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SHADOW OPEN MARKET
COMMITTEE

Policy Statement and
Position Papers

September 30 - October 1,1990

PPS 90-02

THE BRADLEY
POLICY
RESEARCH
CENTER
Public Policy Working Paper Series

f

N 1 V E *

S 1 T V

OF

ROCHESTER

Shadow Open Market Committee

Table of Contents

Page
Table of Contents

i

SOMC Members

ii

SOMC Policy Statement Summary

*

Policy Statement

1
3

Economic Outlook
Jerry L. Jordan

9

Financial Structure Reforms
Jerry L. Jordan

15

Shadow Open Market Committee
Jerry L. Jordan

21

Fiscal Backpeddling
Mickey D. Levy

29

Heinemann Economic Research
H. Erich Heinemann

35

Monetary Policy After OU Shock m
William Poole

57

Foreign Exchange Market Intervention
Anna J- Schwartz

69

Recent Growth of the Monetary Aggregates
Robert H. Rasche

73




i

September 30 - October 1,1990

SHADOW OPEN MARKET COMMITTEE
The Shadow Open Market Committee met on Sunday, September 30, from 2:00 p.m. to
6:00 p.m. in Washington, D.C.

Members of the SQMC;
Professor Allan H. Meltzer, Graduate School of Industrial Administration, Carnegie
Mellon University, Pittsburgh, Pennsylvania 15213 (412/268-2283); and Visiting Scholar,
American Enterprise Institute, Washington, D.C.(202/862-7150)
Mr. H. Erich Heinemann, Chief Economist, Ladenburg, Thalmann & Co., Inc., New
York, New York 10022 (212/940-0250)
Dr. Jerry L. Jordan, Senior Vice President and Economist, First Interstate Bancorp,
Los Angeles, California 90017 (213/614-2920)
Dr. Mickey D. Levy, Chief Economist, CRT Government Securities, New York, New
Yoik (212/858-5545)
Professor William Poole, Center for the Study of Financial Markets and Institutions,
Brown University, Box B, Providence, Rhode Island 02912 (401/863-2697)
Professor Robert H. Rasche, Department of Economics, Michigan State University,
East Lansing, Michigan 48824-1038 (517/355-7755)
Dr. Anna J. Schwartz, National Bureau of Economic Research, Inc., 269 Mercer
Street, 8th Floor, New York, New York 10003 (212/995-3451)




ii

Shadow Open Market Committee

SOMC POLICY STATEMENT SUMMARY

Washington, October 1 — The Shadow Open Market Committee charged today that
Congress and the Administration have failed to deal with the nation's basic fiscal problems.
"No one can be heartened or encouraged by months of negotiations that concentrate on the
least important aspects of fiscal policy, and after much labor, produce little substantive
improvement"
The SOMC, a group of academic and business economists who regularly comment
on public policy, cited three reasons for its concern: "First, there is inadequate reform of
the budget process. Second, insufficient attention was given to the allocative effect of the
budget — principally its effect on saving and investment Third, there appear to be only
marginal cuts in the growth of spending and substantial tax increases."
The SOMC added that "Congressional leaders and the Administration labored long
and produced little. They should not now compound their failure by pushing for an
expansive monetary policy. The appropriate policy for the Federal Reserve is to maintain
money growth on a disinflationary path... Monetary policy is not a substitute for fiscal
policy."
The SOMC, which meets in March and September, was founded in 1973 by
Professor Allan H. Meltzer of Carnegie Mellon and the late Professor Karl Brunner of the
University of Rochester.
The Committee called on the Federal Reserve to continue its battle against inflation.
"In 1973-74 and in 1979-80, we urged the Federal Reserve to ignore the effects of a sharp
run-up in energy costs on prices and output and to maintain the growth rate of money
consistent with declining inflation. We repeat our earlier recommendation."
The SOMC added that "A shift to more restrictive monetary policy is not
warranted... The likely effect would be a more severe recession and higher long-term
inflation... Expansive policy to offset the oil shock is also unwarranted and undesirable...
A more expansive monetary policy now would cause a return of persistent, higher inflation
after the oil shock passes through the economy."
The Shadow Committee also renewed its criticism of U.S. government
manipulation of the foreign exchange market The Committee recommended that the
Treasury Department's Exchange Stabilization Fund "should be abolished." The SOMC
charged that the Federal Reserve's "warehousing" of the Treasury's holdings of foreign
exchange amounted to "off-budget loans" which should be banned.
The SOMC noted that "The U.S. economy has stopped growing. Some sectors
and regions were contracting before the Middle East crisis. Whether or not a "recession" is




1

September 30 - October J,1990

declared to have begun is of little importance. Monetary policy has been a major factor
bringing the economy to this point, but the risk of a decline in real activity has been
heightened byrecentincreases in the price of oil."




2

Shadow Open Market Committee

SHADOW. OPEN MARKET COMMITTEE
Policy Statement
October 1,1990
The U.S. economy has stopped growing. Some sectors and regions were
contracting before the Middle East crisis. Whether or not a "recession" is declared to have
begun is of little importance. Monetary policy has been a major factor bringing the
economy to this point, but the risk of a decline inrealactivity has been heightened by recent
increases in the price of oil
The two effects differ. Monetary actions work by changing demands for goods and
services. Their first effect is on output After a lag, restrictive policy lowers the rate of
inflation. If the Federal Reserve maintains a disinflationary monetary policy, the public
will gainfroma permanent decline in the rate of inflation.
By contrast, the initial impact of the oil shock is on the supply of output Costs of
producing goods and services and transport costs go up as the oil price increase spreads
through the economy. This leads to a temporary increase in the measured rate of inflation
and a temporary reduction in real growth. Once these effects pass through the economy,
inflation returns to the path consistent with the maintained growth of money and output
Monetary Policy
Under current circumstances, Federal Reserve officials have three options. One,
they could interpret the 1990 oil shock as evidence of renewed inflation that must be offset
by slower money growth. Two, they could listen to those who see an oil-induced decline
in output and reduced growth of demand as a reason for increasing money growth to
stimulate aggregate demand. Or, three, they could maintain money growth at a rate
consistent with the long-term growth of output and declining inflation.
In 1973-74 and in 1979-80, we urged the Federal Reserve to ignore the effects of a
sharp run-up in energy costs on prices and output and to maintain the growth rate of money
consistent with declining inflation. We repeat our earlier recommendation.
A shift to more restrictive monetary policy is not warranted. The effect of energy
prices on the price level is a one-time change that will pass through the economy. Federal
Reserve action to prevent the price rise would reduce aggregate demand, deepen the
recession, and increase the cost to the public. Later on, it would create demands for
increased stimulus. The likely effect would be a more severe recession and higher longterm inflation.




3

September 30-October 1,1990

Expansive policy to offset the oil shock is also unwarranted and undesirable.
Faster money growth cannot offset the effect of higher oil prices on the supply of output
A more expansive monetary policy now would cause a return of persistent, higher inflation
after the oil shock passes through the economy.
We urge the Federal Reserve to maintain die long-run policy that it has emphasized
in the past three years. Money growth should be brought to a level consistent with
sustained long-term growth of real output and stable prices. Currently, the Federal
Reserve's announced target for growth of M2 has a mid-point of 5 percent for the four
quarters ending fourth-quarter 1990 and 4j percent for the four quarters of 1991. A 5
percent growth rate is consistent with the Federal Reserve's goal of reducing inflation.
With the economy on the edge of recession, we urge that this target be maintained and
achieved.
The Conduct of Monetary Policy
During the 1960s and 1970s, the Federal Reserve held the Federal fundsratewithin
a narrow band between meetings of the Federal Open Market Committee. This procedure
led the Federal Reserve to produce the swings in money growth that were a principal cause
of the alternating periods of inflation and recession during those decades. The Federal
Reserve abandoned its "narrow band" target for the Federal funds rate in 1979. Since
1987, policymakers have returned to the narrow band.
This is a mistake, and it is likely to be a costly mistake. The unintended
consequences will be a return of alternating periods of excessive and insufficient money
growth that produced rising inflation and a stop-go economy in the 1960s and 1970s.
While we have long urged the Federal Reserve officials to target the growth of the
monetary base to avoid these swings, we recognize that they have rejected this advice. As
an alternative, we urge that they restore the wider band to their Federal funds rate target and
allow the funds rate to fluctuate freely within the wider band. The band should be chosen
to achieve disinflation.
The Credit Crunch and Disintermediation
In the 1960s and 1970s, swings in Federal Reserve policy often produced "credit
crunches." These periods were characterized by high or rising demands to borrow and
slow or negative growth of the monetary base (and other measures of the money supply).
Interest rates rose rapidly and short-term rates surged above long-term rates. With
Regulation Q interestrateceilings in place, the public withdrew time deposits from banks




4

Shadow Open Market Committee

and purchased securities directly in the open market Disintermediation further restricted
banks' ability to lend.
During the recent clamor about the threat of a regulator-induced credit crunch, none
of these characteristic signs of a "credit crunch" have been present There is little evidence
of disintermediation. Aggregate bank loans have grown slowly, but banks have
substantially increased their purchases of securities.
Complaints about a credit crunch reflect the specific problems of certain regions
and individual borrowers. These problems arise because lenders have reevaluated the risk
in particular markets. This is especially true of real estate loans in the Northeast and the
financing of leveraged buyouts. As a result, lenders require more equity investment as a
precondition for loans. The terms and conditions of certain types of loans have tightened,
and the supply of loans for these purposes has been reduced. But there has been no
general "credit crunch." It would be a mistake for public policy to attempt to reverse or
modify the judgment of lenders about the risk in specific markets.
While recently denying there is a credit crunch, Federal Reserve officials
contributed to misunderstanding by claiming that the shrinking size of the savings and loan
sector contributed to the slower growth of monetary aggregates in 1990. This claim is true
for M3, which includes large denomination certificates of deposit at thrift institutions. By
June 1990 these certificates had declined 25 percentfromtheir peak in June 1989. We find
no evidence of a substantial effect of this reduction on growth of narrower monetary
aggregates such as Ml and M2.
Foreign Exchange Intervention
As of June 1990, foreign currency holdings of the Federal Reserve and the
Treasury amounted to $473 billion, SO percent above the June 1989 level. The cumulated
amount of foreign exchange held is more than five times the level maintained in the early
1980s. Since 1987 the Federal Reserve has sterilized increased holdings of foreign
currencies by sales of government securities.
The very large holdings of foreign exchange impose a risk for U.S. taxpayers
without any benefit Further, as we noted in March, purchases by the Treasury's
Exchange Stabilization Fund (ESF) have been financed with funds supplied by Federal
Reserve "warehousing" operations. Warehousing is an off-budget loan from the Federal
Reserve to the Treasury.
On August 14, Chairman Gonzalez of the House Banking Committee held hearings
on the amount of intervention and the method of financing ESF purchases. We urge that
the hearings be followed by legislation to ban "warehousing" as a means of off-budget




5

September 30-October 1,1990

financing, to restrict the amount of exchange market intervention, and to provide a firmer
legal basis for any remaining foreign exchange operations. If authority for intervention is
to be assigned, it should be given to a single agency, the Federal Reserve. The Exchange
Stabilization Fund should be abolished.
The Budget and the Deficit
Yesterday, President Bush announced a compromise agreement with Congressional
leaders to reduce the 1991 fiscal year deficit by $40 billion. The agreement is disappointing
for three reasons: First, there is no meaningful reform of the budget process. Second,
insufficient attention was given to the allocative effect of the budget—principally its effect
on saving and investment Third, there appear to be only marginal cuts in the growth of
spending and substantial tax increases.
No one can be heartened or encouraged by months of negotiations that concentrate
on the least important aspects of fiscal policy, and after much labor, produce little
substantive improvement The deficit as a percent of GNP will rise substantially to nearly
5 percent of GNP.
The budget agreement did little to improve fiscal discipline. Neither Congress nor
the Administration faced up to the need to cut non-military consumption by reducing
entitlements. In an economy near full employment, the growth of investment can increase
only if the growth of consumption declines. The budget agreement includes measures
designed to increase saving and encourage investment However, we regard these
measures as minimal. Much of the deficit reduction is achieved by raising taxes and
reducing defense spending.
Concerns about the impact of the deficit reduction on a fragile economy are
unwarranted. With the projected growth of the economy, the deficit will rise from the
fiscal year 1990 level even if the spending for the bailout of thrift depositors is excluded.
Further, the deficit, and the changes in the deficit, are misleading measures offiscalthrust
A large part of the deficit consists of interest payments, a growing portion of which
are intragovernmental transfers. The government acts as a conduit for collecting and
paying interest The operation has no significance for aggregate economic activity and very
litde effect on income distribution. Excluding interest payments is, therefore, appropriate
in determining the aggregate fiscal stance of the Federal government When this is done,
the deficit is a very small portion of GNP—even when the thrift-related expenditures are
included.




6

Shadow Open Market Committee

Similarly, payments by the Resolution Trust Corporation are a pure transfer, with
little economic or distributional effect The real economic costs of the thrift industry failure
occurred in the past when funds were misallocated and national resources squandered
The central fiscal issues are allocative — how spending and tax policies affect the use of
resources. The budget process focuses on "the deficit" to the exclusion of all other issues.
No rational policy will emerge as long as this remains true.
Congressional leaders and the Administration labored long and produced little.
They should not now compound their failure by pushing for an expansive monetary policy.
The appropriate policy for the Federal Reserve is to maintain money growth on a
disinflationary path. Long-term interest rates should be allowed to fall if market
participants choose to lower these rates. Short-term rates should continue to be set so as to
maintain the Federal Reserve's announced targets for money growth consistent with
declining inflation. Monetary policy is not a substitute for fiscal policy.




7




Shadow Open Market Committee

ECONOMIC OUTLOOK
Jerry L. JORDAN
First Interstate Bancorp

SUMMARY
The course of the economy this year may have detoured slightly, but has not been
derailed by the crisis in Middle Eastern deserts. The U.S. economy was already flirting
with recession before Iraq invaded Kuwait The short-run effects of the invasion create the
worst of all worlds from the viewpoint of economic policymakers — higher rates of
inflation and sluggish growth of output and employment
While some analysts now forecast sustained "stagflation/9 volatility, and
uncertainty, we do not believe that is the most likely outlook for 1991. Instead, the outlook
for the period after the Middle East crisis is quite good The slow economic growth from
late 1989 through 1990 is helping to set the stage for further solid expansion with little
inflation.
Whether or not a "recession" is ultimately declared to have occurred in 1990 is of
little importance. Some sectors and regions of the economy have definitely contracted.
Some will still contract in 1991. Others are still expanding. There is no risk of a
"cumulative contraction." Even if the long expansion since November 1982 is declared to
be over, the depth of the downturn will be shallow and the duration will be short
Pre-invasion Outlook — Before the invasion of Kuwait by Iraq, most
forecasters were revising down their projections of real economic growth for the second
half of 1990. The sustained restrictive policies of the Federal Reserve were holding growth
below potential, while inflationary pressures were still viewed as unacceptable. Before the
"oil shock" of August 1990, inflation this year was generally expected to have been about
the same as 1989's 4.6 percent — too high for the Fed. But, even that rate included the
temporary effects of a run-up of oil prices early in the year.
After the Crisis — The prospects for 1991 will be much more to the
policymakers' liking — lower rates of inflation accompanied by faster growth of output
and employment By the end of 1991, we expect output to be rising at a rate of 25 - 3.0
percent At the same time, we expect consumer prices to rise by no more than 4 percent
and interest rates to fall considerably from their oil-crisis highs.
We look for oil prices in 1991 to average in the range of $19 to $21. Inflation
psychology will improve with lower oil prices, so nominal interest rates will tend down
and restore investor confidence.




9

September 30 - October 1,1990

The housing and auto sectors can be expected to post modest gains from their 1990
cyclical lows. Non-residential construction is likely to remain weak in view of the
continuing glut of office space, hotels, and shopping centers in numerous parts of the
country.
The tradable-goods sector* of the economy performed well in 1990 and should
remain strong in 1991. The spreading industrialization of Asian economies, the renewed
vigor in some of the restructuring economies of Latin America, and the enormous demands
for new physical plant and equipment in Eastern Europe and the Soviet Union suggest a
long and healthy expansion for capital-goods and industrial products firms.
THE U.S. ECONOMY
Iraq's invasion of Kuwait on August 2, 1990, has made interpretation of U.S.
economic policy even more difficult Suddenly, the leap in inflation concerns restricted the
Federal Reserve's options, while estimates of the federal budget deficit were already
escalating.
Federal Reserve policy has been generally restrictive since early 1987. Over the 3^
years ending in mid-1990, the money supply measured in terms of M2 (currency, checking
and savings accounts, and certificates of deposit less than $100,000) increased at an annual
rate of only 4.7 percent This contrasts with the rapid 8.7 percent average rate of increase
during the prior three years.
The intent of U.S. monetary policy is to reduce inflation, with stable prices the
ultimate goal. Zero inflation should not be dismissed as an impossible objective. The
United States experienced inflation averaging only about 1 percent during the early 1960s.
Japan and Germany achieved essentially stable prices as recently as 1987 and recorded
inflation rates of only about 1 percent in 1988.
As the American economy began the second half of 1990, the impact of restrictive
monetary policy was evident Real GNP had expanded at less than a 2 percent annual rate
for five consecutive quarters, with growth averaging barely over 1 percent during the latest
three quarters. This impact was not surprising since changes in monetary policy typically
first affect output before prices, in part because inflationary expectations can prove to be
relatively "sticky."
The Middle East crisis prevented the Federal Reserve from lowering the Federal
funds rate in August 1990 despite growing signs of a slowing economy. Soaring oil and
gold prices, together with a falling dollar, revived inflation concerns. The Fed hopes to
avoid the mistakes of the 1970s when it tried to offset the wealth effects of the oil price




