The swing in inventory investment in the motor vehicle industry has been more pronounced recently. Dealer stocks of new cars and light trucks were drawn down during the first quarter as sales climbed to record levels. Accordingly, auto and truck makers kept assemblies at a high level through June in order to maintain ready supplies of popular models. Even though demand appears to have softened and inventories of a few models have backed up, scheduled assemblies for the third quarter are above the elevated level of the first half.
BUSINESS FINANCE
The economic profits of nonfinancial U.S. corporations posted another solid in-crease in the first quarter. The profits that nonfinancial corporations earned on their domestic operations were 10 percent above the level of a year earlier; the rise lifted the share of profits in this sector’s nominal output close to its 1997 peak. Nonetheless, with investment expanding rapidly, businesses’ external financ-ing requirements, measured as the difference between capital expenditures and in-ternally generated funds, stayed at a high level in the first half of this year. Busi-nesses’ credit demands were also supported by cash-financed merger and acquisi-tion activity. Total debt of nonfinancial businesses increased at a 10-1/2 percent clip in the first quarter, close to the brisk pace of 1999, and available information suggests that borrowing remained strong into the second quarter.
On balance, businesses have altered the composition of their funding this year to rely more on shorter-term sources of credit and less on the bond market, although the funding mix has fluctuated widely in response to changing market con-ditions. After the passing of year-end, corporate borrowers returned to the bond market in volume in February and March, but subsequent volatility in the capital market in April and May prompted a pullback. In addition, corporate bond investors have been less receptive to smaller, less liquid offerings, as has been true for some time.
In the investment-grade market, bond issuers have responded to investors’ concerns about the interest rate and credit outlook by shortening the maturities of their offerings and by issuing more floating-rate securities. In the below-investment-grade market, many of the borrowers who did tap the bond market in February and March did so by issuing convertible bonds and other equity-related debt instruments. Subsequently, amid increased equity market volatility and grow-ing investor uncertainty about the outlook for prospective borrowers, credit spreads in the corporate bond market widened, and issuance in the below-investment-grade market dropped sharply in April and May. Conditions in the corpo-rate bond market calmed in late May and June, and issuance recovered to close to its first-quarter pace.
As the bond market became less hospitable in the spring, many businesses evidently turned to banks and to the commercial paper market for financing. Partly as a result, commercial and industrial loans at banks have expanded briskly, even as a larger percentage of banks have reported in Federal Reserve surveys that they have been tightening standards and terms on such loans.
Underscoring lenders’ concerns about the creditworthiness of borrowers, the ratio of liabilities of failed businesses to total liabilities has increased further so far this year, and the default rate on outstanding junk bonds has risen further from the relatively elevated level reached in 1999. Through midyear, Moody’s In-vestors Service has downgraded, on net, more debt in the nonfinancial business sector than it has upgraded, although it has placed more debt on watch for future upgrades than downgrades.
Commercial mortgage borrowing has also expanded at a robust pace over the first half of 2000, as investment in office and other commercial building strength-ened. Extending last year’s trend, borrowers have tapped banks and life insurance companies as the financing sources of choice. Banks, in particular, have reported stronger demand for commercial real estate loans this year even as they have tightened standards a bit for approving such loans. In the market for commercial mortgage-backed securities, yields have edged higher since the beginning of the year.
THE GOVERNMENT SECTOR
FEDERAL GOVERNMENT
The incoming information regarding the federal budget suggests that the surplus in the current fiscal year will surpass last year’s by a considerable amount. Over the first eight months of fiscal year 2000–the period from October to May–the uni-fied budget recorded a surplus of about $120 billion, compared with $41 billion dur-ing the comparable period of fiscal 1999. The Office of Management and Budget and the Congressional Budget Office are now forecasting that, when the fiscal year closes, the unified surplus will be around $225 billion to $230 billion, $100 billion higher than in the preceding year. That outcome would likely place the surplus at more than 2-1/4 percent of GDP, which would exceed the most recent high of 1.9 percent, which occurred in 1951.
The swing in the federal budget from deficit to surplus has been an important factor in maintaining national saving. The rise in federal saving as a percentage of gross national product from -3.5 percent in 1992 to 3.1 percent in the first quarter of this year has been sufficient to offset the drop in personal saving that occurred over the same period. As a result, gross saving by households, businesses, and gov-ernments has stayed above 18 percent of GNP since 1997, compared with 16-1/2 percent over the preceding seven years. The deeper pool of national saving, along with the continued willingness of foreign investors to finance our current account deficit, remains an important factor in containing increases in the cost of capital and sustaining the rapid expansion of domestic investment. With longer-run projec-tions showing a rising federal government surplus over the next decade, this source of national saving could continue to expand.
