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SHADOW OPEN MARKET COMMITTEE
(SOMC)

Policy Statement and Position Papers

March 6-7,1994

PPS 94-01

BRADLEY POLICY
RESEARCH
CENTER

Public Policy Studies
Working Paper Series

W I L L I A M

SIMON
GRADUATE SCHOOL
OF BUSINESS ADMINISTRATION

UNIVERSTTYOF ROCHESTER
ROCHESTER,

NEW

YORK

14627

Shadow Open Market Committee

TABLE OF CONTENTS

Page
Table of Contents

i

SOMC Members

ii

SOMC Policy Statement Summary

1

Policy Statement

3

Why are Interest Rates Rising?
H. Erich Heinemann
Regulatory Consolidation
LeeHoskins

29

Economic Outlook
Mickey D. Levy

35

Trade Deficits with Japan
Charles L Plosser.

53

Understanding the Monetary Aggregates Today
WilliamPoole

59

9

Public Disclosure and FOMC Deliberations
Robert H. Rasche




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March 6-7,1994

SHADOW OPEN MARKET COMMITTEE

The Shadow Open Market Committee met on Sunday, March 6, 1994 from 2:00 PM to 6:30 PM
in Washington, D.C.

Members of the SOMC:

Professor Allan H. Meltzer, Graduate School of Industrial Administration, Carnegie Mellon
University, Pittsburgh, Pennsylvania 15213 (412-268-2282 phone, 412-268-7057 fax); and Visiting
Scholar, American Enterprise Institute, Washington, DC (202-862-7150 phone)
Mr. H. Erich Heinemann, Chief Economist, Ladenburg, Thalmann & Co., Inc., 540 Madison
Avenue-8th Floor, New York, New York 10022 (212-940-0250 phone, 212-751-3788 fax)
Dr. W. Lee Hoskins, Chairman and CEO, Huntington National Bank, 41S. High Street, Columbus,
Ohio 43287 (614-463-4239 phone, 614-463-5485 fax)
Dr. Mickey D. Levy, Chief Financial Economist, NationsBank, 7 Hanover Square, New York,
New York 10004 (212-858-5545 phone, 212-858-5741 fax)
Professor Charles I. Plosser, William E. Simon Graduate School of Business Administration and
Department of Economics, University of Rochester, Rochester, New York 14627 (716-275-3754
phone, 716-461-3309 fax)
Professor William Poole, Department of Economics, Brown University, Providence, Rhode Island
02912 (401-863-2697 phone, 401-863-1970 fax)
Professor Robert H. Rasche, Department of Economics, Michigan State University, East Lansing,
Michigan 48823 (517-355-7755 phone, 517-336-1068 fax)
Dr. Anna J. Schwartz, National Bureau of Economic Research, 269 Mercer Street - 8th Floor,
New York, New York 10003, (212-995-3451 phone, 212-995-4055 fax)




a.

Shadow Open Market Committee

SOMC POLICY STATEMENT SUMMARY

Washington, D.C. March 7—The Shadow Open Market Committee called on the Clinton
Administration to abandon its current trade policy toward Japan. The policy, the Committee said,
"is short-sighted, wrong-headed, costly to our citizens and damaging to our long-term interests in
peace and stability within Asia."
The SOMC, a group of academic and business economists who regularly comment on public
policy issues, charged that the Administration's effort "even if achieved," would not change the
bilateral or multilateral trade imbalances between the U.S. and Japan. "The main effect would be
to cartelize markets and reduce pressures to innovate and improve products and services."
The Shadow Open Market Committee meets in March and September. It was founded in
1973 by Professor Allan H. Meltzer of Carnegie Mellon University and the late Professor Karl
Brunner of the University of Rochester.
In a policy statement, the Shadow Committee repeated earlier warnings that "current monetary
policy is too easy to sustain non-inflationary growth." The SOMC said that the monetary base
(bank reserves and currency) "should grow at no more than an 8 percent annualized rate." The
SOMC charged that "the Federal Reserve continues to suppress the rise in short-term rates" and
that the quarter-point increase in rates last month was "not enough." The SOMC said that the Federal
Reserve "now runs the risk of returning to its earlier pattern of go-stop-go policy."
The Committee recommended that Congress reject the Treasury Department proposal to
consolidate four federal bank regulatory agencies into a single Federal Banking Commission. "A
single regulator," the Committee said, "would greatly increase opportunities for political pressure,
intervention, and corruption."
The SOMC proposed three changes to resolve the current controversy over Federal Reserve
policy and disclosure of its actions:
(1) Policy decisions should be released at the end of each meeting of the Federal Open Market
Committee. (2) A complete record of discussion and supporting staff documents used at the meeting
should be released after a reasonable delay—say three to five years. (3) Congress should require
the Federal Reserve to state an explicit objective for inflation, the time frame within which it proposes
to achieve the objective and the program for achieving the goal.




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March 6-7,1994

Consideration of these* issues, the SOMC said, is marred by confusions between process and
outcome. Decision making at the Federal Reserve would be hampered by a requirement that all
comments must be on the public record. Decisions are an entirely different matter. Congress and
the public should be able to audit and assess decisions and outcomes. The Federal Reserve should
be held accountable for its actions.




2

Shadow Open Market Committee

SHADOW OPEN MARKET COMMITTEE
Policy Statement
March 7,1994

Inflation has declined to the lowest levels in thirty years. This decline reflects slow money
growth from 1987 to 1990.
Current monetary policy is too easy to sustain non-inflationary growth. The monetary base
(currency plus bank reserves) and money (currency plus demand deposits or Ml) have grown about
10 percent a year since 1990. Many people have been willing to add to their cash balances as interest
rates fell. Money per dollar of GDP increased more than 20% in these years.
The opposite side of rising average cash balances is the relatively slow growth of spending
experienced during the first two years of the currency recovery. Slow growth appears to have ended.
Although the Administration takes credit for improved economic performance, recent growth
mainly reflects past Federal Reserve policy. Private spending for consumption and investment
accelerated in the second half of 1993, despite continued slow growth in California and other regions
affected by defense cutbacks, weather and natural disasters.
The trend rate of growth of real output is 2 to 3 percent a year. The trend rate depends on
growth of productivity and labor force. Actual growth is now significantly above trend, but it cannot
long remain above its trend rate. Productivity and labor force growth have slowed. Nominal
spending has now accelerated.
A sustained 7 percentage point difference between the money growth rate and the trend growth
of real output can be reconciled in only two ways. Either the public continues to accumulate cash
balances or the inflation rate rises. This is a matter of arithmetic. There are no other possibilities
if base money continues to grow at recent rates.
MONETARY POLICY
A year ago, we warned that "recent growth of the domestic base is consistent with growth of
nominal GDP of about 7 percent" We urged monetary restraint but expressed doubt that the Federal
Reserve would act promptly to control inflation. At our September meeting, we warned that Federal
Reserve policy was imprudent We noted that to sustain recent rates of inflation, the public would




3

March 6-7,1994

have to continue to increase its holdings of cash relative to income, and interest rates would have
to decline further. We expressed doubt that long-term rates would continue to fall. We, therefore,
expected spending to rise followed by higher inflation.
The Federal Reserve continues to suppress the rise in short-term rates. Last month the Federal
Reserve responded belatedly to the recent increase in the growth of spending with a modest (25
basis point) increase in short-term interest rates and suggested possible further increases in the
future. This is not enough. Short-term interest rates are unreliable guides to monetary conditions.
Before 1980 the Fed was slow and hesitant to raise interest rates. It now runs the risk of returning
to the earlier pattern of go-stop-go policy.
We believe that excessive money growth, not real growth, brings inflation. More decisive
action is required to restrict the growth of spending by slowing money growth enough to prevent
a rise in inflation. Based on recent growth of output and average cash balances, growth of the
monetary base should be reduced immediately by two percentage points. The monetary base should
grow at no more than an 8 percent annualized rate.
INTERMEDIATE GUIDES
At the recent Humphrey-Hawkins hearings, some members of Congress expressed disappointment that last month's 25 basis point increase in interest rates was followed by a rise in
long-term rates in the next few days. A few days or weeks is too short a period to judge success or
failure of policy actions. Short-term changes in interest rates are unreliable indictors of current or
prospective inflation. The success of the Fed's policy will not be evident until we learn whether it
was able to prevent a rise in inflation without aborting the recovery. If people expect policymakers
to succeed, interest rates will reflect the anticipated low rate of inflation.
The Fed's chance of success would be improved if it adopted a stable policy guideline. Recent
policy statements and actions suggest that the Fed has no clear guides. Last summer, Chairman
Greenspan emphasized real rates of interest as the principal guide to policy. Last month he
emphasized commodity prices, particularly the gold price. All of these measures change in response
to both monetary and non-monetary events and anticipations. For example, wars or gold accumulation by foreigners can raise the gold price without affecting the U.S. inflation rate.
Inflation does not occur because of a rise in the gold price. To the extent that the gold price
anticipates inflation, it does so because money growth is rising faster than the public wishes to add




4

Shadow Open Market Committee

to cash balances. Gold is one of the commodities people buy when they fear inflation, but they can
also buy foreign currency, foreign asset, land and other hedges. All of these prices can and do
change in response to foreign inflation or other events that may have no effect on the U.S. economy.
Excessive money growth causes inflation by increasing spending. We believe this is the
principal reason for those increases in the prices of gold and other commodities that anticipate future
domestic inflation. We doubt that the Fed will stay with its current indicator. We urge a return to
a monetary target—preferably the monetary base.
DISCLOSURE OF FOMC DISCUSSIONS AND ACTIONS
The House Banking Committee recently reopened the issue of Federal Reserve secrecy. One
issue concerns the immediate release of the policy directive following a meeting of the Federal
Open Market Committee (FOMC). A related issue is the full disclosure of the deliberations of the
FOMC discussion for the use of scholars.
Consideration of these issues is marred by confusion between process and outcome. Decision
making at the Federal Reserve, or any other agency, would be hampered by a requirement that all
comments must be on the public record. Immediate release of the minutes, even if possible, would
disrupt the policy making process. Neither Congress nor the public has to observe the process by
which policies are made to keep the FOMC accountable.
Decisions are an entirely different matter. Congress and the public should be able to audit
and assess decisions and outcomes. Their concern is whether the Federal Reserve can do a better
job of preventing inflation or deflation. The Federal Reserve should be held accountable for its
actions.
The Committee recommends three changes in procedures.
1. The policy decision should be released at the end of each meeting. Wefindno basis
for claims that immediate release would be harmful. Correct information is not
harmful and does not reduce market efficiency.
2. The record of discussion and supporting staff documents used at the meeting should
be released after a reasonable delay-i-say three to five years. As in the past, the
Federal Reserve may choose to remove references to individuals, both those participating in the discussion and those referred to by name.
3. Congress should require the Federal Reserve to state an explicit objective for
inflation, the time frame within which it proposes to achieve the objective and the
program for achieving the goal. Central banks in New Zealand and Britain have




5

March 6-7,1994

recently adopted zbro or low inflation as a goal. Congress should impose that goal
on the Fed. In the absence of Congressional action, the Fed itself should adopt and
announce a program to achieve and sustain low inflation.
REGULATORY CONSOLIDATION
In November, the Treasury proposed to combine the four federal bank and thrift supervisory
agencies into a single agency to be called the Federal Banking Commission (FBC). The Federal
Reserve would have a representative on the board of the FBC, but its role would otherwise be limited
to monetary policy, including service as lender of last resort to the financial system.
We believe the Treasury proposal is misdirected and misguided. The costs of duplication in
the current regulatory system are overstated. A single super-regulator is not the right answer. Two
major problems would arise if the Treasury proposal were adopted.
First, innovation would be reduced. Competition between regulators has not produced
excessive laxity. It has provided opportunities for innovation and creativity that have increased
financial services available to businesses and consumers.
Second, a single regulator would greatly increase opportunities for political pressure, intervention, and corruption. The thrift industry was regulated by a single regulator. The regulator at
times responded more to pressure from individual Members of Congress than to the principles of
prudent regulation. The resulting cost to the public far outweighs any prospective saving from
consolidation.
The Federal Reserve does not require regulatory and supervisory powers to conduct monetary
policy. The role of the Federal Reserve should not be confused with the desirability of multiple
regulators.
The Treasury proposal should be rejected. There have been many proposals for fundamental
reform of the financial system to lower risk, increase competition, enhance incentives for innovation
and separate insurance from bank regulation. These proposals should be on the table.
THE U.S.-JAPAN TRADE IMBALANCE
The Administration's efforts to establish numerical targets for Japanese imports of selected
products are not in the interests of the United States or Japan. Numerical targets, even if achieved,
would not change the bilateral or multilateral trade imbalance. The main effect would be to cartelize
markets and reduce pressures to innovate and improve products and services.