10

Shadow Open Market Committee

shock through rapid money creation. The present Federal Reserve believes it is much
easier to reverse a temporary slump in the economy than to quash an upsurge in inflation
and inflation psychology.
If oil prices decline in 1991 as we assume, the Federal Reserve is likely to pursue a
somewhat more expansive policy. We expect M2 growth to equal about 5.3 percent in
1991, compared with the 4.1 percent increase estimated for 1990.
The National Bureau of Economic Research will ultimately decide if the current
downturn in economic activity is sufficiently deep, long, and widespread to be classified as
a recession. Regardless of the outcome, it is clear that certain parts of the economy are
depressed — autos, housing, and non-residential construction. Manufacturing jobs were
reduced by a total of more than 450,000 between the peak of January 1989 and August
1990. At the same time, agriculture, export industries, and various services are holding
their own, while the commercial aircraft industry continues to operate at capacity levels.
Our forecast is that the U.S. economic slump will be short and shallow. The
economy is likely to show no growth on average in the last half of 1990, and real GNP
may still be crawling at only about a 1 percent pace in the first quarter of 1991. Growth
should pick up, however, to about a 3 percent rate by the end of next year.
Just as the slump in American economic activity will be comparatively mild, a
recovery will be restrained. The debt loads of both consumers and industry will limit
spending. The Federal Reserve will attempt to prevent the economy from growing faster
than its potential, which Fed officials view to be about 25 percent per year. The overhang
of unleased office and other non-residential property willrestrictnew activity in that sector.
On balance, we expect real GNP to rise 2.3 percent on a fourth-quarter-to-fourthquarter basis in 1991. This growth rate would mark an improvement over the anemic 0.7
percent gain estimated for 1990. Fourth-quarter-to-fourth-quarter numbers, which give a
better sense of the trend of growth during the year, will indicate a distinctly different picture
than annual averages next year. Real GNP will be up an average of only 1.4 percent in
1991. Our estimates place 1990's average growth number at 1 percent
Consumer confidence dropped sharply in August 1990 with concerns over a
possible recession, inflation, and events in the Middle East Retailers were forced into
heavy discounting to generate volume increases of any size. We expect a moderate pickup
in consumer spending in 1991 as the outlook for employment and income growth
improves. Consumer spending will expand at a rate slightly less than the overall economy,
with a fourth-quarter-to-fourth-quarter real gain of 2.2 percent in 1991. In contrast,
consumer spending is anticipated to end 1990 with a gain significantly less than 1.0
percent




U

September 30 - October 1,1990

We expect 1990 to maik a cyclical low for the auto industry before a modest pickup
occurs in 1991. Combined sales of cars and light trucks are likely to total only 13.8 million
units for all of 1990, the lowest level since 1983. Unit sales should improve to 14.1
million in 1991. Japanese auto makers will continue to shift production to the United
States.
We also expect housing to begin to emerge from the doldrums of 1990. Housing
starts are likely to total less than 1.25 million units for 1990, the lowest since 1982.
Although 1991 will remain a relatively soft year, housing starts should move up to about
1.3 million units.
The easing of fixed-rate mortgages below 10 percent in 1991 should help the
housing industry, although housing has become much less sensitive to swings in market
interest rates since the deregulation of deposit rates in 1982. The availability of adjustablerate mortgages has also cushioned the impact of interest rate changes. Next year's increase
in housing construction will be concentrated in single-family homes, with builders and
lenders limiting the size of development projects.
No improvement in the profitability of most non-residential segments is likely
before 1992. The overbuilt condition of offices, shopping centers, and hotels will continue
to depress the real value of non-residential building in 1991, following a large drop in
1990.
Business spending on capital equipment had been one of the strongest parts of the
economy until declining profits and general economic uncertainty prompted many firms to
defer various outlays. By the second half of 1991, however, we expect business
investment in new equipment to again be growing faster than the overall economy.
Exports will continue to help support economic growth in the United States,
although gains will be much more moderate than in recent years. American producers have
a competitive advantage in various high-technology goods, a position which has been
bolstered further by the dollar's decline on foreign-exchange markets. We expect the
deficit in terms of net exports of goods and services to continue to shrink in real terms over
the forecast period. As a result, American output will berisingslightly faster than our total
consumption.
In contrast to faster growth from the private sector in 1991 relative to 1990, we
anticipate a slower increase in spending from the public sector. Budget pressures will
constrain outlays at the federal, state, and local levels. Events in the Middle East are likely
to slow the rate of decline in military outlays, but they are not expected to reverse a
downward trend. After briefly stabilizing in 1990, defense spending is likely to drop by
1 - 2 percent in real terms next year. This decline in military spending, coupled with slow




12

Shadow Open Market Committee

growth at other levels of government, will hold total public spending to a trend of less than
1 percent real growth during the next two years .
By the middle of 1990, the economic slowdown was affecting not only the job
market in manufacturing and construction but also other areas ranging from retailing to
business services. Labor force growth at less than 1 percent a year will restrain the rise in
unemployment Nevertheless, we expect the jobless rate to peak at about 6 percent in late
1990 or early 1991 before easing back to a level of 5.3 percent by the end of next year.
Profits appear to have borne the primary brunt of the economic slowdown until
now. Economic, or "true" after-tax profits, measure depreciation on a replacement-cost
basis and exclude inventory profits. This measure of profits will probably show a drop of
3 percent when 1990 is over, following last year's 12 percent slide. The profitability
picture should begin to recover in 1991 with better profit margins and volumes. We look
for a 5 percent gain in economic profits for next year as a whole.
Consumer prices are likely to end 1990 with a fourth-quarter-to-fourth-quarter
increase of 6 percent, the largest rise since 1981. Although a discouraging setback, the
outlook for 1991 is much brighter. Much of the acceleration in the 1990 price index can be
attributed to the escalation of energy prices. An expected easing in energy prices in 1991
will partially offset increases in other areas and help dampen the overall rise in prices.
It is important toremember,moreover, that swings in the price of energy represent
mainly a change inrelativeprices. Monetary policyremainsthe primary determinant of the
general rate of inflation. As long as Federal Reserve policyremainsrelativelyrestrictive,
higher energy prices will not feed through the entire wage and price structure. The
tightness of monetary policy during the past three to four years strongly suggests that
inflation will subside in 1991.
Consequently, we believe that consumer prices will rise by 3.9 percent between the
fourth quarters of 1990 and 1991. Largely reflecting continued upward pressure on the
cost of non-wage benefits, employee costs are likely to rise by 5 percent in 1991, slightly
below the 5.1 percent advance estimated for 1990.
The pace of U.S. economic growth, inflation, and events in the Middle East will
dictate the course of interest rates during the next few months. We expect these factors to
produce lower levels of interest rates in 1991.
While temporarily inhibited by events in the Middle East, we expect the Federal
Reserve to reduce its target for the federal funds rate from the 8 percent of September 1990
to as low as 7.25 percent by the spring of 1991. In response to other short-term rates, the
bank prime rate is also likely to ease to 95 percent by the beginning of next year, with a 9




13

September 30-October 1,1990

percent prime possible next spring. A pickup in economic growth would then push shortterm interest rates slightly higher by the end of next year.
Although U.S. monetary authorities can "fine tune" the level of the federal funds
rate and influence other short-term rates, the long-term bond market tends to be more
sensitive to market forces. The market for 30-year Treasury bonds is a minor of U.S.
inflationary expectations. The yield on 30-year bonds had fallen to about 8.35 percent at
the beginning of August 1990, but by the end of the month, inflation concerns stemming
from the Middle East crisis had driven the yield up to 9 percent Resolution of the Middle
East crisis would allow the yield on 30-year government bonds to again move back
towards 8 percent by early next year, its level at the end of 1989. Reflecting this forecast
for long-term Treasury instruments, we expect 30-year fixed-mortgage rates to average 9.7
percent in 1991. This would be downfromthe 10.2 percent average estimated for 1990.
The yield curve was very flat at the end of 1989, with long-term interest rates close
to the level of short-term rates. By August 1990, the yield curve had steepened markedly.
Signs of a slowing economy and increased preference for liquidity had pushed short-term
interest rates slightly lower, but the major steepening was caused by a jump in long-term
rates because of inflation concerns. We expect the entire yield curve to shift downward by
the middle of 1991 and to retain a more normal positive slope next year.




14

Shadow Open Market Committee

FINANCIAL STRUCTURE REFORMS
Jerry L. JORDAN
First Interstate Bancorp
By comparison with other developed countries, the U.S. financial system continues
to be handicapped by fragmentation, overcapacity, excessive dependence on deposit
insurance, and a cumbersome maze of regulation based on a 1930s vintage "permission and
denial" system. The failures in the S&L industry and the weakness in the commercial
banking industry are a result of the regulatory morass, rather than the product of inadequate
regulation.
While some regulators have stated that they see their mandate as "insuring the safety
and soundness of the U.S. financial system," we would argue that there is a more basic
objective. The valid purpose of all economic policy, including regulation of financial
institutions, is to enhance the stability of the U.S. economy and achieve the greatest degree
of sustainable prosperity.
The efficiency and competitiveness of thefinancialsystem is crucial to economic
stability and growth. Any regulation or supervisory practice that lowers our standard of
living should be terminated. Any new proposal for regulation and supervision should meet
the test of economic efficiency and fairness of competition. In this spirit, we believe that
there are a number of reforms that should be implemented.
In framing financial reform legislation, Congress must reform the present deposit
insurance system. While the original intent of deposit insurance was to strengthen the
depository institutions, the effect has been to virtually destroy the S&L industry and greatly
weaken commercial banks. In addition to reforming deposit insurance, Congress should:
(a). Broaden the powers of banks to offer products not normally associated with
the deposit-taking and credit-extension functions of commercial banks,
(b). Remove the geographical restrictions on depository institutions. They have
proved to be a serious limitation to market access, growth, and the ability to
diversify risk,
(c). Ease the regulatory burden on financial institutions. Competitiveness is reduced by the high cost of reserve requirements, deposit insurance, compliance
requirements, and multiple regulatory oversight
(d). Realign capital adequacy rules. Market discipline onrisktaking can be effective if equity and debt capital are adequate. However, capital standards cannot
mitigate the "moral hazard" problems of government deposit insurance.




15

September 30 - October 1.1990

A.

Universal Banking
The ability of American banks to compete with foreign banks is impaired by the
Glass-Steagall restrictions against engaging in the securities business (with a few
exceptions). This is further compounded by the restriction against underwriting insurance,
and again with a few exceptions, acting as an insurance broker.
The "universal" banking license of the European Community (EC), which will
broaden the powers of banks in all member nations to include securities and insurance, will
undoubtedly exacerbate the competitive disadvantage of U.S. banks.
•West Germany, France, the United Kingdom, Belgium, the Netherlands, and
Luxembourg already allow the intermingling of these powers.
•Canada, Italy, and Switzerland allow their banks to engage in the securities business, but
restrictions against offering insurance products remain.
•The United States and Japan currently have the most restrictive banking systems with
respect to the ability to offer a wide array of financial services.
•Close cooperatibn among Japanese banks, securities firms, and insurance companies —
through ownership of stock and overlapping boards of directors — has largely
circumvented the restrictions. Although Article 65 of the Japanese constitution (similar to
Glass-Steagall) is still intact, these "keiretsu" groups, with the tacit understanding of the
Ministry of Finance, have evolved a de facto system less restrictive than would appear on
paper.
•A few exceptions have been recently made in the United States. The Federal Reserve,
empowered to regulate bank-holding companies, has granted permission to a few large
banks to engage in securities underwriting — to a very limited extent. This token
regulatory initiative hardly addresses the gravity of the issue.
B.

Geographical Restrictions
The limitations imposed on U.S. banks by the McFadden Act with respect to
geographical expansion are perhaps the most archaic legacies of the 1920s and 1930s.
Some progress has been made towards removal of boundary lines, but at a snail's pace
through a patchwork of "regional compacts,9' permitting expansion through costly
acquisition across state lines. This process is likely to continue and will help to ease
restrictions somewhat, but this approach is not a good substitute for a uniform national law
that would allow interstate branching.
•The inadequacy of the current rules can best be seen in the concentration of failed savings
and loans associations and troubled banks, in the late 1980s, in Texas and other Southwest
states, whose economies were plunged into "recession" by the sharp drop in oil prices.




16

Shadow Open Market Committee

Banks and thrifts in those regional economies could not diversify their risk by either
gathering deposits or making loans outside of their narrow geographical markets. By
contrast, in the Canadian environment where nationwide banking is the practice,
widespread bank failures did not resultfromregional concentration of loan portfolios in the
energy regions.
•Up to a few years ago, the economics profession was fairly convinced that economies of
scale did not exist for banks larger than $500 million in assets. More recently, there is a
growing body of evidence that argues that technology and the erosion of monopolies allow
larger banks to achieve economies of scale — thus benefiting from efficient use of capital
and human resources to achieve lower unit cost
•For all practical purposes, banks in EC countries, Japan, and Canada hold a substantial
advantage over U.S. banks with their nationwide operations — making our structure not
only inefficient but almost ludicrous. This element of our financial system—geographical
boundaries — is broken and should be fixed without delay.
C.

Reserve Requirements and Other Regulatory Burdens
A recent study by the American Bankers Association indicates that U.S. banks have
the heaviest overall regulatory burden of all G-10 countries. This is based on the costs of
reserve requirements, deposit insurance, reporting requirements, and compliance
regulations. This makes cost of capital higher in the U.S. than in other countries as well.
Reserve Requirements. With reserve requirements as high as 12 percent on
transaction accounts, banks in the United States find themselves operating with relatively
high "effective" cost of deposit funds — and these reserves held at the Federal Reserve
district banks are idle, paying no interest to banks.
•Elsewhere in the world, reserve requirements are in the process of being reduced or
eliminated entirely, and U.S. regulators need toreevaluatethe role that this tax plays. The
low (one-half of 1 percent) reserve requirement in the U.K. is putting pressure on other EC
countries to lower their reserve requirements, especially as the unified "Single Market"
becomes a reality in 1992. Canada is expected to eliminate itsreserverequirements later
this year. The Swiss central banks has on a de facto basis eliminated its reserve
requirements.
Deposit Guarantees. In certain industrial countries, deposit guarantee systems are
voluntary, not administered by government agencies, and are funded by periodic
assessments. In six countries (Canada, Italy, Japan, the Netherlands, the United
Kingdom, and the United States), national/federal government agencies administer the




17

September 30-October 1,1990

depositor protection programs. Of these, regular annual premiums are assessed in Canada,
Japan, and the United States.
•Unfavorably affecting the international competitiveness of American banks is the fact that
annual premiums are highest in the U.S. — 0.12 percent of insured deposits in 1990 and
scheduled by HRREA to rise to 0.15 percent in 1991, and as high as 0.325 if a high failure
rate requires that FDIC funds need to be supplemented. By contrast, the annual premium
in Canada is fixed at 0.1 percent and only 0.012 percent in Japan.
•Clearly, the bitter lessons we have learned about the contribution of our "flat-premium and
broad-coverage" deposit insurance system to the current crisis in the savings and loan
industry argues convincingly for reform, including lessening the cost to financial
institutions.
Reporting Requirements. Supervision of the safety and soundness of banks,
through periodic on-site examinations, independent audits, and written or oral reports, is
more burdensome and costly for American banks than for banks in other industrialized
countries.
•This is because of multiple regulators — the Federal Reserve System, the Office of the
Comptroller of the Currency, the Federal Deposit Insurance Corporation, and 50 state
banking departments. With the exception of Canada, U.S. banks must provide more
frequent financial reports than banks in other countries and are subject to more frequent onsite examinations.
Compliance Regulations. The scope and detail of compliance regulations imposed
on banks in the United States are unmatched in any of the other G-10 countries. The cost
associated with consumer protection, equal opportunity, and community redevelopment
considerations affecting mergers and acquisitions are considerable.
•While government agencies participate with banks in Belgium, France, and the
Netherlands in the pricing of deposit and credit services, this does not constitute as onerous
a burden on their banks as in the U.S.
•The U.K. has enacted a system of anti-fraud regulations in the area of consumer lending
— but again, this compliance regulation is not as onerous as in the United States.
•In France and in Italy, where large banks are being privatized, compliance regulations are
likely to be imposed
D.

Capital Adequacy
Until the risk-based capital requirements are fully implemented in 1991, of the 12
signatory nations to the Basel Accord, U.S. banks will continue to have higher capital
requirements than their foreign counterparts. With U.S. regulators applying a "leverage




18

Shadow Open Market Committee

ratio test" (based on CAMEL ratings) in ruling on a bank's application to expand, U.S.
banks are likely to have higher capital requirements than the Basel standard even after
1991.
•Federal Reserve Chairman Alan Greenspan, in major speeches earlier this year and in
testimony before the House Committee on Banking, Housing, and Urban Affairs (July 12,
1990), strongly proposed capital standards even higher than the 4 percent equity-to-asset
ratios stipulated in the Basel Accord (to some extent, that could raise the 8 percent total
capital-to-asset ratio which the Accord also stipulates). The Chairman's contention is that
the increasingly competitive environment requires high capital standards and that would
strengthen incentives of shareholders to be more prudent and vigilant about the bank's
management, risk strategies, and performance.
•The stated objective of mandating higher capital standards to protect the federallyfurnished deposit insurance is not valid. The "safety net" is intended to protect the real
economy from financial shocks. It would be a mistake to adopt regulatory or supervisory
practices that are intended to "protect the safety net" at the cost of reduced efficiency and
competitiveness of the financial system.
•U.S. regulators should take a balanced approach to setting capital requirements, so that
our banks are not at a disadvantage relative to the higher-leveraged positions of foreign
competitors. Chairman Greenspan's viewpoint should be evaluated in terms of whether
enhanced market discipline would boost the price-earnings ratios of U.S. banks and in turn
reduce their cost of capital.
•Whether or not capital standards are set for U.S. banks at levels higher than those set
among the Basel Accord nations, capital requirements should be identical for all deposittaking intermediaries.
In Conclusion, we need to move rapidly towards modernizing the U.S. financial
system, in order to enhance the ability of our financial institutions to compete at home and
abroad, on a fair and evenhanded basis, with foreign institutions. To do this, we need to
reduce the burden of excessive regulations, eliminate government subsidies wherever
possible, and encourage innovation and efficiency in the development and delivery of
financial services.




19







SHADOW OPEN MARKET COMMITTEE

Jerry Jordan
Chief Economist & Senior Vice President
First Interstate Bancorp

September 30,1990

1

SOURCES OF GNP GROWTH 04/89 THROUGH 02/90
(OislfMoo of 1.1* average real growth rale)

REALGNPGROWTH
(Percent change, annual rata, hal-year avenge)

Consumer

0.1

Government*
Business Investment j

•02

Net Exports
Inventories' -0.1
Housing

I 86 II 87 |
'
' '
I

-*—i
90.

