct Credit Substitutes, and
Residual Interests in Asset Securiti­
In March, the Federal Reserve issued zations,’’ which were issued in Novem­
guidance clarifying that preferred stock ber 2001. The agencies also issued a
issued through special entities owned by question-and-answer document respond­
bank holding companies is not includ­ ing to some questions that have arisen
able in tier 1 capital if it is covered by regarding their rules.
certain hedging derivatives contracts. To
be included in tier 1 capital, the Federal • One policy statement clarified the
Reserve requires that the provisions of risk-based capital treatment of accrued
such preferred stock permit a banking interest receivables for banking orga­
organization to defer dividends for up nizations that securitize credit card
to five years, a feature that allows bank receivables through trusts and record
holding companies to conserve cash in as an on-balance-sheet asset the inter­
times of financial and liquidity pressure. est and fee income due on the secu­
Some hedging derivatives contracts con­ ritized receivables. Because such
travene this policy by requiring a bank amounts of interest and fee income
holding company to make contract pay­ generally must be paid to the trust for
ments on the derivative to its counter- payment to holders of senior positions
party during periods of deferral on the in a securitization before any amount
preferred stock while providing for the is returned to the banking organiza­
deferral of payments to the bank holding tion, the banking organization must
company by the counterparty. treat the accrued interest receivable
as a residual for purposes of risk-
based capital. This treatment results
Statistical Loan Sampling
in the banking organization’s being
at Community Banks
required, under the recourse pro-
In October, the Federal Reserve issued visions of the agencies’ capital rules,
guidance introducing a statistical sam­ to hold ‘‘dollar-for-dollar’’ capital
pling method to increase the compre­ against the receivable amount.
108 89th Annual Report, 2002

• In another policy statement, the agen­ Interagency Advisory on

cies advised examiners and banking Accounting for Accrued Interest
organizations that the use by banking Receivable Related to Credit Card
organizations of adverse supervisory Securitizations
actions or negative changes in super­
visory thresholds as triggers for the In December 2002, the Federal Reserve
early amortization or transfer of ser­ and the other federal banking agencies
vicing in securitizations constitutes an issued guidance regarding the appro­
unsafe and unsound banking practice. priate accounting treatment for finan­
Examples of such supervisory trig­ cial institutions that record an asset
gers include a downgrade in a bank­ commonly referred to as accrued inter­
ing organization’s CAMELS rating, est receivable (AIR) in connection
an enforcement action, or a down- with the securitization of credit card
grade in a bank’s ‘‘prompt corrective receivables. Consistent with generally
action’’ capital category. The supervi­ accepted accounting principles, the
sory concern arises because a banking guidance clarifies that when the terms of
organization that triggers such a provi­ the securitization legally isolate the
sion is likely to already be subject to institution’s (seller’s) right to the AIR,
financial and liquidity pressure. Trig­ the seller generally should report the
gering an early amortization or trans­ AIR as a subordinated retained interest
fer of servicing in a securitization can when accounting for the sale of credit
create or exacerbate liquidity and card receivables. This means that the
earnings problems that may lead to value of the AIR, at the date the receiv­
further deterioration in the banking ables are transferred to the trust, must be
organization’s financial condition. adjusted on the basis of its relative fair
(market) value.
• A third policy statement was intended
to aid examiners and banking orga­
nizations in identifying instances of Business Continuity
‘‘implicit recourse,’’ a term that gener­
ally refers to a banking organization’s In 2002, in response to the events
providing greater credit support to a of September 11, 2001, the Federal
securitization than is required contrac­ Reserve developed a business-continuity
tually. Because banking organiza­ risk profile that provides a consistent
tions’ risk-based capital requirements framework for benchmarking business-
generally are based on their maximum continuity programs and serves as a tool
credit exposure under contract, such in conducting targeted examinations of
capital requirements do not capture business-continuity planning. Federal
the additional credit risk being under- Reserve examiners plan to pilot test the
taken by the organization through its business-continuity risk profile in 2003,
implicit recourse actions. This guid­ with the goal of identifying areas for
ance identifies several types of improvement at individual institutions
implicit recourse and supervisory and developing a profile of business-
actions that the agencies may take to continuity programs at large, complex
address banking organizations’ pro- banking organizations supervised by the
vision of implicit recourse. Federal Reserve.
Banking Supervision and Regulation 109

International Guidance on following issuance of a first paper in

Supervisory Policies October 2001. The purpose of the sec­
ond paper was to discuss and seek feed-
As a member of the Basel Committee on
back on some revisions to the secu­
Banking Supervision (Basel Commit-
ritization framework discussed in the
tee), the Federal Reserve in 2002 par­
two consultative papers. In Decem­
ticipated in efforts to revise the inter-
ber 2002, a committee working group
national capital regime and to develop
issued a paper on pillar III—market
international supervisory guidance. The
discipline—in order to seek feedback on
Federal Reserve’s goals in these activi­
the latest proposals on disclosure.
ties are to advance sound supervisory
policies for internationally active bank­
ing institutions and to improve the sta­ Risk Management
bility of the international banking sys­
The Federal Reserve contributed to sev­
tem. The efforts are described in the
eral supervisory policy papers, reports,
following sections.
and recommendations issued by the
Basel Committee during 2002. These
Capital Adequacy documents were generally aimed at
improving the supervision of banking
The Federal Reserve continued to par­ organizations’ risk-management prac­
ticipate in a number of technical work­ tices. The paper ‘‘Management and
ing groups of the Basel Committee in Supervision of Cross-Border Electronic
efforts to develop a new capital accord. Banking Activities’’ (issued in October)
These groups worked to develop a was prepared for the purposes of identi­
revised consultative paper based on fur­ fying banks’ risk-management respon­
ther deliberations of the committee and sibilities with respect to cross-border
on comments received by the committee banking and focusing attention on the
on its January 2001 consultative paper need for effective home country super-
and on technical papers subsequently vision of, and continued international
issued by the working groups. The com­ cooperation regarding, electronic bank­
mittee and working groups also contin­ ing. The paper ‘‘Sound Practices for the
ued formal and informal communica­ Management and Supervision of Opera­
tion with the banking industry and other tional Risk’’ (issued in July) outlines a
interested parties, including the launch­ set of principles that provide a frame-
ing of a third quantitative impact study, work for the effective management and
referred to as QIS 3. QIS 3 was under- supervision of operational risk. The
taken with the goal of ensuring the effi­ framework is intended for use by banks
cacy of the Basel Committee’s propos­ and supervisory authorities when evalu­
als and gathering information helpful in ating policies and practices related to
assessing whether further modifications the management of operational risk.
are necessary before the committee’s The report ‘‘Supervisory Guidance in
planned release of a revised consultative Dealing with Weak Banks’’ (issued in
paper in spring 2003. March) provides practical guidance for
In addition, in October 2002, a com­ banking supervisors in their work with
mittee working group issued a second weak banks. The guidance includes dis­
working paper on asset securitization, cussions of problem identification, cor-
110 89th Annual Report, 2002

rective action, resolution techniques, Gramm–Leach–Bliley Act

and exit strategies.
The Gramm–Leach–Bliley Act (GLBA)
repealed those provisions of the Glass–
Internal Control, Accounting,
Steagall Act and the Bank Holding
and Disclosure
Company Act that restricted the ability
The Federal Reserve participates in of bank holding companies to affiliate
the Basel Committee’s Task Force on with securities firms and insurance
Accounting Issues and the Transparency companies. The provisions of GLBA,
Group and represents the Basel Com­ together with the Federal Reserve’s
mittee at international meetings on the implementing regulations, establish con­
issues addressed by these groups. In ditions that a bank holding company or
particular, the Federal Reserve in 2002 a foreign bank must meet to be deemed
represented the Basel Committee at a financial holding company and to
meetings of the committee of the Inter- engage in expanded activities.
national Accounting Standards Board In addition to controlling depository
(IASB) that works to improve guidance institutions, a financial holding com­
on accounting for financial instruments. pany may engage in securities under-
In addition, a representative of the Fed­ writing and dealing, serve as an insur­
eral Reserve participates in the IASB’s ance agent and insurance underwriter,
Standards Advisory Council. act as a futures commission merchant,
During 2002 the Federal Reserve also and engage in merchant banking. Per­
contributed to several reports, papers, missible activities also include activities
and comment letters on internal control, that the Board and the Secretary of the
accounting, and disclosure that were Treasury jointly determine to be finan­
issued by the Basel Committee, includ­ cial in nature or incidental to financial
ing a proposed amendment to the activities and activities that the Federal
International Accounting Standard on Reserve determines are complementary
financial instruments, the International to a financial activity and do not pose a
Accounting Standard on disclosures for substantial risk to the safety and sound­
financial statements of financial insti­ ness of depository institutions or the
tutions, guidance on international loan- financial system generally. During 2002,
loss reserving, and a survey of bank the Federal Reserve continued its efforts
disclosure practices. to ensure that supervisory policies
applied to banking institutions are con­
sistent with the provisions of GLBA.
Joint Forum
In its role as holding company super-
In its work with the Basel Committee, visor, the Federal Reserve in 2002 con­
the Federal Reserve also continued its tinued to host cross-sector meetings with
participation in the Joint Forum—a representatives of the banking agencies,
group made up of representatives of the securities and commodities and futures
committee, the International Organiza­ authorities, and state insurance com­
tion of Securities Commissions, and the missions. Cross-sector forums provide
International Association of Insurance an opportunity for multiple supervisors
Supervisors. The Joint Forum works to (both federal and state) to discuss issues
increase mutual understanding of issues of common interest and to enhance com­
related to the supervision of firms oper­ munication and cooperation. Topics dis­
ating in each of the financial sectors. cussed in 2002 included corporate gov-
Banking Supervision and Regulation 111

ernance, the initiatives of the Securities Thus, transparency can promote effi­
and Exchange Commission in imple­ ciency in financial markets and sound
menting the Sarbanes–Oxley Act, and practices by banks. The Federal Reserve
other topics of mutual interest across the also seeks to strengthen audit and con­
sectors. trol standards for banks; the quality of
management information and financial
reporting is dramatically affected by
Sarbanes–Oxley Act internal control systems, including inter­
In October 2002, the Federal Reserve nal and external audit programs.
issued a supervisory letter (SR letter 02– During 2002, the Federal Reserve
20) to give banking organizations Board commented on a proposed
information on the provisions of the Financial Accounting Standards Board
Sarbanes–Oxley Act that set forth stan­ (FASB) standard concerning special-
dards for audits, financial reporting and purpose entities. The Board supports
disclosure, and corporate governance at FASB’s objective to increase trans­
public companies. The provisions apply parency, particularly with respect to
to public companies, including banks off-balance-sheet risk exposures that
and bank holding companies, that have a special-purpose entities can pose to
class of securities registered under sec­ organizations and market participants.
tion 12 of the Securities Exchange Act To further advance objectives related
of 1934 or are otherwise required to to transparency, the Federal Reserve
file periodic reports under section 5(d) works with other regulators, the
of the 1934 act. The Federal Reserve accounting profession, and a wide vari­
staff is working with the other banking ety of market participants, both domesti­
agencies to clarify the applicability of cally and internationally. During 2002,
Sarbanes–Oxley to banking organiza­ the Federal Reserve also worked with
tions. The staff is also considering the the Securities and Exchange Commis­
need for additional standards to reaffirm sion to coordinate an enforcement action
the important duties and responsibili­ against an institution for deficiencies in
ties of banking organizations’ boards of public and regulatory reports and inter­
directors and executive officers. nal controls. Additionally, the Federal
Reserve provided guidance to financial
organizations that faced possible inter­
Efforts to Enhance Transparency ruption in audit services as a result of
The Federal Reserve has long supported problems at a large accounting firm.
sound accounting policies and mean­
ingful public disclosure by banking and
financial organizations to improve mar­ Bank Holding Company
ket discipline and foster stable finan­ Regulatory Financial Reports
cial markets. Effective market discipline
can serve as an important comple­ The Federal Reserve requires that U.S.
ment to bank supervision and regula­ bank holding companies submit peri­
tion. The more informative the informa­ odic regulatory financial reports. These
tion released by financial institutions, reports, the FR Y–9 series and the
the better the evaluation of counterparty FR Y–11 and FR 2314 series for non-
risks by market participants can be and bank subsidiaries, provide information
the better their adjustments to the avail- essential to the supervision of the orga­
ability and pricing of funds will be. nizations and the formulation of regula-
112 89th Annual Report, 2002

tions and supervisory policies. The Fed­ essential information for supervising
eral Reserve also uses the information and regulating nonbank subsidiaries and
in responding to requests from the Con­ reduces burden. Under the new frame-
gress and the public for information on work, bank holding companies file a
bank holding companies and their non- detailed report (FR Y–11 or FR 2314)
bank subsidiaries. for their more-significant nonbank sub­
The FR Y–9 series of reports pro­ sidiaries quarterly or annually, depend­
vides standardized financial statements ing on total assets or other reporting
for the consolidated bank holding com­ criteria. Bank holding companies must
pany. The reports are used to detect also file, annually, an abbreviated, four-
emerging financial problems, review item report (FR Y–11S or FR 2314S)
performance and conduct pre-inspection for their smaller nonbank subsidiaries.
analysis, monitor and evaluate risk pro- The smallest nonbank subsidiaries,
files and capital adequacy, evaluate nearly three-fifths of all nonbank subsid­
proposals for bank holding company iaries, are now exempt from all filing
mergers and acquisitions, and analyze requirements.
the holding company’s overall finan­ In addition, functionally regulated
cial condition. The nonbank subsidi­ nonbank subsidiaries generally are no
ary series of reports aids the Federal longer required to file individual non-
Reserve in determining the condition bank subsidiary reports with the Federal
of bank holding companies that are Reserve. In keeping with provisions of
engaged in nonbanking activities and in the Gramm–Leach–Bliley Act, the Fed­
monitoring the volume, nature, and con­ eral Reserve will rely on reports and
dition of their nonbanking subsidiaries. information provided to the primary
In March 2002, several revisions to regulator. The Federal Reserve will con­
the FR Y–9C report were implemented tinue to collect limited information on
to make it consistent with revisions to nonbank subsidiaries of bank holding
the bank Call Report and to conform to companies on a consolidated basis in
changes in generally accepted account­ FR Y–9 reports.
ing principles. Also, the relevance of the
FR Y–9 series of reports was improved
by revising the existing items and add­
Federal Financial Institutions
ing new items related to new activi­
Examination Council
ties and other developments that may During 2002, the Federal Reserve con­
expose institutions to new or different tinued its active participation as a mem­
types of risk. In addition, a new report ber of the Federal Financial Institutions
(FR Y–9ES) was created to collect Examination Council. Among other
information annually from bank holding activities, the FFIEC revised the bank
companies that are employee stock own­ Call Reports, issued a revised examina­
ership plans. tion framework for information technol­
In December 2002, the nonbank re- ogy service providers, and revised the
porting framework for non-functionally- information systems manual.
regulated nonbank subsidiaries of U.S.
bank holding companies was stream- nonbank subsidiaries, which are entities whose
lined.6 The revised framework provides primary regulator is an organization other than
the Federal Reserve, namely, the Securities and
Exchange Commission, the Commodity Futures
6. Non-functionally-regulated nonbank subsidi­ Trading Commission, state insurance commission­
aries are distinguished from functionally regulated ers, or state securities departments.
Banking Supervision and Regulation 113

Bank Call Reports ing. The revisions would add several

items related to bank credit card activi­
As the federal supervisor of state mem­
ties, break down two existing items to
ber banks, the Federal Reserve, acting in
provide more detail to address safety
concert with the other federal banking
and soundness considerations, and add
agencies through the FFIEC, requires
a supplement to the report that would
banks to submit quarterly Reports of
enable the agencies to collect a limited
Condition and Income (Call Reports).
amount of data from certain banks in the
Call Reports are the primary source of
event of an immediate and critical need
data for the supervision and regulation
for specific information. The proposed
of banks and for the ongoing assessment
revisions also include a few processing
of the overall soundness of the nation’s
changes to implement a new Call Report
financial structure. Call Report data,
business model the agencies plan to
which also serve as benchmarks for
institute in 2004.
the financial information required by
many other Federal Reserve regulatory
financial reports, are widely used by Information Technology
state and local governments, state bank­
Also in 2002, the FFIEC issued a
ing supervisors, the banking industry,
revised framework for the interagency
securities analysts, and the academic
examination program for information
technology service providers. Examina­
For the 2002 reporting period, the
tions of these providers of information
FFIEC implemented several revisions to
technology and processing services to
the Call Report. The principal revisions
financial institutions are conducted by
the Federal Reserve or other financial
institution supervisory agencies under
• Breaking down several existing bal­ the Bank Service Company Act. The
ance sheet and income statement revised framework is designed to pro-
items into greater detail to facilitate mote a more risk-based rationale for
supervision and to implement two conducting such examinations by identi­
new accounting standards fying and analyzing material supervi­
sory risks to financial institutions that
• Collecting new information on the fair use the services of these companies. It
value of credit derivatives, the volume includes risk-focused criteria for deter-
of merchant credit card sales, and the mining the examination schedule and
amount of past-due loans and leases the scope of the exams. The revised
held for sale. framework was implemented as a two-
year pilot program that began in January
The FFIEC also revised the Report 2002.
of Assets and Liabilities of U.S. In addition, in 2002 the FFIEC began
Branches and Agencies of Foreign to prepare for the issuance of revisions
Banks (FFIEC 002), effective with the to the FFIEC information systems
June 2002 report, to maintain consis­ manual, last updated in 1996. A project
tency with the Call Report. plan for the development of individual
In November, the Federal Reserve booklets to replace the current man­
and the other federal banking agencies ual’s chapters was established. Federal
proposed a small number of revisions to Reserve and other agency examiners
the Call Report for March 2003 report­ participated in field testing the booklets
114 89th Annual Report, 2002

on technology service providers, infor­ SIT Project Management

mation security, and business continuity.
Field testing of booklets on outsourc­ In 2002, the SIT project management
ing, audits, electronic banking, whole- staff made significant progress in identi­
sale payment systems, retail payment fying opportunities for enhancing busi­
systems, and Fedline is scheduled for ness value through the use of infor­
early 2003. Booklets on management, mation technology. In March, the
development and programming, and supervision function received approval
operations are scheduled for develop­ to implement a Systemwide technology
ment in 2003. platform for scheduling examination
resources. The staff provided substantial
resources and leadership in developing
Supervisory Information a business case and evaluating tech­
Technology nology alternatives for the deployment
of an enterprise document management
The Supervisory Information Technol­ system. Staff members also provided
ogy (SIT) function within the Board’s substantial assistance and resources to
Division of Banking Supervision and support modernization of the Shared
Regulation facilitates the management National Credit Program. The modern­
of information technology within the ization is an interagency effort aimed at
Federal Reserve’s supervision function. reducing examination costs and improv­
Its goals are to ensure that ing the timeliness and reliability of data
associated with the review of large,
• IT initiatives support a broad range of syndicated credit facilities of commer­
supervisory activities without duplica­ cial banks. The staff continued to assess
tion or overlap opportunities to improve the delivery
of information technology services for
• The underlying IT architecture fully supervision in conjunction with efforts
supports those initiatives of Board and Reserve Bank internal IT
• The supervision function’s use of
technology leverages the resources
and expertise available more broadly National Information Center
within the Federal Reserve System The National Information Center (NIC)
is the Federal Reserve’s comprehensive
• Practices that maximize supervision’s repository for supervisory, financial, and
business value and cost effectiveness banking structure data and documents.
are identified, analyzed, and approved NIC includes the National Examination
for implementation. Data (NED) system, which provides
supervisory personnel and state banking
SIT works through assigned staff at authorities with access to NIC data, and
the Board of Governors and the Reserve the Central Document and Text Reposi­
Banks and through a Systemwide com­ tory, which contains documents support­
mittee structure that ensures that key ing the supervisory process.
staff members throughout the Federal In 2002, the NED system was modi­
Reserve System participate in identify­ fied in accordance with a policy change
ing requirements and setting priorities regarding the supervision program for
for IT initiatives. small bank holding companies, to com-
Banking Supervision and Regulation 115

plement the web-enabled NED applica­ In 2002 the Federal Reserve trained
tion, and to add functionality that further 2,748 students in System schools, 492 in
supports the supervision of banking schools sponsored by the FFIEC, and
institutions. Changes to the production 52 in other schools, for a total of 3,292,
application were also made to accom­ including 214 representatives of foreign
modate changes in the commercial central banks (table). The number of
bank Call Report and the bank holding training days in 2002 totaled 16,824.
company FR Y–9 reports. A new ver­ The System gave scholarship assis­
sion of the Central Document and Text tance to the states for training their
Repository was implemented to handle examiners in Federal Reserve and
a larger volume of documents. FFIEC schools. Through this program,
454 state examiners were trained—
345 in Federal Reserve courses, 92 in
Staff Development FFIEC courses, and 17 in other courses.
The Federal Reserve System’s staff A staff member seeking an exam­
development program trains staff iner’s commission is required to take a
members at the Board of Governors, first proficiency examination, as well
the Reserve Banks, and state banking as a second proficiency examination in
departments who have supervisory and one of three specialty areas: safety and
regulatory responsibilities; students soundness, consumer affairs, or informa­
from foreign supervisory authorities tion technology (table). At the end of
attend training sessions on a space- 2002, the System had 1,234 field exam­
available basis. The program’s goal is, iners, of which 892 were commissioned
in part, to provide greater cross training (table).
in the agencies. Training is offered at
the basic, intermediate, and advanced
levels in the four disciplines of bank
Regulation of the

supervision: bank examinations, bank

U.S. Banking Structure

holding company inspections, surveil- The Board of Governors administers the

lance and monitoring, and applications Bank Holding Company Act, the Bank
analysis. Classes are conducted in Merger Act, the Change in Bank Con­
Washington, D.C., and at other locations trol Act, and the International Banking
and are sometimes held jointly with Act as they apply to bank holding com­
other regulators. panies, financial holding companies,
The System also participates in train­ member banks, and foreign banking
ing offered by the FFIEC and by certain organizations. In doing so, the Federal
other regulatory agencies. The System’s Reserve acts on a variety of proposals
involvement includes assisting in the that directly or indirectly affect the
development of basic and advanced structure of U.S. banking at the local,
training in relation to emerging issues as regional, and national levels; the inter-
well as in specialized areas such as trust national operations of domestic banking
activities, international banking, infor­ organizations; and the U.S. banking
mation technology, municipal securities operations of foreign banks.
dealing, capital markets, payment sys­
tems risk, white collar crime, and real
estate lending. In addition, the System
Bank Holding Company Act
co-hosts the World Bank Seminar for Under the Bank Holding Company Act,
students from developing countries. a corporation or similar organization
116 89th Annual Report, 2002

Training Programs for Banking Supervision and Regulation, 2002

Number of sessions conducted

Total Regional

Schools or seminars conducted by the Federal Reserve

Core schools
Banking and supervision elements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 7
Operations and analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 5
Bank management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 1
Report writing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 16
Management skills . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 10
Conducting meetings with management . . . . . . . . . . . . . . . . . . . . . . . . . . 18 18

Other schools
Loan analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 3
Examination management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 6
Real estate lending seminar . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 1
Specialized lending seminar . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 0
Senior forum for current banking and regulatory issues . . . . . . . . . . . . 2 2
Banking applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 0

Principles of fiduciary supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 1

Commercial lending essentials for consumer affairs . . . . . . . . . . . . . . . 3 3
Consumer compliance examinations I . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 0
Consumer compliance examinations II . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 2
CRA examination techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 2
Fair lending examination techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 2

Foreign banking organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 3

Information systems continuing education . . . . . . . . . . . . . . . . . . . . . . . . 2 0
Capital markets seminars . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 10
Technology risk integration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 13
Leadership dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 6
Seminar for senior supervisors of foreign central banks 1 . . . . . . . . . . . 1 1

Other agencies conducting courses 2

Federal Financial Institutions Examination Council . . . . . . . . . . . . . . . . . . 34 3
The Options Institute . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 2

1. Conducted jointly with the World Bank. 2. Open to Federal Reserve employees.

must obtain the Federal Reserve’s considers the financial and managerial
approval before forming a bank hold­ resources of the applicant, the future
ing company through the acquisition prospects of both the applicant and the
of one or more banks in the United firm to be acquired, the convenience and
States. Once formed, a bank holding needs of the community to be served,
company must receive Federal Reserve the potential public benefits, the com­
approval before acquiring or estab­ petitive effects of the proposal, and the
lishing additional banks. The act also applicant’s ability to make available to
identifies other activities permissible the Board information deemed neces­
for bank holding companies; depend­ sary to ensure compliance with applica­
ing on the circumstances, these activi­ ble law. In the case of a foreign banking
ties may or may not require Federal organization seeking to acquire control
Reserve approval in advance of their of a U.S. bank, the Federal Reserve also
commencement. considers whether the foreign bank is
When reviewing a bank holding com­ subject to comprehensive supervision or
pany application or notice that requires regulation on a consolidated basis by its
prior approval, the Federal Reserve home country supervisor. Data on deci-
Banking Supervision and Regulation 117

Results of Proficiency Examinations, 2002

Second proficiency exam

Result proficiency
exam Safety and Consumer Information
soundness affairs technology

Passed . . . . . . . . . . . . . . . . . . . . . . . . 133 82 29 3
Failed . . . . . . . . . . . . . . . . . . . . . . . . . 17 15 0 2

Total . . . . . . . . . . . . . . . . . . . . . . . . . . 150 97 29 5

sions regarding domestic and interna­ ies firms and insurance companies and
tional applications in 2002 are shown in may engage in certain merchant bank­
the accompanying table. ing activities. Bank holding companies
Bank holding companies generally seeking financial holding company sta­
may engage in only those activities that tus must file a written declaration with
the Board has previously determined to the Federal Reserve System; most decla­
be closely related to banking under sec­ rations are acted upon by one of the
tion 4(c)(8) of the act. Since 1996, the Reserve Banks under delegated author­
act has provided an expedited prior- ity. In 2002, 82 domestic financial hold­
notice procedure for certain permissible ing company declarations and 7 foreign
nonbank activities and for acquisitions bank declarations were approved.
of small banks and nonbank entities. Financial holding companies do not
Since that time the act also has permit­ have to obtain the Board’s prior
ted well-run bank holding companies approval to engage in or acquire a com­
that satisfy certain criteria to commence pany engaged in certain new financial
certain other nonbank activities on a de activities that are permissible under the
novo basis without first obtaining Fed­ Gramm–Leach–Bliley Act. Instead, the
eral Reserve approval. financial holding company must notify
Since 2000, the Bank Holding Com­ the Board within thirty days after com­
pany Act has permitted the creation mencing the new activity or acquiring
of a special type of bank holding com­ a company engaged in the new activity.
pany called a financial holding com­ A financial holding company may also
pany. Financial holding companies are engage in certain other activities that
allowed to engage in a broader range of have been determined to be financial in
nonbank activities than are traditional nature or incidental to a financial activ­
bank holding companies. Among other ity or that are determined to be comple­
things, they may affiliate with securit­ mentary to a financial activity.

Trends in Reserve Bank Supervision Levels, 1998–2002

Type of staff 2002 2001 2000 1999 1998

Field examination staff . . . . . . . . . 1,234 1,242 1,172 1,216 1,250

Commissioned field staff . . . . . 892 861 786 893 933
118 89th Annual Report, 2002

Decisions by the Federal Reserve on Domestic and International Applications, 2002

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 . . . . . . . 6 0 0 0 0 0 144 58 208
Merger of bank
company . . . . . . . 2 0 0 0 0 2 28 12 44
Acquisition or
retention of
bank . . . . . . . . . . . . 7 1 0 0 0 2 85 41 136
Acquisition of
nonbank . . . . . . . . 0 0 3 0 0 8 0 101 112
Merger of bank . . . . . . 7 0 0 0 0 1 78 0 86
Change in control . . . . 0 0 1 0 0 0 0 160 161
Establishment of a
branch, agency,
or representative
office by a
foreign bank . . . . 2 0 0 19 0 0 0 0 21
Other . . . . . . . . . . . . . . . 58 0 0 54 0 88 464 453 1,117

Total . . . . . . . . . . . . . . . . 82 1 4 73 0 101 799 825 1,885

Bank Merger Act When the FDIC, the OCC, or the

OTS has jurisdiction over a merger, the
The Bank Merger Act requires that
Federal Reserve is asked to comment on
all proposals involving the merger of
the competitive factors. By using stan­
insured depository institutions be acted
dard terminology in assessing competi­
on by the appropriate federal banking
tive factors in merger proposals, the four
agency. If the institution surviving the
agencies have sought to ensure consis­
merger is a state member bank, the Fed­
tency in administering the Bank Merger
eral Reserve has primary jurisdiction.
Act. The Federal Reserve submitted
Before acting on a merger proposal, the
515 reports on competitive factors to the
Federal Reserve considers the finan­
other agencies in 2002.
cial and managerial resources of the
applicant, the future prospects of the
existing and combined institutions, the
Change in Bank Control Act
convenience and needs of the commu­ The Change in Bank Control Act
nity to be served, and the competitive requires persons seeking control of a
effects of the proposed merger. It also U.S. bank or bank holding company to
considers the views of certain other obtain approval from the appropriate
agencies regarding the competitive fac­ federal banking agency before complet­
tors involved in the transaction. During ing the transaction. The Federal Reserve
2002, the Federal Reserve approved is responsible for reviewing changes in
86 merger applications. the control of state member banks and
Banking Supervision and Regulation 119

bank holding companies. In its review, operations; the managerial resources

the Federal Reserve considers the finan­ of the foreign bank; whether the home
cial position, competence, experience, country supervisor shares information
and integrity of the acquiring person; regarding the operations of the foreign
the effect of the proposed change on the bank with other supervisory authorities;
financial condition of the bank or bank whether the foreign bank has provided
holding company being acquired; the adequate assurances that information
effect of the proposed change on compe­ concerning its operations and activities
tition in any relevant market; the com­ will be made available to the Board, if
pleteness of information submitted by deemed necessary to determine and
the acquiring person; and whether the enforce compliance with applicable law;
proposed change would have an adverse whether the foreign bank has adopted
effect on the federal deposit insurance and implemented procedures to combat
funds. As part of the process, the Fed­ money laundering and whether the home
eral Reserve may contact other regula­ country of the foreign bank is develop­
tory or law enforcement agencies for ing a legal regime to address money
information about acquiring persons. laundering or is participating in multilat­
The appropriate federal banking agen­ eral efforts to combat money launder­
cies are required to publish notice of ing; and the record of the foreign bank
each proposed change in control and to with respect to compliance with U.S.
invite public comment, particularly from law.
persons located in the markets served by In 2002, the Federal Reserve
the institution to be acquired. approved 21 applications by foreign
In 2002, the Federal Reserve banks to establish branches, agencies,
approved 161 changes in control of and representative offices in the United
state member banks and bank holding States.
Overseas Investments by
International Banking Act U.S. Banking Organizations
The International Banking Act, as U.S. banking organizations may engage
amended by the Foreign Bank Supervi­ in a broad range of activities overseas.
sion Enhancement Act of 1991, requires Many of the activities are conducted
foreign banks to obtain Federal Reserve indirectly through Edge Act and agree­
approval before establishing branches, ment corporation subsidiaries. Although
agencies, commercial lending company most foreign investments are made
subsidiaries, or representative offices in under general consent procedures that
the United States. involve only after-the-fact notification
In reviewing proposals, the Federal to the Board, large and other significant
Reserve generally considers whether investments require the prior approval
the foreign bank is subject to compre­ of the Board. Excluding proposals relat­
hensive supervision or regulation on a ing to large domestic mergers, the Board
consolidated basis by its home country in 2002 approved 23 proposals for
supervisor. It also considers whether the significant overseas investments by
home country supervisor has consented U.S. banking organizations. The Federal
to the establishment of the U.S. office; Reserve also approved 1 application to
the financial condition and resources of acquire an Edge Act corporation, 1
the foreign bank and its existing U.S. application to extend the corporate exist-
120 89th Annual Report, 2002

ence of an existing Edge Act corpora­ the Federal Reserve reviewed 10 stock
tion, and 1 application to establish or repurchase proposals by bank holding
acquire a new agreement corporation. companies; all were approved by a
Reserve Bank under delegated authority.
Applications by Member Banks
State member banks must obtain Federal Public Notice of