6

Shadow Open Market Committee

The Japanese current-account surplus with the United States and the rest of the world has
increased in recent years. The principal reason is the long Japanese recession; Japan's imports have
declined relative to its exports. For several years before 1991, the opposite was true. Japan's
economy grew faster than ours, and its current-account surplus declined.
Focus on trade in goods and services or the current-account balance neglects the principal
reason for imbalances. These imbalances are caused by differences in investment and saving in
Japan, the United States and other countries. Between 1986 and 1990, Japan saved more than 19
percent of its GDP, invested 16 percent domestically, and lent or invested the difference, nearly 3
percent, abroad. Japan's surplus will continue as long as the Japanese save more than they invest
During the same years—1986-90—the United States saved about 2 1/2 percent of GDP and
invested (net) about 5 percent domestically. The excess of investment over saving was financed
by borrowing, equity investment from abroad and sales of new and existing assets. The United
States' large current-account deficit is the result. Our deficit, like Japan's surplus, is just the mirror
image of our international borrowing and lending. The borrowing and lending are the result of
differences between domestic saving and investment
None of this has been changed by quotas on U.S. imports of autos, steel, textiles, machine
tools, or computer chips, and none would be changed if the Japanese government (unwisely) agreed
to the proposed numerical targets for specific Japanese imports. Increased exports of specific
products to Japan cannot change the current-account balance. Deregulation of the Japanese economy
can only affect the current-account balance by changing Japanese decisions to save or invest An
effect of this kind cannot be ruled out, but it is unlikely to be large.
Our discussion should not be read as a justification of restrictive practices by Japanese producers or the Japanese government All countries—the U.S. included—restrict trade in one or
another way. The burden of these restrictions falls mainly on the consumers in the home country.
Consumers benefit when governments eliminate these practices; they lose when the practices
increase.
In the postwar years, the United States led the world toward freer trade. This policy proved
itself by providing impetus for the growth of world trade and the resultant increase in living standards
at home and abroad. For the last seven years, under several administrations, the U.S. government
has worked to improve the rules for trade and dispute settlement under GATT. The Clinton
Administration successfully completed the most recent negotiation.




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March 6-7,1994

We urge President Clinton to stop demanding numerical targets and threatening bilateral
sanctions. The Administration should use the GATT mechanism to resolve specific complaints
against Japan. The Japanese bilateral current-account surplus with the United States is on all fours
with the United States bilateral surplus with Europe or Mexico. Bilateral imbalances are not a
problem. If the U.S. wants to reduce its total current-account deficit, the best available means is to
encourage domestic saving.
Current trade policy toward Japan is short-sighted, wrong-headed, costly to our citizens, and
damaging to our long-term interests in peace and stability within Asia. It should be abandoned.




8

Shadow Open Market Committee

WHY ARE INTEREST RATES RISING?
H. Erich HEINEMANN
Ladenburg, Thalmann & Company, Inc.

Long-term Treasuries, which sold to yield 5.75 percent in October, now return about 6.75
percent That is more than half way to our interim target for 1994 of 7.6 percent. Investors who
bought puts on the Treasury bond future have doubled their money in four months.
The rise in yields reflects the reaction of market participants to actions by the Federal Reserve
System. Our work indicates that since 1985 sustained changes in the second derivative of total
bank reserves have been associated with analogous patterns in observed rates of so-called core
inflation after a lag of about three years. Put differently, the 55 percent increase in total bank
reserves from January 1984 to January 1987 eventually led to faster inflation, tight money and
recession. We believe the 48 percent increase in total bank reserves from November 1990 to
November 1993 is likely to have a similar result
In our view, central bank policy has already planted the seeds of the next inflation. To
overwork the metaphor, these seeds are now sprouting. They will blossom later this year. Recognition of the latent threat of inflation could unhinge the apparently placid relationship between
the Federal Reserve System and the Clinton Administration. In the White House model, low nominal
rates are necessary for growth. Pressure from the White House economic team to hold rates down
would only fan the fear of inflation, but Mr. Clinton's advisors do not seem to recognize this risk.
Our Baseline Forecast of faster inflation in 1994 and 1995 may be incorrect However, the
short-term accuracy of this prediction is not relevant. Rates have gone up (and will go up), regardless
of currently reported rates of inflation. Ladenburg, Thalmann & Co. warned clients a year ago that
"Double-digit rates of expansion in reserves—the high-powered funds that represent raw material
for the money supply—cannot go on indefinitely."
"Eventually, the Fed will have to slow the rate of reserve expansion, regardless of the
objections on Capitol Hill. When it does, the action will send a shock wave through Wall Street.
Rates will go up. The longer the Fed tries to keep interest rates down, the more they will ultimately
rise." PROSPECTS FOR MONEY AND THE ECONOMY, March 8,1993.




9

March 6-7.1994

A year later, the centtil bank is saying essentially the same. "In conducting policy through
1993, the Federal Open Market Committee recognized that it was maintaining a very accommodative
stance in reserve markets. Reserve conditions had been eased to this degree over the prior four
years to counter the effect of some unusual factors restraining aggregate demand. The Committee
recognized that, as these forces abated, short-term interest would likely have to rise to forestall
inflationary pressures that would eventually undermine the expansion."
In theory, interest rates should move parallel to expected changes in inflation. Thus, some
people were surprised when rates rose following (1) the Fed's announcement of a "tightening"
designed to head off future inflation and (2) disclosure that the seasonally adjusted consumer price
index was unchanged in January. This was the first month since August 1989 that this key measure
of inflation did not increase. The actual inflation rate has changed little over the last six months.
In practice, bond investors are often more concerned with the short run results of actions by
the monetary authorities than their long-term implications. Bond prices usually go up when the
Fed eases (even though this may eventually be inflationary) and down when it tightens (even though
this may be anti-inflationary).
Immediate prospects for changes in liquidity and the cost of carrying highly-leveraged bond
positions appear more important than the eventual outlook for the real value of the investment The
most extreme example was the spring of 1984. Inflation was close to 4 percent and Fed policy was
tight. Nevertheless, the yield on 30-year Treasuries hit 14 percent
In our view, technical market forces exaggerated the rise in rates in the last few weeks. Traders
in Treasury bond futures and options profit most when prices are volatile. Together with their
acolytes in the economics community, they work overtime to whipsaw investor sentiment between
euphoria and despair, and then back again.
Modern trading techniques make financial markets symmetrical. It is no more difficult for
professionals to profit when bond or stock prices fall than when prices rise. The bond market's
sharp response to otherwise encouraging economic news clearly had its roots in such speculation.
For the moment, bonds now appear to be "oversold." Don't be surprised if the market rallies and
rates decline temporarily.
Long-term, basic forces point toward a bear market in bonds. First, the Federal Reserve's
easy money policy since 1991 has raised expected inflation. Market participants describe the Fed's
recent decision to allow a quarter point in short-term rates as a preemptive strike against inflation.
That perception does not square with reality.




10

Shadow Open Market Committee

Fed actions added a record $26 billion to total bank reserves over the last 36 months (FRB
St Louis data). This high-powered money will be raw material for monetary expansion and inflation
in 1994 and 1995. To repeat, the rise in bank reserves planted seeds of the next inflation. These
seeds are likely to germinate this spring and summer, no matter how the Fed manipulates short
rates.
Second, projections by the White House and the Congressional Budget Office show that the
U.S. Treasury borrowing is likely to total more than $800 billion during the Clinton Administration.
This would be unchanged from President Bush—despite propaganda about budget cuts.
Treasury borrowing has had little effect on rates because net private credit demand has been
at a postwar low. Now, by contrast, private borrowing has begun to rebound. Nonfinancial,
nonfederal borrowing rose at a rate of about 5 percent in the second half of 1993. Compare that
with the 2.8 percent rate of gain since mid-1991. Cyclical rises in the total need for funds are
normally linked with higher nominal credit costs.
The Federal Reserve's decision to allow short-term rates to go up—while inadequate and
tardy—at least holds hope of an eventual serious effort to contain inflation. Signs of parallel
long-term fiscal restraint are hard to find, White House propaganda notwithstanding.
President Clinton imposed a Reaganesque clamp on U.S. spending in hisfirstyear in office.
Federal cash outlays fell $26 billion in calendar year 1993, compared to a $119 billion surge in the
year ended in the second quarter of 1992. Recession-related income maintenance programs have
receded as the economy recovered, and U.S. disarmament (post Gulf War and post Cold War) has
gathered momentum.
The White House cannot sustain such budgetary gains. Mr. Clinton has ambitious plans to
boost the role of government His plans all carry price tags. The official deficit forecast for fiscal
year 1994 is $235 billion. That is about equal to the actual shortfall for the 12 months ended January.
Since Treasury revenues are now rising at an annual rate of more than $75 billion, it follows that
the President intends to boost outlays by that amount Otherwise, the tide of red ink would fall.
If our model of the economic activity is correct, then the primary impact of the Federal
Reserve's stimulus will show up in nominal, rather than real, demand for goods and services. Current
dollar spending rose at an annual rate of 6.1 percent in the last two years, up from 4.2 percent in
the two years ended in the fourth quarter of 1991. In the eight quarters ended in 1989, nominal




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March 6-7,1994

demand rose at an annual rate of 6.8 percent. The 1987-89 period was followed by accelerating
inflation, while the rate of price change fell after the 1990-91 episode. Time will tell about more
recent developments.
According to the Congressional Budget Office, the capacity of the U.S. economy for noninflationary growth hit a postwar low in 1993. Sharp increases in marginal tax rates are likely to
inhibit the net formation of new business. Over the last dozen years, newly-formed firms accounted
for about 90 percent of net price job creation.
We continue to believe that weaker economic data are likely in the weeks immediately ahead.
The surge in activity in the fourth quarter was too rapid to be sustained. Consumers have been
spending much more than they have been earning. With job prospects still uncertain, capacity for
additional debt is limited. Cutbacks in the growth of consumer outlays are inevitable. In a world
of just-in-time inventory management, these cutbacks are likely to echo quickly through the
industrial sector.
Here are a few examples of areas that we think are vulnerable:
1. Real merchandise exports averaged $475 billion at a seasonally adjusted annual
rate last fall, up at a rate of 32 percent from the average of $433 billion in the three
months ended August A rate of increase of 7 to 7.5 percent is more likely in 1994.
2. The gross value of consumer durables produced soared at a 27 percent rate from
September through January (also based on three-month moving averages). Our
Baseline Forecast suggests that a growth rate well under 10 percent is probable this
year, with a further slowdown likely in 1995.
3. Real contracts and orders for plant and equipment have gone up at a 33 percent rate
over the last seven months and at a 56 percent rate over the last three months. We
expect increases closer to 10 than 20 percent this year. New orders for nondefense
capital goods, ex aircraft, were down almost 7 percent in January, the biggest
monthly drop since early 1991. Aircraft orders were up, but that was only a
temporary blip in a disastrous long-term slump.
4. Housing starts (both total and single family) soared at rates of in excess of 30 percent
from March of last year through December. The big drop in starts in January was
influenced by bad weather, but only modestly. The weather is always lousy in
January and the data are adjusted for that We expect starts to settle down in a zone
around 1.3 million units a year, somewhat below the 1.46 million average in the
fourth quarter.
Conventional wisdom in the financial community is that the economic expansion is now
broad-based and thus likely to continue in a zone between 3 and 4 percent growth. A more accurate
observation would be that the economy has a split personality. Consumer purchases of durable




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Shadow Open Market Committee

goods, business fixed investment, housing and inventories have been rising at an annual rate of
more than 10 percent during the 1991-93 period of recovery and expansion. However, these areas
(the "cyclical sectors") are only 25 percent of the economy.
The other 75 percent of the economy (consumer nondurables, services, foreign trade and
government purchases) has expanded at a rate of nine-tenths of one percent. Historically, growth
of less than 1 percent in the noncyclical sectors has been associated with recession rather than
expansion.
The overwhelming consensus for solid economic growth in 1994 rests on a belief that
employers will pile on another 2 million or more new jobs on top of the 1.9 million they added last
year. Investors should remember that the 2.3 million gain in nonfarm payroll employment thus far
in the expansion is less than half of the standard of earlier recovery cycles.
Moreover, almost all the net job gains over the last two years have been in the relatively,
stagnant noncyclical sectors of the economy. Productivity gains in the private service sector (which
accounts for 100 percent of new creation over the last 15 years) have stalled. Flat productivity and
rising unit labor costs in private services suggest a weak foundation for rapid growth in employment.
For January alone, job changes were close to the usual seasonal pattern. The number of
nonfarm jobs dropped by more than 2.3 million, not seasonally adjusted, normal for that time of
year. Retailing health, services and temps account for two-thirds of net jobs added in the last two
years. All three have subpar wages and hours.
Recent conversations with leading business economists confirmed this picture of a two-tier
economy. Hard goods are booming. Sixty percent of the output of the steel industry is on allocation
and prices are rising rapidly. Some steel service centers (which handle odd-lot orders for the
industry) report record-breaking activity. In Milwaukee, a protypical capital goods town, industry
executives say there are scattered shortages of skilled labor.
At least one U.S. auto company is now running its plants on a three-shift, 24-hour day basis.
Another producer is still on two shifts a day, but it is scheduling so much overtime that its plants
are operating about 20 hours a day.
Inventories of major kitchen appliances are at unusually low levels (in part due to a
weather-induced shutdown). Appliance prices which have not changed since 1987, are likely to
rise this year. However, appliance manufacturers expect a drop in sales of new single-family homes
later this year to lead to a parallel reduction in purchases of their products.