>42

I 911 » 921

0

-f-+92
0.4
0.6
'EiduoTng Commodity Craft Corp. purchases

+

0.8

B

MONEY AND PRICES
(Quarterly, percent change over year ago)

DEFENSE SPENDING
(Percent ot GNP.fiscalyear)
Vietnam

I I I I 11 11 I t I I I I I I I I 11 I I I I I 11 I I'l 11 ri I I I 11 1
83

M




85

8
6

67

6
8

89

9e
0

91
1

91
2

Shadow Open Market Committee

September 30, 1990

NONFARM EMPLOYMENT GROWTH

UNEMPLOYMENT RATE

(Changefromprior month, in thousands)

(AI Workers, Percent)
500-r

Mr

400 |
300 |

Mt

100
0

4i

I I I I I I I I I I I I I I I I I I I I
J F M A M J J A S O N D J F M A M J J A
1983
'
1990

a

8wTX>nth
average

I

r
mm

200
50 +

12-month
imago

•100 •

V-rt-rf

L7

J F M A M J J A S O N D J F M A M J J A
198}
*
1990

MANUFACTURING EMPLOYMENT

CORPORATE CASH FLOW
(Quarterly, percent change over prior year)

P a n g *fromprior monlh, h thousands)
» T

J F M A M J J A S O N D | J F M A M J J A
1989
1990



565860626466687072

Shadow Open Market Committee

74

7678608284868890

September 30,1990

3

INDEX OF LEADING ECONOMIC INDICATORS

INDUSTRIAL PRODUCTION

(Percent change from prior month)

(Percent changefromprior month, annual rate)

J F M A M J J A S O N D J F M A M J J
198}
I
1990

I I I I I I I
J F M A M J J A S O N O J F M A M J J A
19S9
'
1990

DURABLE GOODS ORDERS

MERCHANDISE-TRADE DEFICIT

(Percent change (mm prior month)

(Billions of defers, seasonally adjusted)

J F M A M J J A S O N O J F M A M J J
1989
1990

I

J F M A M J J A S O N D J F M A M J J
1989
'
1990

I




Shadow Open Market Committee

I I I I I I I I |

I I I I I I I

September 30, 1990

CONSUMER PRICE INDEX

CRUDE OIL PRICES

(Monthly change, annual rate)

(West Texas Intermediate, dollars par barrel)
3432- [

SpCl

/

302826-

[
I

September 14 WeeWy Average Contract $29.75
September 19 Close Spot $33.20

AT
JV

242220-

18 JA /

^

^

Cortrad * 0 * A

kf

16

I

I I

I I

v

I l l

I I I I I

I I I I

I I

I

14 Jllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllll

J F M A M J J A S O N O J F M A M J J A
1989
1990

02

03
1990

1989

8
EXCHANGE RATE -DM/$

EXCHANGE RATE- YEN*

(WeeWy averages*)

(Weekly averages9)
160

T

Yen*

137.65

02

03

iMlHHIIIHIIHlllllllHMIlHIllllllllllllHllinMINiniMMIIlHHHlllHHIlM.MlMl
Ot




02

03
1989

04
01
02
* Usl point Is Thursday ctose

03
1990

01

02

Shadow Open Market Committee

03
1989

04
01
'last port b Thursday dose

19S0

September 30,1990

MONETARY BASE* AND GNP

TOTAL RESERVE GROWTH
(Percert change ovtr prior quarter, annual rata)

80

81

82

83

87

84

(Quarterly, percent change over year ago)

89

90Q2

63
64
85
86
87
88
89
•Adjusted tor foreign currency holdings beginning 4th quarter 1989

^

M2 GROWTH

CURRENCY GROWTH
(Percent change over prior month, annual rate)

(Percent change, 4th quarter to 4th quarter)

M I 11 I M f I f I M 1 I I I I I t I I I I t 1 I I I
Jin 83

May-88




Sep-88

Jan 89

May-89

Sep 89

Jan-90

May 90

84

85

Shadow Open Market Committee

86

87

89

90e

911

921

September 30,1990

3-MONTH T-BILL & 30-YEAR GOVERNMENT

YIELD CURVE, 3 MONTHS TO 30 YEARS

BOND-EQUIVALENT YIELDS
(Weekly averages*, percent)

August 23,1990

Gov! Bond

,.j^A^««»<<«->>fr»»^^t«<>^*w^<^'Wc:*w>^r\w»

Septerrber20,1990

30-YrGo/tBond 9.03

3M m
o
01

m

02

03
1989

04
01
•UstpoNblhursdaydost

02

03
1990

1 3

5

FED FUNDS & 3-MONTH T-BILL QUOTED RATES

7

10

Years

INTEREST RATE FORECASTS
(Percent, quarterly averages, bond equivalent yields)

(Weekly averages', percent)

September 20 Spot Rates
Fed Funds 8.19
T-BiB
7.38

01




02

03
1989

04
01
'last point is Thursday dose

02

03
1990

1 I I I I I I I M » I I I I I M I I I I I 111 I I I 1 1 I 1 M <
84 ' 85 ' 88 ' 87 ' 88 ' 89 ' 90e ' 9tl f 92!

Shadow Open Market Committee

September 30, 1990




Shadow Open Market Committee

FISCAL BACKPEDDLING
Mickey D.LEVY
CRT Government Securities, Ltd.

The deterioration in the budget outlook has been startling, and the response of
policymakers has been equally disappointing. The deficit has zoomed; it will exceed $200
billion in Fiscal Year 1990 and is estimated to be approximately $270 billion in FY1991,
$200 billion excluding the additional working capital for the Resolution Trust
Corporation's restructuring of the savings and loan industry. That represents a sharp
reversal from the marked improvement between 1986 and 1989. While the budget
numbers have changed for the worse, the real concern remains the same: the lack of budget
discipline and the reluctance of policymakers to come to grips with what is needed to
achieve desired fiscal and economic objectives, confusion about the proper roles of fiscal
and monetary policies, and a faltering budget process that continues to rely on GrammRudman-Hollings (GRH), whose flawed structure is as much a hindrance as a help to
attempts to achieve sound fiscal policy.
During the last several decades, most of variability in the deficit trend has been due
to trends in federal outlays, while tax revenues have not deviated significantly as a percent
of GNP. The sharp rise in deficits through the mid-1980s occurred as rapid growth in the
non-means-tested entitlement programs in the 1970s was joined by the early 1980s defense
buildup to push spending from below 20 percent of GNP in the late 1960s to a peak 24.3
percent in 1983. From 1974 to 1983, spending grew 12.2 percent annually, 4.1 percent in
real terms, while tax revenues changed little as a share of GNP. The "tax cuts" of the
Economic Recovery Tax Act of 1981 merely prevented taxesfromrising sharply as a share
of GNP. From 1983 through 1989, deficits declined from 6.3 percent of GNP to 2.9
percent in 1989, as spending growth slowed sharply and outlays recededfrom24.3 percent
of GNP to 22.2 percent, despite the significant rise in net interest outlays. Under the GRH
budget process, the bulk of the spending cuts have occurred in national defense and nondefense discretionary spending, while tax revenues have risen as a share of GNP.
The sharp jump in the deficit in FY 1990 - over $40 billion above the $152 billion in
1989 - has been due approximately equally to the shortfall in tax revenues and the spurt in
spending. Tax revenues are expected to grow only 5.4 percent, less than two-thirds the
Administration's earlier estimate. This has resulted from economic weakness and an
unanticipated decline in receipts relative to national income. Sizeable spending increases
have occurred in social security and Medicare, deposit insurance, net interest, and several
means-tested entitlement programs, including Supplemental Security Income (SSI),




29

September 30-October 1,1990

unemployment insurance, family support payments and foodstamps, reflecting rising
caseloads as the economy deteriorates.
While economic sluggishness will continue to suppress tax revenues and boost
spending on means-tested entitlement programs in FY1991, the dramatic increases in
projected deficits in 1991-1993reflectlargely the costs of the S&Lrestructuringand higher
net interest outlays. The Congressional Budget Office estimates that with proper
authorization, additional working capital for the RTC will cost approximately $138 billion
during 1991-1993 ($39 billion in 1991, $73 billion in 1992 and $26 billion in 1993).
Sadly, this explosion of outlaysrepresentsanother episode in a long series of unanticipated
jumps in non-means-tested entitlement spending: like other entitlement programs, the
federal government's obligation to finance the S&Lrestructuringis an open checkbook
whose total outlays will be determined by caseload The beneficiaries of the government's
largess have no income or wealth requirements.
Unlike other entitlements, however, these government obligations for the costs of
the S&L restructuring have already been spent; they are merely a realization of prior
obligations. These are a symptom of the unwillingness of elected officials to address
deposit insurance and other sources of the savings and loan collapse. As such, they
measure in large part the unnecessary and wasteful misallocation ofresourcesof a bungled
public policy.
Consequently, spending for non-means-tested entitlement programs, including
deposit insurance, continues to rise as a share of total federal outlays and GNP. Spending
for them will cost approximately $580 billion in 1991, a 27.8 rise since 1989, including a
21.3 percent increase in Medicare. They will account for 42.8 percent of total federal
outlays. In comparison, spending for means-tested entitlements will be approximately
$112 billion in 1991. This accounts for only 16.2 percent of all entitlement spending, and
8.3 percent of total federal outlays.
The renewed spurt in federal spending, over 9 percent annually in 1991-1992, will
push outlays from 22.2 percent of GNP in 1989 to over 24 percent in 1991,retracingover
half of the earlier decline. Consequently, deficits will rise above 4 percent of GNP and the
federal debt-to-GNP ratio will continue to increase. Persistent economic weakness, a
virtually ensured outcome, will raise spending, suppress taxrevenues,and push deficits far
above official estimates. Meanwhile, spending on investment-oriented programs, including
education, infrastructure, andresearch,continue to lag.




30

Shadow Open Market Committee

The Misguided Budget Debate
The debate about what to do about the soaring spending and deficits is not
heartening. Even if a compromise package yields $50 billion in deficit cuts in FY1991,
which under current circumstances seems unlikely, the deficit is on a rising trend.
Moreover, the top priority of reducing deficits by whatever means continues to dominate
the debate, with scant attention paid to how the federal budget allocates national resources
and how the economic and financial responses to a fiscal package depend crucially on the
particular mix of tax and spending changes. In his July 1990 Humphrey Hawkins
testimony, Federal Reserve Chairman Greenspan reiterated the need for large deficit cuts
but stated his indifference between tax increases and spending cuts. This notion has carried
into the mindset of die Congressional conferees.
GRH only reinforces this misguided bias. Its deficit targets divert attention away
from important economic issues of the budget, and exclude from the sequestration process
over half of all federal outlays, including social security and several other transfer
programs. Thus, it steers the fiscal debate away from transfer and entitlement programs
that in fact are at the core of the deficit problem and are sorely in need of restructuring. The
fiscal debate must be refocussed, and a clearer understanding of the objectives of fiscal
policy and the role taxes and spending play in achieving desired economic outcomes is
required.
The policy debate is also being influenced by the misguided notion that any negative
impact on the economy of a deficit cut may be offset by a shift toward monetary easing.
This notion has been abetted by the Federal Reserve and the CBO, and condoned by the
Administration. Alan Greenspan has stated on numerous occasions that the Fed would
ease monetary policy in response to a budget compromise that involved significant deficit
cuts (a "tightening" of fiscal policy). The CBO's baseline forecast (The Economic and
Budget Outlook: An Update, July 1990) asserts that a sizeable cut in the deficit would
strengthen the economy because of offsetting expansive monetary policy.
Attempts to adjust monetary policy in response tofiscalactions in order to achieve a
desired fiscal-monetary policy mix are misguided because they assume incorrectly that
monetary policy and fiscal policy are substitutes for achieving the objectives of long-run
economic growth and stable prices. Such substitutability requires that a shift in fiscal
policy is capable of generating a permanent shift in aggregate demand, while a shift toward
monetary stimulus is capable of raising long-run output Instead, excessively stimulative
monetary policy generates inflation, but does not raise long-run potential output Fiscal
policy alters the allocation of national resources between the public and private sectors and




31

September 30 - October 1,1990

influences long-run potential output by altering incentives to consume, save and invest, but
does not generate a permanent shift in aggregate demand
Moreover, even the attempt to change the policy mix to achieve a desired short-run
economic outcome requires that die magnitude and timing of the economic impacts of fiscal
and monetary policies are understood; they are not In light of the disarray of fiscal policy,
the general lack of understanding about its impacts, and misperceptions about the
substitutability of fiscal and monetary policy, efforts to adjust monetary policy to fiscal
actions are counterproductive, and using the carrot of easier monetary policy as an
inducement to achieve a budget compromise is potentially dangerous.
Fiscal Disappointment
Since last Spring, as the chances of a significant breakthrough on the budget and
fiscal policy have faded with the slumping economy, skyrocketing federal costs of the S&L
restructuring, and the higher interest rates and defense requirements associated with the
Mid-East crisis, the budget process has emerged without substance or direction. Budget
recommendations that are rational economically are deemed unacceptable politically;
political squabbles take precedence over economic common sense. Both political parties
are guilty; they concentrate on incremental changes that fit into their short-term political
puzzle rather than the broader changes in resource allocation necessary to achieve their
long-run economic goals. They expend energy on placing political blame for the S&L
debacle, rather than addressing the failed policies that are the true source of the problem.
Lessons from past mistakes go unlearned. The Administration and to a lesser extent the
CBO continue to base budget projections on overly optimistic assumptions, without
sufficient contingency planning. In particular, the Administration continues to assume
sustained healthy real GNP growth (driven primarily by rapid improvement in productivity)
and significant declines in real interest rates, which lowers projected deficits, but is
seemingly inconsistent GRH has failed as an effective discipline on the budget process,
and it has not encouraged the type of policy changes that are necessary to avoid fiscal
calamities. Yet, GRH continues to command center stage because, sadly, the policymakers
seem out of ideas. Until the flaws in the budget process are recognized and corrected,
fiscal policy will remain disappointing.




32

Shadow Open Market Committee

Table 1
SELECTED BUDGET PROJECTIONS*
(Fiscal Year)
Actual
1989

1990

1991

1992

1993

1994

Receipts
President's Baseline
CBO Baseline

990.7
990.7

1044.0
1044.0

1121.7
1123.0

1194.5
1188.0

1278.7
1260.0

1363.1
1337.0

Outlays
President's Baseline
CBO Baseline**

1142.6
1142.6

1262.5
1238.0

1353.1
1355.0

1399.5
1426.0

1413.9
1455.0

1442.7
1483.0

152.0

218.5

231.4

205.0

135.0

79.6

152.0
152.0
159.0

161.3
195.0
156.0

168.8
232.0
162.0

163.7
239.0
179.0

140.6
194.0
181.0

121.3
146.0
176.0

136.0

100.0

64.0

28.0

0.0

Receipts, % Change
President's Budget
CBO Baseline

9.0
9.0

5.4
5.4

7.4
7.6

6.5
5.8

7.0
6.1

6.6
6.1

Outlays, % Change
President's Budget
CBO Baseline

7.4
7.4

10.5
8.3

7.2
9.4

3.4
5.2

1.1
2.0

2.0
1.9

As a percentage of GNP:
Revenues
President's Budget
CBO Baseline

19.2
19.6

19.1
19.1

19.2
19.3

19.0
19.1

19.0
19.0

19.0
19.0

Outlays
President's Budget
CBO Baseline

22.2
22.1

23.1
22.6

23.1
23.2

22.0
23.0

21.0
22.0

20.1
21.0

Deficit
President's Budget
CBO Baseline

2.9
2.9

4.0
3.6

4.0
4.0

3.3
3.8

2.0
2.9

1.1
2.1

Publicly-held debt
President's Budget
CBO Baseline

42.5
42.5

43.5

44.7

45.8

45.9

45.1

Deficits
President's Baseline
President's Baseline
(excluding RTQ
CBO Baseline
CBO excluding RTC
Amended GRH Targets
(1987)

.....

•Sources: Executive Office of the President, Mid-Session Review of the Budget, July 1990, and
Congressional Budget Office, The Economic and Budget Outlook: An Update, July 1990.
••Includes necessaryresourcesbeyond current law for savings and loan restructuring.




33

September 30 - October 1,1990

Table 2
CBO, ADMINISTRATION, AND BLUE CHD? ECONOMIC PROJECTIONS
(Calendar Years 1989-1995)
Forecast
1990
1991

1992

Projected
1993 1994

1995

5,236
5,236

5,534
5,583

5,893
6,002

6,279
6,439

6,688
6,881

7,121
7,324

7,579
7,771

Real GNP (Percentage) change, year-overyear)
CBO
Administration
Blue Chip

2.9
3.0
2.9

2.0
2.8
1.9

2.5
3.2
2.3

2.6
3.2
2.8

2.6
3.1
2.7

2.6
3.0
2.4

2.6
3.0
2.6

Consumer Price Index
(Percentage change,
year-over-year)
CBO
Administration
Blue Chip

4.8
4.8
4.8

4.8
4.8
4.8

4.2
4.1
4.3

4.2
4.0
4.0

4.0
3.7
4.1

4.0
3.4
4.0

4.0
3.0
4.0

Implicit GNP Deflator
(Percentage change,
year-over-year)
CBO
Adrninistration
Blue Chip

4.2
4.2
4.2

4.1
4.2
4.2

3.9
4.2
4.1

3.8
4.0
3.8

3.8
3.7
3.9

3.8
3.4
3.8

3.8
3.1
3.8

Three-Month Treasury
Bill Rate (Percent)
CBO
Administration
Blue Chip

8.1
8.1
8.1

7.6
7.7
7.7

6.9
6.8
7.5

6.7
5.8
7.0

6.2
5.1
7.0

5.6
4.8
6.9

5.4
4.4
6.7

Ten-Year Government
Note Rate (Percent)
CBO
Administration
Blue Chip

8.5
8.5
8.5

8.5
8.5
8.5

7.8
7.9
8.3

7.4
7.0
8.0

7.2
6.1
7.8

6.9
5.8
7.8

6.8
5.4
7.8

Inflation-Adjusted
Three-Month Treasury
BUI Rate
CBO
Administration
Blue Chip

3.3
3.3
3.3

2.8
2.9
2.9

2.7
2.7
3.2

2.7
1.8
3.0

2.6
1.4
2.9

1.6
1.4
2.9

1.4
1.4
2.7

Estimated
1989
National GNP
(Billions of dollars)
CBO
Administration

Sources: Executive Office of the President, Mid-Session Review of the Budget, July 16,1990;
Congressional Budget Office, The Economic and Budget Outlook: An Update, July 1990; and
Eggert Economic Enterprises, Inc., Blue Chip Economic Indicators, June 10,1990.




34

Shadow Open Market Committee

HEINEMANN ECONOMIC RESEARCH
H. Erich HEINEMANN
Ladenburg Thalmann & Co., Inc.