Reserve approval to establish domestic Federal Reserve Decisions

branches, and all member banks (includ­

Most decisions by the Federal Reserve
ing national banks) must obtain Federal
that involve a bank holding company,
Reserve approval to establish foreign
a bank merger, a change in control, or
branches. When reviewing proposals to
the establishment of a new U.S. banking
establish domestic branches, the Federal
presence by a foreign bank are effected
Reserve considers the scope and nature
by an order or an announcement. Orders
of the banking activities to be con­
state the decision, the essential facts
ducted. When reviewing proposals for
of the application or notice, and the
foreign branches, the Federal Reserve
basis for the decision; announcements
considers, among other things, the con­
state only the decision. All orders and
dition of the bank and the bank’s experi­
announcements are made public imme­
ence in international banking. In 2002,
diately; they are subsequently reported
the Federal Reserve acted on new and
in the Board’s weekly H.2 statistical
merger-related branch proposals for
release and in the monthly Federal
836 domestic branches and granted prior
Reserve Bulletin. The H.2 release also
approval for the establishment of 5 new
contains announcements of applications
foreign branches.
and notices received by the Federal
State member banks must also obtain
Reserve but not yet acted on. For each
Federal Reserve approval to establish
pending application and notice, the
financial subsidiaries. These subsidiaries
related H.2A contains the deadline
may engage in activities that are finan­
for comments. In 2002, the Board’s
cial in nature or incidental to finan­
web site ( con­
cial activities, including securities- and
tinued to provide information on orders
insurance agency-related activities. In
and announcements.
2002, 3 applications for financial sub­
sidiaries were approved.
Timely Processing of
Stock Repurchases by Applications
Bank Holding Companies The Federal Reserve sets internal target
A bank holding company may repur­ time frames for the processing of appli­
chase its own shares from its share- cations. The setting of targets promotes
holders. When the company borrows efficiency at the Board and the Reserve
money to buy the shares, the trans- Banks and reduces the burden on appli­
action increases the company’s debt cants. Generally, the length of the target
and decreases its equity. The Federal period ranges from 12 days to 60 days,
Reserve may object to stock repurchases depending on the type of application or
by holding companies that fail to meet notice filed. In 2002, 93 percent of deci­
certain standards, including the Board’s sions were made within the target time
capital adequacy guidelines. In 2002, period.
Banking Supervision and Regulation 121

Enforcement of
Several regulatory agencies enforce
Other Laws and Regulations
the Board’s securities credit regulations.
The SEC, the National Association of
The Federal Reserve’s enforcement Securities Dealers, and the national
responsibilities also extend to financial securities exchanges examine brokers
disclosures by state member banks; and dealers for compliance with Reg­
securities credit; and efforts, under the ulation T. With respect to compliance
Bank Secrecy Act, to counter money with Regulation U, the federal banking
laundering. agencies examine banks under their
respective jurisdictions; the Farm Credit
Financial Disclosures by Administration, the National Credit
State Member Banks Union Administration, and the Office
State member banks that issue securities of Thrift Supervision examine lenders
registered under the Securities Exchange under their respective jurisdictions; and
Act of 1934 must disclose certain infor­ the Federal Reserve examines other
mation of interest to investors, including Regulation U lenders.
annual and quarterly financial reports Since 1990 the Board has published
and proxy statements. By statute, the a nonexclusive list of foreign stocks
Board’s financial disclosure rules must that are eligible for margin treatment
be substantially similar to those of the at broker–dealers on the same basis as
Securities and Exchange Commission. domestic margin securities. In 2002 the
At the end of 2002, 17 state member foreign list was revised in March and
banks were registered with the Board September.
under the Securities Exchange Act.
Anti–Money Laundering
Securities Credit The Department of the Treasury’s reg­
Under the Securities Exchange Act, the ulation (31 CFR 103) implementing
Board is responsible for regulating the Currency and Foreign Transactions
credit in certain transactions involving Reporting Act (commonly referred to as
the purchase or carrying of securities. the Bank Secrecy Act, or BSA) requires
The Board’s Regulation T limits the banks and other types of financial insti­
amount of credit that may be provided tutions to file certain reports and main­
by securities brokers and dealers when tain certain records. These documents
the credit is used to trade debt and record information on persons involved
equity securities. The Board’s Regula­ in large currency transactions and on
tion U limits the amount of credit that suspicious activity related to possible
may be provided by lenders other than violations of federal law, including
brokers and dealers when the credit is money laundering, terrorism, and other
used to purchase or carry publicly held financial crimes. The act is a primary
equity securities if the loan is secured tool in the fight against money launder­
by those or other publicly held equity ing; its requirements inhibit money
securities. The Board’s Regulation X laundering by creating a paper trail of
applies these credit limitations, or mar- financial transactions that helps law
gin requirements, to certain borrowers enforcement and regulators identify and
and to certain credit extensions, such as trace the proceeds of illegal activity.
credit obtained from foreign lenders by In addition to the specific require­
U.S. citizens. ments of the Bank Secrecy Act, the
122 89th Annual Report, 2002

Board’s Regulation H (12 CFR 208.63) In 2002, the Federal Reserve contin­
requires each banking organization ued to provide expertise and guidance
supervised by the Federal Reserve to to the BSA Advisory Group, a commit-
develop a written program for BSA tee established by the Congress at the
compliance that is formally approved Department of the Treasury that seeks to
by the institution’s board of directors. reduce unnecessary burdens created by
The compliance program must (1) estab­ the BSA and to increase the utility of
lish a system of internal controls to data gathered under the act to aid regu­
ensure compliance with the act, (2) pro- lators and law enforcement. The Fed­
vide for independent compliance test­ eral Reserve also assisted the Treasury
ing, (3) identify individuals responsible Department in providing feedback to
for coordinating and monitoring day-to- financial institutions on the reporting of
day compliance, and (4) provide train­ suspicious activity.
ing for personnel as appropriate. To Since the terrorist attacks of Septem­
monitor compliance, each Reserve Bank ber 11, 2001, and continuing through
designates senior, experienced examin­ 2002, the Federal Reserve has played an
ers as BSA and anti-money-laundering important role in many joint activities
contacts. During examinations of state with bank supervisory and law enforce­
member banks and U.S. branches and ment authorities and the banking com­
agencies of foreign banks, examin­ munity, both domestically and abroad,
ers review the institution’s compliance to combat money laundering and terror­
with the BSA and determine whether ist financing. The Federal Reserve Bank
adequate procedures and controls to of New York created a dedicated e-mail
guard against money laundering are in system for financial institutions to
place. report matches on the law enforcement
The Board has a Special Investiga­ list of ‘‘suspected terrorists’’ and, at the
tions Section in the Division of Banking request of law enforcement and pursu­
Supervision and Regulation that con- ant to subpoenas, searched the records
ducts financial investigations, provides of Fedwire for information related to the
expertise to the U.S. law enforce­ terrorist acts. In addition, multi-agency
ment community for investigation and teams led by various U.S. government
training initiatives, and offers training agencies were deployed to foreign coun­
to various foreign central banks and tries to analyze bank and other financial
government agencies; section staff also records. On several of these occasions,
speak at banking conferences to pro- senior Reserve Bank examiners traveled
mote best practices in the industry with and worked with the teams. In the wake
respect to anti-money-laundering initia­ of the terrorist attacks, the FBI formed
tives. Internationally, section staff have a multi-agency law enforcement task
provided anti-money-laundering train­ force to trace the transactions and assets
ing and technical assistance to countries of terrorists; staff of the Special Inves­
in Asia, eastern Europe, South and tigations Section participate in the task
Central America, and the Caribbean. force.
Staff members have also participated To address the mandates of the USA
extensively in numerous multilateral PATRIOT Act, the Federal Reserve
anti-money-laundering initiatives such issued a number of supervisory letters to
as the Financial Action Task Force all domestic and foreign banking orga­
and the Basel Committee on Banking nizations under its supervision on such
Supervision. topics as private and correspondent
Banking Supervision and Regulation 123

Extensions of Credit by State Member Banks to their Executive Officers, 2001 and 2002

Range of interest
Period Number Amount (dollars) rates charged

October 1–December 31 . . . . . . . . . . . . . . . . 727 64,965,000 1.0–20.0

January 1–March 31 . . . . . . . . . . . . . . . . . . . 620 65,557,000 2.0–19.8
April 1–June 30 . . . . . . . . . . . . . . . . . . . . . . . . 632 69,260,000 3.0–19.8
July 1–September 30 . . . . . . . . . . . . . . . . . . . 740 78,073,000 2.0–19.8
October 1–December 31 . . . . . . . . . . . . . . . . 644 72,668,000 2.0–19.8

Source. Call Reports.

banking as well as new information- Extensions of Credit to

sharing protocols. The letters described Executive Officers
the act’s requirements in these areas and
Under section 22(g) of the Federal
the new rules that have been or will be
Reserve Act, a state member bank must
include in its quarterly Call Report
At the request of Treasury Depart­
information on all extensions of credit
ment staff, and consistent with statutory
by the bank to its executive officers
requirements for consultation, the Fed­
since the date of the preceding report.
eral Reserve continues to actively assist
The accompanying table summarizes
in the development of many other new
this information for 2002.
rules related to the PATRIOT Act. The
Federal Reserve’s Patriot Act Working
Group, which is composed of senior,
experienced Bank Secrecy Act/anti-
Federal Reserve Membership
money-laundering examiners from At the end of 2002, 2,977 banks were
throughout the System, met several members of the Federal Reserve System
times during 2002. The group worked and were operating 50,095 branches.
on interim examination procedures rela­ These banks accounted for 38 percent
tive to the act’s provisions and are con­ of all commercial banks in the United
tinuing to develop a new training cur­ States and for 74 percent of all commer­
riculum for examiners. cial banking offices.

Federal Reserve Banks

The Federal Reserve Banks and their positioned to meet public demand for
Branches carry out a number of System cash in the event of an emergency.
operations, including operating a nation- During the year, the Reserve Banks
wide payments system, distributing the and the Board also reviewed and
nation’s currency and coin, and serving enhanced their mechanisms for crisis
as fiscal agent and depository to the communications between the Board,
United States. Federal Reserve offices, other govern­
ment agencies, financial industry partici­
pants, System employees, the media,
Major Initiatives and the general public.
During 2002, the Federal Reserve Sys­ The events of September 11, 2001,
tem took a number of significant steps illustrated the interdependence among
to enhance further its resilience in participants in the financial system and
case of emergency. It worked to ensure the way that business concentration,
market liquidity, continuity of Federal both market-based and geographic, can
Reserve operations, and effective Fed­ intensify disruptions. The New York
eral Reserve communications. In addi­ Reserve Bank contributed to two white
tion, it supported two efforts to increase papers on these matters that the Board,
the resilience of the private sector’s together with other regulatory agencies,
financial system infrastructure. published for comment during the year.
While the Reserve Banks have his­ One paper discussed sound practices to
torically worked to ensure the continuity increase the resilience of critical U.S.
of their operations, they undertook sev­ financial markets in the face of a
eral projects in 2002 to reassess the regional disaster. The other paper con­
adequacy of their business-continuity sidered potential structural changes in
plans and to make them more robust. the way settlement services for govern­
The Banks strengthened their ability to ment securities are provided and pre­
provide liquidity by enhancing backup sented a framework for discussing issues
for open market operations and the dis­ that need to be further explored. In
count window. As a result, the Federal response to public comments on the lat­
Reserve is better positioned to provide ter paper, the Board in November cre­
necessary market liquidity, helping to ated a private-sector working group to
ensure that payment systems and finan­ explore ways the clearing banks for gov­
cial markets can continue to function ernment securities could substitute for
smoothly during a financial crisis. each other should the services of either
In addition, the Reserve Banks eval­ be interrupted or terminated. The work­
uated their Fedwire contingency plans, ing group was asked to submit a report
their business-continuity planning pro­ to the Board before the end of 2003.
cess, staff concentration and leadership The Reserve Banks also worked to
succession, telecommunications and net- improve the efficiency of their opera­
work contingency, and the physical tions through a strategy of standardi­
security of their facilities and personnel. zation and consolidation of a variety
Moreover, the Reserve Banks are better of information systems, operations, and
126 89th Annual Report, 2002

programs. For example, the Reserve years, the Federal Reserve Banks have
Banks are standardizing and consolidat- recovered 98.8 percent of their priced
ing a number of financial management services costs, including the PSAF
applications for budgeting, cost account- (table).
ing, and accounts payable. In addition, Overall, fees charged in 2002 for
efforts are under way to move separate priced services increased approximately
human resources information and pay- 1.3 percent from 2001.2 Revenue from
roll systems in each of the twelve Dis- priced services amounted to $916.3 mil-
tricts into common systems located in lion, other income related to priced ser-
a single District. The Reserve Banks vices was $2.1 million, and costs related
have also initiated efforts to consoli- to priced services totaled $891.7 mil-
date their electronic access customer- lion, resulting in net income of
support function as well as human $26.6 million and a recovery rate of
resources operations into fewer sites. 93.3 percent of costs, including the
Finally, the Reserve Banks are imple- PSAF.3
menting a standard health insurance
program and have adopted a standard
prescription drug plan. The expected
Commercial Check
benefits of these consolidations and
Collection Service
standardized programs include lower In 2002, operating expenses and
administrative and operating costs and imputed costs for the Reserve Banks’
improved functionality. check collection service totaled
$751.2 million, while revenue amounted
to $759.2 million and other income was
Developments in
$1.7 million, resulting in net income of
Federal Reserve Priced Services
$9.7 million. In 2001, by comparison,
operating expenses and imputed costs
The Monetary Control Act of 1980 totaled $754.4 million, while revenue
requires that the Federal Reserve set amounted to $764.7 million and other
fees for providing ‘‘priced services’’ to income was $28.5 million, resulting
depository institutions that, over the in net income of $38.9 million. The
long run, recover all the direct and indi- decline in check service revenue in 2002
rect costs of providing the services
as well as the imputed costs, such as
services; in the pro forma statements at the end of
the income taxes that would have been this chapter, Board expenses are included in oper-
paid and the return on equity that would ating expenses and Board assets are part of long-
have been earned had the services been term assets.
provided by a private firm. The imputed 2. Based on a chained Fisher Ideal price index
not adjusted for quality changes.
costs and imputed profit are collectively 3. Financial data reported throughout this
referred to as the private-sector adjust- chapter—revenue, other income, cost, net reve-
ment factor (PSAF).1 Over the past ten nue, and income before taxes—can be linked to
the pro forma statements at the end of this chapter.
Other income is revenue from investment of clear-
1. In addition to income taxes and the return on ing balances net of earnings credits, an amount
equity, the PSAF is made up of three imputed termed net income on clearing balances. Total cost
costs: interest on debt, sales taxes, and assess- is the sum of operating expenses, imputed costs
ments for deposit insurance by the Federal Deposit (interest on debt, interest on float, sales taxes, and
Insurance Corporation. Also allocated to priced the Federal Deposit Insurance Corporation assess-
services are assets and personnel costs of the ment), imputed income taxes, and the targeted
Board of Governors that are related to priced return on equity.
Federal Reserve Banks 127

Priced Services Cost Recovery, 1993–2002

Millions of dollars except as noted

Revenue from Operating Targeted return Total Cost recovery

Year expenses and
services 1 on equity costs (percent) 3
imputed costs 2

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 57.2 832.9 104.2
2000 . . . . . . . . . . . . . . . . . . . . . . 922.8 818.2 98.4 916.6 100.7
2001. . . . . . . . . . . . . . . . . . . . . . . 960.4 901.9 109.2 1,011.1 95.0
2002 . . . . . . . . . . . . . . . . . . . . . . 918.3 891.7 92.5 984.3 93.3

1993–2002 . . . . . . . . . . . . . . . . 8,450.5 7,963.0 591.4 8,554.4 98.8

Note. In this and other tables in this chapter, compo- 2. For the ten-year period, includes operating expenses
nents may not sum to totals or yield percentages shown of $7,114.7 million, imputed costs of $489.7 million, and
because of rounding. Amount in bold is a restatement due imputed income taxes of $265.1 million. Also includes
to errors in previously reported data. the effect of one-time accounting changes net of taxes of
1. For the ten-year period, includes revenue from ser- $74.1 million for 1993 and $19.4 million for 1995.
vices of $8,183.0 million and other income and expense 3. Revenue from services divided by total costs.
(net) of $267.5 million.

was largely the result of declining vol- lower-than-expected returns on pension

ume and customers’ moving to lower- credits.
margin products. The Reserve Banks To address the apparent continuing
handled 16.6 billion checks in 2002, decline in check volumes, the Reserve
a decrease of 1.9 percent from 2001 Banks are developing a business and
(table). The decline in Reserve Bank operational strategy that will position
check volume appears to be consistent the service to achieve its financial and
with nationwide trends away from the payment system objectives over the long
use of checks and toward greater use of term. In 2002, the Banks contracted
electronic payment methods.4 Although with a consultant to analyze their check-
the Reserve Banks took steps to reduce processing infrastructure. The analysis
check operating costs in 2002, the defined criteria for balancing efficient
reductions were largely offset by provision of service in a declining-
volume environment with the need to
4. The Federal Reserve System’s recent retail provide an adequate level of service
payments research suggests that the number of nationwide. The Banks have used these
checks written in the United States has been criteria to develop potential options as
declining since the mid-1990s. See Geoffrey R. to the number, location, and operational
Gerdes and Jack K. Walton II, ‘‘The Use of
Checks and Other Noncash Payment Instru-
capabilities of its check-processing
ments in the United States,’’ Federal Reserve sites. Subsequently, the Reserve Banks
Bulletin, vol. 88 (August 2002), pp. 360–74. (The announced that they are reducing their
article is available on the Board’s web site at check service operating costs through a combination of measures: streamlining
During the late 1990s, the volume of checks pro-
cessed by the Reserve Banks rose, albeit slowly, their check-management structures,
suggesting that the proportion of interbank checks reducing staff, decreasing the number of
cleared through the Reserve Banks increased. check-processing locations, and increas-
128 89th Annual Report, 2002

Activity in Federal Reserve Priced Services, 2002, 2001, and 2000

Thousands of items

Percent change
Service 2002 2001 2000
2001 to 2002 2000 to 2001

Commercial check . . . . . . . . . . . . . . . . . 16,586,804 16,905,016 16,993,800 −1.9 −.5

Funds transfer . . . . . . . . . . . . . . . . . . . . . 117,133 115,308 111,175 1.6 3.7
Securities transfer . . . . . . . . . . . . . . . . . 8,480 6,708 5,666 26.4 18.4
Commercial ACH . . . . . . . . . . . . . . . . . 4,986,152 4,448,361 3,812,191 12.1 16.7
Noncash . . . . . . . . . . . . . . . . . . . . . . . . . . 333 412 519 −19.2 −20.7
Cash transportation . . . . . . . . . . . . . . . . 9 18 19 −52.5 −7.0

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

ing processing capacity in other loca- Commercial Automated

tions. The Reserve Banks will continue Clearinghouse Services
to provide check services nationwide.
The volume of checks for which the Reserve Bank operating expenses and
Federal Reserve office that serves the imputed costs for commercial automated
depositing bank is not the office that clearinghouse (ACH) services totaled
serves the paying bank increased $62.5 million in 2002. Revenue from
4.4 percent, from 3.6 billion in 2001 to ACH operations and other income
3.7 billion in 2002. Of all the checks totaled $71.8 million, resulting in net
presented by the Reserve Banks to pay- income of $9.3 million. The Reserve
ing banks, 22.0 percent (approximately Banks processed 5.0 billion commercial
3.6 billion checks) were presented elec- ACH transactions (worth $13.1 trillion),
tronically, compared with 21.7 percent an increase of 12.1 percent from 2001.
in 2001. The Reserve Banks captured Consolidation of customer support
images of 8.1 percent of the checks they activities to two Reserve Bank offices
collected, the same percentage as in was completed during 2002. These two
2001. Banks now share responsibility for
The Reserve Banks continued in 2002 supporting all ACH operations, includ-
a check modernization project begun ing ensuring the timely and accurate
in 2000 to install uniform software and processing of payments, maintaining the
hardware for check processing, check integrity of the ACH application, moni-
imaging, and check adjustments in all toring file processing, and responding to
Reserve Bank offices and to give customers’ questions. Before consolida-
depository institutions web-based access tion, these responsibilities were handled
to check services. The Reserve Banks by each of the twelve Reserve Banks.
expect to recover the cost of the project
over the long run because the mod- Fedwire Funds and€
ernization effort will increase operat- National Settlement Services€
ing efficiency and make it possible to
offer additional services to depository Reserve Bank operating expenses and
institutions. imputed costs for the Fedwire Funds
Federal Reserve Banks 129

and National Settlement Services Fees Paid by Depository Institutions for

totaled $53.5 million in 2002. Revenue Selected Federal Reserve Priced Services,
2001 and 2002
from these operations totaled $58.6 mil-
lion, and other income amounted to
$0.1 million, resulting in net income of Item 2001 2002
$5.2 million.
Fedwire Funds Transfers,
by Volume Tier1
Fedwire Funds Service Tier (number of
transfers per month) 2
The Reserve Banks’ Fedwire Funds 1 (1 to 2,500) . . . . . . . . . . . . . . . . .33 .31
2 (2,501 to 80,000) . . . . . . . . . . . .24 .22
Service allows depository institutions 3 (80,001 and more) . . . . . . . . . . .16 .15
to draw on their reserve or clearing bal- Off-line surcharge . . . . . . . . . . . . . . . 15.00 15.00
ances at the Reserve Banks and transfer National Settlement
funds to other institutions that maintain Services
Entries, each . . . . . . . . . . . . . . . . . . . . .95 .80
accounts at the Reserve Banks. In 2002, Files, each . . . . . . . . . . . . . . . . . . . . . . 12.00 14.00
the number of Fedwire funds transfers Minimum per month . . . . . . . . . . . . 60–100 60–100
originated by depository institutions Fedwire Securities
increased 1.6 percent from 2001, to Transfers
approximately 117.1 million. The Account maintenance
Per issue . . . . . . . . . . . . . . . . . . . . . .45 .41
Reserve Banks reduced the transfer fees Per account . . . . . . . . . . . . . . . . . . 15.00 15.00
for each of the volume-based tiers Transfers, each 2 . . . . . . . . . . . . . . . . .70 .66
(table). The off-line funds transfer sur- Off-line surcharge . . . . . . . . . . . . . . . 25.00 25.00
charge remained unchanged.5 Noncash Collection
The final phase of consolidation of Bonds, each . . . . . . . . . . . . . . . . . . . . 40.00 40.00
the operations of the Fedwire Funds Deposit envelopes
(per envelope of coupons) 3
Service was completed in May. Also 1–5 . . . . . . . . . . . . . . . . . . . . . . . . . . 4.75 4.75
during 2002, the Reserve Banks 6–50 . . . . . . . . . . . . . . . . . . . . . . . . . 2.50 2.50
improved the resilience of the service Cash letters
by increasing the readiness of a third (flat fee, by number of
envelopes of coupons) 3
data processing center. In the event of 1–5 . . . . . . . . . . . . . . . . . . . . . . . . . . 7.50 7.50
6–50 . . . . . . . . . . . . . . . . . . . . . . . . . 15.00 15.00
an outage at the primary or second-
ary site or at both sites, resources at Return items, each . . . . . . . . . . . . . . 20.00 20.00
the third site are available to support 1. Rates apply only to their specified volume tiers.
same-day recovery of Fedwire appli- 2. Originated and received.
cations. This enhancement adds to the 3. Deposits and cash letters may contain no more than
50 envelopes of coupons.
already robust contingency capabilities
provided by the primary and secondary
sites. The three sites are distant from service would open at 9:00 p.m. eastern
each other. time (ET), three and one-half hours
In December, the Board requested earlier than the current opening time
comment on a proposal to expand the of 12:30 a.m. ET. The earlier opening
operating hours for the on-line Fedwire time is intended to facilitate the func-
Funds Service. Under the proposal, the tioning and continued development of
the payments system and to increase
efficiency and reduce risk in making
5. Depository institutions that do not have an
electronic connection to the Fedwire funds trans- payments and settlements. The proposal
fer system can originate transfers via ‘‘off-line’’ does not affect the Fedwire Securities
telephone instructions. Service.
130 89th Annual Report, 2002

National Settlement Service securities to the Fedwire system was

completed in March; the securities are
Private clearing arrangements that now transferred and settled on the Fed-
exchange and settle transactions may wire Securities Service. The final phase
use the Reserve Banks’ National Settle- of consolidation of the operations of the
ment Service to settle their transactions. Fedwire Securities Service, an effort to
The Reserve Banks provide settlement reduce costs, was completed in May.
services to approximately seventy local Operational support for processing joint
and national private arrangements, pri- custody collateral was also consolidated
marily check clearinghouse associations in May.
but also other types of arrangements.
Also during 2002, the Reserve Banks
In 2002, the Reserve Banks processed
increased the readiness of a third data
more than 415,000 settlement entries
processing center for the Fedwire Secu-
for these arrangements.
rities Service to serve as a backup in
the event of an outage at the primary
Fedwire Securities Service or secondary site or both. Processing
resources at the third site are available
The Fedwire Securities Service allows
to support same-day recovery of the
participants to electronically transfer
Fedwire applications. This enhance-
securities issued by the U.S. Treasury,
ment to the third site adds to the
federal government agencies, and other
already robust contingency capabilities
entities to other participants in the
provided by the primary and secondary
United States.6 Reserve Bank operating
sites. The three sites are distant from
expenses and imputed costs for provid-
each other.
ing this service totaled $21.5 million in
2002. Revenue and other income totaled
$23.8 million, resulting in net income of Noncash Collection Service
$2.3 million. Approximately 8.5 million The Reserve Banks provide a service
transfers were processed by the service to collect and process municipal bearer
during the year, an increase of 26.4 per- bonds and coupons issued by state and
cent from 2001. The basic per-transfer local governments (referred to as ‘‘non-
fee for transfers originated and received cash’’ items). The service, which is cen-
by participants and the monthly account tralized at one Federal Reserve office,
maintenance fees were lowered, while processed 333,000 noncash transac-
the off-line securities transaction sur- tions in 2002. Operating expenses and
charge remained unchanged. imputed costs for noncash operations
Conversion of Government National totaled $1.5 million in 2002, and reve-
Mortgage Association (Ginnie Mae) nue totaled $1.7 million, resulting in net
income of $0.2 million.
6. The expenses, revenues, and volumes
reported here are for transfers of securities issued
by federal government agencies, government- Special Cash Services
sponsored enterprises, and international institu-
tions. When the Reserve Banks provide transfer, The Reserve Banks charge fees for
account maintenance, and settlement services for providing special cash-related services,
U.S. Treasury securities, they are acting as fiscal such as packaging currency in a
agents of the United States. The Treasury Depart-
ment assesses fees on depository institutions for
nonstandard way. These services—
some of these services. For details, see the section collectively referred to as ‘‘special cash
‘‘Fiscal Agency Services’’ later in this chapter. services’’—account for a very small
Federal Reserve Banks 131

proportion (less than 1 percent) of the tions continued for the introduction of a
total cost of cash services provided to new currency design, which includes
depository institutions by the Reserve new and enhanced security features.
Banks. Operating expenses and imputed
costs for special cash services totaled
$1.4 million in 2002. Revenue and other Developments in

income also totaled $1.4 million, result- Fiscal Agency and

ing in no net income. Government Depository Services

The total cost of providing fiscal agency

Float and depository services to the Treasury
and other government agencies in 2002
Federal Reserve float decreased in 2002
amounted to $308.5 million, compared
to a daily average of −$318.6 million,
with $285.4 million in 2001 (table). The
from a daily average of $604.6 million
majority of these costs were incurred on
in 2001.7 The Federal Reserve includes
behalf of the Treasury. Treasury-related
the cost of or income from float associ-
costs were $269.4 million in 2002, com-
ated with priced services as part of the
pared with $246.5 million in 2001, an
fees for those services.
increase of 9.3 percent. The cost of pro-
viding services to other government
Developments in agencies was $39.1 million, compared
Currency and Coin with $38.9 million in 2001. In 2002,
as in 2001, the Treasury and other
The Reserve Banks received 34.7 bil-
government agencies reimbursed the
lion notes from circulation in 2002, a
Reserve Banks for costs to provide these
3.1 percent increase from 2001, and
made payments of 35.4 billion notes
to circulation in 2002, a 2.9 percent
increase from 2001. The Banks received Fiscal Agency Services
43.4 billion coins from circulation in
2002, a 9.3 percent increase from 2001, As fiscal agents, the Reserve Banks pro-
and made payments of 58.6 billion coins vide to the Treasury services related to
to circulation in 2002, a 3.0 percent the federal debt. For example, they
increase from 2001. issue, transfer, reissue, exchange, and
The Reserve Banks enhanced their redeem marketable Treasury securities
national business-continuity framework and savings bonds; they also process
for the cash services function during the secondary market transfers initiated by
year. This effort included the refinement depository institutions. Additionally, the
of operating procedures, expansion of Reserve Banks support Treasury and
the crisis partner network for the Banks, other government agencies in their
and continuation of cash contingency efforts to modernize government pay-
testing. ment and accounting systems.
Also during the year, the Federal
Reserve worked closely with the Bureau Marketable Treasury Securities
of Engraving and Printing as prepara-
Reserve Bank operating expenses for
7. Float results from differences in the timing
activities related to marketable Treasury
of exchanges of debits and credits (settlements) securities (Fedwire Securities Service,
between entities in financial transactions. TreasuryDirect, marketable issues, and
132 89th Annual Report, 2002

Expenses of the Federal Reserve Banks for Fiscal Agency and Depository Services,
2002, 2001, and 2000
Thousands of dollars

Agency and service 2002 2001 2000

Department of the Treasury

Bureau of the Public Debt
Savings bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68,888.3 69,569.8 70,786.7
TreasuryDirect and Treasury coupons . . . . . . . . . . . . . . . . . . . 33,953.6 36,610.1 42,372.4
Commercial book entry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,830.1 9,998.1 13,924.6
Marketable Treasury issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,597.6 11,366.8 14,224.3
Computer applications and infrastructure development
and support . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,349.6 222.4 . . .
Other services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,385.8 1,255.7 96.8
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131,005.0 129,022.9 141,404.7

Financial Management Service

Treasury tax and loan and Treasury general account . . . . . 30,111.0 31,106.0 38,649.0
Government check processing . . . . . . . . . . . . . . . . . . . . . . . . . . 30,284.4 30,310.2 31,866.9
Automated clearinghouse . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,280.0 9,665.2 10,799.1
Government agency deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,082.2 2,272.9 2,218.8
Fedwire funds transfers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201.4 199.2 182.9
Computer applications and infrastructure development
and support . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46,782.6 27,281.3 21,209.6
Other services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,173.1 3,490.2 5,805.8
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123,914.7 104,324.9 110,732.2

Other Treasury
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,471.2 13,149.8 10,362.8
Total, Treasury . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269,390.9 246,497.5 262,499.7
Other Federal Agencies
Department of Agriculture
Food coupons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,240.8 13,197.2 16,463.7
U.S. Postal Service
Postal money orders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,381.6 11,255.0 9,213.5
Miscellaneous agencies
Other services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,494.1 14,434.0 13,747.1
Total, other agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,116.5 38,886.2 39,424.3

Total reimbursable expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308,507.4 285,383.7 301,924.0

Note. Amounts in bold are restatements due to reclas- . . . Not applicable.

sification of previously reported data.