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March 6-7,1994

Makers of a wide range of capital goods continue to enjoy the benefits (and endure the
problems) of a roaring boom. One of the world's largest producers of high-technology equipment
said its global order volume in the three months ended January was 35.2 percent ahead of the like
period a year ago. Similarly, orders in the three months ended January 1993 were up more than 30
percent from 1992.
Outside the U.S., the pace is picking up as well. Total orders for manufactured goods are up
more than 10 percent in Canada. Export orders in Germany, which were down for almost two years,
are now solidly in the black and rising rapidly.
Among the major industrial economies, only Japan is still in a deepening recession. Analysts
at a major diversified U.S. manufacturing company expect industrial production in Europe to rise
more than 2 percent this year and close to 4 percent next year. In Asia, exclusive of Japan, gains
of almost 10 percent are likely.
By contrast, growth in chemical output has been moderate and prices of most commodity
chemicals are still flat to down. Major producers have cutback capital spending plans in the chemical
and paper industries because of continuing problems with overcapacity.
Retail demand for durable goods continues to be strong despite an unexpectedly large drop
in sales in January. However, growth in real spending is far ahead of advances in real income, so
substantial cutbacks are inevitable. Increase in outlays for nondurables and services (85 percent of
total consumer outlays) remain sluggish at best
The basic factors that determine the long-term capacity of an economy for non-inflationary
growth are (1) the number of workers and how much they work (labor input) and (2) how much
each worker produces per hour (productivity). The 1.79 percent increase in U.S. economic capacity
in fiscal year 1993 (a low for the postwar period) probably understates the potential for U.S. growth
in the 1990s. Even so, the economy is more and more muscle bound.
Many forces influence the capacity of an economy to grow without inflation. The most
important are demographics, saving, investment and foreign trade. A growing population may help
growth, but not necessarily. High levels of saving and investment (in physical and human capital)
give workers tools they need to increase productivity. Free trade channels resources to sectors that
do best, which also boosts productivity.




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Shadow Open Market Committee

In the U.S., gains in employment have slowed steadily since the 1970s. That is one result of
a marked decline in population growth, partially offset by a huge expansion in the proportion of
women who work outside the home. More recently, that ratio has appeared to level off, particularly
in the age brackets between 25 and 44, the core of the work force. Similarly, the erosion in
employment of older males, aged 45 to 64, also seems to be ending.
More troubling is the long-term slump in productivity growth. Many analysts challenge the
data compiled by the Bureau of Labor Statistics which show this trend. The most common complaint
is that the government fails to measure much of the output in the service sector, and therefore
understates gains in productivity.
To avoid this problem, we use real after-tax income per full-time equivalent worker as a proxy
for productivity. Clearly, real income per worker and productivity are essentially synonymous. A
society cannot pay itself more than it can produce. Manufacturing productivity is rising at
remarkable rates. According to the BLS, output per hour in that sector rose at a 7.8 percent annual
rate in the fourth quarter of 1993. This is superb performance, but it will not sustain the growth of
productivity in the overall economy. Manufacturing is only about 20 percent of total value added
in the U.S.
Our analysis shows the slowdown in the growth of productivity has been mostly in services.
Productivity in nonmanufacturing (services and construction) was little changed from the fourth
quarter of 1992 to the four quarter of 1993. Service productivity has slumped despite a big gross
investment in information technology. Partly, this reflects the fact that much of the job growth
since World War II has been in very small companies in parts of the service economy where gains
in real output per hour are hard to achieve. Health service occupations are a good example
Equally important is the long-term drop in net investment in the U.S. from about 5 percent
of net domestic product in late 1970s to zero in 1992 and about 2 percent today. Gross investment
has been high, but much of this was short-lived equipment Thus, the rate of net addition to the
nation's stock of real capital has gone down.
The conclusion is clear: The sustained ability of the U.S. to expand without inflation has
fallen by roughly half in the last 40 years—from about 5 percent to about 2.5 percent. The economy
is vulnerable to inflation, no matter how the Fed may try to manipulate short-term rates.




15

LADLiNHURG, TI1ALMANN / I I U I N l i M A N N l i C O N O M I C K l i S l i A U C U
Baseline Forecast - March 1994
I
TIlEliCONOMY:
Gross Domestic Product ($87)
PctCfcg
Persoaal Coasamptioa ($87)
PctCfcg
Basaess Iavestmeat ($87)
PctCfcg
Struct ares ($87)
Prod. D v . Eqaip. ($87)
Rcsdeatial IavesL ($87)
PctCfcg
Cfcaage ia Iaveatory ($87)
Net Exports ($87)
Goverameat Purchases ($87)
PctCfcg
Fiaal Domestic Sales ($87)
PctCfcg
Gross Dam. Prod. ($Carreat)
PctCfcg
Disposable Iacome ($87)
PctCfcg
Saviags Rate (Perccat)
Opcratiag Profits ($ Carrcat)
PctCfcg
Iadastrial Prod. (1987-100)
PctCfcg
Hoasias Starts (Mill. Uaits)
PctCfcg
Tot Vehicle Sales (Mill Uaits)
rctCfcg
Noatarm Payroll Jobs (Mill)
PctCfcg
Uscmptoymeat Rate (Perec at)*
GDP Deflator (1987=100)
PctCfcg
CPI Less Baergr (1982-84=100)
PctCfcg
Fedl Deficit ($Carreat N I A )
F I N A N C I A L MARKETS:
Federal Faads Rate
Tarec-moatk Bills (Discoaat)
Prime Rate, Major Baaks
30-Year Treasury Boads
Moacy Sappiy ( M l , $ Carrcat)
PctCfcg
Velocity (Ratio: G D P to M l )
Trade-Weighted $ (1973=100)

IV93 A

f'94F

tl'94 F

Hl'94 F

IV94 F

l'95F

ll'95 F

1993 A

1994 F

1995?!

$5,232.1
7.50%
$3,508.6
4.57%
$625.3
22.14%
$156.3
$469.0
$226.9
30.97%
$13.4
($84.1)
$942.0
0.13%
$5,302.8
6.64%
$6,532.4
8.81%
$3,761.3
5.79%
4.10%
$493.9
23.51%
113.10
7.51%
1.460
54.13%
14.546
32.49%
110.860
1.74%
6.43%
124.9
1.23%
151.6
3.07%
($209.7)

$5,260.3
2.2%
$3,531.8
2.7%
$639.5
9.4%
$154.4
$485.1
$239.0
23.0%
$12.4
($105.2)
$942.9
0.4%
$5,353.2
3.9%
$6,621.8
5.6%
$3,786.1
2.7%
4.4%
$501.4
6.2%
114.2
4.0%
1.46
0.8%
14.4
-4.3%
111.1
0.9%
6.8%
125.9
3.3%
153.0
3.7%
($196.1)

$5,291.7
2.4%
$3,550.5
2.1%
$652.3
8.2%
$155.9
$496.3
$243.9
8.6%
$14.4
($115.0)
$945.6
1.1%
$5,392.4
3.0%
$6,727.7
6.6%
$3,808.7
2.4%
4.5%
$509.2
6.4%
115.2
3.6%
1.33
-31.7%
14.4
1.2%
111.5
1.3%
6.7%
127.1
4.0%
154.5
4.0%
($179.0)

$5,309.6
1.4%
$3,571.7
2.4%
$660.2
5.0%
$157.2
$503.1
$236.6
-11.5%
$15.4
($121.9)
$947.6
0.8%
$5,416.1
1.8%
$6,835.2
6.5%
$3,823.9
1.6%
4.3%
$514.8
4.5%
116.2
3.2%
1.29
-12.2%
14.0
-11.8%
111.7
0.7%
6.6%
128.7
5.1%
156.5
5.3%
($161.7)

$5,332.4
1.7%
$3,589.3
2.0%
$676.0
9.9%
$162.1
$513.9
$233.5
-5.2%
$18.6
($130.6)
$945.7
-0.8%
$5,444.5
2.1%
$6,950.7
6.9%
$3,842.9
2.0%
4.3%
$521.0
4.9%
117.3
3.9%
1.33
12.3%
13.8
-5.5%
112.0
1.2%
6.5%
130.3
5.1%
158.5
5.1%
($160.1)

$5,367.5
2.7%
$3,608.8
2.2%
$689.8
8.5%
$165.1
$524.7
$239.8
11.2%
$17.0
($134.5)
$946.7
0.4%
$5,485.0
3.0%
$7,082.8
7.8%
$3,858.8
1.7%
4.2%
$527.2
4.9%
117.9
2.3%
1.33
2.0%
14.1
9.6%
112.5
1.7%
6.3%
132.0
5.0%
160.5
5.3%
($158.3)

$5,399.0
2.4%
$3,629.0
2.3%
$700.4
6.3%
$167.3
$533.1
$242.1
4.0%
$20.8
($141.2)
$947.9
0.5%
$5,519.5
2.5%
$7,203.2
7.0%
$3,877.4
1.9%
4.1%
$532.5
4.1%
118.9
3.2%
1.30
-9.6%
14.0
-3.9%
112.7
0.7%
6.2%
133.4
4.5%
162.3
4.5%
($155.0)

$5,137.7
3.04%
$3,453.7
3.35%
$591.7
11.80%
$151.7
$440.0
$214.2
8.62%
$15.6
($76.4)
$939.0
•0.66%
$5,198.5
3.69%
$6,379.4
5.65%
$3,701.8
1.91%
4.05%
$463.2
13.75%
111.08
4.23%
1.291
6.88%
13.887
8.24%
110.170
1.52%
6.73%
124.16
2.53%
150.1
3.10%
($227.1)

$5,298.5
3.1%
$3,560.8
3.1%
$657.0
11.0%
$157.4
$499.6
$238.3
11.3%
$15.2
($118.2)
$945.5
0.7%
$5,401.5
3.9%
$6,783.8
6.3%
$3,815.4
3.1%
4.4%
$511.6
10.5%
115.7
4.2%
1.35
4.7%
14.1
1.9%
111.6
1.3%
6.6%
128.0
3.1%
155.6
3.6%
($174.2)

$5,416.8
2.2%
$3,641.6
2.3%
$706.4
7.5%
$168.4
$538.1
$242.2
1.6%
$23.3
($145.3)
$948.6
0.3%
$5,538.8
2.5%
$7,273.0
7.2%
$3,883.9
1.8%
4.0%
$534.6
4.5%
119.3
3.1%
1.32
-2.0%
13.99
-1.1%
112.78
1.1%
6.2%
134.26
4.9%
163.41
5.0%
($152.2)

2.99%
3.08%
6.00%
6.13%
$1,124.6
11.06%
5.81
94.83

3.3%
3.2%
6.2%
6.4%
$1,150.7
9.6%
5.75
95.7

3.5%
3.3%
6.2%
6.7%
$1,175.7
9.0%
5.72
94.8

3.9%
3.6%
6.5%
7.0%
$1,199.2
8.2%
5.70
96.1

4.4%
4.1%
6.8%
7.6%
$1,222.3
7.9%
5.69
95.8

4.9%
4.5%
6.9%
7.8%
$1,239.6
5.8%
5.71
97.7

5.5%
5.2%
7.5%
7.9%
$1,258.6
6.3%
5.72
97.4

3.02%
3.02%
6.00%
6.60%
$1,078.7
11.60%
5.92
93.17

3.8%
3.6%
6.4%
6.9%
$1,187.0
10.0%
5.84
95.6

5.6%
5.3%
7.6%
8.1%
$1,265.4
6.6%
5.75
97.9

A=Actual F=Forecast Billions of dollars unless noted.
'Break in series, January 1994. ••Compensation, productivity and unit labor costs are index numbers, 1982= 100.
 Sources: Haver Analytics; Heinemann Economic Research


MONETARY POLICY AND INFLATION
Bank Reserues, Left
Core Inflation, Right

6 20X A

1
2
6.00*/

5.25X

4.50X

3.75X

N
0
N
T
H
C
H
11
=
N
G
V
£i

3.00X
i

i i i i i i i i i i i i i i i i i i i i i > i i 'i i i i i i i i i i i i i i

Jan
1985
Notes:

Jan
1987

Jan
1989

Jan
1993

i i i i i i

Jan
1995

Jan
1997

The chart shous annualized 36-month changes in total bank
reserues lagged 36 months (left scale, line) and 12-month
changes in the CPI less food and fuel (core inflation, right
scale, dot). The uertical lines show recession.

Sources: Hauer Analytics;



Jan
1991

i

Heinemann Economic Research

S

CYCLES IN FEDERAL RESERUE POLICY

H 20x I
R
E
E 16x
Y
E \2y. I
A
R
8x
C
H
A 4x A
N
G
0
E
S
Motes:

-Uolcker-

OO

Total Bank Reserues

MMimiliiiliiimiii
Ql
1983

Ql
1985

Ql
1987

Ql
1989

Ql
1991

The chart shous three-year grouth rates (SAAR) in total
bank reserues adjusted for reserue requirement changes
(FRB uersion). The uertical lines show the tenures of
Paul Uolcker and Alan Greenspan as Fed chairmen.