Federal Reserve actions have resulted in a prolonged drop in monetary growth.
Total reserves held by U.S. banks have shown almost no change since 1987. This was an
unusually long period for such "high-powered" money to be frozen.
The increase in total reserves has been below the level consistent with continued
economic expansion. Business activity has stalled and is now starting to decline. The
surge in energy prices this summer is likely to make the slump more severe. However,
higher oil prices were not the proximate cause of the downturn.
In September 1989, we reported to the SOMC that our Baseline Forecast indicated
"a recession during the first half of 1990." While this projection was premature, its thrust
was correct Hopes that the slow economic growth of late 1989 and early 1990 would set
the stage for a more sustainable pace of expansion have proved unfounded.
Present patterns indicate that the recession will continue at least until spring 1991.
Our current Baseline Forecast shows a moderate rebound beginning in the second quarter
of next year (see attached tables).
Despite the spike in producer and consumer prices caused by the oil shock, chances
for price stability have improved. Federal Reserve policy - which we have characterized as
a "preemptive strike against inflation" - has created a climate of disinflation. Asset prices especially for real estate - have tumbled. Corporate profits have declined because business
managers have been unable to pass higher costs tofinalpurchasers.
In a climate of sustained monetary restraint, increases in the relative price of energy
should be disinflationary. Higher consumer outlays for energy will absorb income
otherwise available for purchase of other goods and services.
We concur with other members of the SOMC that the core rate of inflation peaked
during the first half of 1989. Owing to the long lag between monetary actions and the
subsequent impact on price behavior, core inflation should continue to decline in the years
immediately ahead.
As the underlying pattern of disinflation becomes clearer to market participants,
interest rates should decline. The yield on long-term Treasury bonds, currently hovering
around 9 percent, should drop at least a full percentage point by next spring. The Federal
funds rate, the target for day-to-day Fed operations, is likely to decline from about 8




35

September 30-October 1,1990

percent at present to a range of 6.5 percent to 7 percent These developments should be
associated with an acceleration in monetary growth.
Negotiations over the Federal budget, which have been occupying center stage in
Washington, seem unlikely to result in fundamental fiscal reforms. Instead, we expect a
grab bag of miscellaneous tax increases and spending cuts designed to force the Federal
Reserve to reduce interest rates. How much the federal deficit actually declines (if, indeed
it declines at all) will be more a function of economic performance than of political
decisions about particular revenues and expenditure programs.
The Treasury's red ink seems unlikely to pose a significant barrier to lower interest
rates. Granted the deficit will likely rise close to 5 percent of GNP in 1991 (far above our
comfort level), interest payments will represent the vast bulk of this shortfall. Interest
payments, of course, are a very special kind of transfer payment As the SOMC has
pointed out previously, the Treasury is simply a conduit for these funds. It takes them in
and pays them out, sometimes to Ate same people.
In fact, the basic Federal budget - revenues less outlays other than interest - is
currently in surplus, as it usually is at the end of an expansion. That probably won't be
true next year. Even so, the basic federal deficit should be modest
Keep in mind that private demand for credit has been exceptionally weak. The
increase in non-financial, non-federal debt was 7.6 percent of GNP in the second quarter,
the lowest for a period of purported economic expansion in more than 20 years. The
collapse in consumer borrowing shows what has been happening in private credit markets.
Rates normally decline during periods of recession despite increased Treasury needs. The
1990-91 recession should be no exception.
Incoming economic data highlight the pattern of recession. Non-farm employment,
as measured by the Labor Department's household survey, declined 524,000 over the past
three months, down at an annual rate of 1.8 percent From June 1989 through August
1990, employment rose at a rate of less than one-tenth of one percent. Industrial
production, up at a 5.25 percent rate during 1987 and 1988, has increased at a rate of less
than 1 since April 1989.
Under pressure from the Fed, consumer spending is headed south. On the
assumption that consumer prices rose no more than six-tenths of one percent in August (a
conservative estimate), real retail sales last month declined at a rate of more than 13 percent,
and were unchanged from August 1988. That sort of decline is consistent with the onset of
recession.
New orders for non-defense capital goods averaged $37.4 billion per month in the
three months ended July, down at an annual rate of 15 percent from the average of $403




36

Shadow Open Market Committee

billion in January. In longer perspective, capital goods orders have hardly changed since
the summer of 1988.
Business outlays for structures (the "plant" side of plant and equipment spending)
were lower in the second quarter of 1990 than in 1988. Spending for producers' durable
equipment dropped at an annual rate of almost 5 percent in the second quarter. Each of
these indicators - plus a host of other measures - point toward an economic contraction.
Federal Reserve actions over the past six months have increased the likelihood that
the next recession will be more severe than was likely at the time of our meeting in midMarch. Policymakers have been reluctant to allow short-term interest rates to decline, even
though demand for credit is weak. During the three months ended in July (the most recent
period for which data are available) domestic non-financial debt rose at a rate of less than 7
parent, its slowest growth in the past IS years - including the bottom of the severe 198182 recession.
In this environment, the Federal Reserve has had to drainreservesfrom the banking
system to prevent rates from declining. Total bank reserves averaged $59.8 billion in
August Over the past 18 months, total bank reserves have declined by an average of $33
million per month, one of the longest periods ofreservecontraction in the postwar period.
This pattern of go-stop monetary policy has placed the Federal Reserve in jeopardy.
More than a year ago, Federal Reserve chairman Alan Greenspan conceded that he could
not "rule out a policy mistake as the trigger for a downturn." Mr. Greenspan told the
House Subcommittee on Domestic Monetary Policy that "we at the Federal Reserve might
fail torestraina speculative surge in the economy or fail torecognizethat we were holding
reserves too tight for too long." He added that "what we seek to avoid is an unnecessary
and destructive recession." Subsequent Fed actions have increased the probability that this
will occur.
Senior policymakers are well aware that when real economic activity declines in
earnest, the Fed finds itself under intense pressure to reverse course and reflate the
economy. This is the message from the so-called summit negotiations over the federal
budget Mr. Greenspan is now in a position where he will have to ratify whatever political
deal that comes out of the summit with easy money. Thus, there is a clear risk that gostop-go monetary policy - the Fed's traditional trademark - will be perpetuated. If so, this
would impose needless costs on the economy. It would also raise the long-run expected
rate of inflation.
At this point, the Fed's challenge is to devise a strategy to consolidate its gains in
the battle against inflation. The danger, as an anonymous member of the Federal Open
Market Committee warned recently, is that "a substantial weakening of the economy would




37

September 30-October 1.1990

be followed by rapid monetary growth and a markedreboundin activity - a pattern that
would be unlikely to foster the objective of price stability over time."
A year ago, we predicted that therealreturnon dollar assets would decline in the
months ahead. "In that case," we said, "the dollar will weaken and continue to decline
through much of 1990." This was'a good forecast The Federal Reserve's trade-weighted
dollar index was above 102 in September 1989, up more than 10 percent from its low in
November 1988. It is now about 85.
The deficit in U.S. international payments has improved steadily since 1986. Real
"net exports," as defined in die national income accounts, were at a negative $39.9 billion
annual rate in the second quarter of 1988, a gain of more than $10 billion from a year
earlier. Even though the growth rate of U.S. merchandise exports has dropped
considerably, further gains in U.S. trade are likely as domestic demand slumps.
Imports, which have already slowed substantially, should grow even less rapidly as
consumer demand continues to decline. Hopefully, exports should pick up as domestic
capacity is freed to service markets overseas. We believe that the U.S. "surplus" in
international service transactions is significantly overstated. Apart from this problem,
however, the officially-reported deficit on goods and services should continue to dwindle.
We expect trade to play a major role in limiting the downturn.
When the Federal Reserve adheres to a policy of moderate, stable expansion in the
money supply, the economy prospers. When the authorities deviate from this path - either
by freezing the money supply or by bringing it to a boil - the economy suffers. The
Federal Reserve has made a major gain against inflation over the past two years. This
advantage must not be frittered away with erratic policy.
Meanwhile, analysis of the U.S. economy is complicated by apparently identical,
but conflicting measures of activity. Consider the following example: In the past three
months, non-farm employment (A) rose 48,000 or (B) fell 524,000? In the spring quarter,
business investment rose (A) 3.1 percent or (B) dropped 5.2 percent? In both cases, the
answers are BOTH A AND B, depending on which statistics you choose.
Partly, this is simply an arcane problem in economic numerology. Economists get
paid to explain such anomalies. At present, however, the question has broad meaning - for
the economy, for financial markets and for the election in November. If business activity
has simply slowed, which is implied by the "A" answers, then the economy will likely
keep growing. Interest rates will stay high.
By contrast, if business has stalled - that's the message from answer "B" - then a
recession is probable. Rates will come down. Democrats may boost fheir already lopsided




38

Shadow Open Market Committee

majorities in Congress. Backlash from the downturn could force Alan Greenspan to
resign.
We believe the preponderance of economic evidence shows a recession already
underway. Put differently, the drop of 524,000 non-farm jobs from May to August
reported by the Labor Department's monthly survey of the nation's households appears
closer to reality than the increase of 48,000 reported by its tabulation of business and
government payrolls.
Similarly, we think the report by the Bureau of Economic Analysis that business
investment in plant and equipment declined at an annual rate of 5.2 percent in the second
quarter was accurate. By contrast, the Census Bureau's latest survey of capital spending
plans produced a parallel estimated that outlays rose at a rate
percent
Many economists, perhaps a majority, have been focusing on the numbers that
indicate continued growth. However, we think these analysts have been looking at
phantom jobs and phantom factories. It is obvious that the Fed's three and one-half year
campaign of tight money has succeeded all too well. Not only has business activity slowed
down - that is no longer a matter of debate - but, as already noted, telltale signs of a
cumulative contraction are now easy to see.
The fact that the federal government publishes alternative measures of the same
phenomenon is an old story. The Labor Department's household survey, for example, is a
measure of the number of people who have jobs. The Bureau of Labor Statistics uses this
tabulation to determine total employment and unemployment as well as the unemployment
rate.
By contrast, the so-called payroll survey is a count of the number of jobs. Because
self-employed individuals are excluded from this tally, payroll employment is less than total
employment On the other hand, if a person holds more than one job, then he or she is
counted for each job.
Despite such differences, changes in the household and payroll employment
measures are normally quite similar on average. However, this is not true at present
According to the BLS, the number of payroll jobs rose by more than 2 million in the year
ended August 1990, while the number of people with jobs increased by less than 250,000.
The discrepancy between the rates of change in these two basic measures was
almost 1.8 million, roughly equal to records posted in June 1990 and June 1985. A
divergence of this sort should have prompted inquiries by journalists and financial analysts
eager to gain insights into the probable direction of the economy. In fact, it was ignored.
The BLS has had little to say about the discrepancies in its data. However, our analysis




39

September 30 - October 1,1990

shows that the payroll employment measure systematically overstates economic growth
during periods of weakness or decline in GNP.
In part, this may be the result of difficulties with the model government statisticians
use to estimate hiring by newly formed businesses. The BLS has been routinely adding
about 80,000 jobs a month to its payroll tabulation to account for employment at new
firms.
The Census Bureau's survey of intended capital spending appears to suffer from an
analogous distortion. Historically, changes in this series have correlated closely with
changes in non-residential fixed investment reported by the Bureau of Economic Analysis
in the GNP accounts. Closely, that is, until 1989, when a huge disparity developed.
Economists at the Census Bureau are frank to say they have no idea what caused
this discrepancy. They add that they intend to try to offset the overstatement in 1989 with
an understatement in 1990. Even so, the figures for 1990 capital spending that the Census
Bureau reported last week were far stronger than those in the latest GNP report In the
circumstance, my advice would be to ignore the survey data. Instead, concentrate on the
GNP numbers, which in our view show an economy slowly sliding into recession.
Until recently, we were in a small minority warning of an impending downturn in
the economy. Since die Gulf crisis erupted last month, of course, the consensus has begun
to shift Now, establishment economists are starting to tell their clients, as the Morgan
Bank put it recently, that the U.S. "appears likely to move into recession."
"Higher oil prices and falling construction will cause the economy to stall over the
next few months," the bank added. "The likelihood that this initial weakening will have
secondary effects on business and consumer spending points to an outright recession,
commencing within the next month or two and continuing into the first half of next year."
It's time to forget about fantasies of rising employment and capital spending, and
focus instead on the fact of a falling economy.




40

HEINEMANN ECONOMIC RESEARCH
Baaallna Forecast - 8aptambar 1000
lYMA

tirot F

IVOIF

&&A

IOOOF

1001F

$4,177.3
6.6%
$2,661.1
4.0%
$408.7
6.7%
$370.7
6.2%
$163.0
16.0%
$21.2
($42.0)
$866.2
2.0%
$4,108.0
4.6%
$6,623.7
7.0%
$2,046.6
4.0%
4.6%
$327.1
61.6%
100.6
6.2%
1,447.3
46.4%
0.6
0.6%
116.1
2.8%
6.0%
142.0
3.6%
112.2
6.7%
126.6
-2.1%
130.4
2.1%
138.6
2.6%
($246.3)

$4,236.6
6.7%
$2,702.1
6.3%
$616.1
16.6%
$306.1
16.3%
$100.3
40.6%
$13.3
($66.6)
$866.1
1.4%
$4,277.6
7.6%
$6,030.7
8.2%
$2,087.0
6.7%
4.7%
$340.0
17.0%
112.3
0.7%
1,486.7
11.3%
10.0
12.1%
110.0
3.2%
6.6%
143.1
3.2%
113.3
3.0%
126.4
-0.6%
140.2
2.4%
130.6
3.0%
($236.6)

$4,117.7
2.6%
$2,666.6
1.0%
$606.1
3.0%
$363.7
6.2%
$187.0
-4.0%
$10.1
($64.1)
$602.0
0.6%
$4,162.6
1.7%
$6,200.6
6.7%
$2,860.0
2.4%
4.6%
$311.6
-7.7%
106.1
2.6%
1,380.2
-7.1%
0.020
-6.6%
117.3
2.0%
6.3%
132.3
2.0%
112.0
-0.3%
116.1
3.3%
126.3
4.1%
128.3
4.6%
($134.3)

$4,146.2
0.7%
$2,660.6
0.6%
$606.6
-0.1%
$363.0
-0.2%
$170.0
-3.8%
$7.6
($38.4)
$823.6
2.6%
$4,178.8
0.6%
$6,403.3
6.6%
$2,003.3
1.2%
• 6.1%
$207.8
-4.4%
106.0
0.6%
1.263.7
-0.7%
0.4
-6.4%
117.7
0.4%
6.6%
136.6
3.4%
110.6
-1.1%
123.4
4.6%
132.4
4.0%
134.6
4.8%
($160.2)

$4,166.3
0.2%
$2,666.6
-0.6%
$406.6
-1.4%
$376.4
-1.2%
$162.7
1.6%
$7.6
($41.1)
$861.1
3.3%
$4,166.6
0.2%
$6,770.0
6.0%
$2,033.7
1.0%
6.0%
$311.6
4.6%
100.1
0.2%
1370.6
0.3%
0.7
2.6%
117.6
0.0%
6.1%
141.4
3.4%
111.4
0.6%
127.0
2.0%
138.6
4.6%
138.2
2.6%
($233.2)

6.24%
6.26%
7.7%
7.0%
6.61%
6.1%
7.4%
7.0%
6.7%
Federal Funds Rata
7.76%
7.76%
6.0%
6.2%
7.66%
7.6%
6.6%
6.2%
6.0%
Three-month Bills (Discount)
10.00%
10.04%
0.3%
6.6%
0.6%
6.7%
6.3%
6.1%
10.60%
Prima Rata, Major Banks
6.44%
6.66%
0.1%
6.2%
6.3%
6.1%
7.7%
6.6%
7.03%
30-Year Treasury Bonds
$807.4
$616.4
$874.2
$846.6
$800.2
$667.6
$860.2
Money 8uppfy (M-1, $ Currant)
$700.6
$830.2
3.6%
4.1%
3.1%
6.2%
4.6%
4.0%
6.1%
7.4%
6.2%
PetChO
6.763
6.611
6.704
6.616
6.716
6.712
6.660
6.736
6.680
Velocity (Ratio: QNP TO M-1)
2.1%
3.6%
6.0%
-6.6%
1.7%
3.6%
2.0%
-4.3%
-1.2%
PetCho
02.7
66.7
63.6
03.1
62.7
70.6
61.6
07.3
62.3
rradt-WelgMtd $ (1073-100)
$1.1
$2.3
($6.0)
($7.0)
$6.0
$3.3
($7.0)
($3.0)
($6.0)
Memo: CCC Purchaaaa
4-Aetual F-Forecast Billions of dollars unless notsd.
4
Adjusted for Commodity Crsdlt Corp. purchassa. ••Compensation, productivity and unit labor costs are Index numbers, 1082-100.
Source: Cltlbaae; Hslnsmann Economic Research

0.22%
6.11%
10.67%
6.46%
$763.7
1.0%
6.636
6.6%
06.7
($4.7)

6.1%
7.6%
0.6%
8.7%
$813.3
3.6%
6.764
1.8%
88.4
($10)

7.0%
6.2%
6.4%
6.1%
$661.0
6.0%
6.604
-0.0%
61.8
($11)

ME ECONOMY;
Gross National Product ($82)
PetCho
Personal Consumption ($82)
PetCho
Business Investment ($82)
PetCho
Prod. Our. Equip. ($82)
PetChg
Residential Invest. ($82)
PetCho
Chanoe In Inventory ($62)°
Nat Expoftt ($82)
Government Piirehaaea ($82)*
PetCho
Pinal Oomaatle Bales (882)
PetCho
ttroaa Nafl Prod. <$ Currant)
PetCho
Disposable Income ($82)
PetCho
Bavlno* Rata (Pareant)
Oparatlno Proflta ($ Currant)
PetCho
Industrial Prod. (1087-100)
PetCho
Houtffno Star* (Miff. Units)
PetCho
Auto Batea (Million Unfie)
PetCho
Total Employment (Millions)
PetCho
Unemployment Rata (Peroant)
Comp. Par Hour Non-Farm Bua*#
PetCho
Produetfvfty Non-Farm But**
PetCho
Unit Labor Coat Non-Farm But**
PetCho
(INP Deflator (1062-100)
PetCho
CPf Leee Enaroy (1062-84-100)
PetCho
Federal Deficit ($ Currant)

FINANCIAL MARKETS'