Treasury coupons) totaled $57.4 mil- provides custody services only.8 Almost
lion, a 1.0 percent decrease from 2001. 98 percent of the total par value of Trea-
The Reserve Banks processed 167,000 sury securities outstanding at year-end
tenders for Treasury securities (exclud- 2002 was held by the Fedwire Securities
ing tenders processed by the Treasury, Service. The Reserve Banks in 2002
which were previously included in this originated 8.3 million transfers of Trea-
figure), compared with 181,000 in 2001, sury securities, a 6.2 percent increase
and handled 2.5 million reinvestment from 2001.
requests, compared with 2.8 million in TreasuryDirect customers may sell
2001. their securities for a fee through Sell-
The Reserve Banks operate two book- Direct, a program operated by one of the
entry securities systems for Treasury Reserve Banks. The Bank sold nearly
securities: the Fedwire Securities Ser-
vice, which provides custody and trans- 8. TreasuryDirect was designed for individuals
fer services, and TreasuryDirect, which who plan to hold their securities until maturity.
Federal Reserve Banks 133

14,000 securities worth $589.8 million interest rate being determined by auc-
in 2002, compared with nearly 15,000 tion. This pilot program added approxi-
securities worth $699.9 million in 2001. mately $3.0 million to the Treasury’s
It collected more than $464,000 in fees investment income.
on behalf of the Treasury, a decrease of
9.1 percent from the almost $510,000 in Payments Processed for the Treasury
fees collected in 2001.
Reserve Bank operating expenses
related to government payments
Savings Bonds
amounted to $38.8 million in 2002. The
Reserve Bank operating expenses for Banks processed 883.2 million ACH
savings bond activities totaled transactions for the Treasury, a decrease
$68.9 million in 2002, a decrease of of 1.9 percent from 2001, and nearly
1.0 percent from 2001. The Banks 140,000 Fedwire funds transfers, a
printed and mailed 37.2 million savings decrease of 10.2 percent from 2001.
bonds on behalf of the Treasury’s Bu- They also processed 289.3 million paper
reau of the Public Debt, a 1.5 percent government checks, a decrease of
decrease from 2001. They issued nearly 16.3 percent from 2001. In addition, the
4.7 million new Series I (inflation- Banks issued 368,000 fiscal agency
indexed) savings bonds and 27.9 million checks, a decrease of 15.5 percent from
new Series EE savings bonds. In addi- 2001.
tion, the Banks processed approximately During the year, the Reserve Banks
618,000 redemption, reissue, and assisted Treasury’s efforts to facilitate
exchange transactions, a 9.7 percent electronic payments to the federal gov-
increase from 2001. Reserve Bank staff ernment. The Banks operate, a
responded to 1.6 million service calls Treasury program that allows members
from owners of savings bonds, approxi- of the public to pay the government
mately the same number as in 2001. over the Internet. The Banks also oper-
ate the Treasury’s Paper Check Conver-
sion program, whereby checks written
Depository Services to government agencies are converted at
The Reserve Banks maintain the Trea- the point of sale into ACH transactions.
sury’s funds account, accept deposits of In 2002, the first full year of operation
federal taxes and fees, pay checks drawn for both programs, the Reserve Banks
on the Treasury’s account, and make originated nearly 215,000 ACH transac-
electronic payments on behalf of the tions through the programs, a significant
Treasury. increase from the 10,000 originated in
Federal Tax Payments
Services Provided to Other Entities
Reserve Bank operating expenses
related to federal tax payments in The Reserve Banks provide fiscal
2002 totaled $30.1 million. The Federal agency and depository services to other
Reserve enhanced the Treasury tax and domestic and international agencies
loan program at midyear by pilot testing when they are required to do so by the
the Term Investment Option, whereby Secretary of the Treasury or when they
the Treasury can place investments with are required or permitted to do so by
depository institutions for a set term, the federal statute. One such service is the
134 89th Annual Report, 2002

provision of food coupon services for each other and to depository institutions
the Department of Agriculture. Reserve is substantially complete. The technol-
Bank operating expenses for food cou- ogy has improved the speed, reliability,
pon services in 2002 totaled $10.2 mil- and performance of the depository insti-
lion, 22.4 percent lower than in 2001. tutions’ electronic connections during
The Banks redeemed 500.5 million food contingencies as well as the capacity
coupons, a decrease of 14.7 percent and flexibility to support new electronic
from 2001. services using web-based technologies.
As fiscal agents of the United States, Also, several major cost-reduction
the Reserve Banks also process all initiatives to centralize or standardize
postal money orders deposited by banks information technology utilities and
for collection. In 2002, they processed resources common to the Reserve Banks
216.5 million postal money orders, a have begun. Projects are under way to
decrease of 5.6 percent from 2001. standardize certain local area network
components as well as desktop hard-
ware and software to facilitate interoper-
Electronic Access ability, improve network efficiency, and
The Federal Reserve continued in 2002 increase productivity. Certain Reserve
to improve electronic access for deposi- Banks are supporting common informa-
tory institutions and to offer web-based tion technology functions such as desk-
applications for imaging checks, order- top standardization and management,
ing cash, and processing savings bonds. remote access, and incident response.
Specifically, the Reserve Banks made These initiatives are expected to contrib-
the strategic decision to deliver services ute to a System effort to reduce informa-
using web-based technologies in the tion technology costs over the long term.
next two years and to discontinue devel-
opment of the FedLine for Windows NT
operating system. This strategic direc-
Examinations of the
tion will allow the Banks to provide
Federal Reserve Banks
more-flexible access to the full array of Section 21 of the Federal Reserve Act
financial information and transaction requires the Board of Governors to order
services, including high-risk Fedwire an examination of each Federal Reserve
and ACH, and to improve the quality of Bank at least once a year. The Board
financial services. engages a public accounting firm to per-
To complement the move to web- form an annual audit of the combined
based electronic access, the Reserve financial statements of the Reserve
Banks plan to consolidate the customer Banks (see the section ‘‘Federal Reserve
support function for electronic access at Banks Combined Financial Statements’’).
each Reserve Bank to two sites during The public accounting firm also audits
2003 and 2004. The consolidation is the annual financial statements of each
expected to improve the efficiency and of the twelve Banks. The Reserve Banks
consistency of customer support. use the framework established by the
Committee of Sponsoring Organizations
of the Treadway Commission (COSO)
Information Technology in assessing their internal controls over
Implementation of frame relay technol- financial reporting, including the safe-
ogy on the telecommunications network guarding of assets. Within this frame-
connecting the Reserve Bank offices to work, each Reserve Bank provides an
Federal Reserve Banks 135

assertion letter to its board of directors Reserve’s Federal Open Market Com-
annually confirming adherence to the mittee (FOMC), the division also exam-
COSO standards, and a public account- ines the accounts and holdings of the
ing firm certifies management’s asser- System Open Market Account at the
tion and issues an attestation report to Federal Reserve Bank of New York and
the Bank’s board of directors and to the the foreign currency operations con-
Board of Governors. ducted by that Bank. In addition, a pub-
The firm engaged for the audits of the lic accounting firm certifies the sched-
individual and combined financial state- ule of participated asset and liability
ments of the Reserve Banks for 2002 accounts and the related schedule of par-
was PricewaterhouseCoopers LLP ticipated income accounts at year-end.
(PwC). Fees for these services totaled Division personnel follow up on the
$1.0 million. To ensure auditor indepen- results of these audits. The FOMC
dence, the Board requires that PwC be receives the external audit reports and
independent in all matters relating to the the report on the division’s follow-up.
audit. Specifically, PwC may not per-
form services for the Reserve Bank or
others that would place it in a posi-
Income and Expenses
tion of auditing its own work, mak- The accompanying table summarizes
ing management decisions on behalf the income, expenses, and distributions
of the Reserve Banks, or in any other of net earnings of the Federal Reserve
way impairing its audit independence. Banks for 2001 and 2002.
In 2002 the Reserve Banks engaged Income in 2002 was $26,760 million,
PwC for advisory services totaling compared with $31,871 million in 2001.
$176,600 for project management advi- Expenses totaled $2,862 million ($2,071
sory services related to the System’s million in operating expenses, $156 mil-
check modernization project. The Board lion in earnings credits granted to
believes that these advisory services do depository institutions, $205 million in
not directly affect the preparation of assessments for expenditures by the
the financial statements audited by PwC Board of Governors, and $430 mil-
and are not incompatible with the ser- lion for the cost of new currency).
vices provided by PwC as an indepen- Revenue from priced services was
dent auditor. $916.3 million.
The Board’s annual examination of The profit and loss account showed a
the Reserve Banks in 2002 included a net profit of $2,149 million. The profit
wide range of off-site and on-site over- was due primarily to unrealized gains on
sight activities conducted by the Divi- assets denominated in foreign curren-
sion of Reserve Bank Operations and cies revalued to reflect current market
Payment Systems. Division staff moni- exchange rates. Statutory dividends paid
tors the activities of each Reserve Bank to member banks totaled $484 million,
on an ongoing basis and conducts $56 million more than in 2001; the
on-site reviews according to the divi- increase reflects an increase in the capi-
sion’s risk-assessment methodology. tal and surplus of member banks and a
The 2002 examination also included consequent increase in the paid-in capi-
assessing the efficiency and effective- tal stock of the Reserve Banks.
ness of the internal audit function. Payments to the U.S. Treasury in the
Each year, to assess compliance with form of interest on Federal Reserve
the policies established by the Federal notes totaled $24,496 million in 2002,
136 89th Annual Report, 2002

Income, Expenses, and Distribution of Net Earnings

of the Federal Reserve Banks, 2002 and 2001
Millions of dollars

Item 2002 2001

Current income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,760 31,871

Current expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,227 2,085
Operating expenses 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,071 1,834
Earnings credits granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156 250

Current net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,533 29,786

Net additions to (deductions from, − ) current net income . . . . . . . . . . . . . . . 2,149 −1,117
Assessments by the Board of Governors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 635 634
For expenditures of Board . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205 295
For cost of currency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 430 339

Net income before payments to Treasury . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,048 28,035

Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 484 428
Transferred to surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,068 518

Payments to Treasury 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,496 27,089

1. Includes a net periodic credit for pension costs of 2. Interest on Federal Reserve notes.
$157 million in 2002 and $331 million in 2001.

down from $27,089 million in 2001; the The average rate of interest earned
payments equal net income after the on the Reserve Banks’ holdings of gov-
deduction of dividends paid and of the ernment securities declined to 4.11 per-
amount necessary to bring the surplus of cent, from 5.46 percent in 2001, and
the Reserve Banks to the level of capital the average rate of interest earned on
paid in. loans declined to 1.94 percent, from
In the ‘‘Statistical Tables’’ section of 3.18 percent.
this volume, table 5 details the income
and expenses of each Reserve Bank for
2002, and table 6 shows a condensed Volume of Operations
statement for each Bank for the years Table 8 in the ‘‘Statistical Tables’’ sec-
1914 through 2002. A detailed account tion shows the volume of operations in
of the assessments and expenditures of the principal departments of the Federal
the Board of Governors appears in the Reserve Banks for the years 1999
section ‘‘Board of Governors Financial through 2002.

Holdings of Securities and Loans Federal Reserve Bank Premises

The Reserve Banks’ average daily hold- In 2002, design work continued for the
ings of securities and loans during 2002 Dallas Reserve Bank’s new Houston
amounted to $621,834 million, Branch building and the Chicago Bank’s
an increase of $62,511 million from Detroit Branch building. Also, the Board
2001 (table). Holdings of U.S. govern- approved the purchase of property for
ment securities increased $62,795 mil- the new Detroit Branch building and a
lion, and holdings of loans decreased new building program for the Kansas
$284 million. City Bank. The St. Louis Reserve Bank
Federal Reserve Banks 137

Securities and Loans of the Federal Reserve Banks, 2000–2002

Millions of dollars except as noted

Item and year Total government Loans 2
securities 1

Average daily holdings 3

2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 528,139 527,774 365
2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 559,323 558,926 397
2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 621,834 621,721 113

Earnings 4
2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,760 32,737 23
2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,536 30,523 13
2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,527 25,525 2
Average interest rate (percent)
2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.20 6.20 6.27
2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.46 5.46 3.18
2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.11 4.11 1.94

1. Includes federal agency obligations. 4. Earnings have not been netted with the inter-
2. Does not include indebtedness assumed by the Fed- est expense on securities sold under agreements to
eral Deposit Insurance Corporation. repurchase.
3. Based on holdings at opening of business.

continued to analyze its long-term plan- for the main chiller plant in the head-
ning options for its headquarters facility. quarters building was completed, and
The multiyear renovation program at the annex building in New York City
the New York Reserve Bank’s head- was sold.
quarters building continued, including At all facilities, security enhancement
the cleaning and repair of the exterior programs were undertaken as a result of
stonework. The improvement program the events of September 11, 2001.
138 89th Annual Report, 2002

Pro Forma Financial Statements for Federal Reserve Priced Services

Pro Forma Balance Sheet for Priced Services, December 31, 2002 and 2001
Millions of dollars

Item 2002 2001

Short-term assets (Note 1)

Imputed reserve requirements
on clearing balances . . . . . . . . . . . . 1,047.8 860.8
Investment in marketable securities . . . 9,051.3 7,747.3
Receivables . . . . . . . . . . . . . . . . . . . . . . . . . 78.7 76.5
Materials and supplies . . . . . . . . . . . . . . . 3.4 3.1
Prepaid expenses . . . . . . . . . . . . . . . . . . . . 34.8 30.5
Items in process of collection . . . . . . . . 6,958.6 1,772.1
Total short-term assets . . . . . . . . 17,174.7 10,490.3

Long-term assets (Note 2)

Premises . . . . . . . . . . . . . . . . . . . . . . . . . . . . 475.0 473.0
Furniture and equipment . . . . . . . . . . . . . 179.2 176.1
Leases and leasehold improvements . . 91.2 88.1
Prepaid pension costs . . . . . . . . . . . . . . . . 809.2 760.8
Total long-term assets . . . . . . . . . 1,554.6 1,498.0

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . 18,729.3 11,988.3

Short-term liabilities
Clearing balances and balances
arising from early credit
of uncollected items . . . . . . . . . . . . . 10,550.2 8,524.5
Deferred-availability items . . . . . . . . . . . 6,886.4 1,855.7
Short-term debt . . . . . . . . . . . . . . . . . . . . . . .0 20.8
Short-term payables . . . . . . . . . . . . . . . . . . 83.9 89.2
Total short-term liabilities . . . . . 17,520.5 10,490.3

Long-term liabilities
Long-term debt . . . . . . . . . . . . . . . . . . . . . . .0 519.7
benefits obligation . . . . . . . . . . . . . . 272.3 257.8
Total long-term liabilities . . . . . 272.3 777.4
Total liabilities . . . . . . . . . . . . . . . . . . . . . . 17,792.8 11,267.7

Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 936.4 720.6

Total liabilities and equity (Note 3) . . . 18,729.3 11,988.3

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.
Federal Reserve Banks 139

Pro Forma Income Statement for Federal Reserve Priced Services, 2002 and 2001
Millions of dollars

Item 2002 2001

Revenue from services provided

to depository institutions (Note 4) . . . . . . 916.3 926.5
Operating expenses (Note 5) . . . . . . . . . . . . . . . . 876.0 814.9
Income from operations . . . . . . . . . . . . . . . . . . . . 40.2 111.7
Imputed costs (Note 6)
Interest on float . . . . . . . . . . . . . . . . . . . . . . . . . . −6.8 15.5
Interest on debt . . . . . . . . . . . . . . . . . . . . . . . . . . .0 32.0
Sales taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.4 12.6
FDIC insurance . . . . . . . . . . . . . . . . . . . . . . . . . . .0 4.6 .0 60.1
Income from operations after
imputed costs . . . . . . . . . . . . . . . . . . . . . . . . . 35.6 51.6
Other income and expenses (Note 7)
Investment income . . . . . . . . . . . . . . . . . . . . . . . 148.9 273.3
Earnings credits . . . . . . . . . . . . . . . . . . . . . . . . . −146.8 2.1 −239.4 33.9
Income before income taxes . . . . . . . . . . . . . . . . 37.7 85.4
Imputed income taxes (Note 8) . . . . . . . . . . . . . . 11.0 26.9
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26.6 58.5
Memo: Targeted return on equity (Note 9) . . . 92.5 109.2

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.

Pro Forma Income Statement for Federal Reserve Priced Services, by Service, 2002
Millions of dollars

Com- Com-
mercial Fedwire Fedwire Noncash Cash
Item Total mercial
check funds securities services services

Revenue from services

(Note 4) . . . . . . . . . . . . . . . . 916.3 759.2 58.6 23.7 71.7 1.7 1.4

Operating expenses
(Note 5) . . . . . . . . . . . . . . . . 876.0 744.3 50.7 20.3 58.0 1.4 1.4
Income from operations . . . . . . 40.2 14.9 7.9 3.5 13.7 .2 −.0

Imputed costs (Note 6) . . . . . . . 4.6 2.9 .7 .3 .7 .0 .0

Income from operations
after imputed costs . . . . . . 35.6 12.0 7.3 3.1 13.0 .2 −.0
Other income and expenses,
net (Note 7) . . . . . . . . . . . . 2.1 1.7 .1 .0 .2 .0 .0
Income before income taxes . . 37.7 13.7 7.4 3.2 13.2 .2 −.0

Imputed income taxes

(Note 8) . . . . . . . . . . . . . . . . 11.0 4.0 2.2 .9 3.9 .1 −.0

Net income . . . . . . . . . . . . . . . . . . 26.6 9.7 5.2 2.3 9.3 .2 −.0

Memo: Targeted return on

equity (Note 9) . . . . . . . . . 92.5 78.2 5.5 2.2 6.5 .1 .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.
140 89th Annual Report, 2002


Notes to Pro Forma Financial Statements for Priced Services
(1) Short-Term Assets ment factor (PSAF). The PSAF consists of the taxes that
would have been paid and the return on capital that would
The imputed reserve requirement on clearing balances
have been provided had priced services been furnished by
held at Reserve Banks by depository institutions reflects a
a private-sector firm. Other short-term liabilities include
treatment comparable to that of compensating balances
clearing balances maintained at Reserve Banks and
held at correspondent banks by respondent institutions.
deposit balances arising from float. Other long-term lia-
The reserve requirement imposed on respondent balances
bilities consist of accrued postemployment and postretire-
must be held as vault cash or as non-earning balances
ment benefits costs and obligations on capital leases.
maintained at a Reserve Bank; thus, a portion of priced
services clearing balances held with the Federal Reserve
is shown as required reserves on the asset side of the (4) Revenue
balance sheet. Another portion of the clearing balances Revenue represents charges to depository institutions for
is used to finance short-term and long-term assets. The priced services and is realized from each institution
remainder of clearing balances is assumed to be invested through one of two methods: direct charges to an institu-
in three-month Treasury bills, shown as investment in tion’s account or charges against its accumulated earn-
marketable securities. ings credits.
Receivables are (1) amounts due the Reserve Banks for
priced services and (2) the share of suspense-account and
difference-account balances related to priced services. (5) Operating Expenses
Materials and supplies are the inventory value of short- Operating expenses consist of the direct, indirect, and
term assets. other general administrative expenses of the Reserve
Prepaid expenses include salary advances and travel Banks for priced services plus the expenses for staff
advances for priced-service personnel. members of the Board of Governors working directly on
Items in process of collection is gross Federal Reserve the development of priced services. The expenses for
cash items in process of collection (CIPC) stated on a Board staff members were $5.1 million in 2002 and
basis comparable to that of a commercial bank. It reflects $4.9 million in 2001. The credit to expenses under
adjustments for intra-System items that would otherwise SFAS 87 (see note 2) is reflected in operating expenses.
be double-counted on a consolidated Federal Reserve The income statement by service reflects revenue,
balance sheet; adjustments for items associated with non- operating expenses, and imputed costs. Certain corporate
priced items, such as those collected for government overhead costs not closely related to any particular priced
agencies; and adjustments for items associated with service are allocated to priced services in total based on
providing fixed availability or credit before items are an expense-ratio method, but are allocated among priced
received and processed. Among the costs to be recovered services based on management decision. Corporate over-
under the Monetary Control Act is the cost of float, or net head was allocated among the priced services during
CIPC during the period (the difference between gross 2002 and 2001 as follows (in millions):
CIPC and deferred-availability items, which is the portion
of gross CIPC that involves a financing cost), valued at 2002 2001
the federal funds rate.
Check . . . . . . . . . . . . . . . . . . . . . 40.3 43.5
(2) Long-Term Assets ACH . . . . . . . . . . . . . . . . . . . . . . 4.1 4.4
Fedwire funds . . . . . . . . . . . . . . 3.3 3.5
Consists of long-term assets used solely in priced ser- Fedwire securities . . . . . . . . . . 1.9 1.9
vices, the priced-services portion of long-term assets Noncash services . . . . . . . . . . . .1 .1
shared with nonpriced services, and an estimate of the Special cash services . . . . . . . . .1 .0
assets of the Board of Governors used in the development
Total . . . . . . . . . . . . . . . . . . . . . . 49.7 53.4
of priced services. Effective Jan. 1, 1987, the Reserve
Banks implemented the Financial Accounting Standards
Board’s Statement of Financial Accounting Standards (6) Imputed Costs
No. 87, Employers’ Accounting for Pensions (SFAS 87).
Imputed costs consist of interest on float, interest on debt,
Accordingly, the Reserve Banks recognized credits to sales taxes, and the FDIC assessment. Interest on float is
expenses of $48.4 million in 2002 and $101.0 million in derived from the value of float to be recovered, either
2001 and corresponding increases in this asset account. explicitly or through per-item fees, during the period.
Float costs include costs for checks, book-entry securi-
(3) Liabilities and Equity ties, noncash collection, ACH, and funds transfers.
Interest is imputed on the debt assumed necessary to
Under the matched-book capital structure for assets, finance priced-service assets. There was no debt in 2002
short-term assets are financed with clearing balances in because clearing balances fund short-term and long-term
2002 and short-term payables and short-term debt in debt. The sales taxes and FDIC assessment that the Fed-
2001. Long-term assets are financed with clearing bal- eral Reserve would have paid had it been a private-sector
firm are among the components of the PSAF (see note 3).
ances in 2002, and in 2001 with long-term debt and Float cost or income is based on the actual float
equity in a proportion equal to the ratio of long-term debt incurred for each priced service. Other imputed costs are
to equity for the fifty largest bank holding companies, allocated among priced services according to the ratio of
which are used in the model for the private-sector adjust- operating expenses less shipping expenses for each ser-
Federal Reserve Banks 141

vice to the total expenses for all services less the total reserve or clearing balances or by billing institutions
shipping expenses for all services. directly. Float recovered through direct charges and per-
The following list shows the daily average recovery of item fees is valued at the federal funds rate; credit float
actual float by the Reserve Banks for 2002 in millions of recovered through per-item fees has been subtracted from
dollars: the cost base subject to recovery in 2002.

Total float −9.3 (7) Other Income and Expenses

Unrecovered float 68.6 Consists of investment income on clearing balances and
Float subject to recovery −77.9 the cost of earnings credits. Investment income on clear-
Sources of recovery of float ing balances represents the average coupon-equivalent
Income on clearing balances −8.2 yield on three-month Treasury bills applied to the total
As-of adjustments −309.3 clearing balance maintained, adjusted for the effect of
Direct charges 430.8 reserve requirements on clearing balances. Expenses for
Per-item fees −809.8 earnings credits granted to depository institutions on their
clearing balances are derived by applying the average
Unrecovered float includes float generated by services federal funds rate to the required portion of the clearing
to government agencies and by other central bank ser- balances, adjusted for the net effect of reserve require-
vices. Float recovered through income on clearing bal- ments on clearing balances.
ances is the result of the increase in investable clearing
balances; the increase is produced by a deduction for float (8) Income Taxes
for cash items in process of collection, which reduces Imputed income taxes are calculated at the effective tax
imputed reserve requirements. The income on clearing rate derived from the PSAF model (see note 3).
balances reduces the float to be recovered through other
means. As-of adjustments and direct charges refer to float (9) Return on Equity
that is created by interterritory check transportation and
the observance of non-standard holidays by some deposi- The after-tax rate of return on equity that the Federal
tory institutions. Such float may be recovered from the Reserve would have earned had it been a private business
depository institutions through adjustments to institution firm, as derived from the PSAF model (see note 3).

The Board of Governors and the

Government Performance and Results Act
Under the Government Performance and and discusses validation of data and veri­
Results Act of 1993 (GPRA), federal fication of results. The performance
agencies are required to prepare, in con­ report indicates that the Board generally
sultation with the Congress and outside met its goals for 2000–01. A scheduling
stakeholders, a strategic plan covering a problem with state bank regulatory
multiyear period and to submit annual agencies was cited as a reason for not
performance plans and performance meeting all of the goals. Accordingly,
reports. Though not covered by the act, the Board is implementing a new sched­
the Board of Governors is volunta­ uling system that will help resolve
rily complying with many of the act’s the problem.
mandates. The strategic plan, performance plan,
and performance report are available
on the Board’s public web site
Strategic and Performance Plans (
and Performance Report /rptcongress). The Board’s mission
The Board’s current strategic plan in statement and a summary of the goals
the GPRA format, released in Decem­ and objectives set forth in the strategic
ber 2001, covers the period 2001–05. and performance plans are given below.
The document articulates the Board’s
mission, sets forth major goals for the
period, outlines strategies for achieving Mission
those goals, and discusses the environ­
ment and other factors that could affect The mission of the Board is to foster the
their achievement. The strategic plan stability, integrity, and efficiency of the
also addresses issues that cross agency nation’s monetary, financial, and pay­
jurisdictional lines, identifies key quan­ ment systems so as to promote optimal
titative measures of performance, and macroeconomic performance.
discusses performance evaluation.
The 2002–03 performance plan and
the 2000–01 performance report were Goals and Objectives
posted on the Board’s public web site The Federal Reserve has three primary
in November 2002 for access by the goals with interrelated and mutually
Congress, the public, and the General reinforcing elements:
Accounting Office. The performance
plan sets forth specific targets for some
of the performance measures identi­ Goal
fied in the strategic plan (except those
associated with the monetary policy To conduct monetary policy that pro-
function). The performance plan also motes the achievement of maximum
describes the operational processes and sustainable long-term growth and the
resources needed to meet those targets price stability that fosters that goal.
144 89th Annual Report, 2002

Objectives • Promote equal access to banking

• Stay abreast of recent developments • Administer and ensure compliance
and prospects in the U.S. economy with consumer protection statutes
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 in out congressional intent, striking the
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
tively in rapidly changing economic To provide high-quality professional
circumstances and in an evolving oversight of Reserve Bank operations
financial market structure and to foster the integrity, efficiency,
• Contribute to the development of U.S. and accessibility of U.S. payment and
international policies and procedures, settlement systems.
in cooperation with the Department of
the Treasury and other agencies Objectives
• Promote understanding of Federal • Develop sound, effective policies
Reserve policy among other govern­ and regulations that foster payment
ment policy officials and the general system integrity, efficiency, and
public. accessibility
• Produce high-quality assessments of
Federal Reserve Bank operations,
Goal projects, and initiatives that help Fed­
eral Reserve management foster and
To promote a safe, sound, competitive, strengthen sound internal control
and accessible banking system and systems and efficient and effective
stable financial markets. performance
• Conduct research and analysis that
Objectives contributes to policy development
• Provide comprehensive and effective and increases the Board’s and others’
supervision of U.S. banks, bank and understanding of payment system
financial holding companies, foreign dynamics and risk.
banking organizations with U.S.
operations, and related entities
Interagency Coordination
• Promote overall financial stability,
manage and contain systemic risk, and Interagency coordination helps focus
ensure that emerging financial crises efforts to eliminate redundancy and
are identified early and successfully lower costs. As mandated by the Gov­
resolved ernment Performance and Results Act
• Improve efficiency and effectiveness and in conformance with past practice,
and reduce burden on supervised the Board has worked closely with other
institutions federal agencies to consider plans and
The Board of Governors and the Government Performance and Results Act 145

strategies for programs, such as bank officers of the five agencies has been
supervision, that transcend the jurisdic­ created to address and report on issues
tion of each agency. Coordination with related to those general goals and objec­
the Department of the Treasury and tives that cross agency functions, pro-
other agencies is evident throughout grams, and activities. This working
both the strategic and performance group has been meeting since June
plans. Much of the Board’s formal effort 1997. These and similar planning efforts
to plan jointly has been made through can eliminate redundancy and signifi­
the Federal Financial Institutions cantly lower the government’s costs for
Examination Council (FFIEC), a group data processing and other activities, as
made up of the five federal agencies that well as lower depository institutions’
regulate depository institutions.1 In costs for complying with federal regula­
addition, a coordinating committee of tions, while enhancing public access to
representatives of the chief financial the data.

1. The FFIEC consists of the Board of Gover­ forms for the federal examination of financial
nors of the Federal Reserve System, the Federal institutions and to make recommendations to pro-
Deposit Insurance Corporation, the National mote uniformity in the supervision of financial
Credit Union Administration, the Office of the institutions. The FFIEC also provides uniform
Comptroller of the Currency, and the Office of examiner training and has taken a lead in develop­
Thrift Supervision. It was established in 1979 pur­ ing standardized software needed for major data
suant to title X of the Financial Institutions Regu­ collection programs to support the requirements of
latory and Interest Rate Control Act of 1978. The the Home Mortgage Disclosure Act and the Com­
FFIEC is a formal interagency body empowered to munity Reinvestment Act.
prescribe uniform principles, standards, and report

Federal Legislative Developments€

On November 26, 2002, President Bush five-member vote if fewer than five
signed the Terrorism Risk Insurance Act members are in office at the time of the
of 2002 into law. Section 301 of that action (that is, if more than two seats on
act amended section 11 of the Federal the Board are vacant). Second, it allows
Reserve Act (12 U.S.C. 248) to enhance those members of the Board that are
the Board’s ability to respond to emer­ available to approve a loan to a nonde­
gency situations. Before the amend­ pository institution under section 13(3)
ment, the Federal Reserve Act allowed of the Federal Reserve Act if these
the Board to take five types of actions available members unanimously deter-
only upon the affirmative vote of at mine that (1) unusual and exigent cir­
least five Board members. Among the cumstances exist and the borrower is
actions requiring supermajority approval unable to secure adequate credit accom­
was Board authorization of a Federal modations from other sources; (2) action
Reserve Bank to extend credit to a on the loan is necessary to prevent,
nondepository institution in unusual correct, or mitigate serious harm to the
and exigent circumstances under sec­ economy or the stability of the U.S.
tion 13(3) of the Federal Reserve Act. financial system; (3) all available tele­
See 12 U.S.C. § 343; see also 12 U.S.C. phonic, telegraphic, and other means
§§ 248(b), 347a, and 461(b)(3) and have been used to attempt to contact
(b)(4). the other members of the Board; and
These five-member voting require­ (4) action on the loan request is neces­
ments could have impaired the Board’s sary before the other Board members
ability to act in an emergency. The Ter­ can be contacted. At least two Board
rorism Risk Insurance Act amended members must be available and partici­
these requirements in two respects. First, pate in the emergency loan approval,
it allows fewer than five Board mem­ and any loan made by a Reserve Bank
bers, by unanimous vote, to approve any under this emergency procedure must be
action that would otherwise require a payable upon demand.


Record of Policy Actions

of the Board of Governors

Regulation A rate. A secondary credit program,

Extensions of Credit with an interest rate initially 50 basis
by Federal Reserve Banks points above the primary credit rate, is
available in appropriate circumstances
Regulation D to depository institutions that do not
Reserve Requirements qualify for primary credit.
of Depository Institutions The revisions are intended to improve
the functioning of the discount window
October 31, 2002—Amendments and do not indicate a change in the
stance of monetary policy. The seasonal
The Board amended Regulations A and credit program, used mainly by small
D to implement new discount window banks that have pronounced seasonal
programs, effective January 9, 2003. funding needs, remains essentially
Votes for this action: Messrs. Greenspan,
Ferguson, and Gramlich, Ms. Bies, and
Messrs. Olson, Bernanke, and Kohn.
Regulation C
The revisions to Regulation A replace Home Mortgage Disclosure
the adjustment and extended credit pro-
grams with new primary and secondary January 23, 2002—Amendments
credit programs, reorganize and stream-
line the rule, and would facilitate a The Board approved amendments to
reduction of the primary credit rate in Regulation C, which implements the
the event of a financial emergency. The Home Mortgage Disclosure Act, to
Board also amended Regulation D to expand the amount of data and num­
conform the calculation of penalties for ber of lenders subject to the reporting
reserve deficiencies, which are based on requirements of the act, effective Janu­
the discount rate, to the new discount ary 1, 2003.
rate framework. Votes for this action: Messrs. Ferguson,
Under the new primary credit pro- Meyer, and Gramlich, Ms. Bies, and
gram, the Federal Reserve Banks offer Mr. Olson.
very short term credit, at an interest rate
above the targeted federal funds rate, as The Home Mortgage Disclosure Act
a backup source of liquidity to deposi­ requires covered lenders to collect,
tory institutions that are in generally report, and publicly disclose certain data
sound financial condition. The Reserve on home purchase and home improve­
Banks establish the primary credit rate ment loans (both loans they originate
at least every two weeks, subject to and those they purchase) and applica­
review and determination by the Board, tions that do not result in originations.
through the same procedure that had These data include the race, ethnicity,
been used to set the adjustment credit sex, and income of the applicants and
152 89th Annual Report, 2002

borrowers and the location of the prop­ ment to require reporters under the act
erty. The amendments require, among to use 2000 census data, effective Janu­
other things, that lenders report loan- ary 1, 2003.
pricing data showing the spread between
the annual percentage rate charged for Votes for this action: Messrs. Greenspan,
originated loans and the rate on U.S. Ferguson, and Gramlich, Ms. Bies, and
Mr. Olson.
Treasury securities having comparable
maturity periods, if the spread equals The Board extended for one year the
or exceeds certain thresholds set by effective date of amendments approved
the Board. Lenders are also required to on January 23, 2002, as discussed
identify loans subject to the Home Own­ above, to give institutions sufficient time
ership and Equity Protection Act and to implement the new reporting require­
report denials of applications for credit ments. The extension allows institutions
received through certain preapproval to fully implement the new rules with-
programs. In addition, the amendments out jeopardizing the quality and useful­
expand the regulation’s coverage of ness of the data and without incurring
nondepository lenders by adding a substantial additional implementation
dollar-volume test of $25 million in costs that could be avoided by a delay
total home purchase loan originations in the effective date. The Board also
(including refinancings of home pur­ adopted an interim amendment to
chase loans) for the preceding year. improve the accuracy and usefulness
The Board published for comment a of the data submitted under the act by
proposal that reporting thresholds for requiring reporters to use 2000 census
first-lien loans be set at 3 percentage data, effective January 1, 2003.
points above the U.S. Treasury rate and
5 percentage points above that rate for
subordinate-lien loans. The Board also June 3, 2002—Amendments
requested public comment on requiring
lenders to collect, for applications and The Board approved amendments to
originated loans, data on whether the implement the following proposals
application or loan is secured by a first made in connection with the January
or subordinate lien on a dwelling or is 2002 amendments to Regulation C:
unsecured (the lien status) and requiring establish reporting thresholds for loan-
lenders to request, for loan applications pricing data and require reporting of
made by telephone, the race, ethnicity, lien-status data, effective January 1,
and sex of the applicant. 2004, and require lenders to request
additional information in telephone
applications, effective January 1, 2003.
May 2, 2002—Delay of Effective
Date and Interim Amendment Votes for this action: Messrs. Greenspan,
Ferguson, and Gramlich, Ms. Bies, and
The Board extended the effective date Mr. Olson.
for most of the amendments to Regula­
tion C, which expand the amount of data As discussed above, the Board
and number of lenders subject to the approved amendments to the data col­
reporting requirements of the Home lection requirements of Regulation C on
Mortgage Disclosure Act, from Janu­ January 23, 2002. It also published for
ary 1, 2003, to January 1, 2004. The comment proposals that would estab­
Board also adopted an interim amend­ lish thresholds for reporting loan-pricing
Record of Policy Actions of the Board of Governors 153

data based on a rate spread (between the 2001, to June 30, 2002, warranted an
annual percentage rate on a loan and the increase in the low reserve tranche
yield on comparable U.S. Treasury secu­ from $41.3 million to $42.1 million,
rities) of 3 percentage points for first- and the Board amended Regulation D
lien loans and 5 percentage points for accordingly.
subordinate-lien loans; require lenders The Garn–St Germain Depository
to report the lien status of applications Institutions Act of 1982 establishes a
and originated loans; and require lend­ zero percent reserve requirement on the
ers to request the race, ethnicity, and first $2 million of an institution’s reserv­
sex of telephone applicants. The Board able liabilities. The act also provides for
approved these proposals with the effec­ annual adjustments to that exemption
tive dates indicated. amount based on percentage increases
in reservable liabilities at all depository
institutions over the one-year period
Regulation D ending on the most recent June 30.
Reserve Requirements of The growth in total reservable liabili­
Depository Institutions ties from June 30, 2001, to June 30,
2002, warranted an increase in the
October 1, 2002—Amendments reservable liabilities exemption level
from $5.7 million to $6 million, and
The Board amended Regulation D to the Board amended Regulation D
increase the amount of net transac­ accordingly.
tion accounts at depository institutions For institutions that report weekly, the
to which a lower reserve requirement amendments adjusting the low reserve
applies (low reserve tranche) and the tranche and the reservable liabilities
amount of reservable liabilities exempt exemption level are effective for the
from reserve requirements (reservable fourteen-day reserve computation period
liabilities exemption level) for 2003, beginning Tuesday, November 26, 2002,
effective for the reserve computation and for the corresponding fourteen-day
period beginning November 26, 2002, reserve maintenance period beginning
for institutions reporting weekly. Thursday, December 26, 2002. For insti­
Votes for this action: Messrs. Greenspan,
tutions that report quarterly, the amend­
Ferguson, and Gramlich, Ms. Bies, and ments are effective for the seven-day
Messrs. Olson, Bernanke, and Kohn. reserve computation period beginning
Tuesday, December 17, 2002, and for
Under the Monetary Control Act of the corresponding seven-day reserve
1980, depository institutions, Edge and maintenance period beginning Thurs­
agreement corporations, and U.S. agen­ day, January 16, 2003.
cies and branches of foreign banks are Nonexempt depository institutions
subject to reserve requirements set by that have total reservable liabilities
the Board. The act directs the Board to greater than the amount exempted from
adjust annually the amount of the low reserve requirements ($6 million in
reserve tranche on the basis of percent- 2003) report either weekly or quarterly
age changes in net transaction accounts depending on the amount of their total
at all depository institutions over the deposits. To ease the reporting burden
one-year period ending on the most on small institutions, the Board requires
recent June 30. The growth in total nonexempt depository institutions with
net transaction accounts from June 30, total deposits below a specified level
154 89th Annual Report, 2002