Sources: Hauer Analytics;



-Greenspan-

Heinemann Economic Research

Ql
1993

THE DOUNTREND IN U.S. GROWTH POTENTIAL

1957
Notes:

1961

1965

1969

1973

1981

1985

1989

1993

The chart shous year-to-year percentage changes in potential output (real GDP) as calculated by the Congressional
Budget Office. Data are for fiscal years ending second
quarter until 1976; third quarter thereafter.

Sources: Congressional Budget Office;



1977

Heinemann Economic Research

REAL INCOME PER UORKER IS BELOU TREND
T
H
0
U
S
A
N
D

1
•

t

4

1
9
8
7

TT

TT

FT

TT

Real Disposable Income per Worker
Trend - 1948-1973

$49
$36
$28
$22 i

$17 A
Ql
1948
Notes:

Ql
1953

Ql
1958

Ql
1968

Ql
1973

Ql
1978

Ql
1983

Ql
1988

The chart shous real after-tax income per full-time
equiualent worker. Trend line is based on data from 1948
through 1973. Data are natural logs transposed on the
uertical axis. Uertical lines shou recessions.

Sdurces: Hauer Analytics;



Ql
1963

Heinemann Economic Research

Ql
1993

THE FLAT TREND IN PRIUATE SERUICE PRODUCTIUITV
Productiuity, Priuate Seruices

I

a
cs

I

Ql
1948
Notes:

Ql
1953

Ql
1958

Ql
1963

Ql
1973

Ql
1978

Ql
1983

Ql
1988

Ql
1993

The chart shous an estimate of productiuity in the priuate
seruice sector (real priuate seruice consumption per priuate
seruice worker). Data are index numbers, 1987 = 100, SA.
The uertical lines shou periods of recession.

Sources: Hauer Analytics;



Ql
1968

Heinemann Economic Research

GAINS IN SERUICE PRQDUCITIUITY HAUE STALLED
C
H
A
N 3.&/A
G
E
l.S'/A
I
N

3

P
E
R -1.5*
C
E
N -3.0*
T
Ql
1967
Notes:

Ql
1973

Ql
1976

Ql
1979

Ql
1982

Ql
1985

Ql
1988

Ql
1991

The chart shous annual percent changes priuate seruice product iuity (real priuate seruice consumption per priuate seruice uorker). Index numbers, 1987 = 100, SA. The uertical
lines shou periods of recession in the economy.

Sources:



Ql
1970

Hauer Analytics;

Heinenann Economic Research

PRODUCTIUITV A N D EMPLOVMENT DETERMINE ECONOMIC CAPACITY

$

F
I 7.5/C
U
E
6.0xJ
Y
E
A 4.5X
R
en

C 3.0*/.
H
A
N l.S'/A
G
E
S
Ql
1953
Notes:

Ql
1957

Ql
1961

Ql
1965

Ql
1973

Ql
1977

Ql
1981

Ql
1985

Ql
1989

Ql
1993

The chart shous changes in economic capacity (productiuity
plus employment, line) and changes in employment (dot).
Space between line and dots is change in productiuity
(total businessj 1982-100). Uertical lines are recessions.

Sources: Hauer Analytics;



Ql
1969

Heinemann Economic Research

Ql
1997

DEMAND IN MONEY TERMS AND ECONOMIC CAPACITY
—
—

F

^

I 15.0/
u
V
E
1Z.&/J
Y
E
A 9.0*
R

Nominal GDP Change I
Capacity Change
1

|

6.Ox
•

1

*•
"|«

hi

i

•

1

1

"••

•i

I"

••"**• 1

l

3.Ox

/

•'

1

!•' f "

J

1

1

0 J r-i—«—r -r — i — i * - H 1 1 1 1 1 1 1 8 1 —*1—1 l • 1 — i — i — i — i — H
T—\—r-~i—i—i—1
Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997
1

C
H
A
N
G
E
S

i

Notes:

The chart shnus changes in demand in money terms (nominal
GDP, line) and changes in economic capacity (employment plus
productiuity, dot). The space between the line and the dots
is the rate of inflation. Uertical lines are recessions.

Sources:



Hauer Analytics;

Heinemann Economic Research

DEMAND CHANGE MINUS CAPACITV CHANGE EQUALS INFLATION CHANGE

Demand Change Minus Capacity Change
Consumer Price Change

I

Ql
1953
Notes:

Ql
1957

Ql
1961

Ql
1965

Ql
1973

Ql
1977

Ql
1981

Ql
1985

Ql
1989

Ql
1993

The chart shouis changes in demand in money terms (nominal
GDP) MINUS changes in economic capacity (employment plus
productiuity) line, and changes in the consumer price index
(CPIU, 1982-84=100, dot). Uertical lines are recessions.

Sources: Hauer Analytics;



Ql
1969

Heinemann Economic Research

Ql
1997

GR8UTH IN THE CYCLICAL SECTBRS BF THE EC8N8MY IS STRANG
D
E
U
I 25.0X

Cyclical Sectors ($87)

A
T
I 12.5*
8
N

%

F
R
8-12.5*
N

NO

N-25.0x4
8
R
Qi
N
I960
Notes:

Qi
1963

QI

1966

qi
1969

qi
1975

qi
1978

qi
1981

qi
1984

qi
1987

qi
1990

The chart shous year-ouer-year changes in the "cyclical"
sectors (consumer durables, business inuestment, housing and
inuentories), minus the mean rate of change, 1959-1993
(3.90 percent). 1987 $. Uertical lines are recessions.

Sources: Hauer Analytics;



qi
1972

Heinemann Economic Research

qi
1993

GROUTH IN THE NONCYCLICAL SECTORS OF THE ECONONV IS UEAK

I
S

I

Notes:

The chart shous year-ouer-year changes in "non-cyclical"
sectors of the economy (GDP minus consumer durables and
inuestment), minus the mean rate of change, 1959-1993
(2.76 percent). 1987 $. Uertical lines are recessions.

Sources: Hauer Analytics;



Heinemann Economic Research




March 6-7,1994

28

Shadow Open Market Committee

REGULATORY CONSOLIDATION
LeeHOSKINS
The Huntington National Bank

SINGLE REGULATOR: A BAD IDEA
The idea of a super-regulator for banks and thrifts misses the fundamental point. Given the
rapidly changing financial marketplace, the real issue is not the regulatory structure itself, but the
effects of regulation on the cost and availability of products consumers demand. The primary
objective of any regulatory reform should be to free financial institutions from the regulatory burdens
that prevent them from meeting consumer demands in an efficient fashion. Recent proposals that
address the structure of the regulatory system are treating symptoms rather than the source of the
problem—regulation itself.
The consolidation of all federal regulatory authority into a single institution is a bad idea for
several reasons. First, it would stifle creativity and innovation on the part of both regulators and
the regulated firms, with no guarantee of better or less costly regulation. Differences in the
incentives, goals and powers among the separate regulatory agencies promote a flexibility in the
conduct of regulation that cannot be legislated, even by the most vigilant and responsive of lawmaking bodies. Second, a single, monolithic federal regulator might be more susceptible to political
pressure, especially if it does not have a truly independent charter and governing board. The record
of the savings and loan industry demonstrates the dangers of insufficient checks and balances in
the regulatory process. Third, and most importantly, stripping the Federal Reserve of its regulatory
power would threaten the independence of the monetary policymaking process. The supervisory
and rule-making authority of the Federal Reserve translates into substantial grass roots support that
can be used to fend off challenges to the institution's independence.
RECENT REFORM PROPOSALS
The idea of banking agency reform has been around almost as long as the regulatory system
itself. The latest version is a Treasury Department plan, announced last November 23, to combine
the four federal bank and thrift supervisory authorities into a single new agency that would be called
the Federal Banking Commission (FBC). The FBC would assume the current regulatory functions
of the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), the Comptroller




29

March 6-7,1994

of the Currency (OCC), and the Office of Thrift Supervision (OTS). The stated intent of the proposal
is to eliminate wasteful duplication and inconsistencies in the content and enforcement of statutes
and modernize a system that is viewed as having grown out of disjointed reactions to past crises.
The Fed would retain its role as lender of last resort and its responsibilities in connection with
monetary policy and the payments system. The FDIC would continue to manage the deposit
insurance system, with authority to conduct special examinations of insured institutions. The entire
responsibilities of the OCC and OTS would be assigned to the FBC and the existing agencies would
be abolished.
The FBC would be governed by a five-member board, consisting of a chairman appointed
by the President to a four-year term and confirmed by the Senate, the Secretary of the Treasury or
his designee, a member of the Federal Reserve Board appointed by the Board, and two members
with different political affiliations appointed by the President to staggered five-year terms and
confirmed by the Senate.
The Federal Reserve has offered an alternative that would also merge the OCC and OTS and
strip the FDIC of regulatory authority for healthy institutions, but would preserve and significantly
expand the Fed's regulatory role. The primary regulator of a banking company would be determined
by the charter of the institution's lead bank. The new agency would regulate thrifts and banking
Companies whose lead banks are nationally chartered. The Fed would regulate all companies whose
lead banks are state-chartered and the holding companies and non-bank affiliates of selected large
banks, regardless of charter. The Fed wold also retain its bank holding company rule-making power
and responsibility for foreign bank supervision. The number of federal regulatory agencies would
be reduced to two, and each banking organization would have a single primary regulator. The Fed
proposal demonstrates that it is not necessary to take the risks associated with a single regulator
and give up the advantages of multiple regulators in order to achieve most of the benefits from
consolidation.
PRESERVING INNOVATIONS
The multiple regulator system, which has evolved over decades is by no means perfect, but
it does provide an effective means of encouraging adaptability to rapidly changing circumstances
by regulators and permitting some degree of creativity and innovation on the part of regulated
institutions. With respect to regulators, much of the evolution in permissible bank powers and
products necessary to keep pace with the changing desires of consumers and businesses has been




30

Shadow Open Market Committee

driven by the constructive competition among federal regulators. For example, when the OCC
liberalized restrictions on activities by national banks in the 1960s, the conversion option allowed
state chartered banks to shift from Fed regulation to OCC regulation and exercise those broader
powers. Again, during the 1970s, many banks changed their charters to avoid the high costs of Fed
membership. This shift, in part, prompted an important legislative change—the Monetary Control
Act of 1980.
With respect to the regulated institutions, the patchwork of federal regulatory agencies offers
the opportunity to seek the most appropriate regulator for a given business mix, and in so doing
helps protect financial firms and their customers from the supervisory inertia and high costs of a
single regulator. An expansion-minded bank holding company, for example, can under certain
circumstances reach across state lines more easily by purchasing a thrift institution, which faces
fewer restrictions on interstate activity. In fact, a bank can conceivably convert from a national or
state charter to a thrift charter in order to offer a growing list of services made possible by technological advances or made popular by evolving customer preferences but that it cannot legally
provide under a commercial bank charter. An institution with a heavy focus on securities sales
might find regulation by the OCC more appropriate than regulation by the Federal Reserve, which
seems to place more onerous constraints on such activities. A large bank holding company might
save time and trim expense by converting the charter of its lead bank from national to state to reduce
the number of primary regulators examining the institution from two to one. In short, the existence
of multiple federal regulators permits regulated institutions to adapt to change in the market place
by changing charters. The resulting competition among regulators limited the need for such moves.
In addition, the projected cost savings from consolidation of the federal regulatory agencies
might be overstated. Concentrated power breeds waste and inefficiency, while competition fosters
innovation and efficiency. As a result, it is unlikely that the estimates of cost savings from regulatory
consolidation can be realized, or if realized, then sustained. Much of the projected savings could
be achieved through partial consolidation and better coordination among existing agencies, without
forgoing the savings and other advantages that accrue from competition.