$4,133.3
0.3%
$2,660.0
-0.6%
$608.4
-3.6%
$386.4
-6.2%
$161.6
-6.6%
$13.0
($47.0)
$607.2
0.6%
$4,167.3
-1.1%
$6,260.3
3.0%
$2,663.2
1.2%
4.6%
$200.0
-10.1%
106.1
0.2%
1,347.7
3.1%
6.744
-66.6%
117.8
1.0%
6.3%
133.4
2.7%
111.4
-2.1%
110.8
6.2%
126.0
3.6%
130.3
4.6%
($160.1)

C3L&
$4,160.6
1.7%
$2,677.3
1.1%
$614.6
6.0%
$300.6
6.7%
$168.3
16.1%
($0.2)
($36.4)
$614.0
3.0%
$4,106.1
2.7%
$6,376.4
6.7%
$2,000.0
2.6%
4.0%
$206.6
8.4%
106.3
0.7%
1,464.3
36.6%
0.734
63.6%
116.1
1.0%
6.3%
134.4
3.0%
110.6
-2.1%
121.3
6.1%
120.6
4.0%
132.6
7.1%
($166.3)

1Q8LA
$4,162.7
1.2%
$2,670.3
0.3%
$607.6
-6.2%
$386.2
-4.6%
$163.0
-10.6%
$12.7
($30.0)
$810.6
2.4%
$4,160.0
-0.6%
$6,461.0
6.6%
$2,007.0
0.8%
6.1%
$306.6
13.7%
100.6
4.3%
1,100.3
-63.6%
0.661
-6.1%
116.3
0.7%
6.3%
136.3
6.6%
111.2
1.6%
122.6

ni'oo F

$4,161.4
-1.1%
$2,666.0
-1.7%
$604.6
-2.3%
$361.2
-6.1%
$176.0
-14.7%
$16.6
($40.6)
$826.4
3.3%
$4,176.1
-1.4%
$6,663.0
7.7%
$2,010.2
0.4%
6.2%
$200.3
-0.1%
100.0
1.6%
1,176.7
-7.6%
0.3
-11.3%
117.7
-2.0%
6.6%
137.6
4.0%
111.0
-0.7%
124.0
4.6%
4.4%
133.6
131.0
4.6%
6.0%
134.0
136.2
4.4%
3.6%
($184.0) ($106.6)

IVOOF
$4,128.2
-2.2%
$2,664.0
-2.1%
$406.3
-7.3%
$373.6
-7.8%
$172.4
-7.7%
$10.0
($37.6)
$633.4
3.4%
$4,166.1
-1.0%
$6,602.0
2.6%
$2,606.1
-2.1%
6.3%
$268.6
-13.6%
107.0
-7.0%
1,166.6
3.4%
6.0
-14.6%
116.0
-2.6%
6.0%
136.7
3.2%
110.2
-2.6%
126.6
6.1%
136.6
6.1%
136.1
2.6%
($207.0)

roiF
$4,066.2
-3.8%
$2,627.7
-3.0%
$466.0
-7.4%
$366.4
-6.6%
$172.4
-0.0%
($7.0)
($32.6)
$841.7
4.1%
$4,127.7
-2.6%
$6,602.7
0.6%
$2,666.6
-0.0%
6.6%
$263.0
-7.6%
106.6
-4.3%
1,220.7
16.7%
0.3
16.6%
116.7
-0.0%
6.4%
130.8
3.3%
100.6
-2.6%
127.7
6.0%
137.0
4.6%
137.0
2.6%
($216.4)

ii'oi F
$4,120.4
3.2%
$2,636.0
1.1%
$401.8
4.0%
$372.3
7.8%
$176.0
6.6%
$2.0
($34.6)
$640.2
3.6%
$4,162.0
2.4%
$6,714.0
6.2%
$2,011.6
3.2%
6.1%
$204.0
17.0%
107.6
$.2%
1,316.1
32.0%
0.6
11.3%
117.3
1.0%
6.3%
140.6
2.7%
110.6
4.0%
127.3
-1.2%
138.7
4.6%
137,7
2.1%
($236.6)

September 30-October 1,1990

$ Change
$36.6

iiraoA
H'80A
PctChg $ Change PctChg $ Change
1.6%
$17.6
3.6%
$16.3

tvaoA
1989 A
PctChg $ Change PctChg $ Change Pet Chg
1.6%
$3.6
0.4% $100.9
2.6%

-0.2%

$6.6

0.8%

$30.0

3.0%

($6.4)

-0.5%

$60.3

1.3%

$10.6

1.0%

$6.4

0.6%

$7.6

0.8%

«M.0)

-0.6%

$18.9

0.6%

Prod. Dur. Equip. ($82)

$8.4

0.6%

$10.9

1.1%

$6.7

0.6%

($6.2)

-0.5%

$16.9

0.6%

Residential Invest. ($82)

($16)

-0.2%

($57)

-0.6%

($37)

-0.4%

($2.6)

-0.3%

($7.8)

Change in Inventory ($82)*
Net Exports ($82)
Government Purchaeee ($82)*

$10.9
$24.6
($6.6)

1.1%
2.4%
-0.6%

$3.0
($2.2)
$4.2

0.3%
-0.2%
0.4%

ill

THE ECONOMY:
Groat National Product ($82)

-1.0%
-1.0%
0.6%

($0.6)
$16.2
$1.1

-0.1%
1.6%
0.1%

$11.1
$21.6
$6.7

0.3%
0.6%
0.2%

$16.6

1.6%
2.7%

3.8%
2.4%

($11.6)

-1.1%
1.6%

$68.0

1.7%

Personal Consumption ($82)

($2.1)

Business Investment ($82)

Final Domestic Sales ($82)
GNP ($62) Four qtr chg (%)
THE ECONOMY:
Gross National Product ($82)

$1.1
T90 A
$ Change
$17.2

0.1%
3.2%

H'OOA

PctChg $ Change
1.7%
$12£

$39.0

1900 F
ttrooF
tVQOF
PctChg $ Change PctChg $ Change PctChg $ Change
-2.2%
$30.6
-1.1%
($23.2)
1.2%
(111.3)

-0.2%

Pet Chg
0.7%

Personal Consumption ($82)

$7.4

0.7%

$2.0

0.2%

($11.3)

-1.1%

($13.9)

-1.3%

$12.6

Business Investment ($82)

$6.2

0.6%

($6.8)

-0.7%

($3.0)

-0.3%

($06)

-0.9%

($0.4)

-0.0%

Prod. Dur. Equip. ($82)

$6.4

0.6%

($4.6)

-0.4%

($6.0)

-0.6%

($7.6)

-0.7%

($0.8)

-0.0%

Residential Invest ($82)

$6.6

0.6%

($6.3)

-0.6%

(67.1)

-0.7%

($3.6)

-0.3%

($7.1)

-0.2%

($23.1)
$12.6
$7.7

-2.2%
1.2%
0.7%

$21.9
($4.6)
$4.9

2.1%
-0.4%
0.6%

$4.1
($0.6)
$6.6

0.4%
-0.1%
0.6%

(S6.9)
$2.6
$6.9

-0.6%
0.3%
0.7%

($11.3)
$16.7
$20.6

-0.3%
0.4%
0.6%

$27.8

2.7%
1.3%

($6.2)

-0.6%
1.2%

($14.6)

-1.4%
0.6%

($20.0)

-1.9%
-0.1%

$26.0

0.6%

Changs in Inventory ($82)*
Net Exports ($82)
Government Purchases ($82)*
Final Domestic 8ales ($82)
GNP (682) Four qtr chg (%)

1*01 F
($40.0)

-3.6%

H'91 F
$32.2

3.1%

IH'91 F
$66.9

6.6%

IV91F
68.2

6.7%

($26.3)

-2.6%

$7.3

0.7%

$26.1

2.6%

41.0

Business Investment ($82)

($0.4)

-0.9%

$6.9

0.6%

$6.9

0.7%

Prod. Dur. Equip. ($82)

($8.2)

-0.6%

$6.9

0.7%

$7.4

Residential Invest ($82)

($0.0)

-0.0%

$3.6

0.3%

($17.9)
$6.3
$8.3

-1.7%
0.6%
0.6%

$9.9
($2.0)
$7.6

($27.4)

-2.6%
-1.6%

$24.3

Gross National Product ($82)
Personal Consumption ($82)

Change In Inventory ($82)*
Net Exports ($82)
Government Purchases ($82)*
Final Domestic 6alee ($62)
GNP ($82) Four qtr chg (%)




42

1W1F

0.3%

7.1

0.2%

4.0%

-13.2

-0.3%

19.4

1.9%

-7.0

-0.2%

0.7%

16.3

1.6%

-4.6

-0.1%

$7.0

0.7%

16.3

1.6%

2.8

0.1%

1.0%
-0.2%
0.7%

$16.3
($7.4)
$6.1

1.8%
-0.7%
0.6%

-7.9
-13.6
2.9

-0.8%
-1.3%
0.3%

-0.2
-2.7
27.4

-0.0%
-0.1%
0.7%

2.4%
-1.0%

$46.1

4.6%
0.6%

79.6

7.9%
2.6%

10.0

0.2%

Shadow Open Market Committee

THE RECESSION OF 1990

I960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990
Notes: The chart shows the difference between year-over-year changes
in nonfaPM eMPloyaent and the average change in nonfarn
enployMent, 1960-1990. Household Survey, Data in percent,
seasonally adjusted. The vertical lines show recessions.
Sources: Citibase; Heinenann Economic Research




43

September 30-October 1,1990

S
I
X

TIGHT HONEY PUT A CRIMP IN CONSUMER SPENDING
12K

Q

U
A
R
T
E
ft
C
H
A
N
G
E

8X \

Money Supply
(M-3 - Line)

4'/
Consider
Spending
(Goods - Pot)
-4'/
1968 1963 1966 1969 1972 1975 1978 1981 1984 1987 1998
Notes: The chart shows annual pates of change over successive sixquarter periods in (1) peal M-3 and (2) peal personal
consuMption of durables and nonduralles, Underlying data
seasonally adjusted. The vertical lines show recessions,
Sources: Citibase; Heinenann EconoMic Research




44

Shadow Open Market Committee

CAPITAL SPENDING IS HEADED FOR RECESSION
1
8
N
0
N
T
H
C
H
A
N
G
E
S

1968 1963 1966 1969 1972 1975 1978 1981 1984 1987 1998
Notes: The chart shows annual rates of change over successive 18-Month
periods in real contracts and orders for plant and equipment
(BCD Series # 28). Seasonally adjusted. Data SMOothed with
a 3-Month Hoving average. Vertical lines show recessions.
Sources: Citibase; HeineMann EconoMic Research




45

September 30 - October I.1990

THE SLUMP IN CONSUMER BORROWING

1968 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990
Notes: The chart shows the deviation froM trend in the year-overyear rate of change in total consumer installment credit
outstanding. Data in percent at seasonally adjusted annual
rates. The vertical lines show recessions.
Sources: Citibase; Heineaann Economic Research




46

Shadow Open Market Committee

MUel-Fvtl
F deralfcsene
e
•
(1)

(2)

(3)

(4)

Mai
Brie

JanlSOB

Feb

to
*pr

tor
to
Ad
tag
Sp
e
Oct
MM

lee
J » 1989

Feb

to
*r

to

Jun

Jul
4U9

S>
o
Oct
M
w

tec
J»19»
lib

to
tor

tor
Jw
Jul
JuafE
t

2603
261.9
26X2
26X2
266.7
268.4
2X1.1
271.2
272.4
273.4
274.5
275.2
276.6
2773
278.2
278.2
2783
279.0
280.0
280.8
281.8
282.8
283.2
284.9
2873
289J
291.fi
2933
294.4
296.3
297.9
301.2

Bm
a
OVTEKT

198J

1»3
20X7
28X2
203.4
204.8
20X1
207.3
20X7
209J
21X7

teenies

62.4
62.6

623
63.8

6X3
63.4

64J
63.9
63.7

617
63J

2UJ

43.4

21X2
214.1
21S3
21X7
216.4
217.2
217J
21X6
2193
220.0
220.4
221.9
224.6
226.6
228.4
230.1
231.6
233.4
23X4
238.0

6X4
6X2
62.9
62.5
61.9
61.8
62.2
09

623
62J
62J
6X0
62.9

6X1
6X4
63.4

62J
62.9

623
6X2

fctia ad taetary truth

(5)

(6)

(7)

dsporit
tiabil.

281.3
20x2
279.9
2823
2963
3013
3023
30X6
jftfr
3D6J
310.4
31X1
310.1
310.1
316.6
3D5.1
3D2.S
301.4
296.9
28X8
274.6
2653
263.8
25X7
249.9
2483
244.6
2403
2473
246.1
24X0
247.0

Sarins
•.Stall
lemsits*

Tue
•posits

S2J
55X8
S5X0
58L7
5623
56X8
57X0
569.8
S68J
56X0
567.8
5683
S65.1
565.1
56X0
859.2
552.4
549.3
554.1
5543
5563
560.8
561.4
565.4
56X7
567.2
56SJ
569.6
566.0
568.3
566.1
5693

1866.6
18B6.1
19013
19133
1922.6
1928.4
19343
1937.2
1941 J)
1948.3
1956.6
193X2
1959.6
1960.7
1964.2
19693
1971.6
1978.4
198X7
20D2J
2009.8
2017.4
2D27.1
2D35.0
2D3B.1
2045.6
2055.9
2062.3
2064 J)
2064.1
2067.2
20723

4883
492.8
495.9
497J
50X8
50X7
514.2
521.1
S29J
535.9
537.1
541.1
546.7
55X3
560.1
5683
57X1
574.9
574.7
570.5
565.6
562J
561.0
3583
554.2
550.1
544J
538.2
535.2
532.6
530.7
52X4

Tic

47

(8)

(9)

Facia
leposits

Treasury
leposits

(10)

iDt-

hand
(emits

Includes Money Kvtet teposit Accounts




lordfceetanrBase)

(S Billons)

Adjusted
Monetary
Base

(Federal

11.8
11.0
10.9

1X0
1L0
1X6
12.0

11J
1X1
1X6
1L0
1L4
1U
1L2
103

24.9

2X2
223
2X7
30.4
21.0
22.0
11.9

243
27.7
16.2
22.9
25.0

103

2X9
18J
2X2
343

11.7
11.7

26.2
23.0

103
1X1
1L6

24.9

10.5

10.9

1X9
2DJ

HI

14.7
19.6

11.4

2X2

UL7

22.0

10.6
10.6
11.1
10.5
10.4
10.9

U.7
20.0
25.2
20.9

153
2X1

Total
leposits**

32253
3252J
32653
3287.2
3323.4
333X8
3354.8
3359.7
3flRff_^
3396.6
3399J
3414.0
3417.6
3426.3
3432.5
3432.6
3444.4
3441.9
3450.1
3439.4
34423
3438.7
3439.1
344X2
3439.5
3444.1
3440.7
3441.2
3448.8
34423
3434.7
34483

September 30 - October 1.1990

Mfel-ftrt2
Meri| feme fctia aid toeta? Mb
(11)

fete

Adjusted
tesen*
btio
(910)

Mm

o.ara

Feb

0JM3
0.0191
0.0192

Iter

Apr
fey
Jlfl

Jul
Ag
u
Sp
e
Oct
to
fee

ojm
man

M

0.0151
0.0190
O.018B
fUBOB
0.0188
0JU86
0.0185
ILQ184
0.0183
0.0182
0.0180
0.0180
0.0180
0.0181
0.0182
0.0183
0.018S
0.0183
0.0183
0.0183
0.0184
0JU8I
0.0182
0.0183
0J182

lugfE

fUff

0*1*9
Feb
Iter
4PT

to

Jm
Ad
lug
SEP

Oct
to
fee
J»199Q

Feb
liar

Ipr
fey
An




(12)

(15)

(14)

(IS)

(]£)

Currency
tatio

Smugs
ISnll
lis
feposit
btio

Urge
lis
leposit
btio

todeposit
Lufail.
tatio

(214)

(¥4)

(474)

0.35B7
0.3605
0.3O£
0.3606
0.3617
0.3613
0.XK
0.3OB
0.3669
03692
0J7U
0J727
0.3773
0J789
0JB2I
0JBS7
0.3921
0-3951
OJRtt
0JH2
0.3941
0.3923
0J925
0.3925
0.3991
0.3995
0.4015
0.4040
0.402
0.4107
0.4158
0.4180

3JBQ3
3.4119
3.42Q
3.4127
3.4192
3.4023
3JX35
3J998
3.4124
3.4301
3.449
3.4475
3.4C7
3.4697
3.4808

0.8946
8J915
0J935
0JB70
8.8506
8J940
0.9021
0.9145
8,9314
8.9435
8,9459
0.9521
0.9674
8.9791
0.9948
1.0143
1.0375
1.0466
1.0372
1.8289
1.0164
1.0034
0.9989
0.9874
0.9849
0.9699
8.9566
0.9449
0.9456
0.9372
0.9375
0-9226

IW
3.5692
3^017
1909
34108
&4US
3.5974
1005
3.5992
3.4220
34065
3.6145
X4206
34466

usn
ZJW

Lfl»

48

(17)

(18)

Foreigi
leposit
btio

Irasury
feposit
fetio

Money
feltipiier

(7/4)

(8/4)

(9/4)

(2«4/U

0.5094
0-5007
OJ043
0JQ3B
8-5269
0-5316
0.53M
05416
8.S367
(L53B9
0.5467
IL5474
0.S483
0.5493
0.56Z3
4L5436
0.5476
ILS487
0.5350
0.5154
0.4934
0.4734
0.4697
0.4522
0.4441
0.4381
8.4300
0.4222
0.4369
0.439
0.433

0.8214
0.0199
10196
IL0196
0.0196
0.0205
0.02U
0JU95
8JU95
4)0,187

0.0451
0.0510
0.0402
0JDB7
0.0541
0.0371
0JB86
0JBD9
4UN31
0J48B
0.0285
0.0403
0.0442
0JM5B
0.0321
0JB61
0.0621
0.0477
0.0415
dJIBSO
0.0447
0.0369
0-0262
0JB47
0.0412
0JB8B
OJB94
0JBS1
0.0445
0.0368
0.0270

2J8Q3
2-0717
2J7W
2-H762
2.8709
2.8752
2J729
2JK57
2.8547
2J442
2.8364
2.8343
2J142
2JU00
2J979
2J854
2JU0
2J471
2.75/2
2.7536
2.7530
2.7611
2J611
2.7630
2.7383
2J399
2J318
2J243
2,7092
2-7059
2-6909
£4808

MSB

SJ194
0J2Q1
0.0196
0JU98
QWff
QQlffl
0.0190
0.0213
OLoeu
0.0189
0.O99
0.0207
0.0194
0JU98
0.0203
0.0189
0.0186
8.0186
0JD56
0.0185
0.0194
0J191