(nonexempt deposit cutoff level) to Regulation H implements the provi­

report their deposits and reservable lia­ sion of the Riegle–Neal Interstate Bank­
bilities quarterly or less frequently, ing and Branching Efficiency Act of
while larger institutions must report 1994 that prohibits a bank from estab­
weekly.1 To reflect the growth of total lishing or acquiring a branch outside
deposits at all depository institutions its home state primarily for the purpose
from June 30, 2001, to June 30, 2002, of deposit production. That act also
the Board increased the nonexempt provides guidelines for determining
deposit cutoff level from $106.9 million whether the bank is reasonably helping
to $112.3 million, to be implemented in to meet the credit needs of the commu­
September 2003. nities served by the branch. Congress
Exempt institutions (those with total enacted the prohibition to ensure that
reservable liabilities equal to or less the authorization for interstate branches
than the reservable liabilities exemption would not result in banks’ taking depos­
level of $6 million in 2003) with at least its from a community without reason-
$6 million in total deposits may report ably helping to meet the credit needs of
annually, and exempt institutions with that community.
less than $6 million in total deposits are The Gramm–Leach–Bliley Act of
not required to file deposit reports. 1999 expands the prohibition against
deposit-production offices to include
any branch of a bank controlled by an
Regulation H out-of-state bank holding company. The
Membership of State Banking Board, the Federal Deposit Insurance
Institutions in the Federal Reserve Corporation, and the Office of the
System Comptroller of the Currency jointly
May 30, 2002—Amendments amended their regulations on June 5,
2002, to conform to the expanded
The Board amended Regulation H to prohibition.
include any branch of a bank controlled
by an out-of-state bank holding com­ Regulation H
pany under the prohibition against using Membership of State Banking
interstate branches primarily for deposit Institutions in the Federal Reserve
production, effective October 1, 2002. System
Votes for this action: Messrs. Greenspan, Regulation Y
Ferguson, and Gramlich, Ms. Bies, and
Mr. Olson. Bank Holding Companies and
Change in Bank Control
January 28, 2002—Amendments
1. All U.S. branches and agencies of foreign
banks and Edge and agreement corporations are The Board reduced, for state member
required to submit the Report of Transaction banks and bank holding companies, the
Accounts, Other Deposits, and Vault Cash risk weighting in capital standards for
(FR 2900) weekly regardless of size. In addition, certain claims on securities firms, effec­
depository institutions that obtain funds from non-
U.S. sources or that have foreign branches or inter- tive July 1, 2002.
national banking facilities continue to be required
to file the Report of Certain Eurocurrency Trans- Votes for this action: Messrs. Greenspan,
actions (FR 2950/FR 2951) at the same frequency Ferguson, Meyer, and Gramlich, Ms. Bies,
as they file the FR 2900 report. and Mr. Olson.
Record of Policy Actions of the Board of Governors 155

The Board, the Federal Deposit Insur­ required for particular international
ance Corporation, the Office of the assets. The amendments conform these
Comptroller of the Currency, and the provisions to those of the other fed­
Office of Thrift Supervision jointly eral banking agencies by eliminating
amended their risk-based capital stan­ requirements for a particular accounting
dards for supervised banking and sav­ method for fees on international loans
ings institutions on March 27, 2002, to and requiring instead that institutions
reduce the risk weight applied to certain follow generally accepted accounting
claims on, and claims guaranteed by, principles (GAAP) for such fees.
qualifying securities firms incorporated
in the United States and in other coun­
tries that are members of the Organ­
Regulation W
isation for Economic Co-operation
Transactions between Member
and Development (OECD). The Federal
Banks and Their Affiliates
Deposit Insurance Corporation and the October 31, 2002—New
Office of Thrift Supervision also con- Regulation
formed their capital standards to those
of the other agencies by permitting a The Board approved new Regulation W,
zero percent risk weight for certain which comprehensively implements sec­
claims on qualifying securities firms that tions 23A and 23B of the Federal
are collateralized by (1) cash on deposit Reserve Act, effective April 1, 2003.
in the lending institution or (2) securi­
ties issued or guaranteed by the U.S. Votes for this action: Messrs. Greenspan,
Ferguson, and Gramlich, Ms. Bies, and
government or its agencies or OECD Messrs. Olson, Bernanke, and Kohn.
central governments.
Sections 23A and 23B of the Federal
Reserve Act restrict loans by a member
Regulation K bank to its affiliates, asset purchases
International Banking Operations by a member bank from its affiliates,
and certain other transactions between a
December 30, 2002—Amendments member bank and its affiliates. The pur­
The Board amended provisions of Regu­ pose of the statute is to limit a member
lation K on international lending super- bank’s risk of loss in transactions with
vision to conform to technical changes affiliates and to limit a member bank’s
adopted by the other federal banking ability to transfer to its affiliates the
agencies, effective February 10, 2003. benefits arising from its access to the
federal safety net. Regulation W unifies
Votes for this action: Messrs. Greenspan, in one document previous interpre­
Ferguson, and Gramlich, Ms. Bies, and tations of sections 23A and 23B as
Messrs. Olson, Bernanke, and Kohn. well as new interpretations of the
statute, including interpretations that
Subpart D of Regulation K, which address derivative transactions, intra­
implements the International Lending day extensions of credit, and financial
Supervision Act of 1983, governs inter- subsidiaries.
national lending by state member banks, The Board also approved a preamble
bank holding companies, and Edge and to Regulation W that provides a detailed
agreement corporations engaged in explanation of the rule. In addition, the
banking and specifies when reserves are Board published for comment a pro-
156 89th Annual Report, 2002

posed rule that would limit the current ated third party if such purchases are
exemption from section 23A for certain made under the same conditions and
loan purchases from an affiliate. restrictions applicable to national banks.
A state member bank must receive the
prior approval of the Board’s Director
of the Division of Banking Supervision
Policy Statements and and Regulation to engage in equity
Other Actions hedging activities and must conduct
its equity derivative and equity hedging
February 11, 2002—Statement on activities in accordance with applicable
Equity Hedging Activities by State law.
Member Banks
The Board issued a statement indicating April 5, 2002—System Regulations
that it would not apply section 9 of the for Federal Reserve Law
Federal Reserve Act to prohibit a state Enforcement Officers
member bank from acquiring equity
securities to hedge its bank-permissible The Board approved regulations gov­
equity derivative transactions if such erning the exercise of law enforcement
transactions are conducted in accor­ authority by designated Federal Reserve
dance with the same restrictions applica­ System personnel, effective June 7,
ble to national banks, effective Febru­ 2002.
ary 21, 2002.
Votes for this action: Messrs. Greenspan,
Votes for this action: Messrs. Greenspan, Ferguson, and Gramlich, Ms. Bies, and
Ferguson, and Gramlich, Ms. Bies, and Mr. Olson.
Mr. Olson.
The USA PATRIOT Act of 2001
Section 9 of the Federal Reserve Act amended section 11 of the Federal
provides that state member banks are Reserve Act to provide federal law
subject to the same limitations and con­ enforcement authority for protection
ditions on the purchase, sale, underwrit­ personnel at the Federal Reserve Banks,
ing, and holding of investment securities and for special agents in the Protective
and stock that apply to national banks. Services Unit and security officers at the
The Office of the Comptroller of the Board. The implementing regulations,
Currency has determined that national which were subsequently approved by
banks may acquire equity securities to the Attorney General of the United
hedge their exposure to customer-driven States in accordance with the act, autho­
equity derivative transactions lawfully rize designated on-duty personnel to
entered into by the bank. Such transac­ carry firearms when protecting System
tions may include equity swaps, equity- personnel, property, or operations; make
index swaps, equity-index deposits, and arrests for violations of federal law; and
equity-linked loans. Accordingly, the obtain law enforcement information.
statement provides that the Board would The regulations also contain specific
not apply section 9 of the act to prohibit training requirements and rules govern­
a state member bank from purchasing ing the use of law enforcement author­
equity securities to hedge risks aris­ ity. The Board delegated authority to
ing from equity derivative transactions each Reserve Bank to designate law
entered into by the bank with an unaffili­ enforcement personnel.
Record of Policy Actions of the Board of Governors 157

April 18, 2002—Joint Agency (2) reject all payments with settlement-
Statement on Parallel-Owned day finality that would cause an insti­
Banking Organizations tution to exceed its daylight overdraft
capacity level.
The Board approved an interagency
statement on the potential risks posed by Votes for this action: Messrs. Greenspan,
parallel-owned banking organizations Ferguson, and Gramlich, Ms. Bies, and
and the supervisory approach to address Messrs. Olson, Bernanke, and Kohn.
those risks, effective April 23, 2002.
These proposed changes were among
Votes for this action: Messrs. Greenspan, several modifications to its payments
Ferguson, and Gramlich, Ms. Bies, and system risk policy that the Board had
Mr. Olson. published for comment in June 2001
after a broad review of the policy. An
The Board, the Federal Deposit Insur­
institution’s net debit cap refers to the
ance Corporation, the Office of the
maximum dollar amount of uncollateral­
Comptroller of the Currency, and the
ized daylight overdrafts that it may incur
Office of Thrift Supervision jointly
in its Federal Reserve account. A day-
issued a statement on parallel-owned
light overdraft occurs when a depository
banking organizations on April 23,
institution’s Federal Reserve account
2002. A parallel-owned banking organi­
is in a negative position at any time
zation is created when a U.S. depository
during the business day.
institution and a foreign bank are both
Although the Board chose not to
controlled directly or indirectly by one
implement the two proposals in the fore-
person or a group of persons rather than
seeable future, it will continue to ana­
by a bank or thrift holding company
lyze the benefits and potential draw-
subject to supervision by a federal regu­
backs of a third proposed modification:
lator. Accordingly, each of the organi­
a two-tiered pricing system for day-
zation’s banks is supervised by only the
light overdrafts in which institutions
regulatory authority for the home coun­
that pledge collateral to the Federal
try of the bank. The interagency state­
Reserve Banks would pay a lower fee
ment contains guidance on identifying
on their collateralized daylight over-
parallel-owned banking organizations,
drafts than on their uncollateralized day-
reviews the risks associated with them,
light overdrafts.
and discusses actions that the agencies
may take to minimize those risks. It also
describes the agencies’ approach to Discount Rates in 2002
applications and notices filed by U.S.
depository institutions in parallel-owned During 2002, the Board of Governors
banking organizations. approved one change in the basic dis­
count rate charged by the Federal
Reserve Banks. On November 6, the
August 13, 2002—Policy Statement basic rate was reduced by 1⁄2 percentage
on Payments System Risk point to a level of 3⁄4 percent. The rates
The Board decided not to adopt two for seasonal and extended credit, which
proposed changes to its payments sys­ were recalculated biweekly in accor­
tem risk policy that would (1) lower dance with market-related formulas,
self-assessed net debit caps and elim­ exceeded the basic rate by different
inate two-week average caps and amounts during the year. On October 31,
158 89th Annual Report, 2002

the Board approved new discount recovery over the coming year. There
window programs, effective January 9, were no further decisions on the basic
2003. discount rate in 2002.

Basic Discount Rate Structure of Discount Rates

The Board’s decisions on the basic dis­ The basic discount rate was the rate
count rate were made against the back- normally charged on loans to depository
ground of the policy actions of the Fed­ institutions for short-term adjustment
eral Open Market Committee (FOMC) credit, and it continued to be set on
and related economic and financial the basis of general monetary policy
developments. These developments are considerations. The Federal Reserve
reviewed more fully in other parts of Banks provided two other types of dis­
this Report, including the minutes of the count window credit: (1) seasonal credit,
FOMC meetings held in 2002. whose purpose was to assist smaller
institutions in managing liquidity needs
that arose from regular seasonal swings
Reduction in the Basic Rate in
in loans and deposits, and (2) extended
November 2002
credit, which was available in appropri­
Before November 6, the Board re- ate circumstances to depository institu­
viewed, but took no action on, requests tions that experienced somewhat longer-
by a number of Federal Reserve Banks term liquidity needs. The rates on both
to raise or lower the basic discount rate. types of credit were calculated every
The Board’s decision on November 6 two weeks in accordance with formulas
was consistent with its practice in recent based on market interest rates. Under
years generally to adjust the basic rate those formulas, the rates charged for
when the FOMC makes changes to its seasonal credit in 2002 were somewhat
target for the federal funds rate. Under- higher than the basic discount rate, and
lying the decisions on both rates in 2002 the rate on extended credit was 50 basis
was the persistence of a high degree of points higher than that for seasonal
uncertainty about the outlook for contin­ credit. During 2002, the rate for sea­
ued economic recovery in the context sonal credit ranged from a high of
of an uneven pace of expansion and, 1.85 percent to a low of 1.30 percent,
particularly over the summer and fall, a and the rate for extended credit ranged
predominance of downside risks to the from a high of 2.35 percent to a low of
economy. By early November, generally 1.80 percent. At the end of 2002, the
disappointing information on the per­ structure of discount rates was as fol­
formance of the economy seemed to lows: a basic rate of 0.75 percent for
presage a longer-lasting spell of subpar short-term adjustment credit and rates of
economic growth than had been antici­ 1.30 percent for seasonal credit and
pated earlier. Although the stance of 1.80 percent for extended credit.
monetary policy was already accommo­
dative, the FOMC and the Board on
November 6 approved relatively sizable
Board Votes
reductions of 1⁄2 percentage point in the Under the Federal Reserve Act, the
target rate for the federal funds rate and boards of directors of the Federal
the basic discount rate to enhance the Reserve Banks are required to establish
prospects of a strengthening economic rates on loans to depository institutions
Record of Policy Actions of the Board of Governors 159

at least every fourteen days and must ment of the lending Federal Reserve
submit the rates to the Board of Gover­ Bank, are in generally sound financial
nors for review and determination. Dur­ condition. Primary credit will be
ing 2002, the Reserve Banks submitted, extended at a rate above the federal
on the same schedule, requests to renew funds rate to be established at least every
the formulas based on short-term market two weeks, subject to the Board’s
interest rates for calculating the rates review and determination. By applying
on seasonal and extended credit. Votes an above-market rate and restricting
on the reestablishment of the formulas eligibility to generally sound institu­
for these flexible rates are not shown in tions, the primary credit program is
this summary. All votes taken by the expected to substantially reduce the
Board of Governors during 2002 were need for the Federal Reserve to review
unanimous. the funding situations of borrowers and
monitor their use of borrowed funds.
Vote on the Basic Discount Rate Secondary credit will be available in
appropriate circumstances to depository
November 6, 2002. Effective this date, institutions that do not qualify for pri­
the Board approved actions taken by the mary credit. When the new programs
directors of the Federal Reserve Banks were approved, the Board expected that
of New York, Dallas, and San Francisco Reserve Banks would initially establish
to reduce the basic discount rate by a primary credit rate at a level 100 basis
1⁄2 percentage point to 3⁄4 percent. The
points above the federal funds target
same decrease was approved for the
rate and a secondary credit rate at a level
remaining Federal Reserve Banks, effec­
50 basis points above the primary rate.2
tive November 7, 2002. The seasonal credit program was not
Votes for this action: Messrs. Greenspan, affected by these changes. The rate on
Ferguson, and Gramlich, Ms. Bies, and seasonal credit will continue to be set by
Messrs. Olson, Bernanke, and Kohn. a formula based on market interest rates.

New Discount Window Programs Votes for this action: Messrs. Greenspan,
Ferguson, and Gramlich, Ms. Bies, and
On October 31, 2002, the Board Messrs. Olson, Bernanke, and Kohn.
amended its Regulation A to establish
two new forms of discount window
credit, primary and secondary credit, to 2. On January 7, 2003, the Board of Governors
replace adjustment and extended credit, approved requests by the twelve Reserve Banks to
effective January 9, 2003. Primary credit establish primary credit rates of 21⁄4 percent and
secondary credit rates of 23⁄4 percent, which were
will be made available for very short 100 basis points and 150 basis points respectively
terms as a backup source of liquidity to above the FOMC’s target rate for the federal funds
depository institutions that, in the judg­ rate.

Minutes of Federal Open Market

Committee Meetings

The policy actions of the Federal Open execute transactions for the System
Market Committee, contained in the Open Market Account. In the area of
minutes of its meetings, are presented in domestic open market operations, the
the Annual Report of the Board of Federal Reserve Bank of New York
Governors pursuant to the requirements operates under three sets of instructions
of section 10 of the Federal Reserve from the Federal Open Market Com­
Act. That section provides that the mittee: an Authorization for Domestic
Board shall keep a complete record of Open Market Operations, Guidelines for
the actions taken by the Board and by the Conduct of System Open Market
the Federal Open Market Committee on Operations in Federal Agency Issues,
all questions of policy relating to open and a Domestic Policy Directive. (A
market operations, that it shall record new Domestic Policy Directive is
therein the votes taken in connection adopted at each regularly scheduled
with the determination of open market meeting.) In the foreign currency area,
policies and the reasons underlying each the Committee operates under an
policy action, and that it shall include in Authorization for Foreign Currency
its annual report to the Congress a full Operations, a Foreign Currency Direc­
account of such actions. tive, and Procedural Instructions with
The minutes of the meetings contain Respect to Foreign Currency Opera­
the votes on the policy decisions made tions. These policy instruments are
at those meetings as well as a résumé of shown below in the form in which they
the information and discussions that led were in effect at the beginning of 2002.
to the decisions. The summary descrip­ Changes in the instruments during the
tions of economic and financial condi­ year are reported in the minutes for the
tions are based on the information that individual meetings.
was available to the Committee at the
time of the meetings rather than on data Authorization for Domestic
as they may have been revised later. Open Market Operations
Members of the Committee voting for
a particular action may differ among In Effect January 1, 2002
themselves as to the reasons for their
votes; in such cases, the range of their 1. The Federal Open Market Committee
authorizes and directs the Federal Reserve
views is noted in the minutes. When Bank of New York, to the extent neces­
members dissent from a decision, they sary to carry out the most recent domestic
are identified in the minutes and a sum­ policy directive adopted at a meeting of the
mary of the reasons for their dissent is Committee:
Policy directives of the Federal Open (a) To buy or sell U.S. Government
securities, including securities of the Federal
Market Committee are issued to the Financing Bank, and securities that are direct
Federal Reserve Bank of New York as obligations of, or fully guaranteed as to
the Bank selected by the Committee to principal and interest by, any agency of the
162 89th Annual Report, 2002

United States in the open market, from or to 2. In order to ensure the effective conduct
securities dealers and foreign and inter- of open market operations, the Federal Open
national accounts maintained at the Federal Market Committee authorizes the Federal
Reserve Bank of New York, on a cash, regu� Reserve Bank of New York to lend on an
lar, or deferred delivery basis, for the Sys� overnight basis U.S. Government securities
tem Open Market Account at market prices, held in the System Open Market Account to
and, for such Account, to exchange maturing dealers at rates that shall be determined by
U.S. Government and Federal agency securi� competitive bidding but that in no event shall
ties with the Treasury or the individual be less than 1.0 percent per annum of the
agencies or to allow them to mature without market value of the securities lent. The Fed�
replacement; provided that the aggregate eral Reserve Bank of New York shall apply
amount of U.S. Government and Federal reasonable limitations on the total amount of
agency securities held in such Account a specific issue that may be auctioned, and
(including forward commitments) at the on the amount of securities that each dealer
close of business on the day of a meeting of may borrow. The Federal Reserve Bank
the Committee at which action is taken with of New York may reject bids which could
respect to a domestic policy directive shall facilitate a dealer’s ability to control a single
not be increased or decreased by more than issue as determined solely by the Federal
$12.0 billion during the period commencing Reserve Bank of New York.
with the opening of business on the day fol�
lowing such meeting and ending with the 3. In order to ensure the effective conduct of
close of business on the day of the next such open market operations, while assisting in
meeting; the provision of short-term investments for
(b) To buy U.S. Government securities foreign and international accounts main�
and obligations that are direct obligations of, tained at the Federal Reserve Bank of New
or fully guaranteed as to principal and inter� York, the Federal Open Market Committee
est by, any agency of the United States, from authorizes and directs the Federal Reserve
dealers for the account of the Federal Bank of New York (a) for System Open
Reserve Bank of New York under agree� Market Account, to sell U.S. Government
ments for repurchase of such securities or securities to such foreign and international
obligations in 65 business days or less, at accounts on the bases set forth in para-
rates that, unless otherwise expressly autho� graph 1(a) under agreements providing for
rized by the Committee, shall be determined the resale by such accounts of those securi�
by competitive bidding, after applying rea� ties within 65 business days or less on terms
sonable limitations on the volume of agree� comparable to those available on such trans-
ments with individual dealers; provided that actions in the market; and (b) for New York
in the event Government securities or agency Bank account, when appropriate, to under-
issues covered by any such agreement are take with dealers, subject to the conditions
not repurchased by the dealer pursuant to the imposed on purchases and sales of securities
agreement or a renewal thereof, they shall be in paragraph 1(b), repurchase agreements in
sold in the market or transferred to the Sys� U.S. Government and agency securities, and
tem Open Market Account; to arrange corresponding sale and repurchase
agreements between its own account and
(c) To sell U.S. Government securities foreign and international accounts main�
and securities that are direct obligations of, tained at the Bank. Transactions undertaken
or fully guaranteed as to principal and inter� with such accounts under the provisions of
est by, any agency of the United States to this paragraph may provide for a service fee
dealers for System Open Market Account when appropriate.
under agreements for the resale by dealers of
such securities or obligations in 65 business 4. In the execution of the Committee’s deci�
days or less, at rates that, unless otherwise sion regarding policy during any intermeet�
expressly authorized by the Committee, shall ing period, the Committee authorizes and
be determined by competitive bidding, after directs the Federal Reserve Bank of
applying reasonable limitations on the vol� New York, upon the instruction of the Chair-
ume of agreements with individual dealers. man of the Committee, to adjust somewhat
Minutes of FOMC Meetings 163

in exceptional circumstances the degree of Against the background of its long-run

pressure on reserve positions and hence the goals of price stability and sustainable eco�
intended federal funds rate. Any such adjust� nomic growth and of the information cur�
ment shall be made in the context of the rently available, the Committee believes that
Committee’s discussion and decision at its the risks continue to be weighted mainly
most recent meeting and the Committee’s toward conditions that may generate eco�
long-run objectives for price stability and nomic weakness in the foreseeable future.
sustainable economic growth, and shall be
based on economic, financial, and mone�
tary developments during the intermeeting
period. Consistent with Committee prac� Authorization for Foreign
tice, the Chairman, if feasible, will consult Currency Operations
with the Committee before making any
In Effect January 1, 2002
Guidelines for the Conduct of 1. The Federal Open Market Committee
System Open Market Operations authorizes and directs the Federal Reserve
Bank of New York, for System Open Market
in Federal Agency Issues Account, to the extent necessary to carry out
the Committee’s foreign currency directive
In Effect January 1, 2002 and express authorizations by the Commit-
tee pursuant thereto, and in conformity with
1. System open market operations in Fed� such procedural instructions as the Commit-
eral agency issues are an integral part of total tee may issue from time to time:
System open market operations designed to
influence bank reserves, money market con� A. To purchase and sell the following
ditions, and monetary aggregates. foreign currencies in the form of cable trans�
fers through spot or forward transactions on
2. System open market operations in Fed� the open market at home and abroad, includ�
eral agency issues are not designed to sup- ing transactions with the U.S. Treasury, with
port individual sectors of the market or the U.S. Exchange Stabilization Fund estab�
to channel funds into issues of particular lished by Section 10 of the Gold Reserve
agencies. Act of 1934, with foreign monetary authori�
ties, with the Bank for International Settle�
ments, and with other international financial
Domestic Policy Directive institutions:
Canadian dollars Mexican pesos
In Effect January 1, 20021 Danish kroner Norwegian kroner
Euro Swedish kronor
The Federal Open Market Committee seeks Pounds sterling Swiss francs
monetary and financial conditions that will Japanese yen
foster price stability and promote sustainable
growth in output. To further its long-run B. To hold balances of, and to have
objectives, the Committee in the immediate outstanding forward contracts to receive or
future seeks conditions in reserve markets to deliver, the foreign currencies listed in
consistent with reducing the federal funds paragraph A above.
rate to an average of around 13⁄4 percent. C. To draw foreign currencies and to
permit foreign banks to draw dollars under
The Committee also approved the the reciprocal currency arrangements listed
sentence below for inclusion in the press in paragraph 2 below, provided that draw�
statement to be released shortly after the ings by either party to any such arrangement
shall be fully liquidated within 12 months
December 11, 2001, meeting: after any amount outstanding at that time
was first drawn, unless the Committee,
1. Adopted by the Committee at its meeting on because of exceptional circumstances, spe�
December 11, 2001. cifically authorizes a delay.
164 89th Annual Report, 2002

D. To maintain an overall open posi- ing operating arrangements with foreign

tion in all foreign currencies not exceeding central banks on System holdings of foreign
$25.0 billion. For this purpose, the overall currencies, the Federal Reserve Bank of
open position in all foreign currencies is New York shall not commit itself to maintain
defined as the sum (disregarding signs) of any specific balance, unless authorized by
net positions in individual currencies. The the Federal Open Market Committee. Any
net position in a single foreign currency is agreements or understandings concerning the
defined as holdings of balances in that cur- administration of the accounts maintained by
rency, plus outstanding contracts for future the Federal Reserve Bank of New York with
receipt, minus outstanding contracts for the foreign banks designated by the Board
future delivery of that currency, i.e., as the of Governors under Section 214.5 of Regu-
sum of these elements with due regard to lation N shall be referred for review and
sign. approval to the Committee.
2. The Federal Open Market Commit- 5. Foreign currency holdings shall be in-
tee directs the Federal Reserve Bank of vested to ensure that adequate liquidity is
New York to maintain reciprocal currency maintained to meet anticipated needs and so
arrangements (‘‘swap’’ arrangements) for the that each currency portfolio shall generally
System Open Market Account for periods up have an average duration of no more than
to a maximum of 12 months with the follow- 18 months (calculated as Macaulay dura-
ing foreign banks, which are among those tion). When appropriate in connection with
designated by the Board of Governors of the arrangements to provide investment facilities
Federal Reserve System under Section 214.5 for foreign currency holdings, U.S. Govern-
of Regulation N, Relations with Foreign ment securities may be purchased from for-
Banks and Bankers, and with the approval of eign central banks under agreements for
the Committee to renew such arrangements repurchase of such securities within 30 cal-
on maturity: endar days.
6. All operations undertaken pursuant to
of arrangement the preceding paragraphs shall be reported
Foreign bank (millions of promptly to the Foreign Currency Sub-
dollars equivalent) committee and the Committee. The Foreign
Currency Subcommittee consists of the
Bank of Canada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 Chairman and Vice Chairman of the Com-
Bank of Mexico . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
mittee, the Vice Chairman of the Board of
Governors, and such other member of the
Any changes in the terms of existing swap Board as the Chairman may designate (or in
arrangements, and the proposed terms of any the absence of members of the Board serving
new arrangements that may be authorized, on the Subcommittee, other Board members
shall be referred for review and approval to designated by the Chairman as alternates,
the Committee. and in the absence of the Vice Chairman of
the Committee, his alternate). Meetings of
3. All transactions in foreign currencies the Subcommittee shall be called at the
undertaken under paragraph 1.A. above request of any member, or at the request of
shall, unless otherwise expressly authorized the Manager, System Open Market Account
by the Committee, be at prevailing market (‘‘Manager’’), for the purposes of reviewing
rates. For the purpose of providing an invest- recent or contemplated operations and of
ment return on System holdings of foreign consulting with the Manager on other mat-
currencies, or for the purpose of adjusting ters relating to his responsibilities. At the
interest rates paid or received in connection request of any member of the Subcommittee,
with swap drawings, transactions with for- questions arising from such reviews and con-
eign central banks may be undertaken at sultations shall be referred for determination
nonmarket exchange rates. to the Federal Open Market Committee.
7. The Chairman is authorized:
4. It shall be the normal practice to arrange
with foreign central banks for the coordina- A. With the approval of the Commit-
tion of foreign currency transactions. In mak- tee, to enter into any needed agreement or
Minutes of FOMC Meetings 165

understanding with the Secretary of the Trea- currencies, and to facilitate operations of the
sury about the division of responsibility for Exchange Stabilization Fund.
foreign currency operations between the Sys-
tem and the Treasury; C. For such other purposes as may be
expressly authorized by the Committee.
B. To keep the Secretary of the Trea-
sury fully advised concerning System for- 4. System foreign currency operations shall
eign currency operations, and to consult with be conducted:
the Secretary on policy matters relating to A. In close and continuous consulta-
foreign currency operations; tion and cooperation with the United States
C. From time to time, to transmit Treasury;
appropriate reports and information to the B. In cooperation, as appropriate, with
National Advisory Council on International foreign monetary authorities; and
Monetary and Financial Policies.
C. In a manner consistent with the obli-
8. Staff officers of the Committee are autho- gations of the United States in the Interna-
rized to transmit pertinent information on tional Monetary Fund regarding exchange
System foreign currency operations to appro- arrangements under the IMF Article IV.
priate officials of the Treasury Department.
9. All Federal Reserve Banks shall partici- Procedural Instructions with
pate in the foreign currency operations for
System Account in accordance with para- Respect to Foreign Currency
graph 3 G(1) of the Board of Governors’ Operations
Statement of Procedure with Respect to For-
eign Relationships of Federal Reserve Banks In Effect January 1, 2002
dated January 1, 1944.
In conducting operations pursuant to the
authorization and direction of the Federal
Foreign Currency Directive Open Market Committee as set forth in the
Authorization for Foreign Currency Opera-
In Effect January 1, 2002 tions and the Foreign Currency Directive,
the Federal Reserve Bank of New York,
1. System operations in foreign currencies through the Manager, System Open Market
shall generally be directed at countering dis- Account (‘‘Manager’’), shall be guided by
orderly market conditions, provided that the following procedural understandings
market exchange rates for the U.S. dollar with respect to consultations and clearances
reflect actions and behavior consistent with with the Committee, the Foreign Currency
the IMF Article IV, Section 1. Subcommittee, and the Chairman of the
2. To achieve this end the System shall: Committee. All operations undertaken pur-
suant to such clearances shall be reported
A. Undertake spot and forward pur- promptly to the Committee.
chases and sales of foreign exchange.
1. The Manager shall clear with the Sub-
B. Maintain reciprocal currency committee (or with the Chairman, if the
(‘‘swap’’) arrangements with selected for- Chairman believes that consultation with the
eign central banks. Subcommittee is not feasible in the time
C. Cooperate in other respects with available):
central banks of other countries and with
international monetary institutions. A. Any operation that would result in a
change in the System’s overall open position
3. Transactions may also be undertaken: in foreign currencies exceeding $300 million
A. To adjust System balances in light on any day or $600 million since the most
of probable future needs for currencies. recent regular meeting of the Committee.

