Economic Report President

target Federal funds rate brought that rate to 4.75 percent, its lowestvalue in 4 years.TURMOIL IN FINANCIAL MARKETSThe past year was a tumultuous one in U.S. financial markets. Thefirst half of the year witnessed an extension of the highly favorableconditions that had prevailed over the previous several years. Yieldson intermediate- and long-term Treasury securities moved in a fairlynarrow band that was centered a little below the levels that had prevailedduring the latter part of 1997. Most households and firmsenjoyed ample access to credit on good terms. Meanwhile equity pricesrose sharply, with most major indexes hitting record highs in Julythat ranged from 17 to 28 percent above their values at the beginningof the year.Financial conditions during the second half of the year were lessfavorable. In mid-August Russia devalued the ruble and effectivelydefaulted on its domestic debt, marking a new round of the financialcrisis in emerging markets that had begun in Southeast Asia a yearearlier. As the international financial turmoil worsened, investors’desire to shift their portfolios away from emerging marketeconomies—a trend that had been apparent over the previous year—intensified, and they began to shy away from all but the safest andmost liquid assets in the markets of the industrial countries. (Chapter6 discusses developments in international financial markets atlength.) Among U.S. assets, the shift of investor preferences awayfrom private securities and toward government securities caused thedifference, or spread, between private and Treasury yields to spikeupward. Yields on higher quality corporate debt were little changed(although the spread between these yields and Treasury yieldswidened as the latter fell), but businesses with lower credit ratingsfaced much higher costs of borrowing. Moreover, issuance of corporatedebt slowed sharply, banks tightened terms and standards on businessloans (although the volume of lending actually increased significantly),and stock prices dropped steeply.Financial conditions improved markedly after mid-October, partly inresponse to the Federal Reserve’s interest rate reductions. Riskspreads narrowed, debt issuance accelerated, and stock marketsrebounded to new highs. Nevertheless, some American businessesapparently faced more limited access to credit and a higher cost of borrowingat the end of 1998 than at the beginning of the year.COMPONENTS OF SPENDINGAs already noted, real GDP increased at an annual rate of 3.7 percentbetween the fourth quarter of 1997 and the third quarter of 1998(Table 2-1), close to the pace of the previous 2 years. Quarterly output47