UMfi

Shadow Open Market Committee

1*1*2
Federal teen* Action aid taetvy frurtk
(GDvond Annual totes of Change)
This i s muited for by dnngs io the:
Federal
•eserw
Actions
Itooetary {Monetary
frwth
lase
OH) frwtb)

tote
Jan 1988

11.72
2.92
5.90
12.05
4.49
9.65

Feb
Iter

Ar
p
fey
Jun
Jul
Ag
u
SEP

Oct
tar
Dc
e
Jan 1969

Feb
tar
APT

ft*
Jun
Jul
Ag
u
Sp
e
Oct
ft*
tec
Jan 1990

Feb
ttar
APT

toy
Jun
Jul
ftisK

7J3
1.56
0.62
0.31
1.24
2.49
-2.73
1.40
-1.3B
-5J2
-8.76
-3.8$
8.79
1.88
4.27
8.01
1.86
8.44
0.00
10.37
5.26
3.83
-3.11
6.35
-4.3D
9.37
1987
3.78
1988
5.02
1969-Bi
-3.48
1989-UH
5.54
1990 -Bi
3.97
-L57




Oontribution
of the
Honey
IkilUplier

Savings
15*11
Adjusted
feserve
tatio

Curacy
tatio

Urge

lie

Ike

Ieposit
tatio

Ieposit
tatio

itar
Ieposit
Liability
tatio

Foreign
Ieposit
tatio

Treasury
Ieposit
tatio

(L27
-8J6
0J9
-6J6
0.04
8.88
HL36
-8.31
0.01
Q.62
0-25
-0.12
Uk
9.5B
0.3D
8.00
8.03
0.06
•8.49
8J2
6J5
2J8
8.80
-8 JO
-L2D
-0J5
-8.34
-8.05
0.89
7.69
-<L24
-8J7
-4.07
0.89
8.86
-8.03
-6.86
8.29
-8.42
-0.59
8.46
0.08
1.27
8.91
4.64
HL63
-8.y
-8.32
(L25
5JB
-0.00
-1.13
HM
-4J6
-4.65
2.91
4.82
0.04
HL26
-4.51
1.07
-4J9
-4J7
-8.U
L00
4.67
-3.43
-8.3B
-8JB
6J2
-8.12
-8J7
-8.04
-8.04
3.41
-4.91
-0.61
-8.88
-8.32
3.83
0.65
-0.06
8.02
5.93
-8.67
-4.19
-8.97
-4.74
-8.01
0.00
-8.08
3^5
-L85
-8.55
1.48
-8.89
2.00
•4.64
0.86
0-65
ZM
-5^4
-8.98
-8J4
0.75
1.66
-6.0J
-8.18
0.09
-1.46
-8.95
-5.21
-0.09
-8.81
-1.15
-10.19
-2J9
-8.94
1.42
3.49
-8.05
-8.18
6.63
-1.48
-8.40
-5.98
(L27
2J5
0.57
SU
O
0.28
-8.85
8.48
0.42
4.68
4.U
UJ
8.10
0.92
8.58
-4.89
0.37
3.48
-1.60
-8.85
-L82
1.05
-8.05
0.59
-4.76
HL31
-L3B
-4J5
4.58
6.27
0J5
4.25
0.90
-0.03
0.S9
8.64
-L54
3.76
2.85
1.03
1.87
0.43
0.3S
0.12
-0.01
-8.51
-1.16
-0J7
0.54
0.82
-0.02
-8.39
0.89
8.48
7.55
-8.51
-4.03
0J9
-8.32
-11.34
-1.89
0.12
-8.02
11.34
0.15
-10.58
0.11
0.07
0.73
0JB
9.60
0.77
0.71
-0.54
-8.58
0.3B
0.63
8.44
-0.37
0.01
-3.82
-L64
9.08
-3^
(L36
-0.27
0.00
-8.29
0.54
-3.48
-8.05
-3.79
7.31
-(L66
3.58
-(L05
-4.43
-8.83
3.40
-1.17
-6.68
-7.75
-L57
8.18
0.67
8.36
-0.84
-2.3B
6.39
0.05
7.92
1.19
-4.86
-6.61
8.81
0.00
6.44
-6.91
6.61
-7.66
0.60
-8.85
-8.64
-2.18
-3.44
0.70
14.42
-5.05
-0.04
1987
1987
1987
1967
1967
1987
1987
1987
1987
-3J9
-8.34
-4.20
-8.26
-8.04
-3.14
1.06
0.00
6.92
1988
1988
1988
1988
1988
1988
1988
1988
1908
-1J4
-6.22
-8.18
-8.14
-8.81
-1.67
0.00
6.68
8.62
1989-Si 11969-Bi J1969-Bi J1989-Bi J1969-Bi i1989 -IH 1L969-BJ 1L989-IH
19B9-IH
-1J5
-5J3
-8.85
-0.72
1.89
-<L02
2J8
-iJ9
-8.81
1989-IIH 1989-DH J1989-HH 11989-IB1 i19B9-I1N J1989-ISi :1989-ISi i1989-DH .1989-ISi
-4.08
6J6
8.49
8.77
6.18
1.24
-8.98
AJL
8.82
1990-Si !1990 -Si
1990-SI I 1990-IH ]1990-Si 11990-Si :1990-Di
1990-Si
1990-Si
O.U
-4.23
8.3B
-4.93
-0.06
-4.04
HM
0.00
8J3
-0J6
-4J5
8J4
-5J9
-6.11
-iJ»
-6JB
-4J2
4.43
11.91
4.70

-4.22
-3.7B
-0J4
2.47
-2J6
1.96
-L86
-3.09

-5.15

LSI
LB

3.0D
-3J0
-2J0
1.85
-1.95
0.72
-0.45
-3J2
-5^7
-3J8
-114
-2.85
-7J7
-2^0
-5.66
-5JB
-*.40
-4.93

49

L29
-1.65
-0.81

September 30 - October 1,1990

Uble3
Federal teen* Action ad Honetary ffrwtii
* (tamad total fates of flange)
HUS is accounted for by danges i i the:

fate
Jan 1908

Feb
ffar

Ar
p
Itoy

An
Jul
tag
Sp
e
Oct
tot-

tec
Jan 1969

Feb
far
Apr
fay
An
Jul
Ag
u
Sp
e
Oct
Ifcw

tec
Ian 1990

Feb
liar
APT

fey
Jun
Jul
Aug f t




federal tatri•esene
Actions oftfe
ItaneUry (Monetary Honey
froth
lase
llilti(Ihl) frwth) plier
0.31
2.85
6.85
6.96
7.48
8.73
7.12
6.14

8JD

3J3

6.10
4.95
4.95

0.85
0.72
1.35
0.35
0.39
-€.90
-1.70
-5.09
-5.90
-1.27

2J8
4.9B
4.72
4.72
6.11
3.43
6.27
5.21
6.49
2.00
2.36
0.98
5.14

7.94

8J9
7.51
7.56
8.01
7.61

6J7

4JD
4.67
4.19

4J5
2.40
1.79
1.22
2.56
3.24
4.06
4.10
3.S7
4.56
6.92
9.SD
10.01
8.66
6.65
6.27
6.03
9.65

-7J8
-5.09
-1.45
-<L55
-€.08
0.69
-0.48
-€J3
-2.97
-4.12
-4J3
-2.95
-4.34
HL81
-5J5
-4.10
-6.88
-7.13
-3.85
-0.%
0.93

0^2
U5
L5S
-3.49
-3.Z5
-4.80
-2.18
-4.66
-3.91
-5.05
-4.51

fautioi
Adjusted
tesen*
fatio
-0.31
HLS5
-€.61
0.94

U3
0.51
0.47
0.20

U9
1.75

L33
L37
L23
1.72

IJS
IJi
2JB
L81
0.97
HI.48
-1.03
-1.26
-1.06
-0.77

-oji
-€.»
-€.68
-0.74
0.S7
0.84
1.25
-0.61

Currency
fatio
-i.35
-3^3
-€.73
-1J2
-0.74

OJD
HL56
-1.18
-3.18
-4.29
-4.06
-3^6
-H.45
-4.27
-5ja
-4.43
-6.70
-6.46
-3.52
-0.99
0.74
0.43
0.87
0.77
-3J1
-3.73
-4.81
-2.54
-4.93
-4.64
-5.93
-4.49

50

Swings
15*11 large
Ike
Ti*
teposit teposit
fatio
fatio
-1.15
-0.95
-0^9
-0.SB
-€.14
0.42
0.34

0J4
-0J7
-0.61
-€.76
-€.57
-€.61
-€JB
-4J&
-0.82
-1.48

-us

-LOO
-€.60
-€.15
-0.09
-0.18
-€.01
-059
0.04
-€.25
0.02
HL61
-€.26
-€.46
0.13

-€.46
-0J9
1.10

HUK
0.01
-€.01
HL25
-0.41
^L64
-€J0
-€.52
-0J4
-€.39
-€^4
-0.68
-0.75
-€.88
-€.76
HL3&
0.13
0.46
0.52
0.54
6.52
0.36
0.46
0.48
0.65
0.3B
0.30

0.U
0.36

*»teposit
liability
fatio

Foreign
teposit
fatio

0J9
0J2

HUD

(L19
0.11
-€.31
-€.47
-€.46
-€.25
-€.09
-€J4
-€.08
-0.18
-0.16
-€.03
-€^4
0.04
0.01

0JD
0J5
0.48
0.85
0.96

0J7
0.69
0.52

OJO
0.35
0.34
0.03
-0.04
-0.16
0.05

-€.02
0.01
0.03
0.01
-O.Q1
-0.02

COD
0.02
0.04
0.00
-0.01
-€.02
-€.01
0.02
0.01
0.01
-€JH
-€.05
0.00
0.02
0.01
0.01
(LQ2
0.03
0.01
0.02
0.05
-€.01
0.00
0.00
0.01

Treasury
teposit
fatio
0.13
-€J2
-€.01
0.13
-€.05
0.06
0.00
0.S7
-€.10
-€.17
-€.14
0.03
0.06
-€.29
0.13
0.13
-€.23
-€.23
-€.00
0.49
0.03
0.06
0.21
0.35

0.U
-0.2D
0.0B
0.10
-€.08
-€.11

0J2
0.05




Shadow Open Market Committee

1*1*4
Federal teen* Actioo and Itanebry Owth
(Cnvaund Annual Kites of Chaws)
(too)
leserve
teserve
tort late
Grartbtate
Three-nrtb
Mwiin Average
Month to Until

Me
Jan 1989
Feb
Car
*r

to
JIB

Jal
«M9
SEP

Oct
Nw
fee

imm
Feb
liar
Ar
p
Ro
Jw
Id
tog
Sp
e
Oct
M
w
he
Jan 1990
Fb
e
Br
a
APT

lta»
to
Jul
Aug IE

22 JB
4J5
-1.45
10J4
SJt
4J4
9.5?
-3J5
-3.55
L3J
0.79
-LW
-1.41
-104
-5.94
-7.00
-10.45
-2JB
4J4
-0.02
6.97
5JI
0.(9
4.%
-2JB
3.98
5.98
OJB
-11.44
1.44
-7M
15.04
1987
1.24
198B
3^5
1989-W
-4.98
1939-Dl
4.01
1990-01
0-64
-3.40

1.98
5.64
OJB
4.35
4J1
(.82
tU4
3.73
0J9
-1.94
•0.41
-L32
-2J4
-3.51
-3.47
-«4
-7.80
H.49
-1.91
1.56
4.54
4.15
4.39
3.52
OQ
J
1.92
2.44
3.45
-1.49
-3J1
-5J8
2.94

; Federal l a n e lord;

51

ROIFARR EKPIOYKUT • HOUSEHOLD SURVEY
(thoisinds of Ferseis)
toipemd Annul l i t i s i f Change
l?-Stl-lt
l a t t i i l Month

e
: AII n S p
tiralMl
RMtl
: i»ii)

!
;

Sep M

Oct
In
Nc
Jim
ftl

m
r
Ar
p

m
»

:

Jn
M
Ai|
s*i
Oct
tor
Nc
Ja I I
Fee

|
;
J

mr

!

Apr

•

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!

Jn
jii
All

mm 11242S

1.41
t.i4

Ml
2.11

: us
!
!
!
!
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!
j
:
j

;
:
!

2.1)

3.01

2.12

).lt
Ml
Ml
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Ml
Ml
Ml

2.41
2.IS
2.1)

1.11

LSI

US
LI?
Ml
LIS

1.12

1.11

1.14
1.11
l.ll

Ml
M2

Lit
1.11

LS4
LSI
1.41
1.27
1.11

lor

imsi

lie

Fib

Kir

Ar
p

»«»

Jn

Jul

AH

Sp
e

Oct

lot

lie

Jin I I

Fel

Mr
a

Air

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«

112141 11331} 113SS1 113112 11)141 11)115 111414 114211 iion 11(210 11011 11(111 1141)1 11(121 1141S1 U S D ) 114)1) 11S04S

LIS
LIS
LI)

LSI
1.41
1.31
1.24
l.ll

2.17
3.3?
2.11
2.17
2.S4
2.21
2.S2

Jn

Jil

AI|

\

mm mm msti;

4.SI

MO

1.11
1.S4

).27
2.11
2.24
2.SI
1.14
1.77
1.41

LSI

LSI

1.71

1.17
I.S4
1.4S
1.S2
1.S4
1.35

LIS

LSI
LSI
LSI
LSI
1.3!
1.35
1.21
1.12
l.ll

LSI
1.2)
1.17
l.l)

Soiree: Heineunn feonoiic Research




Jin I I

Ml

2.5?

MI

M4
2.12
Ml
2.4?
Ml
2.4?
Ml
1.14
1.11
1.14
l.ll
t.f)
LIS
l.ll
1.11
LSI
1.41
1.41
Ml
LI?

Ot
c

2.12
2.12
2.12
1.11
2.21

LSI
l.)7
1.11
1.21
1.31
1.2?
1.21
1.21
1.33
1.14
1.11
1.14
l.ll
1.14

).2)
2.12
I.S4
2.24
1.41
1.21
l.l?
l.ll
1.31
1.21
1.12
1.2)
1.21
1.17
1.14
l.ll
l.ll

Ml

LSI

1.41

LI)
1.71
1.12
1.11

LI?
LSI
1.71

LI?
1.17

Lit
LIS
1.12

Lit
l.ll
l.l)

LSI
2.47

Ml

1.31
1.11

l.ll

Ml

LIS
1.71
1.11
l.ll
1.12
1.17
1.14
1.12
l.ll
l.l)

MS
Ml

I.S4
l.l)
1.21

-1.12
-Llf
-0.11
•1.14
I.S7

•1.11

-0.71

LSI

LSI

1.11

1.21

M)

Ml

LIS

LSI

Ml

1.41
1.10

l.l?
l.l)
1.21

1.41
1.71

l.ll
1.11
1.21

LIS

l.ll
1.11

Ml
LI?

LI)
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1.7)
1.31
l.ll
1.11
1.11
1.11

I.K
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Ml
l.ll

1.7?
1.74

0.71
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0.24

l.ll
O.S?
0.22

Ml

l.ll

MS

Lit

1.70

LSI

I.2S

Ml

0.14

•Ml

1.21
-0.22

LIS
1.12

LIS
Ml
l.l?

LIS
Lit
Ml
LSI
l.l?
l.ll

LSI

1.21
1.21

LSI
1.S7

1.11
0.27
0.11
1.21

l.ll
1.41

LIS

2.42
2.14
l.ll

LI)
l.ll
1.24
-0.11

LIS
l.ll
0.11
0.22
-0.11
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-1.SS
•1.41

-M2

LIS
Ml

-l.ll
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-1.40
•1.20

-0.04
-0.11
•1.11

-i.ii
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i
|

MIFAM (IPlOrXFI! - PAIROU SURVEY
Unwinds of Person)
CeiponO Annul Rites of Change
Initial Month
Xif 11 $*>

Oct

lev

Dc ami
e

Fb
e

Rir

Ar
p

nr
»

JII

ill

Alt

Sp
e

Oct

lov

Die

JulO

Ftl

Mr

A»r

Rif

111

Jil

Alt

IOSIOI test?! 108451 10(710 107071 107430 107441 107111 107118 101135 101344 101410 I0II1I 108151 108180 101145 101111 10IISI 101151 110111 110117 110117 I10III 110710 ItOIIS

3. it

i.ti
I.JI
3.35

LSI
3.32
3.11

Mr

Mi
MO
MI
Ml
MO
Ml
Ml
Ml
Ml
M4
MO
MO
Ml
Ml
Ml
Ml

Ml
MO
Ml
MO
MS
MO
M4
MO
Mi
Ml
Ml
Ml
Ml
Ml
Ml
MS
MO
MO
Ml
1.41

Ml
Ml
Ml

MS
Ml
MO
Ml
MO
MO
Ml
MO
MS
MS
1.41

MI
Mt
MS
Ml
1.40

Ml
Ml
MS
1.44

Ml
M4

1.41
3.71
1.14

Ml
Ml
Ml
Ml
Ml
Ml
Ml
Ml
Ml
Ml
Ml
Ml
MS
M4
Ml
Ml
Ml
MI

4.10
1.10

Ml
Ml
MO
1.41

Ml
Ml
M4
M4
Ml
Ml
Ml
Ml
Ml
Ml
Ml
Ml
MS
MO

Some: Neifieitnn fconoiic fteseirch




1.41

MS
Ml
1.11
1.10
1.11
1.11
1.01
1.11
1.03

I.I!
MI
MI
Ml

1.03
1.01
1.01

1.11
1.01

MS

Ml

Ml

1.11

1.S1

t.OI
1.11

1.00
1.13

Ml

Ml

I.T!