B. To provide means for meeting Sys- B. Any operation that would result in a
tem and Treasury commitments in particular change on any day in the System’s net posi-
166 89th Annual Report, 2002

tion in a single foreign currency exceeding Present:

$150 million, or $300 million when the Mr. Greenspan, Chairman€
operation is associated with repayment of Mr. McDonough, Vice Chairman€
swap drawings. Ms. Bies€
Mr. Ferguson€
C. Any operation that might generate a Mr. Gramlich€
substantial volume of trading in a particular Mr. Jordan€
currency by the System, even though the Mr. McTeer€
change in the System’s net position in that Mr. Olson€
currency might be less than the limits speci- Mr. Santomero€
fied in 1.B. Mr. Stern€

D. Any swap drawing proposed by a Messrs. Broaddus, Guynn, Moskow,

foreign bank not exceeding the larger of and Parry, Alternate Members
(i) $200 million or (ii) 15 percent of the size of the Federal Open Market
of the swap arrangement. Committee

2. The Manager shall clear with the Com- Mr. Hoenig, Ms. Minehan, and
mittee (or with the Subcommittee, if the Mr. Poole, Presidents of the
Subcommittee believes that consultation Federal Reserve Banks of
with the full Committee is not feasible in the Kansas City, Boston, and St. Louis
time available, or with the Chairman, if the respectively
Chairman believes that consultation with
the Subcommittee is not feasible in the time Mr. Kohn, Secretary and Economist€
available): Mr. Bernard, Deputy Secretary€
Mr. Gillum, Assistant Secretary€
A. Any operation that would result in a Ms. Smith, Assistant Secretary€
change in the System’s overall open position Mr. Mattingly, General Counsel€
in foreign currencies exceeding $1.5 billion Mr. Baxter,2 Deputy General Counsel€
since the most recent regular meeting of the Ms. Johnson, Economist€
Committee. Mr. Reinhart, Economist€
Mr. Stockton, Economist€
B. Any swap drawing proposed by Mr. Connors, Ms. Cumming,
a foreign bank exceeding the larger of Messrs. Howard, Lindsey,
(i) $200 million or (ii) 15 percent of the Ms. Mester, Messrs. Oliner,
size of the swap arrangement. Rolnick, Rosenblum, Sniderman,
and Wilcox, Associate Economists
3. The Manager shall also consult with the
Subcommittee or the Chairman about pro- Mr. Kos, Manager, System Open
posed swap drawings by the System and Market Account
about any operations that are not of a routine
character. Mr. Winn, Assistant to the Board,
Office of Board Members,
Board of Governors
Meeting Held on Mr. Skidmore, Special Assistant to the
January 29–30, 2002 Board, Office of Board Members,
Board of Governors
A meeting of the Federal Open Market
Committee was held in the offices of the Messrs. Ettin and Madigan, Deputy
Board of Governors of the Federal Directors, Divisions of Research
and Statistics and Monetary
Reserve System in Washington, D.C., Affairs respectively, Board of
on Tuesday, January 29, 2002, at Governors
2:30 p.m. and continued on Wednesday,
January 30, 2002, at 9:00 a.m. 2. Attended Tuesday session only.
Minutes of FOMC Meetings, January 167

Mr. Simpson, Senior Adviser, Division Messrs. Beebe, Eisenbeis, Fuhrer,

of Research and Statistics, Goodfriend, Hakkio, Hunter,
Board of Governors Ms. Krieger, and Mr. Rasche,
Senior Vice Presidents, Federal
Messrs. Slifman and Struckmeyer, Reserve Banks of San Francisco,
Associate Directors, Division of Atlanta, Boston, Richmond,
Research and Statistics, Board of Kansas City, Chicago, New York,
Governors and St. Louis respectively

Messrs. Kamin 3 and Whitesell, In the agenda for this meeting, it was
Deputy Associate Directors, reported that advices of the election of
Divisions of International Finance the following members and alternate
and Monetary Affairs respectively,
Board of Governors members of the Federal Open Market
Committee for the period commencing
Messrs. Gagnon 3 and Reifschneider,3 January 1, 2002, and ending Decem-
Assistant Directors, Divisions of ber 31, 2002, had been received and that
International Finance and these individuals had executed their
Research and Statistics
respectively, Board of Governors oaths of office.
The elected members and alternate
Mr. Small,3 Section Chief, Division of members were as follows:
Monetary Affairs, Board of
Governors William J. McDonough, President of the
Federal Reserve Bank of New York,
Mr. Morton, Senior Economist,
with Jamie B. Stewart, Jr., First Vice
Division of International Finance, President of the Federal Reserve Bank
Board of Governors of New York, as alternate.
Messrs. Lebow 4 and Williams,3 Senior Anthony M. Santomero, President of the
Economists, Division of Research Federal Reserve Bank of Philadelphia,
and Statistics, Board of Governors with J. Alfred Broaddus, Jr., President
of the Federal Reserve Bank of Rich-
Messrs. Ahearn 3 and Wright,3 mond, as alternate.
Economists, Division of
International Finance, Board of Jerry L. Jordan, President of the Federal
Governors Reserve Bank of Cleveland, with
Michael H. Moskow, President of the
Mr. Zakrajšek,4 Economist, Division Federal Reserve Bank of Chicago, as
of Monetary Affairs, Board of alternate.
Robert D. McTeer, Jr., President of the Fed-
Ms. Low, Open Market Secretariat eral Reserve Bank of Dallas, with Jack
Assistant, Office of Board Guynn, President of the Federal
Members, Board of Governors Reserve Bank of Atlanta, as alternate.
Mr. Lyon, First Vice President, Federal Gary H. Stern, President of the Federal
Reserve Bank of Minneapolis Reserve Bank of Minneapolis, with
Robert T. Parry, President of the Fed-
eral Reserve Bank of San Francisco, as
3. Attended portion of meeting relating to the alternate.
discussion of monetary policy near the zero bound
on nominal interest rates.
4. Attended portion of meeting relating to the
By unanimous vote, the following
above discussion and to the Committee’s review officers of the Federal Open Market
of the economic outlook. Committee were elected to serve until
168 89th Annual Report, 2002

the election of their successors at the as Manager was satisfactory to the board
first regularly scheduled meeting of the of directors of the Federal Reserve Bank of
Committee after December 31, 2002, New York.
with the understanding that in the event
By unanimous vote, the Authoriza-
of the discontinuance of their official
tion for Domestic Open Market Opera-
connection with the Board of Governors
tions was reaffirmed in the form shown
or with a Federal Reserve Bank, they
would cease to have any official con-
nection with the Federal Open Market
Committee: Authorization for Domestic
Open Market Operations
Alan Greenspan Chairman (Reaffirmed January 29, 2002)
William J. McDonough Vice Chairman
Donald L. Kohn Secretary and 1. The Federal Open Market Committee
Economist authorizes and directs the Federal Reserve
Normand R.V. Bernard Deputy Secretary Bank of New York, to the extent neces-
Gary P. Gillum Assistant sary to carry out the most recent domestic
Secretary policy directive adopted at a meeting of the
Michelle A. Smith Assistant Committee:
Secretary (a) To buy or sell U.S. Government
J. Virgil Mattingly, Jr. General Counsel securities, including securities of the Federal
Thomas C. Baxter, Jr. Deputy General Financing Bank, and securities that are direct
Counsel obligations of, or fully guaranteed as to prin-
Karen H. Johnson Economist cipal and interest by, any agency of the
Vincent R. Reinhart Economist United States in the open market, from or to
David J. Stockton Economist securities dealers and foreign and interna-
tional accounts maintained at the Federal
Thomas A. Connors, Christine Cumming, Reserve Bank of New York, on a cash, regu-
David H. Howard, David E. Lindsey, lar, or deferred delivery basis, for the System
Loretta J. Mester, Stephen D. Oliner, Open Market Account at market prices, and,
Arthur J. Rolnick, Harvey Rosenblum, for such Account, to exchange maturing U.S.
Mark S. Sniderman, and David W. Government and Federal agency securities
Wilcox, Associate Economists with the Treasury or the individual agencies
or to allow them to mature without replace-
ment; provided that the aggregate amount of
By unanimous vote, the Federal U.S. Government and Federal agency securi-
Reserve Bank of New York was selected ties held in such Account (including forward
to execute transactions for the System commitments) at the close of business on the
day of a meeting of the Committee at which
Open Market Account until the adjourn- action is taken with respect to a domestic
ment of the first regularly scheduled policy directive shall not be increased or
meeting of the Committee after Decem- decreased by more than $12.0 billion during
ber 31, 2002. the period commencing with the opening of
By unanimous vote, Dino Kos was business on the day following such meeting
and ending with the close of business on the
selected to serve at the pleasure of the day of the next such meeting.
Committee as Manager, System Open (b) To buy U.S. Government securities
Market Account, on the understanding and obligations that are direct obligations of,
that his selection was subject to being or fully guaranteed as to principal and inter-
satisfactory to the Federal Reserve Bank est by, any agency of the United States, from
of New York. dealers for the account of the Federal
Reserve Bank of New York under agree-
ments for repurchase of such securities or
Secretary’s note: Advice subsequently obligations in 65 business days or less, at
was received that the selection of Mr. Kos rates that, unless otherwise expressly autho-
Minutes of FOMC Meetings, January 169

rized by the Committee, shall be determined Bank account, when appropriate, to under-
by competitive bidding, after applying rea- take with dealers, subject to the conditions
sonable limitations on the volume of agree- imposed on purchases and sales of securities
ments with individual dealers; provided that in paragraph 1(b), repurchase agreements in
in the event Government securities or agency U.S. Government and agency securities, and
issues covered by any such agreement are to arrange corresponding sale and repurchase
not repurchased by the dealer pursuant to the agreements between its own account and
agreement or a renewal thereof, they shall be foreign and international accounts main-
sold in the market or transferred to the Sys- tained at the Bank. Transactions undertaken
tem Open Market Account. with such accounts under the provisions of
(c) To sell U.S. Government securities this paragraph may provide for a service fee
and obligations that are direct obligations of, when appropriate.
or fully guaranteed as to principal and inter- 4. In the execution of the Committee’s
est by, any agency of the United States to decision regarding policy during any inter-
dealers for System Open Market Account meeting period, the Committee authorizes
under agreements for the resale by dealers of and directs the Federal Reserve Bank of New
such securities or obligations in 65 business York, upon the instruction of the Chairman
days or less, at rates that, unless otherwise of the Committee, to adjust somewhat in
expressly authorized by the Committee, shall exceptional circumstances the degree of
be determined by competitive bidding, after pressure on reserve positions and hence the
applying reasonable limitations on the vol- intended federal funds rate. Any such adjust-
ume of agreements with individual dealers. ment shall be made in the context of the
2. In order to ensure the effective conduct Committee’s discussion and decision at its
of open market operations, the Federal Open most recent meeting and the Committee’s
Market Committee authorizes the Federal long-run objectives for price stability and
Reserve Bank of New York to lend on an sustainable economic growth, and shall be
overnight basis U.S. Government securities based on economic, financial, and mone-
held in the System Open Market Account to tary developments during the intermeeting
dealers at rates that shall be determined by period. Consistent with Committee prac-
competitive bidding but that in no event shall tice, the Chairman, if feasible, will consult
be less than 1.0 percent per annum of the with the Committee before making any
market value of the securities lent. The Fed- adjustment.
eral Reserve Bank of New York shall apply
reasonable limitations on the total amount of By unanimous vote, the Committee
a specific issue that may be auctioned, and
on the amount of securities that each dealer approved until the Committee’s first
may borrow. The Federal Reserve Bank regularly scheduled meeting in 2003 a
of New York may reject bids which could further extension of the temporary sus-
facilitate a dealer’s ability to control a single pension of paragraphs 3 to 6 of the
issue as determined solely by the Federal Guidelines for the Conduct of System
Reserve Bank of New York.
3. In order to ensure the effective conduct Open Market Operations in Federal
of open market operations, while assisting in Agency Issues. For the year ahead, the
the provision of short-term investments for Guidelines therefore continued to read
foreign and international accounts main- as shown below:
tained at the Federal Reserve Bank of New
York, the Federal Open Market Committee
authorizes and directs the Federal Reserve
Bank of New York (a) for System Open Guidelines for the Conduct of
Market Account, to sell U.S. Government
securities to such foreign and international System Open Market Operations
accounts on the bases set forth in para- in Federal Agency Issues
graph 1(a) under agreements providing for (Reaffirmed January 29, 2002)
the resale by such accounts of those securi-
ties in 65 business days or less on terms 1. System open market operations in Fed-
comparable to those available on such trans- eral agency issues are an integral part of total
actions in the market; and (b) for New York System open market operations designed to
170 89th Annual Report, 2002

influence bank reserves, money market con- because of exceptional circumstances, spe-
ditions, and monetary aggregates. cifically authorizes a delay.
2. System open market operations in D. To maintain an overall open posi-
Federal agency issues are not designed to tion in all foreign currencies not exceeding
support individual sectors of the market or $25.0 billion. For this purpose, the overall
to channel funds into issues of particular open position in all foreign currencies is
agencies. defined as the sum (disregarding signs) of
net positions in individual currencies. The
By unanimous vote, the Authoriza- net position in a single foreign currency is
tion for Foreign Currency Operations defined as holdings of balances in that cur-
rency, plus outstanding contracts for future
was reaffirmed in the form shown receipt, minus outstanding contracts for
below. future delivery of that currency, i.e., as the
sum of these elements with due regard to
Authorization for Foreign 2. The Federal Open Market Commit-
Currency Operations tee directs the Federal Reserve Bank of
(Reaffirmed January 29, 2002) New York to maintain reciprocal currency
arrangements (‘‘swap’’ arrangements) for the
1. The Federal Open Market Committee System Open Market Account for periods up
authorizes and directs the Federal Reserve to a maximum of 12 months with the follow-
Bank of New York, for System Open Market ing foreign banks, which are among those
Account, to the extent necessary to carry out designated by the Board of Governors of the
the Committee’s foreign currency directive Federal Reserve System under Section 214.5
and express authorizations by the Committee of Regulation N, Relations with Foreign
pursuant thereto, and in conformity with Banks and Bankers, and with the approval of
such procedural instructions as the Commit- the Committee to renew such arrangements
tee may issue from time to time: on maturity:
A. To purchase and sell the following
foreign currencies in the form of cable trans-
fers through spot or forward transactions on Amount of
the open market at home and abroad, includ- Foreign bank arrangement
(millions of
ing transactions with the U.S. Treasury, with dollars equivalent)
the U.S. Exchange Stabilization Fund estab-
lished by Section 10 of the Gold Reserve Act Bank of Canada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
of 1934, with foreign monetary authori- Bank of Mexico . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
ties, with the Bank for International Settle-
ments, and with other international financial
institutions: Any changes in the terms of existing swap
arrangements, and the proposed terms of any
Canadian dollars Mexican pesos new arrangements that may be authorized,
Danish kroner Norwegian kroner shall be referred for review and approval to
Euro Swedish kronor
Pounds sterling Swiss francs the Committee.
Japanese yen 3. All transactions in foreign currencies
undertaken under paragraph 1.A. above
B. To hold balances of, and to have shall, unless otherwise expressly authorized
outstanding forward contracts to receive or by the Committee, be at prevailing market
to deliver, the foreign currencies listed in rates. For the purpose of providing an invest-
paragraph A above. ment return on System holdings of foreign
C. To draw foreign currencies and to currencies, or for the purpose of adjusting
permit foreign banks to draw dollars under interest rates paid or received in connection
the reciprocal currency arrangements listed with swap drawings, transactions with for-
in paragraph 2 below, provided that draw- eign central banks may be undertaken at
ings by either party to any such arrangement nonmarket exchange rates.
shall be fully liquidated within 12 months 4. It shall be the normal practice to
after any amount outstanding at that time arrange with foreign central banks for the
was first drawn, unless the Committee, coordination of foreign currency transac-
Minutes of FOMC Meetings, January 171

tions. In making operating arrangements foreign currency operations between the Sys-
with foreign central banks on System hold- tem and the Treasury;
ings of foreign currencies, the Federal B. To keep the Secretary of the Trea-
Reserve Bank of New York shall not commit sury fully advised concerning System for-
itself to maintain any specific balance unless eign currency operations and to consult with
authorized by the Federal Open Market the Secretary on policy matters relating to
Committee. Any agreements or understand- foreign currency operations;
ings concerning the administration of the C. From time to time, to transmit
accounts maintained by the Federal Reserve appropriate reports and information to the
Bank of New York with the foreign banks National Advisory Council on International
designated by the Board of Governors under Monetary and Financial Policies.
Section 214.5 of Regulation N shall be 8. Staff officers of the Committee are
referred for review and approval to the authorized to transmit pertinent informa-
Committee. tion on System foreign currency operations
5. Foreign currency holdings shall be to appropriate officials of the Treasury
invested to ensure that adequate liquidity is Department.
maintained to meet anticipated needs and so 9. All Federal Reserve Banks shall par-
that each currency portfolio shall generally ticipate in the foreign currency operations
have an average duration of no more than for System Account in accordance with para-
18 months (calculated as Macaulay dura- graph 3 G(1) of the Board of Governors’
tion). When appropriate in connection with Statement of Procedure with Respect to For-
arrangements to provide investment facilities eign Relationships of Federal Reserve Banks
for foreign currency holdings, U.S. Govern- dated January 1, 1944.
ment securities may be purchased from for-
eign central banks under agreements for By unanimous vote, the Foreign Cur-
repurchase of such securities within 30 cal- rency Directive was reaffirmed in the
endar days.
6. All operations undertaken pursuant to form shown below.
the preceding paragraphs shall be reported
promptly to the Foreign Currency Subcom-
mittee and the Committee. The Foreign Cur- Foreign Currency Directive
rency Subcommittee consists of the Chair- (Reaffirmed January 29, 2002)
man and Vice Chairman of the Committee,
the Vice Chairman of the Board of Gover- 1. System operations in foreign curren-
nors, and such other member of the Board cies shall generally be directed at countering
as the Chairman may designate (or in the disorderly market conditions, provided that
absence of members of the Board serving on market exchange rates for the U.S. dollar
the Subcommittee, other Board members reflect actions and behavior consistent with
designated by the Chairman as alternates, the IMF Article IV, Section 1.
and in the absence of the Vice Chairman 2. To achieve this end the System shall:
of the Committee, his alternate). Meetings A. Undertake spot and forward pur-
of the Subcommittee shall be called at the chases and sales of foreign exchange.
request of any member, or at the request of B. Maintain reciprocal currency
the Manager, System Open Market Account (‘‘swap’’) arrangements with selected for-
(‘‘Manager’’), for the purposes of reviewing eign central banks.
recent or contemplated operations and of C. Cooperate in other respects with
consulting with the Manager on other mat- central banks of other countries and with
ters relating to his responsibilities. At the international monetary institutions.
request of any member of the Subcommittee, 3. Transactions may also be undertaken:
questions arising from such reviews and con- A. To adjust System balances in light
sultations shall be referred for determination of probable future needs for currencies.
to the Federal Open Market Committee. B. To provide means for meeting Sys-
7. The Chairman is authorized: tem and Treasury commitments in particular
A. With the approval of the Commit- currencies and to facilitate operations of the
tee, to enter into any needed agreement or Exchange Stabilization Fund.
understanding with the Secretary of the Trea- C. For such other purposes as may be
sury about the division of responsibility for expressly authorized by the Committee.
172 89th Annual Report, 2002

4. System foreign currency operations C. Any operation that might generate a

shall be conducted: substantial volume of trading in a particular
A. In close and continuous consulta- currency by the System, even though the
tion and cooperation with the United States change in the System’s net position in that
Treasury; currency might be less than the limits speci-
B. In cooperation, as appropriate, with fied in 1.B.
foreign monetary authorities; and D. Any swap drawing proposed by a
C. In a manner consistent with the obli- foreign bank not exceeding the larger of
gations of the United States in the Interna- (i) $200 million or (ii) 15 percent of the size
tional Monetary Fund regarding exchange of the swap arrangement.
arrangements under the IMF Article IV. 2. The Manager shall clear with the Com-
mittee (or with the Subcommittee, if the
By unanimous vote, the Procedural Subcommittee believes that consultation
with the full Committee is not feasible in the
Instructions with Respect to Foreign time available, or with the Chairman, if the
Currency Operations, in the form shown Chairman believes that consultation with the
below, were reaffirmed. Subcommittee is not feasible in the time
A. Any operation that would result in a
change in the System’s overall open position
Procedural Instructions with€ in foreign currencies exceeding $1.5 billion
since the most recent regular meeting of the
Respect to Foreign€ Committee.
Currency Operations€ B. Any swap drawing proposed by a
(Reaffirmed January 29, 2002)€ foreign bank exceeding the larger of (i) $200
million or (ii) 15 percent of the size of the
In conducting operations pursuant to the swap arrangement.
authorization and direction of the Federal 3. The Manager shall also consult with
Open Market Committee as set forth in the the Subcommittee or the Chairman about
Authorization for Foreign Currency Opera- proposed swap drawings by the System and
tions and the Foreign Currency Directive, about any operations that are not of a routine
the Federal Reserve Bank of New York, character.
through the Manager, System Open Market
Account (‘‘Manager’’), shall be guided by On January 17, 2002, copies of the
the following procedural understandings
with respect to consultations and clearances continuing rules, regulations, and other
with the Committee, the Foreign Currency instructions of the Committee had been
Subcommittee, and the Chairman of the distributed with the advice that, in
Committee. All operations undertaken pur- accordance with procedures approved
suant to such clearances shall be reported by the Committee, they were being
promptly to the Committee.
1. The Manager shall clear with the Sub- called to the Committee’s attention
committee (or with the Chairman, if the before the January 29–30 organization
Chairman believes that consultation with the meeting to give members an opportunity
Subcommittee is not feasible in the time to raise any questions they might have
available): concerning them. Members were asked
A. Any operation that would result in a
change in the System’s overall open position
to indicate if they wished to have any
in foreign currencies exceeding $300 million of the instruments in question placed
on any day or $600 million since the most on the agenda for consideration at this
recent regular meeting of the Committee. meeting, and no requests for consider-
B. Any operation that would result in a ation were received. Accordingly, all of
change on any day in the System’s net posi- these instruments remained in effect in
tion in a single foreign currency exceed-
ing $150 million, or $300 million when the their existing form.
operation is associated with repayment of By unanimous vote, the minutes of
swap drawings. the meeting of the Federal Open Market
Minutes of FOMC Meetings, January 173

Committee held on December 11, 2001, The information reviewed at this

were approved. meeting indicated that economic activ-
The Manager of the System Open ity probably steadied in the fourth
Market Account reported on recent quarter after a sizable drop in the
developments in foreign exchange summer. Final demand appeared to
markets. There were no open mar- have increased appreciably, reflecting
ket operations in foreign currencies strength in consumer spending and a
for the System’s account in the period smaller decline in business purchases of
since the previous meeting of the durable equipment and software. How-
Committee. ever, businesses met a good part of the
The Manager also reported on devel- pickup in final demand through a large
opments in domestic financial markets runoff of inventories, and as a conse-
and on System open market transactions quence manufacturing activity and pay-
in government securities and federal roll employment continued to weaken
agency obligations during the period late in the year, though at a slower pace.
December 11, 2002, to January 29, Falling energy prices and widespread
2002. By unanimous vote, the Commit- discounting of goods held down con-
tee ratified these transactions. sumer price inflation.
At this meeting, members discussed The labor market deteriorated some-
staff background analyses of the impli- what further in December, and the
cations for the conduct of policy if the unemployment rate continued to climb,
economy were to deteriorate substan- to 5.8 percent. Private nonfarm payrolls
tially in a period when nominal short- fell considerably, with manufacturing
term interest rates were already at very again experiencing the largest job
low levels. Under such conditions, while losses, but the decrease was less than in
unconventional policy measures might previous months and aggregate hours
be available, their efficacy was uncer- worked by private production workers
tain, and it might be impossible to leveled out after six months of decline.
ease monetary policy sufficiently Recent data on initial claims for unem-
through the usual interest rate process to ployment insurance pointed to a further
achieve System objectives. The mem- moderation in employment losses in
bers agreed that the potential for such an January.
economic and policy scenario seemed Industrial production edged down in
highly remote, but it could not be dis- December after having fallen sharply
missed altogether. If in the future such in previous months. A number of
circumstances appeared to be in the pro- industries experienced further reduc-
cess of materializing, a case could be tions in output, with weakness most
made at that point for taking preemptive pronounced in consumer nondurables
easing actions to help guard against and business equipment. In contrast,
the potential development of economic motor vehicle assemblies rose to
weakness and price declines that could a still higher rate, presumably in
be associated with the so-called ‘‘zero response to the robust sales of the
bound’’ policy constraint. preceding two months, and the pro-
The Committee then turned to a dis- duction of semiconductors and com-
cussion of the economic and financial puters continued to strengthen. The
outlook and the implementation of rate of utilization of total manufactur-
monetary policy over the intermeeting ing capacity declined a little further
period ahead. in December, and the average rate
174 89th Annual Report, 2002

for the fourth quarter was at its lowest favorable weather over much of the
quarterly level since 1983. country. Spending on industrial struc-
Growth of consumer spending tures plunged, reflecting low capacity
strengthened considerably late in the utilization in manufacturing and rising
year after a slow advance in the third vacancy rates. Office building activity
quarter. A surge in purchases of motor also fell as increasing amounts of avail-
vehicles in response to attractive financ- able space and uncertainties regarding
ing incentives was a key factor in rents and property values weighed on
the pickup, but expenditures on goods the office market.
other than motor vehicles evidently also Nonfarm inventory liquidation appar-
accelerated slightly. By contrast, spend- ently was very rapid in the fourth quar-
ing on services expanded at a reduced ter, but inventory–sales ratios remained
pace, owing at least in part to relatively elevated in an environment of weak
low demand for residential heating sales. The book value of manufacturing
services. and trade inventories plunged in Octo-
Despite unseasonably warm and dry ber and November (latest data), but
autumn weather, residential construction progress in getting inventory overhangs
slowed somewhat in the fourth quarter. under control was limited. In manu-
For the year as a whole, though, home- facturing, the sector’s stock–shipments
building and home sales remained rela- ratio persisted at a high level despite
tively brisk as very low mortgage rates continuing sizable rundowns in inven-
tended to offset the effects of a weaken- tories since the spring. Wholesalers
ing job market and sluggish growth apparently stepped up their runoffs of
in personal income. An apparent conse- excess stocks in recent months, yet the
quence of reduced income growth and aggregate inventory–sales ratio for the
of lower equity prices was a change in sector had fallen only slightly since mid-
the mix of single-family homebuilding, year. Retailers made greater progress
with less emphasis on construction of in reducing inventories, and despite
high-priced homes. relatively sluggish sales the sector’s
Business expenditures on durable inventory–sales ratio dropped consider-
equipment and software contracted ably and appeared to be at a fairly com-
less rapidly in the fourth quarter, and fortable level.
monthly data indicated that such spend- The U.S. trade deficit in goods and
ing might be bottoming out late in the services narrowed slightly on balance
year despite further decreases in busi- in October and November (latest data)
ness output and continuing weakness in from the third-quarter level (adjusted to
corporate cash flows. Business pur- exclude large, one-time payments by
chases of motor vehicles accounted for foreign insurers related to the events
some of the improvement, and expendi- of September 11) as the value of imports
tures for computers and related equip- for the two-month period fell by more
ment apparently recorded a small gain. than the value of exports. The available
Elsewhere, though, acquisitions of com- information suggested further slight
munications equipment were still on a slippage of economic activity in the
downward trend, and business spending foreign industrial countries in the
in sectors other than high technology fourth quarter. The Japanese economy
and transportation remained weak. Non- remained very weak, economic activity
residential construction declined sharply in the euro area and Canada seemed
further in the fourth quarter despite to have contracted, and growth in the
Minutes of FOMC Meetings, January 175

United Kingdom apparently slowed. to about 13⁄4 percent. The members also
There were some indications, however, agreed that the balance of risks remained
of a brighter economic outlook ahead in weighted toward conditions that could
the euro area, Canada, and the United generate economic weakness in the
Kingdom that would result in part from foreseeable future. The members noted
monetary easing actions that their that there were preliminary signs of
respective central banks had taken. Eco- some abatement of the contractionary
nomic conditions in the major emerging- forces acting on the economy, but they
market countries were mixed. There believed that a subpar economic perfor-
were increasing signs of a recovery in mance was likely to persist for a time.
developing Asia, especially in some of They also recognized that the stance of
the countries that had been hurt by the policy was already quite accommoda-
global high-tech slump, but conditions tive and that much of the effect of recent
in Latin America remained relatively monetary easing actions was yet to be
weak, with the Argentine economy hav- felt. In the circumstances, they saw a
ing deteriorated further. modest further reduction of the federal
Consumer price inflation was quite funds rate as providing some added
low at year-end. With energy prices insurance against a more extended con-
declining, both the consumer price traction of the economy at little risk of a
index (CPI) and the personal consump- pickup in inflation.
tion expenditure (PCE) chain-type price Federal funds traded at rates close to
index edged down on balance in the Committee’s target level of 13⁄4 per-
November and December. Moreover, cent during the intermeeting period. The
excluding the effects of volatile oil Committee’s action had been widely
prices, core consumer price inflation anticipated, but the financial markets
was held down late in the year by wide- evidently interpreted the announcement
spread discounting of goods. Consumer as indicating that the FOMC’s assess-
price inflation as measured by the core ment of the economic outlook was
PCE index declined somewhat on a weaker than had been assumed. Corpo-
year-over-year basis, while core CPI rate announcements of downward revi-
inflation increased slightly in 2001. At sions to forecasts of future revenues
the producer level, core prices for fin- and capital spending also contributed to
ished goods changed little in November some marking down by market partici-
and December, and the index for core pants of prospects for economic activity.
producer inflation slowed noticeably last Yields on Treasury coupon securities
year. With regard to labor costs, growth declined slightly over the intermeeting
of average hourly earnings of produc- period, risk spreads on corporate debt
tion or nonsupervisory workers picked securities changed little, and major
up in November and December, but the indexes of equity prices edged lower on
average wage increase for the year was balance.
moderate and slightly less than that for In foreign exchange markets, the
2000. trade-weighted value of the dollar in
At its meeting on December 11, 2001, terms of the major foreign currencies
the Committee adopted a directive that increased somewhat on balance over
called for implementing conditions the intermeeting period and reached
in reserve markets consistent with a its highest level since the mid-1980s.
decrease of 25 basis points in the Weakness of the Japanese yen was an
intended level of the federal funds rate, important factor in that rise, as market
176 89th Annual Report, 2002

participants focused on continuing ery would be associated with a marked

problems in the Japanese economy and slowing in the contraction of business
on comments by Japanese officials that capital investment and the added con-
seemed to signal a willingness to accept sumer purchasing power arising from
a weaker value for the yen. The dollar recent declines in oil prices. Economic
also appreciated slightly against the expansion was projected to strengthen
euro, perhaps reflecting a market view appreciably by the second half of 2002
that the U.S. economy was likely to lead and subsequently, as the climate for
the rebound from the global slowdown. business fixed investment continued to
In addition, the exchange value of the improve and as a strengthening of for-
dollar increased slightly in terms of an eign economies led to somewhat greater
index of the currencies of other impor- demand for U.S. exports. The unemploy-
tant trading partners, in part because of ment rate would begin to edge down.
the depreciation of the Argentine peso. Subpar expansion over the next few
Growth of M2 slowed slightly in quarters was expected to foster an appre-
December from November’s robust pace ciable further easing of pressures on
and moderated considerably further in resources and some moderation in core
the early weeks of January. The brisk consumer price inflation.
expansion of liquid deposits over recent In the Committee’s discussion of cur-
months had been associated with the rent and prospective economic condi-
effects of mortgage refinancing activity tions, members commented that the
and the substantial decline in the oppor- recent information was more positive
tunity costs of such deposits that was than they had anticipated and seemed
related to previous easing actions. The on the whole to indicate that economic
currency component of M2 also had activity was bottoming out and a recov-
been strong in the latter part of 2001, ery might already be under way. Impor-
largely the result of a pickup in demand tant impetus to economic activity in the
for U.S. currency abroad. The debt of period immediately ahead likely would
the domestic nonfinancial sectors was be provided by a turnaround in inven-
estimated to have expanded at a slightly tory investment following several quar-
slower rate in December, reflecting ters of increasingly large liquidation that
some moderation in business debt had culminated in the outsized decline
financing, a slightly slower pace of in inventories reported for the fourth
household borrowing, and little net bor- quarter. Looking beyond the near term,
rowing by the federal government. members expressed considerable uncer-
The staff forecast prepared for this tainty about the prospective strength of
meeting suggested that economic activ- final demand. The stimulus from fis-
ity likely would start to turn up early cal and monetary actions taken in 2001,
in 2002 as inventory liquidation tapered the impetus to growth from the induce-
off, and would gather strength only ment to new investment provided by
gradually. The monetary ease and fiscal improving technology, and the persist-
stimulus already in place would provide ing uptrend in household spending
impetus for the recovery, though the would support the economic recovery.
wealth effects of earlier reductions in However, household spending had been
equity prices, sluggish growth abroad, relatively robust during the cyclical
and the dollar’s strength would tend to downturn and likely had only limited
offset some of that support for a time. room for a pickup over coming quarters,
The gradual strengthening of the recov- and intense competitive pressures could
Minutes of FOMC Meetings, January 177