SAFETY AND SOUNDNESS
One argument that is often raised against a multiple regulator system is that safety and
soundness of the banking system suffers because of a "competition in laxity" by the agencies. Banks




31

March 6-7,1994

can and do shift charters for a number of reasons. However, over the last 60 years of multiple
federal bank regulators there is little evidence that a competition in laxity weakened the commercial
banking system.
Bouts of instability in the financial system often stem from government intrusion into private
risk bearing activities. Such government intrusion reduces counterparty scrutiny—the essence of
financial contracting. For example, Fed Wire and thefinalityof payment it provides means banks
do not worry about thefinancialhealth of other banks they are doing business with over Fed Wire
because the Fed guarantees the payment The same argument applies to student loan programs,
farm credit programs, housing programs and many more.
The most pervasive intrusion by the federal government into risk bearing activities of private
parties is deposit insurance. The large cost born by taxpayers because of massive failures in the
thrift industry stems more from unlimited deposit insurance than from multiple regulators and a
competition in laxity. The Federal Home Loan Bank Board (FHLBB) was effectively the sole
regulator for the thrift industry at the federal level. The Federal Savings and Loan Insurance
Corporation had backup regulatory and examination authority, but poor coordination and control
prevented the operation of meaningful checks and balances. Moreover, a single federal regulator
is more likely to be vulnerable to political pressure than multiple regulators because it is more costly
and difficult for members of Congress to influence multiple agencies with much broader constituencies. This is even the case if the governing board includes high ranking officials primarily
accountable to the Executive Branch.
INFLATION AND REGULATORY AUTHORITY
It is not at all clear that to be a wise monetary policymaker and nimble lender-of-last resort,
that the central bank must have regulatory authority. The Bundesbank has no such authority, yet
it is generally regarded as a premiere monetary policymaking body. However, there is an important
reason for the Fed retaining its regulatory role. Regulatory authority gives the central bank
broad-based support that can be instrumental in preserving its independence in formulating and
conducting monetary policy. The Federal Reserve's role as a regulator gives it substantial influence
over the banking industry. The Fed's strong ties to prominent businessmen, community leaders,
and academics through the system of Reserve Banks provides an extensive public relations network.
The loss of supervisory authority would diminish the importance and influence of the Reserve




32

Shadow Open Market Committee

Banks, where the vast majority of the Fed's supervisory and regulatory personnel are located, thereby
weakening the Federal Reserve's ability to marshall support for its independent control of monetary
policy.
These concerns would be largely mitigated by a statutory objective that directed the Federal
Reserve to achieve and maintain price level stability. There is a body of research that demonstrates
the importance of central bank independence in promoting the highest sustainable rates of economic
growth and standards of living by controlling inflation. Since no statutory authority for zero inflation
exists, the Fed needs the broad-based support its regulatory apparatus provides. Imperfections that
might result from continuing the system of multiple regulators are far outweighed by the substantial
and verifiable benefits of at least partially insulating monetary policymakers from political pressures
to inflate.
Finally, both the Treasury and Fed proposals for regulatory reform do not address several
important considerations. First, consolidation should not entail the merging of the Savings Association Insurance Fund with the Bank Insurance Fund. Second, the regulatory function of the
National Credit Union Administration should be reviewed, as well. Third, neither the Treasury's
nor the Fed's proposal addresses the fact that bank mergers and acquisitions are the subject of
redundant antitrust review by one of the existing federal banking agencies in addition to the Justice
Department




33




March 6-7,1994

34

Shadow Open Market Committee

ECONOMIC OUTLOOK
Mickey D.LEVY
NationsBanc Capital Markets, Inc.

All of the factors are in place for strong economic growth through 1994. At issue is whether
inflation pressures will mount and whether the Federal Reserve will appropriately tighten monetary
policy from its presently accommodative stance. At stake is the eventual sustainability of the
expansion.
REAL ECONOMIC PERFORMANCE
The economy is benefiting from strong cyclical momentum generated by stimulative monetary
policy as well as a vastly improved foundation for economic expansion provided by the many
noncyclical adjustments that have characterized the economy in recent years.
In contrast to recent recoveries that began with strong spurts of real growth that subsequently
subsided toward a more sustainable pace of expansion, the rebound from the second quarter 1991
trough began very slowly. Real GDP growth would have been much closer to the average of recent
rebounds if it had not been suppressed by the ongoing adjustments in the private and public sectors,
many of which began well before the recession. The foundations for sustained economic expansion
are stronger as a consequence. As such, the slow GDP growth understated actual improvement in
economic performance.
Aided by the strong tailwinds of monetary stimulus, the winding down of these adjustments
presently allows the economy to play catch-up. The pace of growth accelerated in the second half
of 1993, and that momentum is carrying into 1994. The pickup in growth is evident throughout the
private domestic sector. Real domesticfinalsales rose over 5 percent annualized in the second half
of 1993. Government purchases continue to decline with the federal defense downsizing, and the
trade deficit widened significantly in 1993, subtracting from domestic production. While exports
have continued to grow, import growth has accelerated sharply with the stronger domestic consumption and business investment in producer durable goods.
Employment growth has increased 1.75 percent in the last year, and the average workweek
has risen to new highs. The flow of layoffs associated with corporate restructuring has subsided,
while strong product demand is forcing firms to increase labor inputs. Sharp gains in productivity




35

March 6-7,1994

(over 4 percent annualized ih the second half of 1993) have been a key factor driving the spurt in
growth. The improvement in productivity has more than offset the continued modest increases in
compensation and lowered unit labor costs. This has constrained inflation and widened profit
margins. At the same time, product demand has accelerated, providing significant increase in
corporate operating profits and cash flows.
The extraordinary 7.5 percent rate of growth in fourth quarter 1993 will not be repeated, but
strong economic momentum will continue at least through second quarter 1994. Fourth quarter
1993 was boosted by unsustainable growth in residential investment (up 31.0 percent annualized),
business fixed investment (up 22.1 percent), and a sharp rise in exports. Real consumption rose
4.6 percent, even faster than its robust 4.4 percent third quarter pace.
The strong economy in December lifted the level of GDP well above its fourth quarter 1993
average and real consumption rose in January. With this start, real GDP is projected to expand
4-4.5 percent in thefirstquarter 1994. Partially veiled by the bad winter weather, housing activity
and demand for domestic autos remain strong, while manufacturers struggle to maintain adequate
inventories. Business fixed investment is projected to continue growing, fueled by strong product
demand, robust profits and cash flows, and low costs of capital. Continued increases in employment,
hours worked and wages will generate sufficient income growth to sustain rising consumption.
The economy is receiving an additional boost from the government-subsidized rebuilding of
Southern California following the earthquake. A supplemental appropriation of $9 billion will be
added directly to the economy, largely through government purchases. This may stimulate additional private sector activity. The government funds will be allocated throughout 1994. The
extended period of bad weather may shift some growth from thefirstquarter into the second. The
magnitude of this effect is uncertain.
The recent rise in interest rates will not dampen economic momentum in the near term. Rates
are rising as ^reflection of stronger economic growth, higher expected rates of return on investment,
and higher inflation expectations. Monetary policy remains accommodative. The tax increases
will lower disposable income and consumption from what they would be otherwise, but their adverse
impact will be overwhelmed by the economic momentum and accommodative monetary policy.
Real GDP is projected to grow at a 3.25-3.5 percent pace in the second quarter and closer to
3 percent in the second half of the year. The risk is that the momentum will last longer than is
generally anticipated. The cyclical momentum may be sustained by the improved structure of the
economy, particularly the strong gains in productivity and low unit labor cost inflation, and the




36

Shadow Open Market Committee

vastly improved finances of businesses and households and capital positions of banks. Moreover,
there are many new efficiencies in service-producing industries that are not reflected in the productivity statistics. These factors form the basis for healthy growth after the cyclical momentum
fades. Moreover, enactment of NAFTA and GATT raise long-run potential growth. Real GDP is
projected to expand approximately 2.75 percent in 1995.

MONETARY POLICY
Monetary policy has been decidedly stimulative for several years. Bank reserves and the
narrow monetary aggregates have grown very rapidly (during 1992-1993, bank reserves grew 14
percent annualized; the monetary base, 10.3 percent; and Ml, 12.4 percent) and the real funds rate
has been kept close to zero since Fall 1992. As another symptom of accommodative monetary
policy, the yield curve has remained steep and certain commodity futures prices and gold have risen.
M2 growth has been slowed by the continued decline in small time deposits, with the largest drain
flowing from thrift institutions.
Until recently, the rapid money growth and low interest rates were associated with an increased
demand for cash balances and not faster spending. Rather than accelerate nominal GDP, the
excessive liquidity growth merely raised the demand for financial assets and contributed to low
interest rates and rising stock prices. Thus, the income velocity of the narrow monetary aggregates
fell, while M2 velocity rose sharply. The ongoing noncyclical adjustments in the economy that
inhibited spending, particularly the federal defense downsizing, and the shifts in demand among
financial assets contributed to these patterns.
Through third quarter 1993, nominal GDP growth remained modest and consistent with low
inflation. Following a robust fourth quarter 1992, quarterly GDP growth was below 4.5 percent in
each of the first three quarters of 1993. The rising real growth was offset by a gradually declining
GDP deflator, a higher favorable change in the real growth-inflation mix. Underlying this trend,
however, continued rapid money growth added fuel to potential nominal spending.
Nominal GDP growth surged to 8.8 percent in fourth quarter 1993, and is projected to grow
approximately 6.5 percent this quarter. Combined with the modest slowdown in growth of the
narrow monetary aggregates and the beginning of a pickup in M2 growth, income velocity of the
narrow aggregates is declining less rapidly while the sharp increase in M2 velocity is slowing.
Expectation of further increases in short-term interest rates will reduce the demand for Ml relative
to M2 and narrow their growth gap.




37

March 6-7,1994

INFLATION
To date, broad measures of inflation have been flat or declining, but several indicators of
future inflation are flashing warning signals. At issue is whether the warning signals are reliable
predictors of rising inflation, or whether any of the recent changes in the structure of economy will
suppress or at least postpone inflation pressures.
The CPI increased 2.9 percent in the year ending December, and 3.2 percent excluding the
volatile food and energy components. Producer prices have been nearly stable: the PPI rose 0.3
percent, 0.6 percent excluding food and energy. The CPI and PPI rose only modestly in January.
Increases in the GDP deflators have also been trending down: the implicit GDP deflator rose 2.2
percent from fourth quarter 1992 to fourth quarter 1993, while the fixed-weight deflator increased
2.8 percent The implicit deflator rose only 1.5 percent annualized in the second half of 1993,
reflecting the robust growth of business investment in information processing equipment.
Trends in unit labor costs have been every favorable. ULCs in the nonfarm business sector
rose only 1.3 percent from fourth quarter 1992 to fourth quarter 1993, and actually declined 0.9
percent in the second half of the year. ULCs in the manufacturing sector dropped in both 1992 and
1993 and fell at a 3 percent annualized rate in the last year. The sharp decline in ULC inflation
from 5.1 percent in 1990 reflects receding compensation increases as well as productivity gains.
The most recent improvement has come primarily from sharp productivity gains while compensation
increases have begun to stabilize.
Several key indicators point to a traditional cyclical reacceleration of inflation. Rapid money
growth has been inconsistent with low inflation. The yield curve remains very steep, an early
warning of recent cyclical bouts with rising inflation. Gold prices have risen. Commodity prices
are up, although the alarming price increases are in futures while spot prices have been much more
moderate.
The recent sharp acceleration of nominal GDP is a clear concern. Whereas the rising price
variables are expectational, it is certain that if nominal GDP continues to grow anywhere near 7
percent, inflation pressures would mount The Federal Reserve instead forecasts nominal GDP to
grow between 5.5 and 6 percent from fourth quarter 1993 to fourth quarter 1994; implicit in this
forecast is a deceleration of growth following first quarter 1994.
Despite the warning signals of price pressures, broader measures of inflation are projected to
remain near 1993 levels through 1994. The CPI is projected to increase approximately 3-3.5 percent




38

Shadow Open Market Committee

(3 percent excluding food and energy) and the fixed weight GDP deflator approximately 2.5 percent.
A continuation of recent trends in monetary policy and nominal GDP growth would push inflation
above 4 percent in 1995. But even that rise may be avoided by appropriate monetary tightening.
This forecast of restrained inflation in 1994 stems from some of the unique characteristics of
recent economic performance. The increase in aggregate demand that normally would have been
generated by the stimulative monetary policy was constrained by restrictive fiscal policies (declining
defense spending and higher taxes) and selected private sector adjustments. The restructuring and
significant improvements in production processes have raised productivity (and generated efficiencies in the service-producing industries that are not captured in the productivity statics) and
allowed increases in aggregate supply without exerting price pressures.
These favorable adjustments temporarily postpone the inflationary impact of the stimulative
monetary policy and economic pickup. The rising nominal GDP growth through 1994 will be
largely real growth while inflation will remain low. The changes in production processes and labor
markets reduce the already loose and unreliable correlation between inflation and either capacity
utilization or the unemployment rate. Presently, neither measure indicates with any reliability
tightness or lack of supply that would induce inflationary bottlenecks.
But inflation will not stay low without a slowdown in the pace of nominal growth. The gains
in productivity have been part cyclical, and most of the structural improvement has been a one-time
gain rather than a permanent increase in the rate of productivity growth. The mix of continued
rapid growth of nominal GDP eventually would shift more toward inflation. Consequently, keeping
inflation low requires monetary tightening and higher short-term rates. Yet, aided by favorable
improvements in supply, appropriate tightening now would prevent inflation from accelerating in
1995.

INTEREST RATES
Until recently, interest rates followed a unique pattern relative to recent expansions, reflecting
the gradual growth/low inflation environment During the first 6 quarters of economic rebound,
the Federal Reserve cut the funds rate in half, to 3 percent, and intermediate term rates fell nearly
as much. With the Federal Reserve pegging the funds rate at 3 percent, the yield curve flattened
through October 1993 entirely due to bond yields falling, and rates dropped to their lowest level in
decades. This contrasts with the typical pattern of flattening during expansions by short-rates rising
faster than long rates.