1.14

1.41

1.S4

MS

MI
MI

MI
MS

MI

Ml

1.11

1.00

1.00

1.01
1.10

MS
MS
MI

Ml

MS
Ml
Ml
Ml

1.01

1.11

Ml
Ml

MS
Ml
Ml
Ml
MO

t.ot
1.11
1.14
1.03

MS

1.04

1.11
1.01

1.14

Ml
Ml
Ml

MO
Ml
Ml

Ml
Ml
Ml
Ml

1.01

1.11

1.11

1.03

MS
MS
Ml
MS

1.01

MI

MO

Ml
Ml
MS
Mt
MI

Ml
Ml
Ml
Ml

1.01

1.00

Ml
MI
Ml
Ml

Ml
MS
MI
MS

Ml
Ml
Ml
1.10

MO
Ml
MT
MS
MS
1.44

Ml
Ml

1.14

MO
Ml
1.10
1.41

Ml
MI
1.41

Ml
Ml
1.00

Ml
Ml
MO
Ml
Ml
Ml
Ml
Ml
Ml
Ml

Ml
MI
1.14

Ml
1.10
1.13
1.11

Ml
Ml
Ml
Ml

Ml
Ml

1.01
1.14

1.14
1.11

Ml
Ml
Ml
Ml
Ml
Ml
Ml

MO
1.10

0.11

Ml

Ml
Ml
Ml

1.40
1.11
1.11

1.11

4.10

MO
3.01
1.11

Ml
Ml

-0.11

0.11

Oil

-Ml

IEAI PiTMl MIES
(KIIIIMI »f 1 1 lollirt)
12

Cwpotri Ann? l i t i s i f Ckun
Iiltlil Hottk

imn

let

! KIM!

mm

Ot
c

m

tic Jul!

M

m
r

Ar
p

m
r

Jn

Jll

AH

Stt

Ot
c

lot

m
c

Jull

Ftl

mr

»pr

in

Jn

Jll

12IIS7 121114 121SI7 121412 121121 mill 121111 121011 I2I7S7 121111 121171 121122 I21I1S 121412 I2IIII 122112 I21SI4 121114 I1III2 niiii 121212 1IIHI tttMt

i -i.n
: M I u.n

: i.it 17.11 11.71
; i.si M l M l -1.14
; i.» 7.17 M l -M4 -1.22
! MS M l -M? •4.11 -4.14
; I.M M l •MS -4.11 •Ml
: M I M l -Ml -2.21 •MS
: t.i? M l
1.11 -1.41 •Ml
: t.» M l -1.11 -1.72 -1.11
: MI M l M l -Ml 1.12
i i.ii 4.11 1.11 1.11 1.1?
! i.n 1.17 M l 1.12 Ml
! Ml 1.71 LIS -MS -Ml
! Lit M l 1.41 -1.41 •Ml
! M l 1.41 M l -M2 -I.S?
! Ml M? M l 1.24 I.S?
! Mt l . l l I.4S -1.21 -Ml
M l M l -1.11 -Ml •Ml
! M l 1.47 -Ml •1.11 -1.21
•Ml 1.14 -1.71 -1.42 -1.2?
! 1.41 I.7S -1.21 -Ml -I.?1
M l M l -M7 -Ml -1.41
-Ml M l -1.71 -1.21 -1.11
Soirci: NiMiini [comic fttstirch




M|

-7.IS
-7.11 -Ml
-Ml 1.12
-M4 1.11
-l.ll
1.12

M4

Ml

2.41

4.27

Ml

Ml
Ml
Ml

-1.4?

Ml
-Ml

1.27

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45.11

1




Shadow Open Market Committee

MONETARY POLICY AFTER OIL SHOCK HI
William POOLE
Brown University
The Federal Reserve must again cope with difficult conditions arising from an oil
shock. Fortunately, the Fed is in far better shape to deal with this shock than it was when
facing the two earlier shocks. The oil market is not distorted by price controls, which
means that the economy can more easily make the real adjustments required. Although
uncertainty over federal policy on oil market intervention is not entirely absent this time, the
situation is completely different from that in 1973-74 and 1979-80, when speculation on
the government's next move was unavoidably rampant
The state of the macroeconomy in 1990 is also far more favorable for dealing with
the oil shock than it was in 1973-74 and 1979-80. In the earlier episodes, the economy
was under powerful inflationary pressure when the shock hit This time, inflation was
reasonably stable in the months before the shock and the economy was growing very
slowly, although at a level close to capacity output The one negative this time compared
with the two previous shocks is that the potential for serious physical damage to oil
production facilities is far greater now than before. The price of oil is high today not
because the world's production of oil has fallen substantially but because oil traders know
that the probability of a serious decline in production is far from negligible. The oil
markets are working exactly as they should - bidding up the price of oil now promotes
immediate reductions in oil usage, conserving inventories against the probability of future
shortfalls if Saudi production facilities are damaged.
What can and should the Federal Reserve do in these circumstances? The most
important thing is for the Federal Reserve and those looking over its shoulder to recognize
that printing money or manipulating the federal funds rate does not produce oil. The Fed's
job is to avoid adding a monetary disturbance to the real disturbance of a threatened Persian
Gulf war.
If the Fed can't produce oil, can it attack the inflation caused by escalation of oil
prices? The answer is affirmative in the sense that a tighter policy could offset some of the
aggregate price surgefromoil price increases. However, the Fed ought not to pursue such
an effort The increase in oil prices will at most cause a one-shot increase in the price level.
Indeed, if the Fed keeps money growth on an unchanged path, a permanent increase in the
relative price of oil will, as a first approximation, have no permanent effect on the general
price level. In the long run, given unchanged monetary policy, an increase in the relative
price of oil will take the form of a substantial increase in the dollar price of oil and a slight




57

September 30 - October 1,1990

reduction in the prices of all other goods taken together relative to what their prices
otherwise would have been. The net result will be to leave the aggregate price level largely
unaffected.
Some might argue that the Fed should, if faced with a permanent increase in the
relative price of oil, follow an accommodative policy designed to prevent the oil price
increase from forcing the money prices of other goods below the paths they would
otherwise have followed. That argument, however, is mostly beside the point We do not
know that we are faced with a permanent increase in the relative price of oil. In fact, I
argue later that there is a significant probability that oil prices are only temporarily high.
We can all assign different probabilities to various outcomes, but ought to accept the fact
that monetary policy has to play the odds.
Market Responses to the Persian Gulf Crisis
Figures 1 and 2 (end of memo) provide some detail on financial market responses
to the crisis. Treasury yields were falling a bit over the ten days or so prior to Iraq's
invasion of Kuwait on 2 August In the days immediately following the invasion, yields
fanned out, with long yields rising and bill yields falling. Three-month bill yields have
1

3

remained in a range from 7j to 7^ percent (bond yield equivalent basis). The Federal
Reserve has kept the fed funds rate in a tight range from 8 to 8^ percent, except for some
fairly typical spikes on Wednesday settlement days. The dollar has been weak since the
invasion, but it was declining before the invasion, too. The stock market has also been
weak, as we are reminded almost very evening on the TV news.
I have put the stock market and exchange rate indexes together in Figure 2 not to
suggest that they are directly connected but merely as a convenient place to plot both series.
The two are responding to the same news and not to each other. I have been a bit surprised
that the dollar has responded to the crisis by depreciating; in the past, the dollar has often
strengthened during heightened international tensions as investors sought a safe refuge for
their funds. Perhaps the weakness of the dollar reflects investor concerns that substantial
amounts of Kuwaiti and Saudi assets invested in the United States will be withdrawn to
help pay for the military buildup and for assistance to heavily impacted economies of Arab
countries supporting the effort to force Iraq out of Kuwait. Investors may also be
expecting that the United States will bear a far larger financial burden than will other major
economies and that this burden will tend to depreciate the dollar.
The price of oil has, of course, been a regular topic of the evening news, often in
the form of sound bitesfromthe president and members of Congress beating up on the oil




58

Shadow Open Market Committee

companies, "price gougers," and "speculators." However, I have not seen any mention on
the TV news or in financial columns of major newspapers of the oil market's view on how
long high oil prices might last Figure 3 shows the bets that oil futures traders are placing
on the price of oil over the next 18 months. In early July, the market was predicting a
gentle rise in the price of oil In mid-August, oil futures were much higher, but gently
declining from near to distant futures. Compared with mid-August, at the end of
September near futures were much higher but futures prices were steeply declining from
near to distant futures. (Note, by the way, that Figure 3 exaggerates the increase in oil
prices, which is large enough without exaggeration, by not starting the vertical axis at
zero.)
Clearly, the oil market is betting that oil prices will be significantly higher for at
least the next 18 months than the average over the last several years. Still, it is important to
recognize that the market does not today anticipate that the price will remain at $40 per
barrel. This expectation seems to me to be fully justified. The long-run elasticity of
demand for oil is in the neighborhood of -1.0, and the short-run elasticity is in the
neighborhood of -0.3. The price of oil has more than doubled since July; if this increase
were to be permanent, the quantity of oil demanded would be cut in half in the long run.
Of course, many of the adjustments behind this elasticity would be painful. Still,
considering the elasticity of demand provides a check on some of the wild oil price
forecasts floating around. Just considering demand, without taking account of the elasticity
of supply, world oil usage would in time fall short of production at a price of $40 per barrel
even if all Saudi production were lost as well as all Kuwaiti and Iraqi production. At a
doubled price of oil, the United States, for example, would become largely self-sufficient
in oil.
If this argument is correct, why is the price of oil so high today? The reason is that
the adjustments lying behind the demand elasticity take time. Costly investments to
economize on oil are not justified if the oil price shock is expected to be tansitoiy. Many
supply responses also take time and require additional investment Some supply responses
also require congressional actions to open up additional drilling land, and we all know that
Congress rarely sets speed records.
There is much discussion in the press of the inflationary dangers of the oil price
shock. Unfortunately, this discussion usually does not make the distinction between a oneshot increase in the price level and an on-going inflation. The oil price shock will cause at
most a one-shot increase in the price level provided the Fed does not add a monetary shock
to the oil shock.




59

September 30-October 1,1990

The common interpretation in the press of the increase in long-term interest rates
following the Iraqi invasion is that long rates are reflecting higher inflation expectations. I
suspect that this interpretation is incorrect The largest effect on the general price level from
the oil price increase will appear ova- the next six months. Yet, what we see in the term
structure of interestratesin Figure 1 is that short rates have declined while longrateshave
risen. If interest rates in August and September were driven primarily by inflation
expectations, the largest increases inratesshould have been at the short end of the market
In the absence of a change in Fed policy - and I see no signs of a change - the average
inflation rate over the next 30 years will not differ much from what it would have been
without the Iraqi invasion. My reading of Figure 1 is that the term structure has pivoted
around one- to two-year maturities, roughly, with longer rates rising and shorter rates
falling. I think a better explanation of the long end of the market is that investors have tried
to shorten maturities to reduce risk. In the aggregate, of course, investors have to hold the
stock of bonds that is outstanding; their efforts to go short bid up long yields and bid down
short yields.
Monetary Policy
Given these considerations, monetary policy should be based on the expectation
that the long-run price of oil will be substantially below $40 per barrel in 1990 dollars.
However, policy should be robust with respect to a variety of possible short-run outcomes.
In the near term, the price of oil may go substantially higher - if war breaks out - or may
fall substantially - if the crisis is resolved. Or, the price of oil may remain in the
neighborhood of $40 for a time. Given these short-run uncertainties, along with the high
probability that the price of oil in the long run will be substantially below current levels,
monetary policy should steer a middle course.
What does "middle course9' mean? Money growth should be consistent with trend
growth in nominal GNP next year of about 5 percent annual rate, and that means M2
growth at about the same rate. The Federal Reserve should continue with its long-run plan
to gradually chip away at inflation by gradually reducing money growth. Maintaining that
plan will provide assurance to the markets that the Fed will not add its own inflationary
disturbance to that already at hand from the Persian Gulf crisis.
A sensible way to implement the "chipping away" policy under current
circumstances would be to maintain M2 growth in the neighborhood of this year's target
range midpoint of 5 percent until the economy has worked its way through its current
difficulties. If the economy is in a recession at the end of this year, the Fed may find it
politically awkward to reduce its targetrangefor money growth, and in my opinion there




60

Shadow Open Market Committee

would be no reason for it to do so under recession conditions. What is important is that the
Fed not overreact to the recession by pumping up money growth. Nor should the Fed let
money growth sag in a futile effort to hold interest rates up, as has so often occurred during
the early stages of business contractions. A steady policy is what we need to provide a
stable base for adjustments in private markets to cope with the oil shock and recession, if
one occurs.
Money Growth
Figures 4 and 5 provide a perspective on money growth. As shown in Figure 4,
the Fed has brought M2 growth down over the course of the 1980s. M2 growth over the
12 months ending August 1990 was about 5 percent, which is just where it should have
been. However, M2 growth over the six months ending in August, at annual rate of 2.8
percent, was on the low side. Money growth should not remain this low at this time.
Figure 5 shows weekly data on the levels of Ml and M2 - 1 report both measures
because both can be useful in tracking Very short-run developments. Both Ml and M2
have been growing since the invasion. M2 growth over the eight weeks ending 17
September has been about 7 percent at an annual rate. This growth suggests that monetary
policy is not excessively tight at this time, as some have argued. In fact, we might have
expected money growth to be very low over recent weeks given that the Fed is holding the
federal funds rate well above the 3-month bill rate.

Banking andrealEstate His
Some have argued that the Fed ought to ease policy given the high risk of recession
and problems in the banking and real estate industries. Real estate problems are typical of
the late stages of economic expansion. However, I suspect that some of the current
problems in this industry reflect the Tax Reform Act of 1986 (TRA). Lower marginal tax
rates reduce the value of the mortgage interest deduction. Also, TRA reduced the
attractiveness of real estate as a tax shelter. Many provisions in TRA are clearly beneficial
to economic efficiency; part of what we are now seeing in real estate probably reflects a
gradual reallocation ofresourcesin the economyreflectingchanged incentives in the TRA.
Monetary policy could affect this situation only temporarily; as long as the changed fiscal
incentives remain in force, the economy will continue to reallocate resources until a new
equilibrium is established with a smaller stock of structures than would otherwise be the
case.
Problems in the banking industry do not call for a changed monetary policy either.
Bank capital is a concern but monetary policy cannot create bank capital. The Fed, of




61

September 30 - October 1,1990

course, will provide necessary liquidity to calm the markets should major bank failures
occur, but banking problems will not affect the aggregate supply of credit U.S. credit
maikets are extraordinarily fluid and efficient Firms with profitable opportunities will not
have a problem in raising funds through sources other than banks. In fact, one of the
reasons banks are having difficulty is that intense competition has pushed them toward
riskier loans as they have seen, for example, commercial lending opportunities shrink as
firms tapped the commercial paper market directly.

The Budget Accord
One way or another, the federal government will resolve the current budget problem
in some temporary way or another, probably by the time of our meeting but certainly within
a week or two. I emphasize "temporary" because no permanent solution is on the table.
The present negotiations do not contemplate a change in the incentives that have created our
budget problem. For the foreseeable future, the political system will operate with an
incentive system in which votes are gained, net, by increasing spending and lost, net, by
raising taxes. Whatever is the projected size of the deficit reduction for FY 1991 and
following years, I am willing to bet that the actualreductionwill be smaller. The effect of
an accord inreducingthe total stock of bonds (government and private) outstanding below
what it otherwise would have been will be extremely small. For thisreason,we should not
expect that a budget accord will have much effect on interest rates for a given rate of money
growth. The danger is that the Federal Reserve will be pressured into pursuing an easier
policy to "offset" fiscal stringency. The Fed has taken the correct position here - let the
markets judge the significance of the budget action and bid long-term interest rates up or
down appropriately. If a lower federal funds rate is required to maintain money growth
after this marketreaction,then the Fed shouldreducethe funds rate.
Taking account of all these considerations, given that money growth is on target,
and given all the uncertainties that are pushing the markets around, I think the Fed is doing
the right thing at this time in holding the federal funds rate in an unchanged range.
(However, the size of the range is too small, as FU discuss shortly.) We know that
monetary policy affects the economy with a lag, and so the Fed has to be looking ahead. If
data come in showing that aggregate output is falling, it seem safe to assume that the oil
price increase and uncertainty over the war have something to do with the decline. As I
emphasized at the beginning of this memo, the Fed cannot produce oil and it cannot affect
the probability of war. Given these fact, the Fed cannot do anything about declining output
over the next few months, assuming that output does decline. What monetary policy can
do, if all goes well, and what the Fed should try to do, is to prevent the initial disturbance




62

Shadow Open Market Committee

from causing a cumulative decline in economic activity. The key to that effort is to keep
money growth on track, and to permit interest rates to fall, and fall rapidly if necessary to
maintain money growth, if the economy weakens.

Fed Funds Rate
The problem the Fed faces in keeping money growth on track is one of its own
making- its policy of maintaining the federal funds rate in a very narrow band Monetary
policymakers are well known for maintaining ambiguity about what they are doing, and the
Fed certainly follows this practice in its public statements. However, its policy in the credit
markets is anything but ambiguous; the market knows within a few basis points where the
Fed is maintaining the funds rate. The only ambiguity is whether and when the Fed will
change the rate.
The narrow fed funds band has both economic and political disadvantages. The
economic problem is that when economic conditions change the Fed sometimes has
difficulty in adjusting the rate quickly enough to keep money growth from becoming
procyclical. The problem is not that the Fed is inherently sluggish; that problem would be
correctable if it were a problem. The problem is that the Fed cannot easily reverse direction
without upsetting market expectations. If, for example, the Fed lowers the funds rate one
week but then receives new information indicating that therateshould be higher, a reversal
tends to confuse the market about the direction of policy. Many firms, and especially
securities dealers, have highly leveraged positions; they are justifiably annoyed or worse
when the Fed creates surprises for them. The only way to change this situation is to force
dealers and other highly leveraged firms to concentrate on processing information about
market forces rather than to concentrate so heavily on Federal Reserve actions. A wider
band for the federal fundsratewould reduce the problem the Fed faces in avoiding creating
surprises for dealers. The Fed should reduce its overall scale of open market operations
and let the fundsratefluctuate freely in a range at least l | percentage points wide.
The political problem from the narrow fundsraterange is that everyone knows that
the Fed is directly and immediately responsible for changes in the federal funds rate and
almost as directly responsible for money marketratestied closely to the funds rate. There
is no perfect time to change rates; someone has always just closed a deal that is either
favored or hurt by the change. People damaged by aratechange have a perfectly natural
reaction = "why me?" "Why didn't the Fed change the rate a few days earlier, or a few
days later." The Fed has no way to answer such a question because the timing of the Fed's
rate changes is inherently arbitrary.




63

September 30 - October 1.1990

A wider fed funds band would do more than simply provide political cover for the
Fed A wider band would create a genuinereductionin the fraction of the variance of the
funds rate attributable to Fed action. The reduction of the Fed's share of the variance
would mostly reflect an increase in the market "noise" a wider band would permit Some
argue that this noise is a cost to the economy, but the cost if it exists must surely be small.