The recent good news on the federal budget has been primarily on the re-ceipts side of the ledger. Nonwithheld tax receipts were very robust this spring. Both final payments on personal income tax liabilities for 1999 and final corporate tax payments for 1999 were up substantially. So far this year, the withheld tax and social insurance contributions on this year’s earnings of individuals have also been strong. As a result, federal receipts during the first eight months of the fiscal year were almost 12 percent higher than they were during the year-earlier period.
While receipts have accelerated, federal expenditures have been rising only a little faster than during fiscal 1999 and continue to decline as a share of nominal GDP. Nominal outlays for the first eight months of the current fiscal year were 5-1/4 percent above the year-earlier period. Increases in discretionary spending have picked up a bit so far this year. In particular, defense spending has been running higher in the wake of the increase in budget authority enacted last year. The Con-gress has also boosted agricultural subsidies in response to the weakness in farm income. While nondiscretionary spending continues to be held down by declines in net interest payments, categories such as Medicaid and other health programs have been rising more rapidly of late.
As measured by the national income and product accounts, real federal ex-penditures for consumption and gross investment dropped sharply early this year after having surged in the fourth quarter of 1999. These wide quarter-to-quarter swings in federal spending appear to have occurred because the Department of De-fense speeded up its payments to vendors before the century date change; actual deliveries of defense goods and services were likely smoother. On average, real de-fense spending in the fourth and first quarters was up moderately from the aver-age level in fiscal 1999. Real nondefense outlays continued to rise slowly.
With current budget surpluses coming in above expectations and large sur-pluses projected to continue for the foreseeable future, the federal government has taken additional steps aimed at preserving a high level of liquidity in the market for its securities. Expanding on efforts to concentrate its declining debt issuance in fewer highly liquid securities, the Treasury announced in February its intention to issue only two new five- and ten-year notes and only one new thirty-year bond each year. The auctions of five- and ten-year notes will remain quarterly, alternat-ing between new issues and smaller reopenings, and the bond auctions will be semi-annual, also alternating between new and smaller reopened offerings. The Treasury also announced that it was reducing the frequency of its one-year bill auctions from monthly to quarterly and cutting the size of the monthly two-year note auctions. In addition, the Treasury eliminated the April auction of the thirty-year inflation-indexed bond and indicated that the size of the ten-year inflation-indexed note of-ferings would be modestly reduced. Meanwhile, anticipation of even larger surpluses in the wake of the surprising strength of incoming tax receipts so far in 2000 led the Treasury to announce, in May, that it was again cutting the size of the monthly two-year note auctions. The Treasury also noted that it is considering additional changes in its auction schedule, including the possible elimination of the one-year bill auctions and a reduction in the frequency of its two-year note auctions.
Early in the year, the Treasury unveiled the details of its previously an-nounced reverse-auction, or debt buyback, program, whereby it intends to retire seasoned, less liquid, debt securities with surplus cash, enabling it to issue more “on-the-run” securities. The Treasury noted that it would buy back as much as $30 billion this year. The first operation took place in March, and in May the Treasury announced a schedule of two operations per month through the end of July of this year. Through midyear, the Treasury has conducted eight buyback operations, re-deeming a total of $15 billion. Because an important goal of the buyback program is to help forestall further increases in the average maturity of the Treasury’s pub-licly held debt, the entire amount redeemed so far has corresponded to securities with remaining maturities at the long end of the yield curve (at least fifteen years).
STATE AND LOCAL GOVERNMENTS
In the state and local sector, real consumption and investment expenditures regis-tered another strong quarter at the beginning of this year. In part, the unseasona-bly good weather appears to have accommodated more construction spending than usually occurs over the winter. However, some of the recent rise is an extension of the step-up in spending that emerged last year, when real outlays rose 5 percent after having averaged around 3 percent for the preceding three years. Higher fed-eral grants for highway construction have contributed to the pickup in spending. In addition, many of these jurisdictions have experienced solid improvements in their fiscal conditions, which may be allowing them to undertake new spending initiatives.
The improving fiscal outlook for state and local governments has affected both the issuance and the quality of state and local debt. Borrowing by states and municipalities expanded sluggishly in the first half of this year. In addition to the favorable budgetary picture, rising interest rates have reduced the demand for new capital financing and substantially limited refunding issuance. Credit upgrades have outnumbered downgrades by a substantial margin in the state and local sector.