39

March 6-7,1994

Since October 1993, rates have risen significantly and the yield curve has steepened. The
primary culprit has been the sharp acceleration of economic growth and the associated fear of higher
inflation and short-term rates. Recent rises in certain commodity prices, gold and the NAPM price
index have added to these fears. Meanwhile, actual inflation has remained unchanged and the
federal budget outlook has improved significantly.
The funds rate hike in early February heightened these concerns, raising rates and steepening
the yield curve. Even though the Fed's action may not have been too late to prevent a rise in
inflation, clearly it was too late to control inflationary expectations. Now financial markets recognize
the need for higher short-term rates.
The Fed must raise the funds rate further. Pegging the funds rate close to the rate of inflation
since September 1992 has involved excessive money growth. The acceleration of economic growth,
a significant rise in expected rates of return on investment and surging business fixed investment,
and rising loan demand raise the natural rate of interest Preventing the funds rate from rising to
reflect these fundamentals would involve continued excessive money growth and eventually higher
inflation.
The required rise in the funds rate to be consistent with the economy growing along its potential
path without rising inflation is uncertain; what is certain is that significantly slower narrow money
growth is necessary and that requires higher rates. The Federal Reserve is correct in stating that an
inflation-adjusted funds rate of zero is inconsistent with its inflation goals in an expanding economic
environment The Administration has projected modest increases in short-term rates (3-month
Treasury bill rates averaging 3.3 percent in 1994 and 4.1 in 1995), but sustained economic
momentum may require a funds rate above 4 percent by year-end and modestly higher in 1995.
The entire term structure of rates is projected to rise and the yield curve remain steep as long
as the economic momentum is sustained and financial markets fear rising inflation and anticipate
the need for tighter monetary policy. Treasury bond yields are projected to rise to 7-7.5 percent
Good inflation reports are necessary but not sufficient to lower bond yields. Long rates will recede
only when the Fed has raised rates sufficiently and there are clear signs of slower economic growth.
With appropriate monetary tightening, the yield curve would eventually flatten from both ends and
bond yields would fall back to 6-6.5 percent




40

Shadow Open Market Committee

Mickey D. Levy, Ph.D.
Senior Vice President
Chief Financial Economist

NationsBank
NationsBanc Capital Markets, Inc.
7 Hanover Square - 15th Floor
New York, NY 10004-2616
Tel 212-858-5545
Fax 212 858-5741

ECONOMIC AND FINANCIAL PERSPECTIVES




MICKEY D. LEVY
CHIEF FINANCIAL ECONOMIST
NATIONSBANC CAPITAL MARKETS

WASHINGTON, D.C.
MARCH

7,1994

41

March 6-7,1994

I
!

S

N

A

P

S

1993

QUARTERLY DATA

I
1 Nominal GDP
GDP
GNP
Domestic Demand
Final Sales
Consumption
Residential Investment
Business nvestment
Inventory Investment
Government Spending
Exports
Imports
GDP Deflator
Employment Costs (Private)
Unit Labor Costs (Non-Farm)
Productivity (Non-Farm)
Compensation (Non-Farm)
Corporate Profits A/T
Operating Profits A/T
Net Cash Flow
1 Current Account

I

|

(a;
(a
(a
(c I

I

II

6261.6
5078.2
5080.7
5138.1
5048.9
3403.8
211.4
562.3
29.3
931.3
588.0
647.9
123.3
116.8
137.4
114.8
157.7
258.9
271.2
518.7
-22.3

11
1

6327.6
5102.1
5104.1
5177.4
5089.1
3432.7
206.2
584.3
13.0
941.1
593.2
668.4
124.0
117.9
138.2
114.7
158.5
272.3
284.8
533.7
-27.2

H

O

6395.9
5138.3
5145.8
5224.6
5131.8
3469.6
212.1
594.8
6.5
941.7
591.9
678.2
124.5
118.9
138.0
115.8
159.8
274.3
299.1
542.3
-28.0

IV

1

It

6510.8
5212.1
NA
5307.7
5199.4
3503.9
227.2
623.8
12.7
940.1
612.5
708.1
124.9
119.9
137.6
117.0
161.0
NA
NA
NA
NA

4.4
0.8
1.0
2.5
•0.8
0.8
1.5
14.4
N/A
-6.4
-2.4
11.6
3.6
3.9
4.8
-1.7
3.0
1.6
-4.7
1.1
5.5

4.3
1.9
1.9
3.1
3.2
3.4
-9.5
16.6
N/A
4.3
3.6
13.3
2.3
3.8
2.3
-0.3
2.0
5.2
5.0
2.9
-19.5

_ _
I

MONTHLY DATA

Unemployment Rate
Average Workweek (sa)
Avg. Hourly Earnings (sa)
Total Unit Auto Sales
Domestic Unit Auto Sales
Industrial Production
Capacity Utilization
PPI
PPI Ex. Food & Energy
CPI
CPI Ex. Food & Energy
Retail Sales
Housing Starts
Permits
Federal Budget
Durable Goods Orders
Manufacturing Orders
Personal Income ($87)
Consumption ($87)
I Personal Saving Rate
0 Leading Economic Indicators
Total Business Inventories
Inventory/Total Sales
Merchandise Trade
3 Month Bill
2 Year Note
10 Year Note
30 Year Bond
DJIA
S&P 500
U.S. Dollar (FRB)
Yen/$
DM/$
M1
M2
M3
C&l Loans & Non-Financial CP
I Consumer Credit

(b;
(cj |

1
(d

1
(cj
]
1
(cj
(cj
(c
(cj
(c
(cj

I

1994

Oct

Nov




Dec

53.5
110.664

55.3
110.880

57.1
111.070

6.7
34.5
10.92
9.0
7.1
111.9
81.7
123.7
135.7
145.6
153.5
178.5
1409
1304
•45.4
136.6
258.3
4283.7
3496.9
3.8
99.1
869.7
1.45
-10.9
3.10
3.87
5.33
5.94
3625.8
463.90
93.3
107
1.64
1113.4
3547.3
4203.2
742.2
775.6

6.5
34.5
10.93
9.0
7.1
112.8
82.2
123.8
136.1
146.0
154.1
179.8
1406
1374
-38.4
139.7
262.8
4300.5
3499.3
4.1
99.6
874.6
1.44
-9.7
3.19
4.16
5.72
6.21
3674.7
462.89
95.5
108
1.70
1122.4
3558.8
4216.1
740.3
782.6

6.4
34.5
10.95
8.8
7.0
113.9
82.9
123.7
136.3
146.3
154.4
182.0
1571
1476
-8.3
142.6
266.0
4322.7
3515.6
4.2
100.3
874.6
1.43
-7.4
3.15
4.21
5.77
6.25
3744.1
465.95
95.7
110
1.71
1128.5
3565.8
4228.1
NA
789.8

(a) Quarterly % changes are not annualized
(b) Monthly changes are in levels
(c) All changes are in levels or basis points
(d) Monthly: change from same month last yean

__...
I
i 1993

Jan
57.7
111.132

IV

I

M

4.4
2.9
3.3
3.7
3.4
4.4
11.9
7.4
N/A
0.3
-0.9
6.0
1.6
3.4
-0.6
3.9
3.3
0.7
5.0
1.6
-3.3

7.4
5.9
NA
6.5
5.4
4.0
31.7
21.0
N/A
-0.7
14.7
18.8
1.3
3.4
-1.2
4.2
3.0
NA
NA
NA
NA

6.0
3.2
2.9

5.6
2.9
2.9

1994

Oct

Nov

Dec

6.4
162
11
0.05
0.6
0.6

3.4
216
26
-0.24
0.0
0.1

3.3
190
2
-0.08
0.0
0.2

0.3
0.3
0.8
0.6
0.1
0.3
0.3
0.4
0.7

-2.3
-2.3
1.0
0.9
-0.1
0.2
0.2
0.2
1.2

-0.2
5.4
-5.7
2.2
1.7
0.4
0.1
0.32
0.5
0.6
-0.01
1.22
9
29
39
27
1.3
-0.2
2.3
0.8

11.7
7.4
30.7
2.1
1.2
0.5
0.5
0.05
0.7
0.0
-0.01
2.27
-4
5
5
4
1.9
0.7
0.3
1.9

3.7
0.8
0.3
0.3
-0.3
^^^^

0.6
0.5
0.2
0.3
NA
JX^g

Annual: sum of past 12 months

\
]

III

IV

5.6
2.8
2.8

4.1
3.7
3.6
2.5
2.9
2.9
3.1
3.5
3.5
13.5
5.4
8.1
10.1
10.5
11.4
N/A
N/A
N/A
-1.3
0.0
-0.9
3.0
4.0
22
10.5
9.9
9.1
2.8
2.6
27
3.5
3.6
3.7
23
24
1.8
21
1.4
1.5
4.5
3.9
3.3
0.6
6.2
20.4
3.2
10.1
26.0
0.2
3.1
8.4
-625 -35.7 -40.8

Jan

1993
Oct

3.9
2.8
3.1
7.9
14.7
N/A
-0.7
3.5
123
22
3.6
1.3
1.5
28
NA
NA
NA
NA

-17.6
-7.9
-14.2
3.7
NA
NA
NA
NA
NA
NA
NA
NA
-7
-7
-2
4
3.3
1.5
0.8
1.4

1.9
0.5
0.2
0.1
NA
NA!

j
1
1
j
1
1
1
1
]
j
1
1
1
1
I
1
1
j

1
1994 1
Jan 1

Nov

Dec

1.5

3.6

0.7

j

1.8
-1.0
-0.84
-0.3
2.2

1.8
-1.0
-0.92
0.6
25

1.7
-1.0
-0.46
0.9
28

I
1
1
1
1

8.2
127
4.1

1.7
4.8
4.6

6.6 1
9.0 1
4.7 1

1.9
0.1
0.4
2.8
3.1

1.7
0.4
0.5
28
3.2

23
0.3
0.6
29
3.2

23
0.2
0.6
2.4
29

1
1
1
1
1

7.0
14.9
14.3
-251
8.7
5.5
23
3.3
-1.22
1.1
2.9
-0.04
-3.66
20
-21
-126
-159
13.4
125
9.7
-11.7

7.6
14.7
21.0
-257
13.5
8.1
2.9
3.2
-0.47
1.4
3.3
-0.05
-1.84
-2
-42
-115
-140
13.5
9.5
6.0
-12.9

7.7
222
23.4
-226
6.1
3.6
-1.6
2.9
-4.05
1.1
3.0
-0.03
-0.44
-17
-46
-100
-119
13.3
7.0
5.8
-11.4

6.9
10.5
17.5
-240
126
NA
NA
NA
NA
NA
NA
NA
NA
-5
-25
-85
-105
18.0
8.7
4.5
-10.8

1
1
1
1
1
1
j
1
1
1
1
1
1
1
1
1
1
I
1
1
1

10.5
10.7
1.6
0.5
-0.5
5.6

7.1
10.1
1.8
0.9
-1.1
6.3

8.1
9.9
20
1.6
NA
6.6

7.9
9.7
25
23
NA
NA

I
1
1
1
1
1

6.2
1.1
62
1.7
-1.1
26 |
0.26
•0.54
0.9
0.3
0.7
25
7.8
5.0 |
4.6 | 12.9
0.4
4.1

0.2
0.2
0.4
0.0
0.1
-0.5

]

5.1 ]
2.8 J
NA j

12 Month KChang*

1993

6.7
34.8
11.03
5.6
9.3
7.8
7.3
0.5
114.4
0.4
83.1
-0.1
123.9
-0.3
136.9
0.3
146.3
0.3
154.6
2.0
181.0
3.7
1294
26
1360
3.4
15.6
2.6
147.9
1.2
NA
0.4
NA
0.5
NA
-0.16
NA
0.5
NA
0.3
NA
-0.01
NA
-0.28
NA
8
3.08
2
4.14
-3
5.75
•6
6.29
0.9
3868.4
1.0
47Z99
1.3
96.5
1.4
111
1.1
1.74
0.8
1133.6
0.1
3572.4
0.1
4231.8
-0.1
NA
(X^
NA I

\
Yr-to-YrttChanoe

III

Monthly % Change

1993
I

Purchasing Managers Index
Non-Farm Payrolls

T

Quarterly % Change (annualized)
1993

Levels

Shadow Open Market Committee
03/03/94

Chart 1
Selected Indicators: Employment and Earnings
Non-Farm Payroll Employment

90

91

92

93

94

4 i

iiiiuin

89

- Total Nonfarm Estab.: All Employees (Sa, Thous)
- Year/Year

90

20000

i

t

42

i

i

;

I

1

1
S 41

1

v v

*

v

" 'h/ 1/

40

i

;

39
89

19500

A

/i1 A / '
M/v

|

91

17500

o

r

V7<L

_ j

94

90

91

92

93

O

—)
(0
3

1

-4%

i i i i i n i i i i i i i i i i i m i u i i i i i u i i n i i i i i n m i i i i l i n i i i i i u i i.tj._l

89

-6%

94

— Manufacturing: All Employees, (SA, Thous)
— Year/Year

— Manufacturing Average Weekly Hours (NSA)

Employment/Population Ratio

Average Hourly Eamings
11.5

64

11

M
10.5

V

1

'

4.0%

jr

rU

r ^\

-

i

3.0%

t

10 i

1

r-1

! \Ar& \pJ

9.5

i

!
90

91

2.5%

—i

" 2.0%

i

89

62

3.5%
evel

'# 1 ^ .