64

Shadow Open Market Committee

Figure 1
Yieids on U.S. Treasury Securities and Fed Funds
Daiiy, 2 July - 27 September, 1990
Percent
10.00

30-yr. bond

Iraq invades
Kuwait
s

9.50

10-yr. bond
5-yr. bond

9.00

2-yr.bond

8.50

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8.00

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Fed funds

Note: T-bill yields on bond yield equilivaient basis

Figure 2
Stock Prices and Exchange Rate
Daily, 2 July - 27 September 1990
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Figure 3
Term Structure of Oil Futures
Selected Dates
45

27 September 1990

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66

I

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L

Shadow Open Market Committee

Figure 4
M2 Growth, Monthly, January 1982 - August 1990
6-Month and 12-Month Percentage Changes, Annual Rate
Percent
18

6-month

I H I i I I I I 1 I t I 11 1 I I 1 . i i I « I « »

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1985

1986

1987

1988

H i l i i i i n i

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1990

Figure 5
M1 and M2 Levels, Weekly
June - September 1990

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Shadow Open Market Committee

FOREIGN EXCHANGE MARKET INTERVENTION
Anna J. SCHWARTZ
National Bureau of Economic Research

As of June 1990, foreign currency holdings of the Federal Reserve and the
Treasury amounted to $47.29 billion, 50 percent greater than their holdings a year earlier.
During the three month period ending April 1990, the most up-to-date reporting
period for Treasury-Federal Reserve foreign exchange operations, intervention operations
totaled $1.78 billion, of which $138 billion was used to buy yen, the Federal Reserve's
share amounting to $375 million. The balance of $1.2 billion yen and $200 million marks
was financed by the warehousing arrangement between the Federal Reserve and the
Treasury's Exchange Stabilization Fund.
Growing Concern in the FOMC
The report for the period ending April 1990 notes that before March 5, "several
officials within the Federal Reserve had expressed concern that the size of the intervention
operations might contribute to uncertainty about the Federal Reserve's priority toward
achieving price stability. . . . At the time, Federal Reserve holdings of foreign currencies,
taking into account anticipated further interest earnings, were approaching the limit of $21
billion authorized by the Federal Open Market Committee (FOMC). Under these
circumstances, the decision was made not to seek authorization from the FOMC for
continued Federal Reserve operations pending a review of Federal Reserve currency
operations at the FOMCs March 27 meeting. Thus, from March 5 through March 27, all
U.S. intervention operations,... were financed solely by the U.S. Treasury through the
ESF. At the March 27 meeting, the FOMC voted to approve an increase in the authorized
limit on Federal Reserve holdings of foreign currencies from $21 billion to $25 billion."
Purchases of yen thereafter were shared equally between the Federal Reserve and the
Treasury.
The record of policy actions of the FOMC on March 27, 1990, reports that three
governors dissented on the action to increase the authorized limit
Limits on Warehousing Increased
The Treasury warehoused not only the $1.4 billion in yen and marks it acquired in
the three months ending April 1990, but also an additional $600 million of other currencies,
for a total of $2 billion.




69

September 30 - October 2,1990

At the March 27 FOMC meeting the limit on warehousing was also raised, in this
case to $15 billion. The same three governors again dissented, indicating "that in light of
the significant policy issues raised by the duration and scale of the intervention policy they
were unable to concur, as a matter of policy, with the Committee's decisions to increase
further the authorization for warehousing currencies. . . . substantial increases in the
authorized limits on holdings of foreign currencies by the Federal Reserve System for the
U.S. Treasury and the ESF under the warehousing authority were inappropriate in the
absence of a definitive indication of congressional intent in this area. The transactions in
question, which are repurchase agreements that have the characteristics of a loan to the
Treasury, could be viewed as avoiding the congressional appropriations process called for
under the Constitution."
Despite these dissents, a decision to increase warehousing to $25 billion was taken
between the March 27 and July 2-3 meetings of the FOMC.
"Realized Profit" for the Treasury?
For the quarterly period ending April 1990, the Treasury reported $292.4 million
realized profit, "reflecting the difference between the rate at which the warehoused funds
had originally been acquired in the market and the rate at which they were exchanged with
the Federal Reserve." Realized profits for the ESF in this case are offset by an equivalent
loss the Federal Reserve shows in its Suspense Account on the exchange value of the
dollars restored to it under the warehousing arrangement At the end of the year, the
Federal Reserve deducts losses on foreign exchange shown in the Suspense Account from
the amounts it rebates to the Treasury. Accordingly, the Treasury's "realized profit" was
illusory.
Record of Policy Actions of the FOMC July 2-3 Meeting
Therecordreleasedon August 24,1990, reports only the domestic policy directive.
Normally the report also covers the directive for foreign currency operations. The
explanation for the omission appears to be that no transactions occurred during the MayJuly period that will be covered in the next issue of the Quarterly Bulletin of the Federal
Reserve Bank of New York. The August issue of International Financial Statistics shows
an increase in U.S. foreign currency holdings of $860 million between end of April and
end of June. The increase mayreflectinterest earnings on foreign currency holdings rather
than outright acquisitions.




70

Shadow Open Market Committee

Banking Committee Hearings on August 14
Congressional attention has finally been directed to the matter of the large increase
in foreign currency holdings by die Treasury and the Federal Reserve and the warehousing
arrangement On August 14, Chairman Henry Gonzalez of the House Banking Committee,
with no other member present, h6ld hearings at which Under Secretary of the Treasury
David Mulford testified not only on foreign exchange market intervention but also on the
price at which the Treasury sold zero coupon 30-year U.S. Treasury bonds to Mexico as
part of the Brady international debt strategy plan. The issue was whether the sale provided
Mexico a $200 million subsidy. Much of the three and three-quarter hours the hearings
lasted was given over to Mulford's denial that a subsidy had been provided, and the
testimony of a witness from the General Accounting Office, who supported the chairman's
challenge to Mulford's version of the sale.
It seemed ironical to me that so much time was devoted to a possible loss by
taxpayers of $200 million instead of devoting the hearings exclusively to the much greater
potential loss on $46 billion and more in U.S. foreign currency holdings. No
representative of the Federal Reserve appeared. I wondered whether the decision to leave it
to the Treasury to defend the authorities' foreign currency operationsreflectedthe Federal
Reserve's subordinate position in the arrangement or lack of enthusiasm for intervention
activities.
The four witnesses on a panel who discussed intervention (Allan H. Meltzer, Anna
J. Schwartz, Martin May, and Christopher Whelan) at the hearings were in general
agreement that it was ineffective and potentially harmful to domestic monetary policy. It
remains to be seen whether Chairman Gonzalez will pursue his initiative further.
The basic issue is that intervention has no economic rationale. As Allan Meltzer
testified, Congress should abolish the Exchange Stabilization Fund and end the Federal
Reserve's self-authorized right to intervene.




71




Shadow Open Market Committee

RECENT GROWTH OF THE MONETARY AGGREGATES
Robert H. RASCHE
Michigan State University

Since the beginning of 1990 growth of all three monetary aggregates, Ml, M2, and
M3 has been relatively slow compared to both historical growth in the 1980s and the
contemporaneous growth of the monetary base. The Federal Reserve Board has
commented on the slow growth of the aggregates in its 1990 Mid Year Review:
The weakness in the monetary aggregates mainly, though not
wholly, reflected a rechannelling of credit flows away from depository
institutions. . . . the proportion of lending accounted for by depository
institutions was down substantially, much of the decrease related to the
shrinkage of savings and loan associations. Meanwhile, concerns about
credit quality and pressures on capital positions led banks to adopt more
cautious lending postures and to hold down deposit growth.
With depository credit damped, not only were managed liabilities
weak, but banks and thrifts did not bid aggressively for retail funds thereby contributing to reduced growth for M2. In addition, increases in
expected returns on stocks and bonds may have restrained expansion of this
aggregate, although some proportion of the slowdown in M2 remains
unexplained by changes in relative yields or income.1
The S&L crisis is certainly a major factor in the very slow growth of M3 that has
been observed over the past year. Large-denomination time deposits at thrift institutions,
those issued in amounts of $100,000 or more and hence at least partially uninsured, peaked
in June 1989 at $177.8 billion. By December 1989 the stock of these deposits outstanding
had declined by 12.6 percent to $156.8 billion. By July 1990 the stock declined by an
additional 18.1 percent to $130.8 billion. During the same time period large-denomination
time deposits at commercial banks remained virtually unchanged, fluctuating in a range of
$397.0 to $402.0 billion. The impact of the disintermediation of large time deposits at
thrift institutions shows up clearly in the behavior of the t2 multiplier component ratio
tabulated in Table l. 2 From June 1989 through August 1990, this ratio declines by 15.3
percent from a maximum of 1.6082 to 1.3804. Until very recently this disintermediation
appears to be concentrated among potentially uninsured depositors who have little if any
reliable information on which to judge the soundness of particular thrift institutions.
Transactions deposits at thrift institutions are virtually unchanged from a year ago, as are

1 Board of Governors of the Federal Reserve System, 1990 Monetary Policy Objectives, July 18,1990.
For the definitions of Q and other component ratios of various money multipliers see RJEL Rasche and
JM. Johannes, Controlling the Growth cf Monetary Aggregates, Kluwer Academic Publishers, 1987.
2




73

September 30 - October L1990

saving deposits. Small-denomination time deposits at thrifts remained quite stable until late
spring 1990, but have dropped almost five percent in the past four months. It is possible
that this represents a switch of institutions, since the decline in small-denomination time
deposits at thrifts has been almost exactly offset by an increase in small-denomination time
deposits at commercial banks over the recent months.
The question remains how significant this disintermediation effect is for the
narrower monetary aggregates, Ml and M2. This is investigated in Tables 1-5. In Table
1, the component ratios of the money multipliers are presented for both the Board of
Governors Monetary Base (part A) and the Adjusted Monetary Base from the Federal
Reserve Bank of St Louis (part B). For simplicity, die currency ratio tabulated here is the
ratio of currency plus travelers checks to transactions deposits. The only differences in
components is between the reserve ratios, r. The Ml-monetary base multipliers are
tabulated in the right hand column of Table 1. A quick glance confirms that there are no
significant differences in the behavior of the two base concepts over this period.
Tables 2 and 3 show the elasticities of the Ml and M2 monetary base multipliers
with respect to the k, ti, t2 and r ratios. The elasticities with respect to the t2 and r ratios
are identical for both money concepts. This is because the denominators of all the money
multipliers are identical, and the r and t2 ratios only appear in the denominators of the Ml
and M2 multipliers. The important information in these elasticities is that the response in
either the Ml or M2 multiplier that is generated by fluctuations in the t2 ratio is unlikely to
be of major significance for the observed behavior of these monetary aggregates because
the multiplier elasticities are so small.
Tables 4 and 5 show a decomposition of the month-to-month percentage changes
(at annual rates) in both Ml and M2 over the period September 1988 through August 1990.
The allocation of the percentage change in the multipliers is the product of the respective
multiplier elasticity in Table 2 or 3 and the percentage change in the corresponding
component ratio. The %unalloc column indicates the residual percentage change in the
multiplier, which is attributable to fluctuations in the government deposit ratio, in the
foreign official deposit ratio, and to interactions among the various component ratios. With
the exception of M2 in January 1989 and January 1990, the unallocated variation in the Ml
and M2 measures is extremely small. (I haven't been able to track down what is happening
in January; I suspect that there may be some strange behavior arising out of seasonal
adjustment factors.)
One important point to note from these tables is that the dramatic decline in large
time deposits at thrift institutions is not a major factor affecting die behavior of either Ml or
M2. On average over the first eight months Ml and M2 growth have been increased .35




74

Shadow Open Market Committee

percent (annual rates) because of the decline in t2. The most important factors driving Ml
and M2 growth are the growth of the monetary base and fluctuations in the
currency/deposit ratio. To a minor extent Ml and M2 growth have been affected by
fluctuations in the small time deposit ratio, ti. Month-to-month fluctuations, particularly in
M2, attributable to ti are sometimes sizable, but cm average since the beginning of 1990 the
effect of this component has been very small (.5 percent for average M2 growth and -.1
percent for average Ml growth at annual rates since the beginning of 1990). Itis not clear
what is driving the large increase in the currency/deposit ratio shown in Table 1. It does
not seem plausible that there is significant disintermediation out of thrift institutions into
cash in mattresses or safe deposit boxes, particularly among agents who were holding time
deposits larger than $100,000 in thrifts.
Any effect of binding capital requirements would appear in the tables in the form of
marginal money multipliers that are lower than the average money multiplier because of
increases in the reserve ratio. However, reserve ratios for both monetary base concepts
have declined slightly over the past two years and been almost unchanged over the past
year. While individual depository institutions may be experiencing binding capital
requirements, there is no evidence that this is so pervasive that it has any impact on the
banking system as a whole.




75

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Shadow Open Market Committee

Table 2
Ml-Monetary Base Multiplier Elasticities
Monthly, Seasonally Adjusted
A. Board of Governors Monetary Base
el(k)
88:8
88:9
88:10
88:11
88:12
89:1
89:2
89:3
89:4
89:5
89:6
89:7
89:8
89:9
89:10
89:11
89:12
90:1
90:2
90:3
90:4
90:5
90:6
90:7
90:8

el(tl)

el(t2)

el(r)

-.48849
-.48906
-.48845
-.48827
-.49019
-.48786
-.48830
-.48579
-.48703
-.48602
-.48429
-.48573
-.48661
-.48505
-.48656
-.48652
-.48721
-.48631
-.48817
-.48487
-.48542
-.48567
-.48466
-.48580
-.48663

-.14606
-.14402
-.14344
-.14351
-.14143
-.14127
-.14031
-.14103
-.13918
-.13741
-.13816
-.13855
-.13890
-.14039
-.14076
-.14153
-.14139
-.14009
-.13938
-.14163
-.14053
-.13855
-.13903
-.13710
-.13549

r.05318
-.05273
-.05291
-.05288
-.05237
-.05264
-.05259
-.05329
-.05282
-.05238
-.05243
-.05196
-.05084
-.05013
-.04918
-.04870
-.04795
-.04702
-.04594
-.04583
-.04527
-.04461
-.04451
-.04370
-.04290

-.23793
-.23559
-.23502
-.23412
-.23134
-.23128
-.23002
-.23082
-.22784
-.22553
-.22567
-.22547
-.22405
-.22564
-.22503
-.22491
-.22429
-.22166
-.21959
-.22189
-.22014
-.21721
-.21746
-.21378
-.21152

B. St. Louis Fed Monetary Base
88:8
88:9
88:10
88:11
88:12
89:1
89:2
89:3
89:4
89:5
89:6
89:7
89:8
89:9
89:10
89:11
89:12
90:1
90:2
90:3
90:4
90:5
90:6
90:7
90:8




-.51779
-.51808
-.51747
-.51738
-.51829
-.51715
-.51745
-.51682
-.51646
-.51542
-.51421
-.51490
-.51492
-.51444
-.51537
-.51574
-.51621
-.51526
-.51614
-.51548
-.51533
-.51572
-.51589
-.51574
-.51615

-.12807
-.12628
-.12573
-.12567
-.12425
-.12338
-.12252
-.12207
-.12121
-.11949
-.11985
-.12062
-.12135
-.12211
-.12273
-.12314
-.12311
-.12180
-.12163
-.12209
-.12144
-.11939
-.11907
-.11790
-.11658

-.04663
-.04624
-.04638
-.04630
-.04601
-.04597
-.04592
-.04613
-.04600
-.04555
-.04548
-.04524
-.04441
-.04360
-.04288
-.04237
-.04175
-.04088
-.04009
-.03951
-.03912
-.03844
-.03812
-.03758
-.03691

77

-.20862
-.20656
-.20601
-.20502
-.20324
-.20199
-.20087
-.19979
-.19841
-.19613
-.19576
-.19631
-.19574
-.19626
-.19621
-.19568
-.19529
-.19272
-.19162
-.19128
-.19023
-.18716
-.18623
-.18384
-.18200

September 30 - October 1,1990

Table 3
M2-Monetary Base Multiplier Elasticities
Monthly, Seasonally Adjusted
A. Board of Governors Monetary Base
e2(k)

e2(t2)

e2(r)

-.72073
-.72238
-.72278
-.72377
-.72539
-.72620
-.72714
-.72810
-.72941
-.73130
-.73189
-.73174
-.73250
-.73215
-.73235
-.73316
-.73354
-.73545
-.73646
-.73658
-.73725
-.73970
-.74024
-.74213
-.74338

88:8
88:9
88:10
88:11
88:12
89:1
89:2
89:3
89:4
89:5
89:6
89:7
89:8
89:9
89:10
89:11
89:12
90:1
90:2
90:3
90:4
90:5
90:6
90:7
90:8

e2(tl)
.61371
.61565
.61676
.61781
.61943
.62096
.62190
.62347
.62564
.62893
.63070
.63022
.63066
.63042
.62958
.63026
.63018
.63224
.63225
.63191
.63228
.63445
.63409
.63569
.63621

-.04663
-.04624
-.04638
-.04630
-.04601
-.04597
-.04592
-.04613
-.04600
-.04555
-.04548
-.04524
-.04441
-.04360
-.04288
-.04237
-.04175
-.04088
-.04009
-.03951
-.03912
-.03844
-.03812
-.03758
-.03691

-.20862
-.20656
-.20601
-.20502
-.20324
-.20199
-.20087
-.19979
-.19841
-.19613
-.19576
-.19631
-.19574
-.19626
-.19621
-.19568
-.19529
-.19272
-.19162
-.19128
-.19023
-.18716
-.18623
-.18384
-.18200

.
B. St. Louis Fed Adjusted Monetary Base
88:8
88:9
88:10
88:11
88:12
89:1
89:2
89:3
89:4
89:5
89:6
89:7
89:8
89:9
89:10
89:11
89:12
90:1
90:2
90:3
90:4
90:5
90:6
90:7
90:8




-.69143
-.69335
-.69377
-.69467
-.69729
-.69692
-.69799
-.69707
-.69998
-.70190
-.70198
-.70257
-.70419
-.70276
-.70354
-.70393
-.70453
-.70651
-.70848
-.70597
-.70734
-.70965
-.70901
-.71220
-.71386

.59572
.59791
.59905
.59997
.60225
.60307
.60411
.60451
.60766
.61101
.61238
.61230
.61311
.61214
.61156
.61187
.61190
.61395
.61449
.61237
.61318
.61528
.61412
.61649
.61730

78

-.05318
-.05273
-.05291
-.05288
-.05237
-.05264
-.05259
-.05329
-.05282
-.05238
-.05243
-.05196
-.05084
-.05013
-.04918
-.04870
-.04795
-.04702
-.04594
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