well constrain profits, investment, and thrust to the expansion over the nearer
equity prices. As a result, the members term. The inventory correction that had
were concerned that the acceleration in occurred over the past year was of a
final demand could be modest, at least magnitude that would inevitably result
for a time. Against this background, the in a reduced rate of liquidation and an
prospects for continued low inflation eventual restocking unless, contrary to
remained favorable, given the currently current expectations, consumer spend-
reduced utilization of resources and ing were to weaken markedly. The
indeed the prospect for some added accompanying fillip to production and
slack should economic growth remain incomes would have positive feedback
below potential in coming quarters, as effects over time on household expen-
many members anticipated. Moreover, ditures and business investment. The
the further passthrough of earlier extent and timing of the turnaround in
declines in energy prices would con- inventory investment for the economy
tinue to ease pressures on prices and as a whole were subject to a consider-
costs more generally throughout the able degree of uncertainty, but members
economy. noted that some firms already appeared
In preparing for the semi-annual to have adjusted their inventories to
monetary policy report to the Congress, what they viewed as acceptable levels,
the Board members and Reserve Bank and there were indications that some
presidents provided their individual pro- manufacturing firms were making
jections for the growth of GDP, civilian efforts to rebuild inventories in the con-
unemployment, and consumer price text of improving orders. More gener-
inflation for the year 2002. They pro- ally, however, business firms appeared
jected that the economy would begin to to have remained very cautious in set-
recover this year from the generally mild ting their inventory investment plans.
downturn experienced in 2001, but the The evidence of unexpected strength
pace of expansion would pick up only in overall final demand indicated by the
gradually and the unemployment rate just-released GDP report was supported
would climb somewhat further. The cen- by anecdotal commentary from around
tral tendency of their forecasts of growth the nation. Regional economic reports
in real GDP for 2002 was 21⁄2 to 3 per- were somewhat mixed in that declining
cent, measured as the change between activity still characterized conditions in
the fourth quarter of 2001 and the fourth some areas, but the pace of the declines
quarter of 2002, while their forecasts of appeared to have moderated in those
the civilian unemployment rate in the areas and improved conditions were
fourth quarter of the year were centered noted in other parts of the country.
on 6 to 61⁄4 percent. The forecasts Business sentiment, while still quite
of consumer price inflation this year, as depressed in some areas, was described
measured by the PCE chain-type price in many reports as having shifted toward
index, were narrowly clustered around cautious optimism.
11⁄2 percent. Concerning prospective develop-
With regard to the prospective course ments in final demand in major sectors
of the projected recovery, members gen- of the economy, several members under-
erally anticipated that a positive swing scored what they viewed as the key role
in inventory investment abetted by of household expenditures. Such spend-
further growth in consumer spending ing had held up remarkably well in the
would provide an important upward face of major adverse developments,
178 89th Annual Report, 2002

including sharp declines in stock mar- cate that additional impetus, if any, from
ket wealth and rising unemployment, housing construction would be limited
that were exacerbated by the events over the next several quarters.
of September 11. But with households The outlook for business capital
remaining confident about the future and expenditures was improving, but anec-
equity prices having rebounded from dotal reports suggested that business
their post-attack declines, sustained executives were still notably cautious
growth in household expenditures was in formulating their spending plans,
seen as a likely prospect. Such spend- and indications of accelerating capital
ing also would be supported in part investment were still quite limited. In
by some strengthening or less weakness the high-tech sector, positive signs were
in other important sectors of the econ- noted in the demand for computers and
omy. Some members nonetheless cited peripherals, but the outlook for commu-
a number of potential negatives relating nications equipment was still very nega-
to the prospects for consumer spend- tive. Business spending for other equip-
ing, including the possibility of adverse ment was also expected to remain soft.
effects on consumer confidence of fur- On balance, the capital investment sec-
ther anticipated increases in unemploy- tor seemed likely to retard the overall
ment and the risk that generally dis- advance in economic activity during the
appointing business profits or more quarters immediately ahead as many
widespread downward restatements of firms continued to pare excess capacity
reported profits might generate sizable and businesses awaited clearer indica-
declines in stock market prices and con- tions of rising demand and profits.
sumer wealth. Moreover, the unusually Beyond the nearer term, however, the
large sales of motor vehicles and to a favorable outlook for productivity
degree other durable goods during the growth and related profit opportunities
closing months of 2001 might have bor- pointed to a revival of robust capital
rowed to some extent from sales in com- spending. Indeed, past experience sug-
ing months. On balance, the positive gested that once a rebound in capital
and negative factors bearing on the out- spending took hold it easily could
look for consumer spending suggested exceed current forecasts of moderate
that moderate growth was a reasonable acceleration.
expectation. Fiscal policy would continue to pro-
Residential construction expendi- vide substantial stimulus to the econ-
tures, like household spending for con- omy this year in light of the ongoing
sumer goods and services, had held effects of the tax reduction measures
up well despite the cyclical downturn enacted in 2001 and the sharp increase
in employment and sizable net losses in federal government spending in
in stock market wealth. Low mortgage train. This outlook did not incorporate
interest rates and, in recent months, the possible enactment of further tax
favorable weather conditions had pro- cut legislation, whose prospects now
vided vital support to this sector of the seemed to be remote. A partial offset
economy. Recent housing activity, to federal government stimulus was
including record sales in some areas, the likelihood of considerably reduced
suggested persisting underlying strength spending growth at the state and local
in residential construction. Even so, the government levels, where numerous
large additions to the supply of new government entities were experienc-
homes in earlier years tended to indi- ing severe budget strains associated
Minutes of FOMC Meetings, January 179

with recession-related weakness in tax policy had been eased substantially over
revenues. the past year, and, with the real federal
The external sector of the economy funds rate at an unusually low level,
was seen as a source of some poten- policy seemed well positioned to sup-
tial downside for the domestic econ- port an economic recovery as the forces
omy in the period just ahead. Gener- restraining demand abated. In fact, a
ally weak foreign economies and the growing number of indicators pointed to
recent strength of the dollar in foreign a reduction in the pressures holding back
exchange markets were expected to con- the economy and to an emerging busi-
tinue to restrain U.S. exports. Economic ness recovery. In these circumstances, a
recoveries in many foreign nations pause seemed desirable to monitor the
seemed likely over the course of this still-incomplete effects of the Commit-
year, but the strength of those recoveries tee’s easing over the past year—a sig-
was subject to considerable uncertainty, nificant part of which had been imple-
and the risk that serious difficulties in mented in recent months—and the
some important economies might spread contours of the turnaround in economic
could not be overlooked. Recovery activity.
abroad, notably in some key U.S. trad- All the members indicated that they
ing partners, would be tied to an could support the issuance of a public
important extent to the course of U.S. statement indicating that the risks
economic activity and would not be remained tilted toward economic weak-
providing much impetus to U.S. exports ness. Although the economy was prob-
over coming quarters. At this point signs ably strengthening, a variety of factors
of an upturn in foreign trade were not could well keep the pace of expansion
entirely lacking, notably in some high- below the rate of growth of potential
tech goods, but those indications were for a while, even at the current policy
still very limited. stance. Moreover, inflation was running
Inflation was likely to remain quite at a fairly low rate and quite possibly
subdued. Indeed, core inflation could would edge down a little further over
well edge lower. The indirect effects of coming quarters. In these circumstances,
the declines that had occurred in energy the risk to achieving the Committee’s
prices would continue to hold down objective for fostering sustainable eco-
other input prices and be passed on more nomic growth seemed to be greater than
fully to final purchasers. More gener- to its objective of maintaining reason-
ally, the low rate of resource utiliza- able price stability. In the view of a few
tion anticipated over the year ahead, ris- members, an argument could be made
ing productivity, and highly competitive for moving to a balanced-risks state-
market pricing could be expected to ment, given that they could envisage
moderate price pressures. Against that developments that could strengthen the
background, members continued to view economy beyond their current forecasts.
the greater risks to the economy as those However, they agreed that a shift to
relating to concerns about economic balanced risks in conjunction with an
activity rather than prices. unchanged policy stance could at this
In the Committee’s discussion of pol- point be misread in financial markets as
icy for the intermeeting period ahead, all an indication of a much more optimistic
the members agreed that recent develop- view of the economic outlook than the
ments argued for keeping the stance of members currently entertained. Such an
policy unchanged at this time. Monetary interpretation might foster unwarranted
180 89th Annual Report, 2002

and counterproductive adjustments in ing of each year, the members discussed

financial markets. In any event, emerg- their policies regarding the extent of the
ing economic conditions in line with information that is released to the pub-
the members’ current forecasts would lic about its discussions and decisions
provide ample opportunity to shift to along with the timing of the release of
a balanced-risks statement at a future such information. They noted that the
meeting when it might be more clearly changes in disclosure policy and prac-
appropriate. tices implemented in recent years,
At the conclusion of this discussion, including the announcement of policy
the Committee voted to authorize and actions and brief explanations of the
direct the Federal Reserve Bank of New basis for those actions, have served both
York, until it was instructed otherwise, the Federal Reserve and the public well.
to execute transactions in the System They also believed that it would be
Account in accordance with the follow- appropriate to explore whether there
ing domestic policy directive: might be scope for some further evolu-
tion in the Committee’s policies in the
The Federal Open Market Committee direction of greater transparency, though
seeks monetary and financial conditions that additional study and analysis would
will foster price stability and promote sus-
tainable growth in output. To further its long- be needed. They agreed to discuss the
run objectives, the Committee in the imme- issues further at a future meeting.
diate future seeks conditions in reserve It also was agreed that the next meet-
markets consistent with maintaining the fed- ing of the Committee would be held on
eral funds rate at an average of around Tuesday, March 19, 2002.
13⁄4 percent.
The meeting adjourned at 12:30 p.m.
The votes encompassed approval of on January 30, 2002.
the sentence below for inclusion in the
press statement to be released shortly Donald L. Kohn
after the meeting. Secretary

Against the background of its long-run Meeting Held on

goals of price stability and sustainable eco- March 19, 2002
nomic growth and of the information cur-
rently available, the Committee believes that A meeting of the Federal Open Market
the risks continue to be weighted mainly Committee was held in the offices of
toward conditions that may generate eco- the Board of Governors of the Federal
nomic weakness in the foreseeable future.
Reserve System in Washington, D.C.,
Votes for this action: Messrs. Greenspan, on Tuesday, March 19, 2002, at
McDonough, Ms. Bies, Messrs. Ferguson, 9:00 a.m.
Gramlich, Jordan, McTeer, Olson, San-
tomero, and Stern. Vote against this Present:
action: None. Absent and not voting: Mr. Greenspan, Chairman
Mr. Meyer. Mr. McDonough, Vice Chairman
Ms. Bies
Mr. Ferguson
Disclosure Policy Mr. Gramlich
Mr. Jordan
Mr. McTeer
In accordance with the Committee’s Mr. Olson
routine practice of reviewing its rules Mr. Santomero
and regulations at its first regular meet- Mr. Stern
Minutes of FOMC Meetings, March 181

Messrs. Broaddus, Guynn, Moskow, Ms. Low, Open Market Secretariat

and Parry, Alternate Members Assistant, Office of Board
of the Federal Open Market Members, Board of Governors
Ms. Pianalto and Mr. Stewart, First
Mr. Hoenig, Ms. Minehan, and Vice Presidents, Federal Reserve
Mr. Poole, Presidents of the Banks of Cleveland and New York
Federal Reserve Banks of respectively
Kansas City, Boston, and
St. Louis respectively Messrs. Beebe, Eisenbeis, Fuhrer,
Goodfriend, Hakkio, Hunter, and
Mr. Kohn, Secretary and Economist€ Rasche, Senior Vice Presidents,
Mr. Bernard, Deputy Secretary€ Federal Reserve Banks of
Mr. Gillum, Assistant Secretary€ San Francisco, Atlanta, Boston,
Ms. Smith, Assistant Secretary€ Richmond, Kansas City, Chicago,
Mr. Mattingly, General Counsel€ and St. Louis respectively
Ms. Johnson, Economist€
Mr. Reinhart, Economist€ Ms. Hargraves, Vice President, Federal
Mr. Stockton, Economist€ Reserve Bank of New York
Mr. Connors, Ms. Cumming,
Messrs. Howard and Lindsey, By unanimous vote, the minutes of
Ms. Mester, Messrs. Oliner, the meeting of the Federal Open Market
Rolnick, Rosenblum, Sniderman, Committee held on January 29–30,
and Wilcox, Associate Economists 2002, were approved.
By notation vote completed on
Mr. Kos, Manager, System Open March 19, 2002, the members of the
Market Account Federal Open Market Committee voted
unanimously to accept the Report of
Mr. Winn, Assistant to the Board,
Office of Board Members, Board Examination of the System Open Mar-
of Governors ket Account conducted as of the close of
business on November 14, 2001, by the
Messrs. Ettin and Madigan, Deputy Division of Reserve Bank Operations
Directors, Divisions of Research and Payment Systems of the Board of
and Statistics and Monetary Governors.
Affairs respectively, Board The Manager of the System Open
of Governors
Market Account reported on recent
developments in foreign exchange mar-
Mr. Whitesell, Deputy Associate
Director, Division of Monetary kets. There were no open market opera-
Affairs, Board of Governors tions in foreign currencies for the Sys-
tem’s account in the period since the
Mr. Simpson, Senior Adviser, Division previous meeting.
of Research and Statistics, The Manager also reported on devel-
Board of Governors opments in domestic financial markets
and on System open market transactions
Mr. English, Assistant Director, in government securities and securities
Division of Monetary Affairs,
Board of Governors issued or fully guaranteed by federal
agencies during the period January 30,
Mr. Skidmore, Special Assistant to 2002, through March 18, 2002. By
the Board, Office of Board unanimous vote, the Committee ratified
Members, Board of Governors these transactions.
182 89th Annual Report, 2002

At this meeting the staff requested nation of outright purchases of GNMA-

Committee guidance on the priorities, MBS. Although these securities have a
given limited staff resources, it should number of shortcomings as an outright
attach to further studies of the feasibil- investment vehicle from the System’s
ity of outright purchases for the Sys- perspective, the market for GNMA-
tem Open Market Account (SOMA) of MBS was well developed and the secu-
mortgage-backed securities guaranteed rities were guaranteed by the full faith
by the Government National Mort- and credit of the U.S. government.
gage Association (GNMA-MBS) and The Committee then turned to a dis-
the addition of foreign sovereign debt cussion of the economic and financial
securities to the list of collateral eligi- outlook and the conduct of monetary
ble for U.S. dollar repurchase agree- policy over the intermeeting period
ments by the System. Such alternatives ahead.
could prove useful if outstanding Trea- The information reviewed at this
sury debt obligations were to become meeting indicated that economic activ-
increasingly scarce relative to the nec- ity had turned up in the final quarter
essary growth in the System’s portfolio, of last year and strengthened further
and the Committee had previously since then. Consumer spending on
requested initial staff exploration of goods other than motor vehicles was
these options. Noting that many of the brisk in the early part of this year,
staff engaged in these studies were also business purchases of equipment and
involved in contingency planning, which software appeared to be beginning to
had been intensified after the Sep- recover from their marked decline of
tember 11 attacks, the consensus of last year, and housing starts turned back
the members was to give the highest up. Amid signs that most firms had
priority to such planning. All the mem- worked down their inventories to more
bers preferred continued reliance to the comfortable levels, industrial produc-
extent feasible on direct Treasury debt tion increased slightly after having
for outright System transactions, and declined for nearly a year and a half,
they were persuaded that budget devel- and payroll employment appeared to be
opments over the last year meant that bottoming out. Inflation remained low
constraints on Treasury debt supplies despite some firming of energy prices.
would not become as pressing an issue Private nonfarm payroll employment
as soon as they had previously thought. moved up in February, retracing part
Still, given the inherent uncertainty of of January’s drop. Layoffs in manufac-
budget forecasts, the likely significant turing slowed further, the construction
needs for large SOMA operations in industry added back some workers in
coming years and the lead times needed February, and the retail trade and ser-
to implement new procedures, the Com- vices sectors continued to hire in both
mittee decided that the study of alter- months. The unemployment rate edged
native market instruments should go down again in February to 5.5 percent,
forward once it was possible to do so and initial claims for unemployment
without impeding the contingency plan- insurance continued to drop.
ning effort. With regard to the two pro- Industrial production increased some-
posed alternatives for broadening the what in January and February after a
System’s options for open market opera- steep decline from its June 2000 peak.
tions, the members instructed the staff to Manufacturing output rose in both
give a higher priority to further exami- months, and the factory operating rate
Minutes of FOMC Meetings, March 183

moved up slightly from its low level at down in January after a December
year-end. The pickup in manufacturing bounce. Shipments in most other sectors
this year was spread across several recorded increases and were particularly
major industries, including chemicals, robust for machinery, engines, and tur-
computers and semiconductors, paper, bines. Business demand for motor vehi-
and tobacco. In addition, output of com- cles remained mixed, with fleet sales
munications equipment steadied after of light vehicles higher and purchases
having plunged for more than a year. In of medium and heavy trucks somewhat
contrast, production of motor vehicles weaker. Nonresidential construction
and parts changed little over January remained in a slump, with spending on
and February after a surge late in 2001. new office buildings and industrial
Consumer spending remained strong structures down sharply in an environ-
in the early part of the year, despite a ment of elevated vacancy rates.
sizable drop in purchases of light vehi- The pace of liquidation of manufac-
cles in January that was followed by a turing and trade inventories, excluding
rebound in February as manufacturers motor vehicles, slowed in January after
switched from attractive financing terms a very rapid rundown in the fourth quar-
to cash rebates. Outlays for retail items ter, and with sales higher the aggregate
other than motor vehicles expanded fur- inventory–sales ratio declined to its low-
ther in February after the large increases est level since midyear 2000. Manufac-
recorded in the two prior months. Out- turers’ stocks were drawn down sharply
lays for services continued to rise further in January, and the sector’s
moderately in January (latest data). stock-to-shipments ratio fell apprecia-
Consumer purchases were supported by bly. At the wholesale level, the rate
a sizable gain in disposable personal of inventory runoff slowed somewhat,
income in January, and readings on con- but the sector’s inventory–sales ratio
sumer sentiment were close to their his- declined further. The level of inven-
torical averages. tories at the retail level increased some-
Residential construction had been what despite a rise in sales, and the
very strong in the past several months, sector’s aggregate inventory–sales ratio
with new starts reaching their highest was at an historically low level.
level in almost two years. The strength The U.S. trade deficit in goods and
in homebuilding was associated in part services widened somewhat in January.
with unusually warm and dry weather, The value of exports changed little but
but very low mortgage rates also contin- the value of imports rose appreciably, to
ued to play an important role. about the November level. The available
Business spending on durable equip- information indicated that economic
ment and software appeared to be turn- activity in the foreign industrial coun-
ing upward after a marked moderation tries showed little net change in the
in the fourth quarter of the steep decline fourth quarter. The Canadian economy
recorded in the two previous quarters. rebounded from a weak third quarter,
Shipments and orders of nondefense but economic expansion in the United
capital goods were unexpectedly strong Kingdom nearly came to a halt in the
in January. There were signs of recovery fourth quarter, economic activity in the
in the high-tech sector, with shipments euro area slipped a little, and the Japa-
of computers and peripherals increasing nese economy recorded a steep drop.
for a fifth straight month, but shipments There were indications, however, of a
of communications equipment turned gradually improving economic outlook
184 89th Annual Report, 2002

in several of these economies in the first inflation-adjusted federal funds rate was
quarter as a consequence of previous at an unusually low level. As a result,
monetary policy easing actions that their policy was positioned to support an eco-
respective central banks had taken and nomic recovery as forces restraining
from the effects of an improved eco- aggregate demand abated. Nonetheless,
nomic performance in the United States. the members agreed that there were fac-
Among the major emerging-market tors that might keep the pace of expan-
countries, the exports of a number of sion below the rate of growth of poten-
Asian economies were benefiting from tial for a while, and thus the balance
the nascent recovery in high-tech of risks continued to be tilted toward
industries around the world. In Latin economic weakness in the foreseeable
America, although Argentina remained future.
in a steep downward trend, the Mexican The federal funds rate remained close
and Brazilian economies seemed to be to the Committee’s target level of
recovering from weakness in the fourth 13⁄4 percent during the intermeeting
quarter. period. However, short-term market
Consumer price inflation picked up a rates increased slightly over the inter-
bit in January as energy prices posted meeting interval, and yields on longer-
their first increase since September. term Treasury instruments and high-
However, on a year-over-year basis, grade corporate bonds rose by more.
core price inflation as measured by the The rise in rates was sparked initially
consumer price index leveled out at a by market participants’ reading of the
moderate rate, while core PCE (per- Committee’s press statement as sug-
sonal consumption expenditure) price gesting greater-than-expected optimism
inflation declined appreciably. Labor about the economy going forward. That
costs also appeared to have decelerated assessment was subsequently strength-
recently. The employment cost index for ened by data on spending and output
hourly compensation in private industry released during the intermeeting interval
rose moderately in the fourth quarter of that came in well above market expecta-
last year and for the year as a whole. tions. Speculative-grade bond yields fell
Both the salary and benefits components somewhat in reaction to the improved
recorded slightly smaller increases last economic outlook and the perceived
year. Average hourly earnings of pro- reduction of credit risk. Most major
duction and nonsupervisory workers indexes of equity prices moved up
advanced only slightly in January and sharply on the bullish economic reports.
February of this year, and the average In foreign exchange markets, the
wage increase during the twelve months trade-weighted value of the dollar in
through February was slightly lower terms of the major foreign currencies
than that for the twelve-month period eased slightly on balance over the inter-
ending in February 2001. meeting period. The dollar fell more
At its meeting on January 29–30, against the yen than the euro despite
2002, the Committee adopted a directive negative economic news from Japan and
that called for implementing conditions the disappointing reaction to the Japa-
in reserve markets consistent with keep- nese government’s announcement of an
ing the intended level of the federal ‘‘anti-deflation’’ package. The exchange
funds rate at 13⁄4 percent. The members value of the dollar changed little in
noted that policy had been eased sub- terms of an index of the currencies of
stantially over the past year and that the other important trading partners, in part
Minutes of FOMC Meetings, March 185

because of the further depreciation of anticipated earlier despite higher pro-

the Argentine peso. jected growth in structural productivity.
Expansion of M2 rebounded some- Even so, overall activity would remain
what in February from January’s lack- below estimates of the economy’s
luster rate, but growth in the early part potential output for some time, and the
of the year was down sharply from the persistence of underutilized resources
robust pace of late last year. The slow- was expected to keep downward pres-
down apparently was related to the ebb- sure on core price inflation.
ing effect of earlier declines in oppor- In the Committee’s discussion of cur-
tunity costs of holding M2 assets and rent and prospective economic develop-
to the shift of large amounts of money ments, members commented that the
from retail money market funds into decidedly positive information received
bond and equity mutual funds as con- over the intermeeting period provided
cerns about volatility in financial mar- strong evidence that an economic recov-
kets eased. Reduced demand for mort- ery was now under way, though its pro-
gage refinancing also seemed to have spective strength remained subject to
contributed to the deceleration of M2. substantial uncertainty. In this regard it
The debt of the domestic nonfinancial was noted that the economy was under-
sectors was estimated to have increased going significant structural changes and
at a relatively slow rate in January, those changes were adding to the usual
reflecting weak demand for business difficulty of projecting the trajectory of
debt financing and little net borrowing economic activity after a turning point.
by the federal government. Unexpected strength in household
The staff forecast prepared for this expenditures, much reduced weakness
meeting suggested that economic activ- in business capital spending, and sub-
ity was expanding briskly in the early stantial slowing in inventory liquida-
months of the year after having turned tion had produced an earlier upturn in
up and increased modestly in the fourth economic activity than many had antici-
quarter. Elevated household spending pated. A further strengthening of inven-
and a shift from inventory liquidation to tory investment would probably gen-
accumulation would provide significant erate appreciable further growth in
impetus for the recovery in the context business activity over the quarters just
of the substantial monetary ease and fis- ahead. Once the ongoing inventory cor-
cal stimulus already in place. Moreover, rection was completed, however, it was
the recently enacted federal incentive not clear to what extent final demand
for new business equipment invest- in key sectors of the economy, notably
ment along with the outlook for contin- business capital investment, would
ued robust gains in productivity were provide support for further economic
expected to help boost business capi- growth. While the members agreed that
tal spending. At the same time, still- the stimulative fiscal and monetary poli-
depressed equity prices, limited growth cies currently in place would undergird
abroad, and the dollar’s strength would further economic expansion, most con-
tend to hold down the pace of recovery. tinued to anticipate a relatively subdued
On balance, recent developments sug- rate of expansion that would only gradu-
gested that the course of final sales now ally erode current margins of under-
had a more positive contour over the utilized productive resources. The mem-
forecast horizon and that resource utili- bers viewed the outlook for core price
zation would rise somewhat more than inflation as still quite benign, largely
186 89th Annual Report, 2002

reflecting the ample availability of labor a boost to industrial production. Look-

and other producer resources to accom- ing ahead, inventory investment likely
modate rising economic activity and the would turn toward accumulation as
favorable prospects for further robust business firms facing brisk demand and
growth in productivity. depleted stocks stepped up their new
Anecdotal commentary from around orders, providing a source of significant
the country was somewhat less positive strength in fostering economic recovery
on the whole than the recent macroeco- over the near term.
nomic data for the nation. Business con- A major uncertainty in the economic
ditions were reported to be improving in outlook was the extent to which growth
most areas and industries, but the pickup in final demand by households and busi-
was uneven, with continued weakness ness firms would provide ongoing sup-
still characterizing numerous industries. port for the expansion as the impetus
Many business contacts, although some- from inventory investment dissipated.
what less pessimistic about the eco- The prospects for consumer spending
nomic outlook, still did not appear to be remained favorable against the back-
anticipating a strong upturn this year. drop of a solid uptrend in disposable
Gradual recovery was reported in the incomes associated to an important
depressed tourism and travel industries. extent with an improving employment
The manufacturing sector, where much picture, robust underlying growth in
of the economy’s weakness had been labor productivity, and the further
concentrated, was displaying increased phase-in of personal income tax cuts
signs of stabilizing, with activity actu- enacted in 2001. Consumer confidence
ally picking up in a number of industries had improved considerably in recent
and some firms anticipating increases months and consumer expenditures had
in their payrolls over the next sev- displayed surprising strength. Members
eral months after experiencing large nonetheless cited some negatives in the
declines. However, employers in manu- outlook for consumer spending includ-
facturing and other sectors of the econ- ing the possibilities that a negative stock
omy generally remained cautious in market wealth effect stemming from
their hiring policies and in their plans large earlier declines and the somewhat
for capital spending. elevated rate of unemployment would
In their discussion of developments in weigh on consumer confidence. Impor-
key expenditure sectors of the economy, tantly, because consumer spending for
members commented that inventory automobiles and other consumer dura-
investment was likely to remain a piv- bles had been well maintained through
otal factor in the nearer-term perfor- the extended period of economic weak-
mance of the economy. Firms had ness, further gains in such expenditures
moved rapidly to correct earlier inven- were likely to be limited over coming
tory imbalances. Data indicating a very quarters in contrast to the typical surge
large drawdown of inventories in the in past economic recoveries. Moreover,
fourth quarter and further, albeit much energy price increases, especially if they
diminished, liquidation in January along were to become more pronounced,
with anecdotal commentary suggested would tend to hold back household
that inventories were now close to spending. On balance, members saw
desired levels in many industries, nota- moderate further growth in consumer
bly in the retail sector, and the swing spending as a reasonable prospect for
toward smaller drawdowns was giving coming quarters.
Minutes of FOMC Meetings, March 187

After a lull during the fall of 2001, vacancy rates in commercial structures
housing activity had displayed renewed in many parts of the nation. Members
vigor in recent months, in part as a con- nonetheless cited some positives in this
sequence of widely favorable weather outlook that included the favorable
conditions. Indeed, single-family con- effects on incentives to purchase capital
struction was described as a particularly equipment stemming from the outlook
bright sector in a number of local econ- for relatively rapid growth in productiv-
omies. Looking ahead, the favorable ity and the recent passage of legislation
factors affecting consumer spending providing a temporary tax incentive for
more generally along with relatively low investments in equipment and software.
mortgage interest rates were expected to On balance, a substantial pickup in over-
sustain a high level of housing expendi- all capital spending seemed likely to be
tures this year. In keeping with the out- delayed in the absence of surprising
look for consumer durables, however, a strength in final demand, but a wide
long period of active housing construc- range of possible outcomes could not
tion suggested that significant additional be ruled out for this key sector of the
strength in housing was unlikely in com- economy.
ing quarters. Several members referred to the cur-
The members generally viewed busi- rently high degree of fiscal policy stim-
ness fixed investment spending as the ulus, which had been augmented by
key to the strength of economic activity recent legislation. Much of the added
once the thrust from inventory restock- stimulus from the investment incentive
ing had run its course. The outlook for component of that legislation was not
business capital expenditures would be likely to be felt for some period and
governed to an important extent by busi- might occur at a time when the economy
ness expectations regarding sales and would already be expanding at a solid
profits. After the steep declines in busi- pace. Federal spending was increasing
ness investment over the past year, anec- rapidly and its growth could taper off
dotal reports from around the country more slowly than current budget esti-
provided scattered indications of an mates implied. An at least partially off-
upturn but no evidence at this point of setting factor was the prospect that state
any broad-based improvement. Accord- and local government expenditures
ing to such reports and despite the would increase at a reduced pace this
strength of recent economic statistics, year amid widespread budget pressures
which had boosted the economic fore- that had emerged as tax receipts weak-
casts of many observers, business confi- ened along with the economy. However,
dence remained at a low level, evidently some reports indicated that spending on
reflecting a weak outlook for profits local infrastructure projects was con-
in the business community in the con- tinuing at a solid pace in some parts of
text of strong competitive pressures. the nation.
Negative factors bearing on the out- Members saw a number of down-
look for investment in capital equip- side risks from potential developments
ment included the persistence of large abroad. In particular, concern was
margins of excess capacity in many expressed about heightened tensions in
industries. The outlook for commercial the Middle East and their possible
and other nonresidential construction impact on oil markets and the cost of
seemed even less promising, at least for energy. For a variety of reasons, oil
the next several quarters, given high prices already had risen appreciably
188 89th Annual Report, 2002

since the start of the year. With regard to Looking ahead, however, the stance
the outlook for foreign trade, members of policy would need to be adjusted at
reported some indications of an improv- some point to provide less stimulus as
ing volume of trade with some Asian the members gained more confidence
nations. However, the nation’s net that the recovery was becoming better
export position could deteriorate further entrenched and the risks had shifted
when much of the impetus to world toward rising inflationary pressures. The
economic growth was coming from the need to adjust monetary policy during
U.S. economy. the early stages of a recovery presented
The members expected price pres- a special challenge with regard to its
sures to remain relatively contained over timing and extent in that raising rates
the next several quarters in the context prematurely or too precipitately could
of what they anticipated would be only weaken or abort the recovery, while
a gradual reduction of the excess capac- waiting too long could risk a pickup in
ity in labor and product markets as inflationary pressures later. Members
the recovery progressed. Moreover, the concluded that the Committee would be
prospects of relatively robust growth in a better position to assess the appro-
in productivity in a highly flexible and priate timing of a policy change at the
competitive economy likely would mod- May meeting when it would have more
erate the extent of any potential buildup information to gauge the economy’s
in inflationary pressures in the future. performance in two critical areas,
Members nonetheless mentioned some namely developments relating to inven-
potential negatives in this outlook, nota- tory investment and the implications
bly the possibility of rising wage pres- of trends in sales and profits for capital
sures as labor markets became more investment. A reference to the Com-
fully employed and upward price pres- mittee’s currently accommodative pol-
sures stemming from increasing steel, icy stance in the press announcement
energy, and insurance costs. to be issued shortly after this meeting
In the Committee’s discussion of pol- would alert the public to the need to
icy for the intermeeting period ahead, firm policy at some point in the future.
all the members supported a proposal All the members indicated that they
to maintain an unchanged policy stance, could accept a proposal to move the
with the target for the federal funds rate balance of risks statement from poten-
staying at 13⁄4 percent. While the econ- tial weakness to a neutral position. It
omy currently appeared to be expanding was clear that significant downside risks
at a fairly vigorous pace, the advance remained in the economy even apart
importantly reflected a temporary swing from any major unanticipated shocks
in inventory investment and consid- to business and consumer confidence,
erable uncertainty surrounded the out- but in light of the strength of the recent
look for final demand over the quarters economic information nearly all the
ahead. Against this background, the members agreed that a balanced risks
members judged the currently accom- statement now best represented their
modative stance of monetary policy to consensus regarding the economic out-
be appropriate for now, especially in look over the foreseeable future. Mem-
light of the relatively high unemploy- bers noted that a neutral statement did
ment rate, low capacity utilization rates not preclude a tightening policy move
in numerous industries, and quiescent should the latter seem warranted by rap-
inflation pressures. idly evolving economic conditions.
Minutes of FOMC Meetings, May 189