9

0%
k.

18000

93

I !

e
>

<D

i

92

!

[l\:

2%

-2%

l l11111111 ii»111111111111 I I I i m i i m i JUJ—I

90

94

19000 h

5 18500

i"

1
Mill

93

Manufacturing Jobs

43
!

92

— Civilian Labor Force: Unemployment Rate, (SA, w/break)

Average Workweek in Manufacturing

h

91

Ann

89

Unemployment Rate

58
56

1.5%
92

93

94

54
70 72 74 76 78 80 82 84 86 88 90 92 94

— Total Private Nonfarm Establishments: Avg. Hourly Earnings
— Year/Year


http://fraser.stlouisfed.org/
NationsBanc Capital Markets. Inc.
Federal Reserve Bank of St. Louis

60

— Civilian Labor Force: Employment Rate (SA, w/break)

43

March 6-7. 1994
03/04/94

Chart 2
Selected Indicators: Income and Profits
Real Per Capita Income

Real Disposable Personal Income

3700

!

•'

\

1 3600

!

!

L

A1

4%

J\*

;MAJr^

-I

3500

'

i

3400 89

i

y

\

X

14400

2%

V
u.

>

14000

-2%
91

92

93

6%

13800

Ai
A\

I
i

1 14200
—j

(0
©

0%

i

90

14600

ver- Year

6%

3800

/

/!

4

% fe

!

(0
(D

>2%

\\SJ\,

/ V\\\

! — J — i — i — i — i — i — i — i — i — i — i — i — i — i — i — i — i — i — i — J — l —1

89

94

90

91

92

93

— Real Disposable Personal Income, ($87)

(0

0% >"

-2%

94

— Real Per Capita Income, ($87)

— Year/Year

§

— Year/Year

The Mix of Profits

Corporate Profits

89

90

91

92

— Corporate Profits with IVA & CCaadj ($Bil)

— Domestic Y/Y

— Year/Year

93

* Rest of the World, Y/Y

— Non-Financial Y/Y

Undistributed Corporate Profits

Personal Saving

80%

140

60%
120
40%

|
JZ

20% 2

5 100

0%
80 h
-20%
60

-40%
89

89

90

91

92

93

94

91

92

93

— Undistributed Corporate Profits

. Saving Rate: Personal Saving/Disposable personal income ($B)


NatkmsBanc Capital Markets. Inc.


90

— Year/Year

44

94

Shadow Open Market Committee
03/01/94

Charts
Indicators of Production
Industrial Production: Durable & Non-Durables

Industrial Production

1111111111 i i 1111111111111111^111111111111111. i . 1111•1111

89

90

91

92

93

94
- Durable Goods, (SA, 1987)
— Non-Durable Goods, (SA, 1987)

— Industrial Production Index (SA, 1987 = 100)
— Year/Year

Capacity Utilization

NAPM - Composite Index

70^
70 72 74 76 78 80 82 84 86 88 90 92 94

70 72 74 76 78 80 82 84 86 88 90 92 94
— NAPM, Composite Index

— Capacity Utilization: Total Industry

Productivity

Durable Goods Orders
20%

118
1

1

^ 10%

1

CO

>§
o

'

i

n

\J AH

0%

^ \

CO

-10%

i
1

I

1

-20%

!

'

Ii

!
A '/
K l\ r
i\ / l/l

^
I \ / V
1 I U
IN
!
!

to A l i
v

\ /Al !
1 v

!

114 I-

1/

•

90

112 i

1/
K

i

V

i
1
'

110!
108

i

92

93

2%

/
O

'
!

\
>

!

/
0%

i I, ,,

i i i i i

89

90

91

, . ....; -2%

, ,.

t i

92

93

94

— Nonfarm Business Sector: Output per hour
— Year/Year

45

£
CO
-C

1

88

94

— New Orders, Durable Goods Industries

 Markets, Inc.
NattonsBanc Capital


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1

91

>

116 u i

1 1 1 1 1 1 1 1 1 1 1 1 i l l 1 1 1 1 1 1 1 I I 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 I 1 1 1 1 I_1_1A.11 1_1 l___A_Ll_A_lJ

89

4%

!

$

March 6-7.1994
03/01/94

Chart 4
Selected Indicators: Consumption
Consumer Confidence Index

Real Consumption
140

4%

120

Year

6%

3600 r

tL

>
O

0%

100

>

©

>

ear-

2%

/V-^

80
60

3100 '—'"""""iiiiiiiimiiii.iuiiiiininiiiiiiiiiiiiiiiiiiiin -2%
89
90
91
92
93
94

40

1 1 1 11 • « I 1 1 1 1 I I t 1 1 1 11 I I I I 11 I I 1 1 1 1 t • 1 I 11 I 1

89

— Total Personal Consumption Expenditures, (82, $Mil)
— Year/Year

90

91

92

• .. I , , . I . . . 1It1

93

94

— Consumer Confidence Index, SA

Real Personal Consumption Expenditures: Services

Real Consumption of Furniture & Household Equipment
240

4%

220
3%

to

-w200
>

z

aar-ove

iL

2%

J 180
S

£

1%

160
140
89

0%
89

90

91

92

93

94

90

91

92

93

94

— Furniture & Household Equipment - Personal Consump ($87)
— Year/Year

— PCE: Services ($87) —Year/Year

Retail Auto Sales

Light Truck Sales
550
500

r

i

i

450

•

'

!

i

•
l

'

i i

< J\\

/ M

:

400
K
350 \ ' A / \ /

300

1
;
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V

250

i

i .JA/^

^

V

•

! 1
il

t

|

93

94

111111111111

89

90

91

92

89

91

92

93

94

- Total-Domestic and Imported Retail Unit Auto Sales, SA (Mil.)

- Domestic Unit Truck Sales - Light 0-10,000 lbs., GVW


NalionsBanc Capital Markets, Inc.


90

46

Shadow Open Market Committee
: 3/04/94

Chart 5
Compensation, Productivity and Unit Labor Costs
Compensation
12%

70

71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94
—

Labor Compensation Per Hour: Nonfarm Business Sector. Year/Year

Productivity

^MJM/h
-6%

I I I 1 It I t I 1 M t I I I

i 1111 »i 111

70

71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88

90

91 92 93 94

Manufacturing Sector: Output Per Hour of All Persons (SA, 1987=100) Year/Year
Nonfarm Business Sector: Output Per Hour of Alt Persons (SA, 1987=100) Year/Year

Unit Labor Cost Inflation
20%
15%
9

cn
c

*t

/~\

10%

O

I

5%

tQ
JZ

I

f°^
•

jjj^O^W

CD

or

0%

V»T

-5%
I

-10%

1 I I 11I l l i a i l J

70

1 i 1 1 _i 1 1 1 1_1_1 1 - L i l J 1 1 1 1 1 1 1 l__t_l_J_l_l_l_LJJLj-i 1 1 1 1 1 1 1 1 1 . 1 . 1 l_l 1 1 1 l L 1 l l.l 1 l.l 1 1 L 1 1 1.1 1 1 1 1 ! L i L L L L L U !

71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88


NatwnsBanc Capital Markets. Inc.


-+- Manufacturing Sector: Unit Labor Costs (SA, 1987=100) Year/Year
— Nonfarm Business Sector Unit Labor Cost, (SA, 1987=100) Year/Year

47

90

91 92 93 94

i

March 6-7,1994
03/04/94

Chart 6
Selected Indicators of Inflation
Producer Price Index

Consumer Price Index

• Total Personal PPI-U, All items (SA)
— Total Personal PPI-U, All items ex. food & energy (SA)

• Total Personal CPI-U, All items (SA)
— Total Personal CPI-U, All items ex. food & energy (SA)

Employment Costs

GDP Deflators
5%

4%

5
3 3%

^

2%
89

90

91

• GDP F.W. Deflator

92

93

94
• Compensation, Pvt Industry — Wages, Pvt Industry
* Benefits, Pvt Industry

- GDP Implicit Deflator

Commodity Prices
20%

1

»
10%

' \'

! i

'
! i ! : 1

i ! /I
r\

!;

j

A*

t

NAPM: Survey of Prices

V

0%

80

I I

70

!

-20%
89

i H i i i m n i i til

90

•

!

!

91

92

93

94

30

MJK'
| i | i
90

j

1

1

J

i

i

j j
1

• i7'

I — h n i i M l i i i l i i i i i i m i i i i i i i i n l

89

- CRB Spot Market Index
- CRB Futures Price Index
* JOC Industrial Price Index

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NationaBane Capital


rt

\i i M

40 !

'•
!
i
II i i n i l i ii 1 i l l m i n i Mi i n i n m i l

!

i

,

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! » •

IQ I I ' I
60 i
50

-10%

!

91

V

h ^-v J
>/

i i n t i n I i 111 I I i JLUm JUU.

92

X i l

93

-NAPM Survey-Diffusion Index, Prices, SA, (%)

48

ml

94

Shadow Open Market Committee

02/24/94

Table 1
Federal Reserve Objectives and Monetary Policy
I.

Selected Economic Variables (Percent Change):
Central Tendency Forecast
Q4:93 to Q4:94

Actual Performance

Real GDP
Inflation (CPI)
Nominal GDP

3 - 3.25
about 3%
5.5-6

2.8; 5.9% in 4th Qtr 1993
2.4; 2.9 ex. Food & Energy
5.1; quarterly pattern in 1993:
4.4%, 4.3%, 4.4%, 7.4%

Unemployment Rate,
4th Qtr. Avg.

6.5 - 6.75

6.7

Selected Monetary Aggregates
Monetary Growth Targets
Q4:92 to Q4:93
Q4:93 to Q4:94
Bank Reserves
M1
M2
M3

Annualized Percent Change
Last 6 Months
Year-over-Year
8.5
9.0
2.0
2.2

(not Targeted)
(not Targeted)
1-5
0-4

1-5
0-4

10.8
9.7
2.5
2.3

Source: Board of Governors of the Federal Reserve System, Monetary Policy Report to the Congress.
February 22, 1994.

Small Time Deposits

Loans Outstanding

1200

20%

7 0 0 I ii 11 n u n i n 11

88

89

ii i ii i ii i H I I I I i m m t i u i n u i ii I I I H I 11 m i l i u m

90

91

92

93

1 .30%

-20%

94

— Money Stock: Small Time Deposits-Total (SA)
— Year/Year

NatfonsBane Capital
 Marirats, Inc.


60%

88
— C & I Loans
*-NonFinCP

49

89

90

91

92

93

94

— C & I Loans Plus Nonfinancial




March 6-7,1994

M3 Velocity
NOMINAL ODFAO

'I'l'l'l'l'lT'l'i'l'

1961

50

1967

1973

1979

1985

1991

Shadow Open Market Committee
03/01/94

Chart 7
Bank Credit Conditions
Commercial & Industrial Loans

U.S. Government Securities
held at Commercial Banks

10%

88

89

90

91

92

93

94

88

89

90

91

92

93

94

— U.S. Government Securities — Yr/Yr

— Commercial & Industrial Loans, Yr/Yr

Loans to Individuals

Real Estate Loans
20%

10%

/

15%

\

!

5%
10%

!

0%

i Ni
I

j
!
u ii I I I I i m i i I I I I I I i i i i m i i

88

89

90

m u m in

H U M

91

92

93

94

— Loans to Individuals, Yr/Yr

—Real Estate Loans, Yr/Yr
NonFinancial Commercial Paper

60%

!

I
-5%

I

r\

1

Federal Reserve Evaluation of Assets of Domestic Banks
by Capital Category
Year-end

i

September

>L

/

I

1

-20%

ill

88

i

\P*

I

i
!

1

i i i i i i i i i i i n i i i i i i i i HII11111111111II1 III II III II11II11»111111111 l l l l 1 1

89

90

91

92

1992

1993

30.4

34.4

67.8

73.3

38.5

45.1

21.8

17.8

31.1

20.5

10.3

8.9

'

0%

!

1991

Undercapitalized

20%

1990

Adequately
capitalized

i

Category
Well capitalized

40%

93

94

Sourer. Board of Govmert of ¥*6tnA R—cv» Sy»t>m. Monrtwy Poicv FUoortto» •
Conor—t. F«bfuwy22.1994

— NonFinancial Commercial Paper, Yr/Yr

51
NationsBanc Capital Markets, inc




March 6-7,1994
03/04/94

Chart 8
Selected Interest Rates
Federal Funds Rate

Inflation Adjusted Federal Funds Rate

70 72 74 76 78 80 82 84 86 88 90 92 94

70 72 74 76 78 80 82 84 86 88 90 92 94

Treasury Yields

Inflation-Adjusted Treasury Yields

20
I

. till

15

Jlf r/is

<D

a 10
CL

•i

/

LAI

r

\ Vw

\

^
-10 *-*
70 72 74 76 78 80 82 84 86 88 90 92 94

70 72 74 76 78 80 82 84 86 88 90 92 94
— 3 Month Bill

— 30 Year Bond

- 3 Month Bill

- 3 0 Year Bond

Treasury Yield Spreads

Corporate Spread over Treasuries

-6 *-*
70 72 74 76 78 80 82 84 86 88 90 92 94

76

— Moody's Baa Corporate - Treasury Composite Yield


NationsBanc Capital Markets. Inc.