THE EXTERNAL SECTOR
TRADE AND THE CURRENT ACCOUNT
The deficits in U.S. external balances have continued to get even larger this year. The current account deficit reached an annual rate of $409 billion in the first quarter of 2000, or 4-1/4 percent of GDP, compared with $372 billion and 4 per-cent in the second half of 1999. Net payments of investment income were a bit less in the first quarter than in the second half of last year owing to a sizable increase in income receipts from direct investment abroad. Most of the expansion in the current account deficit occurred in trade in goods and services. In the first quar-ter, the deficit in trade in goods and services widened to an annual rate of $345 billion, a considerable expansion from the deficit of $298 billion recorded in the second half of 1999. Trade data for April suggest that the deficit may have in-creased further in the second quarter.
U.S. exports of real goods and services rose at an annual rate of 6-1/4 per-cent in the first quarter, following a strong increase in exports in the second half of last year. The pickup in economic activity abroad that began in 1999 continued to support export demand and partly offset negative effects on price competitiveness of U.S. products from the dollar’s past appreciation. By market destination, U.S. exports to Canada, Mexico, and Europe increased the most. By product group, ex-port expansion was concentrated in capital equipment, industrial supplies, and con-sumer goods. Preliminary data for April suggest that growth of real exports re-mained strong.
The quantity of imported goods and services continued to expand rapidly in the first quarter. The increase in imports, at an annual rate of 11-3/4 percent, was the same in the first quarter as in the second half of 1999 and reflected both the continuing strength of U.S. domestic demand and the effects of past dollar appre-ciation on price competitiveness. Imports of consumer goods, automotive products, semiconductors, telecommunications equipment, and other machinery were particu-larly robust. Data for April suggest that the second quarter got off to a strong start. The price of non-oil goods imports rose at an annual rate of 1-3/4 percent in the first quarter, the second consecutive quarter of sizable price increases follow-ing four years of price declines; non-oil import prices in the second quarter posted only moderate increases.
A number of developments affecting world oil demand and supply led to a fur-ther step-up in the spot price of West Texas intermediate (WTI) crude this year, along with considerable volatility. In the wake of the plunge of world oil prices dur-ing 1998, the Organization of Petroleum Exporting Countries (OPEC) agreed in early 1999 to production restraints that, by late in the year, restored prices to their 1997 level of about $20 per barrel. Subsequently, continued recovery of world de-mand, combined with some supply disruptions, caused the WTI spot price to spike above $34 per barrel during March of this year, the highest level since the Gulf War more than nine years earlier. Oil prices dropped back temporarily in April, but in May and June the price of crude oil moved back up again, as demand was boosted further by strong global economic activity and by rebuilding of oil stocks. In late June, despite an announcement by OPEC that it would boost production, the WTI spot price reached a new high of almost $35 per barrel, but by early July the price had settled back to about $30 per barrel.
FINANCIAL ACCOUNT
Capital flows in the first quarter of 2000 continued to reflect the relatively strong performance of the U.S. economy and transactions associated with global corporate mergers. Foreign private purchases of U.S. securities remained brisk–well above the record pace set last year. In addition, the mix of U.S. securities purchased by foreigners in the first quarter showed a continuation of last year’s trend toward smaller holdings of U.S. Treasury securities and larger holdings of U.S. agency and corporate securities. Private-sector foreigners sold more than $9 billion in Treas-ury securities in the first quarter while purchasing more than $26 billion in agency bonds. Despite a mixed performance of U.S. stock prices, foreign portfolio pur-chases of U.S. equities exceeded $60 billion in the first quarter, more than half of the record annual total set last year. U.S. purchases of foreign securities remained strong in the first quarter of 2000.
Foreign direct investment flows into the United States were robust in the first quarter of this year as well. As in the past two years, direct investment in-flows have been elevated by the extraordinary level of cross-border merger and acquisition activity. Portfolio flows have also been affected by this activity. For ex-ample, in recent years, many of the largest acquisitions have been financed by swaps of equity in the foreign acquiring firm for equity in the U.S. firm being ac-quired. The Bureau of Economic Analysis estimates that U.S. residents acquired $123 billion of foreign equities in this way last year. Separate data on market transactions indicate that U.S. residents made net purchases of Japanese equities but sold European equities. The latter sales likely reflect a rebalancing of portfo-lios after stock swaps. U.S. direct investment in foreign economies has also re-mained strong, exceeding $30 billion in the first quarter of 2000. Again, a signifi-cant portion of this investment was associated with cross-border merger activity.
Capital inflows from foreign official sources in the first quarter of this year were sizable–$20 billion, compared with $43 billion for all of 1999. As was the case last year, the increase in foreign official reserves in the United States in the first quarter was concentrated in a relatively few countries. Partial data for the second quarter of 2000 show a small official outflow.