At the conclusion of this discussion, as part of the minutes after the next
the Committee voted to authorize and meeting.
direct the Federal Reserve Bank of New It was agreed that the next meeting of
York, until it was instructed otherwise, the Committee would be held on Tues-
to execute transactions in the System day, May 7, 2002.
Account in accordance with the follow- The meeting adjourned at 1:30 p.m.
ing domestic policy directive:
Donald L. Kohn
The Federal Open Market Committee Secretary
seeks monetary and financial conditions that
will foster price stability and promote sus-
tainable growth in output. To further its long-
run objectives, the Committee in the imme-
diate future seeks conditions in reserve
Meeting Held on
markets consistent with maintaining the fed- May 7, 2002
eral funds rate at an average of around
13⁄4 percent. A meeting of the Federal Open Market
Committee was held in the offices of
The vote encompassed approval of the Board of Governors of the Federal
the sentence below for inclusion in the Reserve System in Washington, D.C.,
press statement to be released shortly on Tuesday, May 7, 2002, at 9:00 a.m.
after the meeting:
Against the background of its long-run Mr. Greenspan, Chairman€
goals of price stability and sustainable eco- Mr. McDonough, Vice Chairman€
nomic growth and of the information cur- Ms. Bies€
rently available, the Committee believes that Mr. Ferguson€
the risks are balanced with respect to pros- Mr. Gramlich€
pects for both goals in the foreseeable future. Mr. Jordan€
Mr. McTeer€
Votes for this action: Messrs. Greenspan, Mr. Olson€
McDonough, Ms. Bies, Messrs. Ferguson, Mr. Santomero€
Gramlich, Jordan, McTeer, Olson, San- Mr. Stern€
tomero, and Stern. Votes against this
action: None. Messrs. Broaddus, Guynn, Moskow,
and Parry, Alternate Members
of the Federal Open Market
Disclosure Policy Committee

By unanimous vote, the Committee Mr. Hoenig, Ms. Minehan, and

approved a proposal to include the vote Mr. Poole, Presidents of the
on monetary policy in the press state- Federal Reserve Banks of
Kansas City, Boston, and
ment released after every meeting, St. Louis respectively
beginning with this meeting. In addi-
tion to identifying the voters, the press Mr. Kohn, Secretary and Economist€
release would indicate the policy pref- Mr. Bernard, Deputy Secretary€
erences of dissenters, if any. Such Mr. Gillum, Assistant Secretary€
information could prove useful to mar- Ms. Smith, Assistant Secretary€
ket participants, who on occasion had Mr. Mattingly, General Counsel€
Mr. Baxter, Deputy General Counsel€
employed indirect and frequently mis- Ms. Johnson, Economist€
leading information to gauge the Com- Mr. Reinhart, Economist€
mittee’s vote before it was released Mr. Stockton, Economist€
190 89th Annual Report, 2002

Mr. Connors, Ms. Cumming, By unanimous vote, the minutes of

Messrs. Howard and Lindsey, the meeting of the Federal Open Market
Ms. Mester, Messrs. Oliner, Committee held on March 19, 2002,
Rolnick, Rosenblum, and Wilcox,
Associate Economists were approved.
The Manager of the System Open
Mr. Kos, Manager, System Open Market Account reported on recent
Market Account developments in foreign exchange mar-
kets. There were no open market opera-
Messrs. Ettin and Madigan, Deputy tions in foreign currencies for the Sys-
Directors, Divisions of Research
and Statistics and Monetary tem’s account in the period since the
Affairs respectively, Board of previous meeting.
Governors The Manager also reported on devel-
opments in domestic financial markets
Messrs. Slifman and Struckmeyer, and on System open market transactions
Associate Directors, Division in government securities and securities
of Research and Statistics,
Board of Governors issued or fully guaranteed by federal
agencies during the period March 19,
Mr. Whitesell, Deputy Associate 2002, through May 6, 2002. By unani-
Director, Division of Monetary mous vote, the Committee ratified these
Affairs, Board of Governors transactions.
By unanimous vote, the Committee
Mr. Clouse, Assistant Director,
Division of Monetary Affairs, approved the extension for one year
Board of Governors beginning in December 2002 of the
System’s reciprocal currency (‘‘swap’’)
Mr. Simpson, Senior Adviser, Division arrangements with the Bank of Canada
of Research and Statistics, and the Bank of Mexico. The arrange-
Board of Governors
ment with the Bank of Canada is in the
Mr. Skidmore, Special Assistant amount of $2 billion equivalent and that
to the Board, Office of Board with the Bank of Mexico in the amount
Members, Board of Governors of $3 billion equivalent. Both arrange-
ments are associated with the Federal
Ms. Low, Open Market Secretariat Reserve’s participation in the North
Assistant, Office of Board American Framework Agreement. The
Members, Board of Governors
early vote to renew the System’s partici-
Mr. Barron, First Vice President, pation in the swap arrangements matur-
Federal Reserve Bank of Atlanta ing in December relates to the provision
that each party must provide six months
Messrs. Eisenbeis, Fuhrer, Goodfriend, prior notice of an intention to terminate
Hakkio, Hunter, Judd, and its participation.
Ms. Perelmuter, Senior Vice
Presidents, Federal Reserve The Committee then turned to a dis-
Banks of Atlanta, Boston, cussion of the economic and financial
Richmond, Kansas City, Chicago, outlook and the conduct of monetary
San Francisco, and New York policy over the intermeeting period
respectively ahead.
The information reviewed at this
Messrs. Altig and Coughlin, Vice
Presidents, Federal Reserve meeting indicated that economic activ-
Banks of Cleveland and St. Louis ity expanded rapidly early in the year.
respectively Consumer spending increased moder-
Minutes of FOMC Meetings, May 191

ately after large gains around the turn than half of its fourth-quarter plunge.
of the year, business outlays on dura- The gain was widespread across market
ble equipment and software apparently groups and industries. High-tech equip-
steadied after a long decline, and single- ment, notably computers and semicon-
family housing activity persisted at a ductors, and motor vehicles and parts
relatively high level. Industrial pro- led the upturn with very large increases,
duction picked up in response to the while the telecommunications and air-
advance in final demand and a slow- craft industries weakened sharply fur-
down in the runoff of excess inventory ther. Capacity utilization in manufactur-
stocks. The demand for labor began to ing continued to rise in March from its
firm in April. Available information low level at year-end, but at the end of
suggested that labor productivity had the first quarter it was still substantially
risen substantially in the first quarter. below its long-run average.
Although the recent surge in energy Consumer spending was well main-
prices boosted headline consumer infla- tained in the first quarter, supported
tion in the first quarter, core measures of by sizable gains in disposable income.
inflation had trended lower over the past Demand for light motor vehicles
year. remained robust, though somewhat
Private nonfarm payroll employment below the fourth-quarter pace, in an
turned up in April after having posted environment of continued aggressive
small declines in February and March manufacturer pricing and low financing
and steep reductions earlier. Job gains in rates. Expenditures on a wide range of
April were spread across a wide range other consumer goods and services
of industries. The services sector regis- expanded briskly.
tered a sizable increase, with much of Residential housing activity surged
that rise occurring in the temporary-help in the first three months of the year,
industry that provides many of its work- evidently spurred by unusually mild
ers to the manufacturing sector. In addi- winter weather and low mortgage rates.
tion, layoffs continued to slow in the Starts of single-family homes reached
manufacturing sector, and some indus- a twenty-three-year high in February
tries recorded their first solid advances before moderating somewhat in March,
in employment in more than a year. but multifamily starts were only slightly
By contrast, the construction industry above the relatively slow pace in 2001.
posted another large job decline as hir- New home sales moderated a bit in the
ing again fell short of the usual seasonal first quarter from the very strong pace of
rise. Despite the pickup in private pay- the fourth quarter, while quarterly sales
rolls, the unemployment rate rose to of existing homes rose on the strength of
6.0 percent in April, perhaps reflecting a record high in February.
to an important extent the incentives Business outlays for durable equip-
created by the new federal program of ment and software had changed little
extended unemployment benefits for thus far this year following the steep
some jobless workers to continue, or decline recorded in 2001. Spending on
resume, looking for work. computer equipment continued to rise
Industrial production increased for a rapidly in the first quarter, and outlays
third straight month in March after the for communications equipment gener-
lengthy decline from its June 2000 peak. ally stabilized after a large and lengthy
In the manufacturing sector, output in decline. By contrast, business purchases
the first quarter retraced a little more of both motor vehicles and aircraft
192 89th Annual Report, 2002

slowed sharply. In the nonresidential early months of the year. The Canadian
construction sector, investment slumped economy appeared to have expanded
in office buildings, industrial structures, robustly in the first quarter, and eco-
lodging facilities, and in drilling and nomic activity in Europe evidently had
mining. Moreover, available informa- turned upward. By contrast, available
tion indicated that this sector would indicators suggested that the Japanese
remain depressed: Vacancy rates for economy was still contracting, though at
office and industrial buildings continued a less rapid rate.
to rise, with deterioration in the office Although higher energy prices contin-
sector especially pronounced in areas ued to push up headline consumer price
dominated by high-tech firms, and prop- inflation in March, inflation had moved
erty values and rents for retail space and downward over the past twelve months.
warehouses weakened. Both the overall consumer price index
The pace of liquidation of manufac- (CPI) and the personal consumption
turing and trade inventories slowed expenditure (PCE) chain-linked index
sharply in January and February after a decelerated significantly over the past
notably large contraction in the fourth year. Moreover, excluding their volatile
quarter, and the aggregate inventory– food and energy components, both mea-
sales ratio declined a bit further. Stocks sures of inflation also fell over the past
of manufacturers continued to fall year. At the producer level, prices for
through March (latest data). Whole- finished goods echoed the pattern of
salers also continued to reduce their consumer prices: Both total and core
inventories during January and February finished goods inflation decelerated on a
(latest data), and the sector’s inventory– year-over-year basis. Labor cost growth,
sales ratio dropped further. At the retail as measured by hourly compensation in
level, stocks jumped in January and Feb- private industry, also appeared to have
ruary, but almost all of the increase slowed a bit over the latest twelve-
occurred at automotive dealers. The month period.
inventory–sales ratio for retail trade At its meeting on March 19, 2002,
edged up over the two months but was the Committee adopted a directive that
still at a relatively low level. called for maintaining conditions in
The U.S. trade deficit in goods and reserve markets consistent with keeping
services widened in January and Feb- the intended level of the federal funds
ruary, reflecting a considerably larger rate at 13⁄4 percent. With the economy
expansion in the value of imports than expanding at a significant pace, the
in that of exports. The rise in imports Committee now saw the risks to achiev-
related in part to the royalties and ing its long-term goals as balanced.
license fees paid to the International Members noted that the impetus for
Olympics Committee for the rights to the economic advance was to a large
broadcast the Winter Olympic Games. extent a temporary swing in inventory
With regard to economic activity investment rather than a clear and sub-
abroad, the available information indi- stantial upswing in final demand. As
cated that, on balance, foreign economic a result, the outlook for the economy
output had rebounded in the first quar- remained somewhat uncertain, and the
ter. The economies of the technology- current accommodative stance of policy
sensitive Asian countries had already continued to be viewed as appropri-
turned up in the fourth quarter and ate. The members contemplated, how-
seemed to have grown rapidly in the ever, that the stance of monetary policy
Minutes of FOMC Meetings, May 193

would have to become less accommo- market funds to stock and bond mutual
dative once clearer evidence emerged funds. Reduced demand for mortgage
that a healthy expansion was firmly refinancing and lower nonwithheld fed-
established. eral payments also contributed impor-
The federal funds rate remained close tantly to the weakness in the broad
to the Committee’s target level of monetary aggregates.
13⁄4 percent during the intermeeting The staff forecast prepared for this
period. However, doubts about the meeting suggested that the expansion in
strength of the recovery owing to the economic activity was slowing substan-
tone of the Committee’s press statement tially in the current quarter but would
along with mixed incoming data on final pick up in the second half of the year
demand, announcements of weaker- and continue at a moderate pace next
than-expected corporate earnings, and year. An emerging shift by businesses
heightening tensions in the Middle East from inventory liquidation to some
prompted declines in yields on short- replenishment of stocks would help
to intermediate-term Treasury securi- boost activity over the next several
ties. Yields on investment-grade bonds quarters, but the ongoing recovery
tended to edge higher, however, in the would depend increasingly on growth in
wake of concerns about the transpar- spending by households and businesses.
ency of the accounting statements of Such spending would be fostered by
some firms. Most major indexes of the monetary ease and fiscal stimulus
equity prices moved down sharply in already in place and abetted by vigorous
response to the outlook for a weaker anticipated growth in structural pro-
economic recovery and the adverse ductivity, which would support house-
implications for corporate profits of hold incomes and business investment
economic and other developments. incentives. With a relatively robust
In foreign exchange markets, the contour for the course of final sales over
trade-weighted value of the dollar in the forecast horizon, the pressure on
terms of the major foreign currencies resources would rise somewhat despite
eased somewhat over the intermeeting the anticipated higher growth of struc-
period. Much of the dollar’s decline tural productivity. Nonetheless, activity
occurred late in the period in response to would remain below the economy’s
the mixed character of U.S. economic potential for a period ahead and the per-
data and relatively small declines in sistence of underutilized resources was
benchmark longer-term yields abroad. expected to contribute to damped core
The dollar rose slightly on average in consumer price inflation.
terms of an index of the currencies of In the Committee’s discussion of cur-
other important trading partners, in part rent and prospective economic devel-
because of the further depreciation of opments, members commented that
the Argentine peso. recently available statistical data and
M2 and M3 contracted in March and anecdotal reports suggested that the
April. The declines evidently reflected expansion in business activity was con-
in part the rising opportunity costs of tinuing. However, it had slowed consid-
holding M2 assets as yields on the erably from its pace earlier in the year
components of M2 declined in lagged when it had received substantial impetus
response to the earlier easing of mone- from a marked slowing in the runoff of
tary policy and fostered transfers out of inventories. How much final demand
M2 funds, especially from retail money would strengthen going forward was
194 89th Annual Report, 2002

still uncertain. A pause in the expansion entrenched economic expansion. How-

was not an unusual development during ever, the pickup likely would be limited
the early stages of a cyclical recovery, inasmuch as household spending had
and the members generally viewed a remained elevated through the period of
pickup in growth as a reasonable expec- economic weakness. Members com-
tation. The currently stimulative stance mented that such an outlook was sub-
of both fiscal and monetary policy ject to uncertainties in both directions.
would tend to undergird final demand, On the upside, faster-than-anticipated
especially in the context of an econ- growth could well materialize in an
omy that had exhibited a marked degree environment of monetary and fiscal pol-
of resilience and strength in underly- icy ease and of gradually firming labor
ing productivity growth that would markets and rising productivity that
bolster household incomes and provide would be boosting income growth. On
incentives for business capital spend- the other hand, employment growth had
ing. Members noted, however, that an been very sluggish to date, with employ-
already high level of consumer spending ers remaining quite cautious in their hir-
pointed to more limited than usual scope ing practices, and continued softness
for further growth in such spending, and in labor markets could damp consumer
gloomy business sentiment in the face confidence. The run-up in energy prices
of disappointing sales and profits raised also was a negative for household pur-
a question about the extent to which chasing power.
business investment would help to lift Household expenditures on new
final demand over coming quarters. homes were likewise at an elevated
Given growth in economic activity level, although members reported weak-
broadly in line with current expecta- ness in some price segments and geo-
tions, inflation was likely to remain graphic areas of the housing market. In
benign for some time in the context of general, however, housing displayed
an apparently strong uptrend in struc- ongoing strength in response to low
tural labor productivity, excess capacity mortgage rates, with rising prices in
in many labor and product markets, and many areas, and the downside risks to
a related absence of pricing power in this sector of the economy appeared
generally very competitive markets. to be limited. At the same time, mem-
In their review of developments and bers anticipated that growth, if any,
prospects in key expenditure sectors of in homebuilding activity would be sub-
the economy, members commented that dued over the next several quarters after
household spending had continued to an extended period of strong expansion.
be well maintained. In the consumer The members generally viewed busi-
area, recent anecdotal reports provided ness fixed investment as the key sector
a somewhat mixed, but on the whole that would determine the strength of the
positive, picture of consumer spending expansion. Such investment had con-
across the nation. Sales of motor vehi- tracted further in the first quarter, but
cles had moderated after a surge during the decline was the smallest in a year.
the closing months of 2001, but they Looking ahead, the members anticipated
remained relatively high and other con- a sluggish and delayed upturn in capi-
sumer outlays had continued to increase. tal expenditures in the next few quar-
Looking ahead, some growth in overall ters against the backdrop of persistently
consumer spending appeared likely in gloomy business sentiment and large
association with the now more firmly margins of excess capacity in numerous
Minutes of FOMC Meetings, May 195

industries. Many business contacts com- closer alignment with sales, members
mented on their unwillingness to expand anticipated much less impetus to overall
capacity until they saw persuasive evi- economic activity from inventories over
dence of growing sales and profits. coming quarters.
Accordingly, much of their current Recent and immediately prospective
investment spending was focused on legislation had increased the fiscal
cost-saving equipment and software in stimulus in the federal budget, and
an effort to bolster profits in a stable members commented that the current
price environment that made it diffi- dynamics of the budget process could
cult to pass on rising costs. The recent result in larger increases in government
passage of temporary legislation that spending than foreseen in recent budget
permitted a partial acceleration of tax estimates. In this regard some expressed
expensing was expected to provide some concern about the longer-term impli-
impetus to capital investments, but the cations of what they saw as a decline
legislation appeared to have had little in fiscal discipline. At the state and
effect thus far. With regard to the out- local government levels, however, dete-
look for nonresidential construction, riorating fiscal positions in 2001 had
members saw little prospect of any impelled many states and localities to
material increase in such construction curb spending and raise various taxes
over the next several quarters, given and fees.
widespread anecdotal and statistical Although foreign economic activity
reports of high vacancy rates and excess appeared to be picking up to some
capacity. extent and the dollar had edged lower,
The markedly reduced pace of inven- net exports were expected to remain a
tory liquidation in the first quarter of the negative factor in the growth of the
year accounted for much of the step-up domestic economy. Members cited
in GDP growth in that quarter and pro- anecdotal reports that tended to support
vided a strong indication that the period statistical evidence of strengthening
of inventory liquidation under way for economies in Europe and a number of
more than a year probably was coming developing Asian nations. Nonethe-
to an end. Indeed, anecdotal reports sug- less, given a recovery in U.S. domestic
gested that efforts to rebuild inventories demand approximating their current
were now being undertaken in a number forecasts, growth in imports likely
of industries, such as steel and motor would exceed that of exports by a wide
vehicles, and one regional survey indi- margin over the forecast horizon.
cated that businesses planned to accu- The outlook for inflation remained
mulate inventories over the next six favorable. Nearly all measures of total
months. However, businesses remained and core prices had decelerated over
quite cautious about the outlook for the past year, and in the context of fore-
sales, and many firms might also be in casts implying a continued sizable gap
the process of adapting to much reduced between actual and potential output,
levels of inventories in relation to sales the risk that inflationary pressures would
rather than restoring earlier inventory– intensify significantly over coming
sales ratios. A shift to inventory stock- quarters appeared to be quite limited;
ing in the near term, possibly in the indeed, inflation might edge a bit lower
current quarter, was seen as a reasonable in the early stages of the expansion. The
expectation, but with numerous firms deceleration in labor costs over the
having already moved production into past several quarters, evidence of a
196 89th Annual Report, 2002

surprisingly strong uptrend in structural ing developments and tighten policy as

labor productivity, low and stable infla- needed later.
tion expectations, and the widespread All the members favored the retention
absence of pricing power in highly of a neutral balance of risks statement to
competitive markets were signs that be released shortly after this meeting.
upside inflation risks in the period ahead Against the longer-term inflation risks
were relatively small. The members inherent in the current stance of policy,
recognized nonetheless that there were the members weighed the possibility
upward pressures on costs in a num- that the expansion could be relatively
ber of areas. These included signifi- subdued for a time, damping prices
cant increases in energy costs in further and failing to reduce margins of
recent months, evidence of an upturn in underutilized resources. In any event, a
some industrial prices, sharp increases neutral statement regarding the risks to
in many insurance costs, continuing the economy in the foreseeable future
upward pressures on medical costs, and would not preclude a preemptive tight-
modest recent declines in the foreign ening adjustment in the stance of policy
exchange value of the dollar. With the stance should new evidence bearing on
stance of monetary policy currently the strength of the expansion and the
quite accommodative, the members outlook for inflation warrant such a pol-
saw the need for careful monitoring of icy move.
the potential for rising inflation pres- At the conclusion of the discussion,
sures as the economic recovery gained the Committee voted to authorize and
momentum. direct the Federal Reserve Bank of New
In the Committee’s discussion of pol- York, until it was instructed otherwise,
icy for the intermeeting period ahead, to execute transactions in the System
all the members agreed on the desirabil- Account in accordance with the follow-
ity of maintaining an unchanged policy ing domestic policy directive.
stance, with the target federal funds rate
staying at 13⁄4 percent. The economic The Federal Open Market Committee
recovery was clearly continuing, but seeks monetary and financial conditions that
its rate of advance had moderated con- will foster price stability and promote sus-
siderably and the economy’s future tainable growth in output. To further its long-
course was subject to a marked degree run objectives, the Committee in the imme-
diate future seeks conditions in reserve
of uncertainty. While the longer-term markets consistent with maintaining the
outlook for a strengthening economy federal funds rate at an average of around
remained favorable, a firming of policy 13⁄4 percent.
at this time would be premature and
would incur an undue risk to a healthy The vote encompassed approval of
expansion. The members recognized the sentence below for inclusion in the
that monetary policy exerted its effects press statement to be released shortly
with a considerable lag and that the after the meeting:
current stance of policy probably was
inconsistent with the Committee’s infla-
tion objective over time. However, cur- Against the background of its long-run
rent inflation pressures were subdued goals of price stability and sustainable eco-
nomic growth and of the information cur-
and were expected to remain so for a rently available, the Committee believes that
considerable period, thereby providing the risks are balanced with respect to pros-
adequate opportunity to evaluate ongo- pects for both goals in the foreseeable future.
Minutes of FOMC Meetings, June 197

Votes for this action: Messrs. Greenspan, Mr. Reinhart, Economist

McDonough, Ms. Bies, Messrs. Ferguson, Mr. Stockton, Economist
Gramlich, Jordan, McTeer, Olson, San-
tomero, and Stern. Votes against this Mr. Connors, Ms. Cumming,
action: None. Messrs. Howard and Lindsey,
Ms. Mester, Messrs. Oliner,
It was agreed that the next meeting Rolnick, Rosenblum, Sniderman,
of the Committee would be held on and Wilcox, Associate Economists
Tuesday–Wednesday, June 25–26, 2002. Mr. Kos, Manager, System Open
The meeting adjourned at 12:15 p.m. Market Account

Donald L. Kohn Messrs. Ettin and Madigan, Deputy

Secretary Directors, Divisions of Research
and Statistics and Monetary
Affairs respectively, Board
Meeting Held on of Governors
June 25–26, 2002
Messrs. Slifman and Struckmeyer,
A meeting of the Federal Open Market Associate Directors, Division
Committee was held in the offices of of Research and Statistics,
the Board of Governors of the Federal Board of Governors
Reserve System in Washington, D.C., Messrs. Freeman 5 and Whitesell,
on Tuesday, June 25, 2002, at 2:30 p.m. Deputy Associate Directors,
and continued on Wednesday, June 26, Divisions of International Finance
2002, at 9:00 a.m. and Monetary Affairs respectively,
Board of Governors
Mr. Greenspan, Chairman€ Mr. English, Assistant Director,
Mr. McDonough, Vice Chairman€ Division of Monetary Affairs,
Ms. Bies€ Board of Governors
Mr. Ferguson€
Mr. Gramlich€ Messrs. Reifschneider 6 and Wascher,6
Mr. Jordan€ Assistant Directors, Division
Mr. McTeer€ of Research and Statistics,
Mr. Olson€ Board of Governors
Mr. Santomero€
Mr. Stern€ Mr. Simpson, Senior Adviser, Division
of Research and Statistics,
Messrs. Broaddus, Moskow, and Parry, Board of Governors
Alternate Members of the Federal
Open Market Committee Mr. Brayton,6 Ms. Dynan,5
Messrs. Lebow 6 and Roberts,6
Mr. Hoenig, Ms. Minehan, and Senior Economists, Division
Mr. Poole, Presidents of the of Research and Statistics,
Federal Reserve Banks of Board of Governors
Kansas City, Boston, and St. Louis
respectively Mr. Bomfim,5 Senior Economist,
Division of Monetary Affairs,
Mr. Kohn, Secretary and Economist€ Board of Governors
Mr. Bernard, Deputy Secretary€
Mr. Gillum, Assistant Secretary€ 5. Attended portion of meeting relating to the
Ms. Smith, Assistant Secretary€ discussion of economic developments.
Mr. Mattingly, General Counsel€ 6. Attended portion of meeting relating to a
Ms. Johnson, Economist€ special agenda discussion of inflation.
198 89th Annual Report, 2002

Mr. Skidmore, Special Assistant to The Committee then turned to a dis-

the Board, Office of Board cussion of the economic and financial
Members, Board of Governors outlook and the conduct of monetary
policy over the intermeeting period
Ms. Low, Open Market Secretariat ahead.
Assistant, Office of Board The information reviewed at this
Members, Board of Governors
meeting indicated that economic activ-
ity continued to expand in recent
Mr. Barron, First Vice President, months, though at a slower pace than
Federal Reserve Bank of Atlanta
earlier in the year. Consumer purchases,
residential housing outlays, and govern-
Messrs. Eisenbeis, Fuhrer, Goodfriend, ment spending recorded smaller gains,
Hakkio, Hunter, Judd, but business investment in durable
Ms. Krieger, and Mr. Rasche,
Senior Vice Presidents, Federal equipment and software appeared to be
Reserve Banks of Atlanta, Boston, leveling out after a long decline. Indus-
Richmond, Kansas City, Chicago, trial production continued to pick up.
San Francisco, New York, and Employment had risen a little, but not
St. Louis respectively enough to lower the unemployment
rate, and labor productivity seemed to
By unanimous vote, the minutes of be trending sharply upward. The surge
the meeting of the Federal Open Market in energy prices this year had boosted
Committee held on May 7, 2002, were headline inflation, but core measures of
approved. inflation had trended lower.
The Manager of the System Open Private nonfarm payroll employment
Market Account reported on recent edged up in April and May after a slow-
developments in foreign exchange mar- down in the first quarter in the pace of
kets. There were no open market oper- layoffs and job separations. Hiring was
ations in foreign currencies for the relatively brisk in the services sector in
System’s account in the period since the the April–May period, with most of the
previous meeting. advances occurring in the temporary-
The Manager also reported on recent help industry. Manufacturing payrolls
developments in domestic financial recorded small declines in both months,
markets and on System open market while the number of jobs in construction
transactions in government securities steadied in May after a large drop in
and securities issued or fully guaranteed April. The civilian unemployment rate
by federal agencies during the period moved down somewhat, to 5.8 percent
May 7, 2002, through June 24, 2002. By in May, but the average rate for the
unanimous vote, the Committee ratified April–May period remained above the
these transactions. level in the two previous quarters.
The Committee voted unanimously to Industrial production rose for a fifth
update its longstanding authorization straight month in May. In manufactur-
for the Federal Reserve Bank of New ing, output increases in April and May
York to enter into agreements that would continued to be spread widely across
enable another Federal Reserve Bank to market groups and industries. The high-
conduct System open market operations tech sector, notably computers and semi-
on a temporary basis in an emergency conductors, and the motor vehicles and
after designation by the Committee or parts sector remained strong, while the
the Chairman. telecommunications and aircraft indus-
Minutes of FOMC Meetings, June 199

tries weakened further. Capacity utiliza- tion of retail space, warehouses, and
tion in manufacturing in May was a institutional structures picked up.
little above its depressed level at year- Liquidation of manufacturing and
end, but substantially below its long-run trade inventories continued in April
average. at about the pace of the first quarter,
Growth of consumer spending slowed and the aggregate inventory–sales ratio
appreciably in April and May from the declined further. In manufacturing, the
brisk pace of the first quarter. Retail rate of liquidation slowed substantially,
sales slumped in May after a sizable and the aggregate stock–shipments ratio
rise in April, largely reflecting weaker for the sector was at a very low level.
spending at apparel stores and general Wholesalers ran down their inventories
merchandise outlets and an apparent in April at a somewhat faster rate than in
pause in purchases of light motor vehi- the first quarter; the sector’s inventory–
cles after an April surge. Real outlays sales ratio fell sharply further to a rela-
on services in April (latest data) were tively low level. Retailers boosted their
unchanged. stocks slightly in April, with all of the
Residential housing activity remained increase occurring at automotive deal-
elevated during April and May. Hous- ers. The sector’s aggregate inventory–
ing starts jumped in May after a small sales ratio edged up in April but
decline in April. The strength in starts remained relatively low.
over the two months evidently reflected The U.S. trade deficit in goods and
the persistence of very positive home- services widened somewhat in April
buying attitudes arising at least in part from both the March and the first-
from low mortgage rates. In May, sales quarter levels, as the value of imports
of new single-family homes established increased significantly more than that of
a new record high, and sales of existing exports. The rise in imports from March
single-family homes were only slightly to April reflected higher prices for
below the peak reached in the first imported oil along with greater demand
quarter. for a wide range of goods. The monthly
The decline in business outlays for step-up in exports was also broadly
durable equipment and software had spread across categories of goods. With
moderated further in the first quarter, regard to economic activity abroad, the
and the available information suggested available information indicated that, on
that spending on equipment and soft- balance, foreign economic output had
ware was turning upward in the second rebounded in the first half of the year,
quarter. Shipments of nondefense capi- though the pace of recovery was uneven
tal goods other than aircraft rose in April across regions and countries. Australia,
and May; shipments of computers and Canada, and emerging Asia had experi-
peripherals remained strong, shipments enced strong growth; the euro area also
of communications equipment were still was expanding, but at a slower rate; and
weak, and shipments of other durable Japan appeared to have experienced a
goods continued to advance. In the limited upturn in its economy. In South
nonresidential construction sector, out- America, Brazil’s economy was expand-
lays for office and industrial structures, ing but its financial markets had come
lodging facilities, and public utilities under considerable stress, and elsewhere
declined substantially. In addition, on the continent economic activity was
expenditures for drilling and mining generally weak, particularly in Argen-
continued to drop. By contrast, construc- tina and Venezuela.
200 89th Annual Report, 2002

Both the consumer price index and dropped somewhat over the intermeet-
the personal consumption expenditure ing period. The dollar’s decline against
chain-linked index indicated that con- the major foreign currencies occurred as
sumer price inflation was moderate questions about the strength of U.S. eco-
during the April–May period. Moreover, nomic recovery and corporate earnings
both measures showed that core price and the related lowering of expectations
inflation during the first five months for near-term monetary tightening led to
of the year had been a bit lower than in concerns that net foreign capital inflows
2001. At the producer level, prices for might not be consistent with a stable
core finished goods changed little over exchange value for the dollar in the con-
April and May and decelerated on a text of growing U.S. net international
year-over-year basis. Labor costs, as indebtedness. By contrast, the dollar
measured by the average hourly earn- rose slightly on average in terms of an
ings of production or nonsupervisory index of the currencies of other impor-
workers, also decelerated. tant trading partners, notably the curren-
At its meeting on May 7, 2002, the cies of several Latin American countries
Committee adopted a directive that that were experiencing political and eco-
called for maintaining conditions in nomic problems.
reserve markets consistent with keeping Growth of the broad monetary aggre-
the intended level of the federal funds gates picked up in May owing to the
rate at 13⁄4 percent, and it also retained a unwinding of distortions from final tax
neutral balance of risks statement. The payments and, apparently, to falling
Committee’s press statement, with its equity prices. The heightened volatility
language indicating that the Commit- of equity markets may have enhanced
tee remained uncertain about the extent the attractiveness of safe and liquid M2
and timing of the strengthening of final assets, including liquid deposits and
demand, was viewed by market par- retail money market funds.
ticipants as expressing less confidence The staff forecast prepared for this
in the strength of the recovery than had meeting suggested that the expansion of
been expected, and yields on Treasury economic activity would pick up in the
securities declined slightly in response. last half of the year from the sluggish
Subsequently, investors became more pace of the second quarter and reach
risk averse in reaction to a mixture of a relatively brisk pace next year. The
economic data releases, growing geo- considerable monetary ease and fiscal
political tensions, further warnings stimulus already in place and the con-
about terrorism, and additional revela- tinuing sizable gains in productivity
tions regarding questionable corporate would provide significant impetus for
accounting practices. Yields on Trea- spending, though weakness in equity
sury securities dropped somewhat on net prices would tend to offset some of that
over the period, rates on lower-quality support. With business capital stocks
bonds rose, and equity prices fell moving closer to desired levels, invest-
sharply further. The federal funds rate ment spending would be boosted by a
remained close to the Committee’s tar- gradually improving outlook for sales
get level of 13⁄4 percent during the inter- and profits, low financing costs, and the
meeting period. temporary federal tax incentive for
In foreign exchange markets, the investment in new equipment and soft-
trade-weighted value of the dollar in ware. A more robust contour for final
terms of the major foreign currencies sales over the forecast horizon would
Minutes of FOMC Meetings, June 201

lead to somewhat greater pressure on and spending and encourage a pickup

resource margins, despite the expected in business investment. The strength
strong growth of structural productiv- in productivity also would help to
ity, though the level of activity would hold down cost and price pressures
remain below the economy’s poten- and, given an economic expansion and
tial for some time. The persistence of resource utilization in line with the
underutilized resources was expected to members’ forecasts, would reinforce the
foster some moderation in core price prospect that core price inflation would
inflation. remain low.
In the Committee’s discussion of cur- In preparation for the midyear mone-
rent and prospective economic condi- tary policy report to Congress, the mem-
tions, members commented that there bers of the Board of Governors and the
had been little change since the May presidents of the Federal Reserve Banks
meeting in the factors bearing on what submitted individual projections of the
they viewed as a favorable outlook for growth of GDP, the rate of unemploy-
a pickup in the expansion. Although ment, and the rate of inflation for the
financial markets, and perhaps busi- years 2002 and 2003. The forecasts of
ness and household confidence, had the rate of expansion in real GDP had
been shaken by revelations of account- central tendencies of 31⁄2 to 33⁄4 percent
ing irregularities, the economy had for 2002, implying growth in the second
continued to expand and the prospects half of the year at a rate close to that
for accelerating aggregate demand currently estimated for the first half, and
remained positive. Some members 31⁄2 to 4 percent for 2003. These rates of
observed, however, that they had growth were expected to keep the civil-
expected to see firmer indications of a ian rate of unemployment in a central
strengthening recovery by the time of tendency of 53⁄4 to 6 percent in the
this meeting. The degree of impetus fourth quarter of 2002 before it fell to
from decelerating inventory liquidation 51⁄4 to 51⁄2 percent by the fourth quarter
and growth in final demand had moder- of 2003. Forecasts of the rate of infla-
ated during the spring, and anecdotal tion, as measured by the chain-type
and other evidence indicated that the price index for personal consumption
performance of various industries and expenditures, pointed to little change
firms had remained uneven. Looking from recent inflation levels and were
ahead, the timing and strength of an centered on a range of 11⁄2 to 13⁄4 per-
upturn in the expansion remained sub- cent for both this year and 2003.
ject to considerable uncertainty, but With imbalances in inventories appar-
in the absence of major further adverse ently largely worked off and the con-
shocks to confidence the members tribution of inventory investment to the
anticipated that economic activity would expansion likely diminishing in coming
accelerate over coming months to a quarters, final demand would play its
pace in the vicinity of, and perhaps usual primary role in determining the
somewhat above, the rate of growth strength of the expansion. In that regard,
of the economy’s potential. In support consumer spending was seen as likely to
of this view, members cited the accom- provide some continuing, though mod-
modative stance of both fiscal and erate, impetus to the growth of the econ-
monetary policy and the continuation omy. A favorable factor in this outlook
of impressive growth in productivity cited by members was the ability and
that should buttress household incomes willingness of households to extract siz-
202 89th Annual Report, 2002

able financing resources for consumer likely to provide much added stimulus
and other expenditures by drawing on to the expansion.
the appreciated equity in their homes A pickup in business spending was
in one form or another. The ample avail- viewed as a key to sustained solid
ability of credit to most consumers growth, and questions about the tim-
was another positive factor. Although ing and strength of such a pickup was
consumer confidence as measured by a major source of uncertainty about
national surveys recently had declined the pace of the expansion in coming
somewhat from relatively elevated lev- quarters. The preconditions for a
els, reports of strength in motor vehicle robust advance in investment spending
sales and in other retail sales in several appeared to be largely in place, includ-
parts of the nation in recent weeks sug- ing the evident progress over the past
gested that consumer spending was con- several quarters in adjusting capital
tinuing to be well maintained. The mem- stocks to desired levels, the temporary
bers recognized that a typical recovery- tax incentive, and the need for competi-
period surge in consumer spending was tive reasons to take advantage of the
unlikely inasmuch as expenditures had availability of increasingly productive
registered solid growth through the eco- equipment. In fact, recent orders and
nomic downturn, implying an absence shipments data suggested an upturn in
of significant pent-up demands. More- spending for new equipment, but the
over, forecasts of even moderate growth improvement was still quite limited,
in spending were subject to downside unevenly distributed across industries,
risks emanating, for example, from pos- and not yet firmly indicative of a sus-
sible further shocks to confidence and tained advance. While the members
household wealth should weakness in expected further gains in spending on
stock prices persist, and from political equipment, they continued to report
turmoil overseas and threats of terrorism widespread pessimism among their busi-
at home. ness contacts, though exceptions had
Homebuilding, though down after an begun to emerge, and the persistence of
unsustainable surge earlier in the year, a high degree of caution that was lead-
had been well maintained in recent ing business executives to defer numer-
months. Recent statistics supported by ous investment projects until they saw
widespread anecdotal reports pointed to more conclusive evidence of stronger
persisting strength in housing activity, sales and profits.
though there were indications of soft- The outlook for nonresidential con-
ness in high-priced homes in at least struction activity remained bleak amid
some parts of the country. Looking for- indications of a widespread overhang of
ward, members expected a high level available space and attendant declines in
of home construction to continue. A rents and property values. Indeed, the
key factor in this outlook was the ready drop in such construction did not appear
availability of mortgage financing to to have run its course for the nation as a
most borrowers at very attractive rates. whole. Even so, the ongoing adjustment
Members also referred to growing of nonresidential capacity to demand
population pressures, abetted by sizable had been substantial in recent quarters
immigration, on increasingly scarce and likely would give way to a modest
buildable land in numerous areas. On recovery during the year ahead.
balance, however, given its already For the economy as a whole, the liqui-
robust level, housing was not seen as dation of business inventories appeared
Minutes of FOMC Meetings, June 203

to be near completion in the current important trading partners. Indeed,

quarter, and some rebuilding in associa- members provided anecdotal reports of
tion with forecasts of moderate expan- better export markets for a number of
sion in sales seemed a likely prospect U.S. products. At the same time, how-
for coming quarters. The restocking was ever, severe problems being experienced
expected to proceed gradually, given the by a number of large countries in South
probable persistence of a relatively high America raised the specter of a deepen-
degree of uncertainty and caution in the ing financial crisis within that region
business community. Such an outlook and the possibility of more widespread
implied that inventory investment would contagion.
supply positive but limited impetus to Given their anticipation of strong pro-
the expansion over the forecast horizon. ductivity growth and continuing slack
The federal tax cuts and large in labor and other markets, members
increases in federal spending legislated expected inflation to remain low over
over the past year were expected to the next several quarters. An underlying
provide support for aggregate demand factor in the good inflation performance
over the projection period. Some mem- of recent years and its extension into
bers expressed concern, however, about the future was the continuing absence of
what they perceived to be the erosion of pricing power throughout the economy,
long-term fiscal discipline and increas- evidently related in part to increased
ing prospects that federal deficits would price competition in markets around
persist even after the economy recov- the world stemming from globalization.
ered, with adverse effects on the domes- Members cited examples of rising prices
tic savings available for investment. for a few products, notably steel, and the
Concurrently, however, at the state and possibility that energy prices might raise
local government level where budget costs. They also referred to the potential
flexibility was more limited, sizable for upward pressure on prices associated
budgetary shortfalls likely would hold with the recent depreciation of the dol-
down expenditures and induce some tax lar. Nonetheless, with rising productiv-
increases, with restraining effects over a ity and moderate wage gains likely con-
period of time. tinuing to help hold down unit labor
With regard to the outlook for the costs, the outlook for subdued inflation
external sector of the economy, the siz- remained promising, especially for the
able decline in the foreign exchange nearer term.
value of the dollar since the start of the The discussion of the inflation out-
year had given rise to market forecasts look was held against the backdrop of
of appreciable further depreciation. The an earlier consideration at this meet-
factors that governed the exchange value ing of the factors behind the decline in
of the dollar were complex, and histori- inflation in the 1990s and the value of
cally forecasts of trends in exchange structural models for forecasting infla-
rates had not been reliable. To the extent tion. Most Committee members, while
that the depreciation of the dollar was acknowledging the deficiencies of struc-
not reversed or that it continued, it tural models, viewed them as useful in
would of course tend to boost net their efforts to understand how the infla-
exports. Exports would in any event be tion process was changing and also as
likely to strengthen somewhat as a con- input to inflation forecasts. The mem-
sequence of the evidently improving bers saw greater productivity growth,
economies of a number of the nation’s changing labor markets, and increased
204 89th Annual Report, 2002

competition in product markets as hav- still somewhat mixed. Still, in current

ing played a part along with mone- circumstances, there was little risk of
tary policy in lowering inflation. They triggering an increase in inflation by
agreed that more research—across coun- waiting for a better reading on the
tries as well as across time—was needed course of the economy. Some members
before they could become more con- were concerned that markets might not
fident about the value and stability of fully appreciate the inevitability of even-
such models. tual policy tightening. However, others
In the Committee’s discussion of pol- pointed out that market participants
icy for the intermeeting period ahead, seemed to have little doubt about the
all the members agreed that recent Committee’s determination to keep
developments argued for maintaining an inflation low and in that context markets
unchanged policy stance, with the target were likely to anticipate Committee
for the federal funds rate remaining at action once incoming information sug-
13⁄4 percent. The members saw favor- gested it was becoming appropriate.
able prospects for a significant accelera- The members said that they could see
tion in the expansion from the reduced risks on both sides of their forecasts,
pace in the current quarter, but consider- which indicated that growth would pick
able uncertainty still surrounded the tim- up and inflation would remain low over
ing and strength of the pickup. In the coming quarters at the current stance
current situation, retention of the cur- of policy. Accordingly, they agreed to
rently accommodative policy stance was retain an assessment of balanced risks to
desirable to counter the lingering effects their long-term objectives in the Com-
of financial and other shocks to the mittee’s post-meeting press release.
economy that were continuing to exert Such a statement would not be an
a depressing impact on output and impediment to adjusting policy should a
resource use. Inflation was still edging significant and unanticipated change in
down, inflation expectations appeared to economic conditions materialize in the
be low and stable, and going forward near term.
the members’ forecasts for growth and At the conclusion of the discussion,
productivity implied that unit costs and the Committee voted to authorize and
prices would remain subdued for some direct the Federal Reserve Bank of New
time. York, until it was instructed otherwise,
A number of members noted that the to execute transactions in the System
current policy stance was too accommo- Account in accordance with the follow-
dative to be consistent over time with ing domestic policy directive.
the Committee’s objectives of price
stability and maximum sustainable eco- The Federal Open Market Committee
nomic growth. Economic performance seeks monetary and financial conditions that
in line with their current forecasts would will foster price stability and promote sus-
tainable growth in output. To further its long-
at some point require an adjustment run objectives, the Committee in the imme-
to policy toward a less accommodative diate future seeks conditions in reserve
stance once more definitive indications markets consistent with maintaining the fed-
of sustained strengthening started to eral funds rate at an average of around
emerge. And given the lags in monetary 13⁄4 percent.
policy such an adjustment would prob-
ably need to be made at a time when The vote encompassed approval of
the incoming economic information was the sentence below for inclusion in the
Minutes of FOMC Meetings, August 205

press statement to be released shortly Mr. Hoenig, Ms. Minehan, and

after the meeting: Mr. Poole, Presidents of the
Federal Reserve Banks of
Against the background of its long-run Kansas City, Boston, and
goals of price stability and sustainable eco- St. Louis respectively
nomic growth and of the information cur-
rently available, the Committee believes that Mr. Reinhart, Secretary and Economist€
the risks are balanced with respect to pros- Mr. Bernard, Deputy Secretary€
pects for both goals in the foreseeable future. Mr. Gillum, Assistant Secretary€
Ms. Smith, Assistant Secretary€
Mr. Mattingly, General Counsel€
Votes for this action: Messrs. Greenspan, Ms. Johnson, Economist€
McDonough, Ms. Bies, Messrs. Ferguson, Mr. Stockton, Economist€
Gramlich, Jordan, McTeer, Olson, San-
tomero, and Stern. Votes against this Mr. Connors, Ms. Cumming,
action: None. Messrs. Howard and Lindsey,
Ms. Mester, Messrs. Oliner,
It was agreed that the next meeting of Rolnick, and Wilcox, Associate
the Committee would be held on Tues- Economists
day, August 13, 2002.
The meeting adjourned on June 26, Mr. Kos, Manager, System Open
Market Account
2002, at 11:40 a.m.
Mr. Winn, Assistant to the Board,
Vincent R. Reinhart Office of Board Members,
Secretary Board of Governors

Messrs. Ettin and Madigan, Deputy

Meeting Held on Directors, Divisions of Research
August 13, 2002 and Statistics and Monetary
Affairs respectively, Board
A meeting of the Federal Open Market of Governors
Committee was held in the offices of
the Board of Governors of the Federal Messrs. Slifman and Struckmeyer,
Reserve System in Washington, D.C., Associate Directors, Divisions
of Research and Statistics,
on Tuesday, August 13, 2002, at Board of Governors
9:00 a.m.
Mr. Whitesell, Deputy Associate
Present: Director, Division of Monetary
Mr. Greenspan, Chairman€ Affairs, Board of Governors
Mr. McDonough, Vice Chairman€
Mr. Bernanke€ Mr. Clouse, Assistant Director,
Ms. Bies€ Division of Monetary Affairs,
Mr. Ferguson€ Board of Governors
Mr. Gramlich€
Mr. Jordan€ Mr. Simpson, Senior Adviser, Division
Mr. Kohn€ of Research and Statistics,
Mr. McTeer€ Board of Governors
Mr. Olson€
Mr. Santomero€ Mr. Skidmore, Special Assistant
Mr. Stern€ to the Board, Office of Board
Members, Board of Governors
Messrs. Broaddus, Guynn, Moskow,
and Parry, Alternate Members Ms. Low, Open Market Secretariat
of the Federal Open Market Assistant, Office of Board
Committee Members, Board of Governors
206 89th Annual Report, 2002

Messrs. Connolly and Stewart, The information reviewed at this

First Vice Presidents, Federal meeting indicated that economic activ-
Reserve Banks of Boston and ity expanded only slightly in the second
New York
quarter. Businesses added a bit to their
inventory positions after an extended
Messrs. Goodfriend, Hakkio, Hunter,
and Rasche, Senior Vice period of sizable declines, but final sales
Presidents, Federal Reserve changed little: business capital spend-
Banks of Richmond, Kansas City, ing weakened somewhat further while
Chicago, and St. Louis growth in consumer spending, residen-
respectively tial housing expenditures, and govern-
ment outlays slowed. The scant infor-
Messrs. Bryan, Cox, and Cunningham, mation available for the third quarter,
Ms. Hargraves, principally July’s very strong motor
Messrs. Rudebusch and Tootell,
Vice Presidents, Federal Reserve vehicle sales, suggested that domestic
Banks of Cleveland, Dallas, demand was still recovering but rela-
Atlanta, New York, San Francisco, tively sluggishly. Industrial production
and Boston respectively had continued to advance since the first
quarter, but the demand for labor ser-
By unanimous vote, the minutes of vices had increased only slightly and the
the meeting of the Federal Open Market unemployment rate had risen. Impor-
Committee held on June 25–26, 2002, tantly, labor productivity continued on
were approved. a strong upward trend. Overall price
By unanimous vote, Vincent R. Rein- inflation had fallen sharply over the past
hart was elected as Secretary and Econ- year, largely reflecting developments in
omist of the Committee for the period the food and energy sectors, and core
until the first regularly scheduled meet- inflation had eased a little.
ing in 2003. Private nonfarm payroll employment
The Manager of the System Open inched up in July after a mild increase in
Market Account reported on recent June, though aggregate hours worked by
developments in foreign exchange mar- production or nonsupervisory workers
kets. There were no open market opera- declined steeply. The help-supply por-
tions in foreign currencies for the Sys- tion of the services sector and the con-
tem’s account in the period since the struction industry recorded substantial
previous meeting. net job losses over the June–July period,
The Manager also reported on devel- but manufacturing registered its small-
opments in domestic financial markets est payroll decline in two years in July,
and on System open market transactions and hiring was relatively brisk in ser-
in government securities and securi- vices other than help-supply. The civil-
ties issued or fully guaranteed by fed- ian unemployment rate edged up in
eral agencies during the period June 26, June, to 5.9 percent, and was unchanged
2002, through August 12, 2002. By in July.
unanimous vote, the Committee ratified Industrial production jumped in June,
these transactions. and gains in output were widespread
The Committee then turned to a dis- across market groups and industries.
cussion of the economic and finan- However, the limited available infor-
cial outlook and the conduct of mone- mation indicated that output leveled out
tary policy over the intermeeting period in July after six consecutive months of
ahead. increases. Capacity utilization in manu-
Minutes of FOMC Meetings, August 207

facturing moved a little higher in June the nonresidential construction sector,

but remained substantially below its outlays for office, industrial, and other
long-run average. structures, lodging facilities, and public
Retail sales were relatively brisk in utilities declined substantially further.
June and July despite plunging equity By contrast, construction of institutional
prices and an apparently marked ero- structures was up again in the second
sion in consumer confidence. House- quarter.
holds spent heavily on motor vehicles in Nonfarm inventory investment turned
response to incentives offered by auto slightly positive in the second quarter
manufacturers, and their expenditures on after several quarters of heavy liquida-
other retail categories were generally tion. Success in pruning inventories had
well maintained. resulted in inventory–sales ratios that
Residential housing activity remained generally were at very low levels across
strong in the second quarter, buoyed by the manufacturing, wholesale, and retail
a very favorable mortgage financing sectors. There appeared to be only a few
environment. The pace of homebuilding industries with still sizable inventory
in the quarter continued well above that overhangs.
seen during the past few years even The U.S. trade deficit in goods and
though single-family housing starts in services widened further in May and for
June did not reach the elevated May the April–May period. The expansion of
level. Sales of new single-family homes the deficit over the two months reflected
in June remained at a record high, but a sharp rise in the value of imports that
sales of existing homes declined notice- exceeded a sizable gain in the value
ably. In the multifamily sector, June of exports. The step-up in imports
starts were in the lower end of their was spread widely across almost all
range over recent quarters. Market con- the major trade categories, with notable
ditions in the condominium and coop- increases in motor vehicles, consumer
erative apartment portion of the housing goods, and machinery. The advance in
sector appeared to be favorable, but exports was primarily in automotive
rising vacancy rates and weaker rents parts, industrial supplies, and capital
apparently hindered the rental apartment equipment. With regard to economic
segment. activity abroad, the available informa-
Business investment in equipment tion, which is released in many cases
and structures declined further in the only with a considerable lag, indicated
second quarter as the continuing down- that foreign economic output generally
draft in nonresidential construction more continued to rebound during the first
than offset a pickup in business spend- half of the year, though the pace of
ing for durable equipment and soft- recovery was uneven across regions and
ware. Despite gradually improving countries. Growth was strong in Can-
fundamentals—rising output and prof- ada, the United Kingdom, and emerging
its, new tax incentives, and a low cost of Asia, but expansion in the euro area
capital—firms remained cautious about and Japan remained sluggish, owing to
stepping up their investments in equip- continued weakness in final domestic
ment and software, and recent data on demand. In South America, economic
orders and shipments of nondefense and financial conditions had deterio-
capital goods coupled with anecdotal rated significantly during the intermeet-
reports suggested further lackluster ing period, especially in Brazil and Uru-
gains in spending in coming months. In guay, and economic activity remained
208 89th Annual Report, 2002

particularly weak in Argentina and trading, as investors sought a safe haven

Venezuela. for their funds and trimmed their expec-
Consumer price inflation trended tations about the path for the intended
down over the past year. Much of the federal funds rate in coming quarters.
drop reflected developments in the However, doubts about corporate bal-
food and energy sectors, but core infla- ance sheets and the prospects for earn-
tion also eased a little. In May and June, ings growth led to steep increases in
both the consumer price and the chain- corporate debt yields, particularly for
weighted personal consumption indexes lower-quality issues.
exhibited little change in total and core In foreign exchange markets, the
prices. Moreover, at the producer level, trade-weighted value of the dollar
inflation in core finished goods was at a changed little on balance in terms of
low rate in the May–June period and the the major foreign currencies over the
past twelve months. With regard to labor intermeeting period, though early in
costs, the employment cost index for the period the dollar declined sharply
hourly compensation of private industry against those currencies amid further
workers increased at a somewhat faster disclosures of U.S. corporate accounting
rate during the three months ended in irregularities and concerns about the
June, reflecting a surge in benefit costs. strength of the U.S. recovery. Against
From a somewhat longer perspective, the background of a similar combination
however, growth of compensation costs of disappointing concerns, European
over the twelve months ended in June stock prices dropped more than those in
was the same as in the previous twelve- the United States, while Japanese equity
month period. prices declined less as incoming data
At its meeting on June 25–26, 2002, seemed to point to a mild pickup of
the Committee adopted a directive that economic activity in Japan. Across all
called for maintaining conditions in the major industrial economies, inves-
reserve markets consistent with keeping tors tended to shift funds toward less
the intended level of the federal funds risky instruments and to lower their
rate at 13⁄4 percent, and it also retained a expectations for policy rates. The dollar
neutral balance of risks statement. There also was little changed on balance
was little market reaction to the Com- against the index of currencies of other
mittee’s rate decision or its statement. important trading partners, even though
Instead, market participants focused several South American countries were
their attention on further revelations experiencing difficult financial and
of corporate malfeasance, fears that political problems.
more earnings restatements would Borrowing by domestic nonfinan-
be announced in the run-up to the cial businesses had been weak recently,
August 14 deadline for certifying cor- likely reflecting deteriorating conditions
porate financial statements, and con- in credit markets and reduced require-
cerns that second-half corporate earn- ments for funds to finance capital spend-
ings might prove disappointing. In this ing projects. Growth of M2 surged in
environment, equity prices plunged July in association with large inflows to
before recovering somewhat later in the liquid deposits and retail money market
intermeeting period; on net, the major funds.
broad equity indexes were down sub- The staff forecast prepared for this
stantially. Yields on Treasury securities meeting suggested that, in light of
also fell markedly on balance in volatile weaker-than-expected incoming eco-
Minutes of FOMC Meetings, August 209

nomic data, the expansion of economic included the stimulative stances of fis-
activity would pick up gradually over cal and monetary policy, the apparent
the next year and a half from the very completion in most industries of efforts
sluggish pace of the second quarter. The to bring inventories and capital facilities
considerable monetary ease and fiscal into desired alignment with expected
stimulus already in place and the con- sales, and the support to consumer
tinuing sizable gains in structural pro- incomes and business incentives pro-
ductivity would provide significant vided by the continued rise in structural
impetus for spending, though the per- productivity. Further gains in productiv-
sisting volatility and weakness in equity ity and the prospect for relatively con-
prices would tend to offset some of that tained demand pressures on resources,
support. Inventory overhangs appeared which were likely to be somewhat more
to have been largely eliminated and limited for a time than members had
business capital stocks to have moved anticipated earlier, would contribute to
closer to desired levels. As a conse- keeping price inflation subdued.
quence, a gradually improving outlook A number of members commented on
for sales and profits, low financing financial developments that appeared to
costs, and the temporary federal tax be holding back the pace of the expan-
incentive for investment in new equip- sion. While prices in equity markets had
ment and software were expected to turned up from their recent lows, the
boost business investment spending. cumulative losses in financial wealth
However, a less robust pickup in final incurred since early 2000 clearly were
sales was now expected over the fore- having an adverse impact on expendi-
cast period, which would put somewhat tures by households and the higher cost
less pressure on resource margins than of equity capital was inhibiting busi-
had been anticipated previously, and the ness investment. The declines in equity
level of activity would remain below prices had been accompanied by a
the economy’s potential for a somewhat heightened degree of risk aversion that
longer time. The persistence of underuti- had led to widened credit spreads in
lized resources was expected to foster financial markets and the curtailment
some moderation in core price inflation. of credit availability to potential borrow-
In the Committee’s discussion of cur- ers whose repayment prospects were
rent and prospective economic devel- viewed as questionable. To an extent
opments, members commented that that was difficult to determine, the cur-
much of the incoming information on rent skittishness in debt and equity mar-
economic activity had been disappoint- kets reflected lender and investor reac-
ing, and many indicated that they had tions to the ongoing revelations of
marked down their growth forecasts for corporate governance failures. Those
the months ahead. Even so, with recent reactions, which were proving to be
weakness concentrated in volatile high- more severe and probably would be
frequency data that might well prove to longer-lasting than many had antici-
be transitory and with business and con- pated, appeared to be contributing to
sumer confidence unlikely to deteriorate more cautious business spending and
further in the absence of a major shock hiring, at least temporarily. It was
to the economy, members continued to unclear when the associated uncertain-
place favorable odds on an underlying ties would diminish and confidence
outlook of strengthening expansion. would begin to rebuild, though the
Factors cited for this positive outlook outlook might come into better focus
210 89th Annual Report, 2002

after the mid-August SEC deadline for sustaining homebuilding activity at a

the certification of financial statements relatively elevated level. Housing mar-
by corporate executives. On the posi- kets continued to exhibit strength across
tive side, home mortgage financing much of the country, with few indica-
remained widely available at low inter- tions of any moderation except for sales
est rates and was providing important of high-priced homes. It was noted that,
support to household spending. More in the absence of an unanticipated down-
generally, interest costs had declined for turn in general economic activity, under-
borrowers with acceptable credit rat- lying pressures for housing as the pop-
ings, and the overall condition of the ulation expanded coupled with the
banking system remained sound with scarcity of viable homebuilding sites in
bank credit widely available. Moreover, urban areas likely would preclude any
for many households, the negative substantial decline in housing activity or
wealth effects stemming from losses on housing prices in the foreseeable future.
equities were offset, at least to some The weakness in business fixed
extent, by continuing increases in home investment was still a depressant on
equity values. These ongoing factors overall economic activity, though the
suggested to some members that the decline in business outlays had abated
effects of the financial restraints on eco- since the latter part of 2001; indeed,
nomic activity might be fairly limited at spending for equipment and software
this point. had edged up in the second quarter. With
In their review of demand prospects excess stocks of capital inventories
in key sectors of the economy, members seemingly worked down to more accept-
noted that household spending was con- able levels in many industries and with
tinuing to play a key role in sustaining expansion in final sales expected to
the expansion. Retail sales, buttressed become more firmly established, an
by strength in motor vehicles, had been acceleration in spending for equipment
well maintained in recent months and software was likely in store. As they
despite survey evidence of declining had at earlier meetings, however, mem-
consumer confidence. The extraction of bers observed that business sentiment
funds from increases in home equity remained extraordinarily cautious on the
evidently remained an important source whole and that business firms in most
of financing for household expenditures, industries continued to direct their
especially including outlays for home investment spending primarily toward
modernization. Looking ahead, the enhancing the productivity of their
anticipated pickup in employment and operations rather than also increasing
related gains in incomes, undergirded capacity. Exceptions cited by members
by continued robust growth in structural included the enlargement of production
productivity, was seen as supporting fur- facilities by some firms in industries
ther expansion in consumer spending. that were currently enjoying vigorous
Some members commented, however, demand, such as producers of motor
that the declines in equity wealth and vehicles. How soon the gloom surround-
the possible persistence of turmoil in ing the outlook for a pickup in sales and
equity markets might continue to profits and the associated concerns in
restrain the pickup in consumer expen- financial markets would dissipate was
ditures in the months ahead. subject to substantial uncertainty, but
In the housing sector, low mortgage increasing needs for capital as the
interest rates remained a key factor in economy continued to expand, further
Minutes of FOMC Meetings, August 211

growth in investment opportunities in growth in their expenditures. Anecdotal

conjunction with the uptrend in struc- reports suggested, however, that sizable
tural productivity, and the temporary tax spending on a variety of construction
incentive provision for equipment and projects was continuing, financed in
software likely would support a sus- part through bond issues. On balance,
tained recovery in investment expendi- the government sector was expected to
tures over coming quarters that would remain a positive factor in the economic
provide essential impetus for lifting eco- recovery.
nomic growth. The depreciation of the dollar and
The prospects for an upturn in non- overall strengthening in foreign eco-
residential construction appeared to nomic activity were projected to foster
many to be more bleak. Reports from moderate added growth in U.S. exports
around the nation pointed to high, and over the next several quarters. However,
in many areas still rising, vacancy rates recent developments, including indi-
for commercial and industrial space, and cations of weaker-than-projected eco-
hotel construction continued to be held nomic recovery in Europe, growing
down by the problems afflicting the questions about the outlook for several
travel industry. Against this backdrop, important economies in South America,
overall nonresidential building activity and the continued sluggish performance
seemed likely to decline further over the of the Japanese economy, threatened
next several quarters. to limit the improvement in exports, at
Business inventories edged up in the least over the nearer term. Providing a
second quarter after declining persis- partial counterweight were anecdotal
tently since early 2001. Indeed, the reports indicating sizable growth in U.S.
strengthening was sufficient to account exports to a number of Asian countries.
for the small advance in GDP in the The outlook for inflation remained
latest quarter. With inventories now very favorable in the context of continu-
apparently close to desired levels in ing slack in labor markets and robust
many sectors of the economy and report- growth in structural productivity. Under
edly below such levels for some retail- these conditions, increases in trend unit
ers, the expected strengthening in final labor costs were likely to remain sub-
sales would probably foster some inven- dued over the next several quarters
tory accumulation over coming quarters, despite likely further escalation in
thereby adding impetus to the projected the cost of worker healthcare bene-
growth of the economy. fits. Indeed, the risks of any significant
Government spending also was run-up in inflation appeared to have
expected to provide ongoing stimulus to receded, and more time than anticipated
the expansion, especially given the pros- earlier was likely to elapse before the
pects for further spending initiatives expansion reached a pace that would
in forthcoming federal legislation. In begin to reduce margins of underutilized
addition, already enacted income tax labor and other producer resources.
cuts and the tax expensing provision for Even so, examples of rising cost and
certain investment outlays would help price pressures were not entirely absent.
to support both consumer and busi- In addition to healthcare insurance costs,
ness expenditures. Concurrently, though, these pressures included insurance
state and local governments facing large costs more generally, steel prices, some
shortfalls in revenues in a sluggish econ- materials costs, and, in association with
omy were holding down the overall the dollar’s depreciation, some upward
212 89th Annual Report, 2002

pressures on import prices. On balance Committee was contemplating easing

and barring a major supply shock to the in the near term. All the members
economy, members saw little reason agreed, however, on the desirability
for concern about the prospect of an of communicating in some form—
increase in inflation in the foreseeable whether in the text of the post-meeting
future. press release or through a shift in the
In the Committee’s discussion of pol- risks statement or both—their view
icy for the intermeeting period ahead, that the expansion recently had been
all the members were in favor of an less robust than expected and that
unchanged policy stance consistent with for the foreseeable future the risks
retaining a target rate of 13⁄4 percent of a more extended period of subpar
for the federal funds rate. Although growth had increased while those of
some economic and financial indicators inflation had declined. Several also
had deteriorated since the June meeting commented that while the shift under
and the members generally had scaled consideration might raise expectations
down their economic forecasts, they of some easing in coming months, those
continued to see favorable prospects expectations and related market adjust-
for a strengthening economy over time. ments would be shaped principally by
To be sure, a further significant weak- the tenor of the incoming economic
ening in economic prospects—for information.
example, that might be associated with At the conclusion of the discussion,
additional deterioration in financial the Committee voted to authorize and
markets—might well call for a policy direct the Federal Reserve Bank of New
response, but for now the members York, until it was instructed otherwise,
viewed the current degree of monetary to execute transactions in the System
accommodation as appropriately cali- Account in accordance with the follow-
brated to provide the stimulus needed ing domestic policy directive.
to foster a solid expansion that would
bring the economy to fuller resource The Federal Open Market Committee
utilization. seeks monetary and financial conditions that
All the members indicated that they will foster price stability and promote sus-
tainable growth in output. To further its long-
could accept, and most said they pre- run objectives, the Committee in the imme-
ferred, a proposal to shift the Com- diate future seeks conditions in reserve
mittee’s assessment of the risks to the markets consistent with maintaining the
economy from the currently neutral federal funds rate at an average of around
statement to one that was tilted toward 13⁄4 percent.
weakness in the foreseeable future. A
few expressed a preference to retain the The vote encompassed approval of
current balanced risks statement for the the sentence below for inclusion in the
press release to be issued shortly after press statement to be released shortly
this meeting. In support of this view, after the meeting:
they underscored the considerable
uncertainty surrounding the outlook for Against the background of its long-run
financial and economic conditions and goals of price stability and sustainable eco-
the prospect that many observers in nomic growth and of the information cur-
rently available, the Committee believes that
financial markets could misread a shift the risks are weighted mainly toward condi-
in the Committee’s assessment of the tions that may generate economic weakness
risks to the outlook as a signal that the in the foreseeable future.
Minutes of FOMC Meetings, September 213

Votes for this action: Messrs. Greenspan, Mr. Baxter, Deputy General Counsel€
McDonough, Bernanke, Ms. Bies, Ms. Johnson, Economist€
Messrs. Ferguson, Gramlich, Jordan, Mr. Stockton, Economist€
Kohn, McTeer, Olson, Santomero, and
Stern. Votes against this action: None. Messrs. Connors, Howard, and
Lindsey, Ms. Mester,
It was agreed that the next meeting of Messrs. Oliner, Rolnick,
the Committee would be held on Tues- Rosenblum, Sniderman, and
day, September 24, 2002. Wilcox, Associate Economists
The meeting adjourned at 12:40 p.m. Mr. Kos, Manager, System Open
Market Account
Vincent R. Reinhart
Secretary Messrs. Ettin and Madigan, Deputy
Directors, Divisions of Research
and Statistics and Monetary
Meeting Held on Affairs respectively, Board
September 24, 2002