78

80

82

84

86

88

90

92

— Spread: 30 Year T Bond - 3 Month T Bill

52

94

Shadow Open Market Committee

TRADE DEFICITS WITH JAPAN
Charles LPLOSSER
W.E. Simon Graduate School of Business Administration
University of Rochester

For the past six months the Clinton Administration has been engaged in a steadily increasing
war of words with the Japanese to pressure them to take concrete actions to reduce their "chronic"
trade surplus with the U.S. by committing to quantitative targets for U.S. goods sold in Japanese
markets. This pressure was, in part, triggered by the finding last summer that Japan did not achieve
its previously agreed to numerical targets on the market share of U.S. imports of microchips to
Japan in 1992. Combined with a steadily deteriorating current account balance with Japan, this has
led the Administration to raise substantially the risks of a serious trade confrontation with the
Japanese in which we all would become the losers. Moreover, the threat, veiled or not, of sanctions
imposes costs on consumers and are unlikely to generate significant results. Markets are disrupted,
and uncertainty is increased.
Unfortunately the Administration seems intent on form over substance. The bilateral trade
balance with any particular country should not be of major concern to the U.S. any more than an
individual's "chronic" imbalance with their local grocery store. Moreover, even successful attempts
to pry open a few selected segments of the Japanese domestic market to foreign producers are
unlikely to have a substantial impact on the balance of trade. The recent variation in our trade
position has much more to do with our own consumption-savings choices and the relative performance of the U.S. economy over the past nine years.
Thefirstchart displays the quarterly dollar volume of imports from and exports to Japan since
1985. These figures include both merchandise trade flows and service flows. It is a mistake to
consistently focus on the merchandise trade balance just because it is produced monthly. The
predominate share of U.S. economic activity is in services and so our trade discussions should
always be on the basis of the current account From 1985 through 1990 U.S. exports rose by 2.5
times, from almost $33 billion in 1985 to over $82 billion in 1990. Over the same period imports
grew by just 46 percent from $78 billion in 1985 to almost $115 billion in 1990. This remarkable
export growth relative to imports substantially reduced our bilateral deficit with Japan. Since 1990,




53

March 6-7,1994

however, U.S. exports to Japan appear to have stagnated while imports have continued to rise
resulting in a current account deficit with Japan that is about the same (in nominal dollars) as it was
in 1986.
This pattern of current account imbalances is not unique to our trade with Japan, but mimics
the overall U.S. trade flows. The second chart shows our current account balance with Japan along
with the overall balance. As can been seen, our trading with the rest of the world excluding Japan
has followed a similar pattern but with even more dramatic swings. Our balance on current account
has deteriorated from a deficit of just over $8 billion in 1991 (an unusually small number due to
payments made in 1991 by foreign governments tofinancethe Gulf War) to a number that is likely
to exceed $107 billion in 1993. Of that nearly $100 billion swing, Japan accounts for less than $30
billion. Thus our current trade deficit with Japan is not something that is unique to Japan and so it
is unlikely to be attributable to their peculiar efforts to restrict our goods.
A primary reason for our declining trade deficit from 1986 through 1990 and for the increasing
deficit since 1991 is the economic performance of the U.S. relative to our trading partners. Slow
economic growth in the U.S. from 1986 through 1990 dampened our demand for imports relative
to our exports. This is most apparent in the case of Japan. In Chart 3 the current account balance
with Japan since 1985 is plotted along with the ratio of the U.S. industrial production index to the
industrial production index in Japan. As can be seen, the U.S. grew more slowly than Japan from
early 1987 until early 1991. Over that same period our trade deficit with Japan steadily declined.
On the other hand, as the U.S. has recovered from recession, we have grown at a significantly faster
rate than Japan. As a consequence, our demand for imports has expanded more than Japan's demand
for U.S. goods and services resulting in a widening trade deficit Until Japan recovers form current
economic slump, it is unlikely that this situation will change. Chart 4 shows that this same pattern
is apparent for the overall current account balance and the output of the U.S. relative to the countries
of the OECD who constitute our major trading partners.
Contributing to the current account deficit is the continued strengthening of U.S. industries'
competitive position and our improving domestic economy. These factors make the U.S. a particularly attractive place to invest Given that the Japanese have a significantly higher domestic
savings rate, their investments will naturally flow to those most promising opportunities, including
the U.S. The flip side of our current account deficit is thus our surplus on the capital account A
potential danger of focusing too intently on reducing the trade deficit is that even if successful we
may, as a consequence, find ourselves strapped for much needed capital if our savings patterns
don't change.




54

Shadow Open Market Committee

What would be in the U.S. best interest is to have Japan recover from their recession as soon
as possible. This would strengthen the demand for U.S. goods and services in Japan. In order to
achieve such a recovery, the Japanese must continue along the path of economic and political reform
—deregulating their markets and distribution networks. Setting numerical targets for U.S. import
penetration merely invites bureaucratic regulation and interference with no assurances of sustained
success.
There are numerous reasons why threats of sanctions such as the so-called Super 301
guidelines are unlikely to work. First, history shows that sanctions usually are answered by
retaliatory tariffs. This clearly harms both countries with consumers paying the heaviest toll. It is
rare that the cost to U.S. consumers of higher prices and less choice is mentioned in discussions to
impose tariffs or duties on imports.
Second, even when successful in prying open selected markets the effects are small, benefiting
a few companies, and are unlikely to improve the trade balance. Opening the Japanese market to
American cigarettes in 1987 resulted in increased market share of U.S. cigarette producers in Japan
but dramatically curtailed the export of U.S. leaf tobacco to Japanese cigarette manufacturers.
Getting Japan to liberalize its import restrictions on beef resulted in an increased sale of American
beef in Japan but also cut into U.S. exports of grain to Japan as that was the primary source of feed
for Japanese beef. Thus even if all Japanese markets were open it does not mean that our bilateral
trade balance would improve.
In a recent Wall Street Journal editorial, chairperson of the President's Council of Economic
Advisors, Laura Tyson, argued that a reduction in Japan's multilateral trade surplus of $50 billion
could result in as many as 100,000 to 300,000 new jobs in the U.S. Even if this were an accurate
assessment it is equivalent to little more than a couple of months of job growth in our economy.
Last year alone U.S. employment rose by over 2.5 million. Put another way, the unemployment
rate would be lowered between one and two tenths of a percentage point.
Third, sanctions seem unlikely to generate the incentives necessary for the Japanese government to fight the domestic political pressure for protection. Why do we think it is any more
likely or reasonable to expect the Japanese government to be successful in eliminating their
protection of rice farmers than we have been in eliminating our protection of honey producers, sugar
producers and other agricultural interests? This is one reason why retaliatory sanctions are often
the most frequent response to higher tariffs. Thus whatever "concessions" are agreed to are unlikely
to generate significant changes in our trade balance.




55

March 6-7,1994

U.S. TRADE WITH JAPAN

)

Jf

«-)

Millions of Dollars
40000

\:

Exports
i

5000

i

i

,

i

i

i

i

i

i i

1985 1986 1987 1988 1989 1990 1991 1992 1993
v Chart 1

TOTAL U.S. CURRENT
ACCOUNT BALANCE AND
BALANCE WITH JAPAN
Millions of Dollars
20000
10000 V

-10000
-20000
-30000
-40000
-50000




•

.

i

.

i

.

i

.

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1985 1986 1987 1988 ,,1989 1990 1991 1992 1993
.
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Chart 2

56

i

Shadow Open Market Committee

U.S. CURRENT ACCOUNT
BALANCE WITH JAPAN AND
RELATIVE OUTPUT
Millions of Dollars

>i< 1987=1.00

"7 3

-2000
-4000 L

Relative Output

A/ y

-6000
-8000
-10000 r \
-12000

Current Account

V

r

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1

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1
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r
-16000 r

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-14000
-18000

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,.^.,l,.,i, 1 , , 1 - L - A

l_a. 1

1985 1986 1987 1988 1989 1990 1991 1992 1993

0.85
0.8

v Chart 3

U.S. CURRENT ACCOUNT
BALANCE AND RELATIVE
OUTPUT WITH OECD

'/
\>
M 1987=1.00

Millions of Dollars

1.06

20000

Current Account
1.04
1.02
Relative Output
1
0.98
0.96
0.94

-50000




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1985 1986 1987 1988 1989 1990 1991 1992 1993
Chart 4

57

0.92




March 6-7,1994

58

Shadow Open Market Committee

UNDERSTANDING THE MONETARY AGGREGATES TODAY
William POOLE*
Brown University

Figure 1 shows three measures of money growth since 1989. Two of these measures, Ml
and M2, are taken directly from official Federal Reserve statistics. The third, MZM, consists of all
balances bearing no interest-rate risk and immediately available at par without penalty. My measure
of MZM is M2 plus institution-only money market mutual funds less small time certificates.1 Over
the twelve months ending January 1994, Ml growth was 9.3 percent. This rate, though down from
the rate of over 13 percent in 1992, is much higher than is consistent with low inflation. M2 growth
is now running at about 2 percent and MZM at about 5 percent. The gap between M2 and Ml
growth mostly reflects the behavior of small time deposits, which have been declining in absolute
level since early 1991.
Journalists, policy analysts, and policymakers today show little interest in data such as those
in Figure 1. They have increasingly argued that the monetary aggregates are of little or no significance for monetary policy under today's conditions. They point to the variability of the income
velocity of money after 1980, and the near zero correlation between any measure of money and
nominal GDP. They argue that monetary regularities have broken down and that money growth is
of no value to policymakers in today's world.
Although monetary behavior in the private economy has been subject to change because of
regulation and deregulation, and because people have been adjusting to an environment of lower
inflation, the most important monetary regularity that "broke down" after 1982 was the longstanding
procyclical behavior of monetary policy. Failure to understand the role of changed monetary policy
risks repeating old policy mistakes that gave rise to observed monetary regularities before 1982.
Sustained high money growth will once again—perhaps this year—create much higher growth of
nominal GDP, and much of this higher growth will appear in the form of higher inflation. My
purpose in this paper is to provide a brief explanation of why policymakers should not ignore money
growth despite experience since 1982.
Before 1980, Ml and M2 displayed similar cyclical patterns, although Ml had a somewhat
more pronounced cyclical amplitude. For almost every business cycle, both money growth and
interest rates rose during the early and middle parts of the cyclical expansion. Toward the end of




59

March 6-7,1994

each expansion, money growth declines, and a few months later interest rates reach a peak, within
a month or two the cycle peaks. Money growth typically declines into the cyclical contraction, and
then begins to rise once again. The cycle trough follows within a few months. Interest rates turn
up within a month or two of the cycle trough. In Figure 2, the business cycles before 1980 display
this typical pattern.
The typical cyclical pattern of money growth and interest rates changed after 1982, as can be
seen clearly in Figure 2. After 1982, large gyrations in money growth and interest rates occurred
without a cyclical contraction until the one beginning in July 1990. Ml growth fell in 1984 as
interest rates rose; Ml growth rose significantly in 1985 and 1986 as interest rates fell. Except for
a few months interruption following the stock market crash in October 1987, interests rates rose
from late 1986 to March of 1989 and then fell almost every month before leveling out at about 3
percent in late 1992. For interest rates to start falling and Ml growth to start rising, well over a
year before the cycle peak, is unprecedented in U.S. history, back to the first availability of monthly
estimates of the money stock in 1907.
The sustained and substantial short-run inverse relationship between Ml growth and T-bill
rate over the period after 1982 is unprecedented in U.S. history, putting aside the periods dominated
by world wars and the Great Depression.2 The typical pattern before 1982, allowing for the lag of
interest rates behind money growth, was a positive relationship reflecting the effect of money growth
on inflation and interest rates, and the usual cyclical patterns. For monthly data January 1960
through December 1982 the simple correlation between Ml growth and the T-bill rate is 0.53; for
the period January 1983 through January 1994, however, the simple correlation is -0.45.
The change in the cyclical behavior of interest rates after 1982 must be attributed primarily
to the Federal Reserve. Except for the period from October 1979 to (about) October 1992, the Fed
has always conducted policy by adjusting money market interest rates. Policy has sometimes
focused on borrowed reserves, sometimes on free reserves, and sometimes on the federal funds rate,
but these are minor variations in the basic theme of controlling money market interest rates.
A point little understood in popular discussions of monetary policy is that an implication of
optimal policy is that the relationship between money growth and GDP growth should disappear.
To understand this point, consider the simplifying assumption that the central bank is trying to
stabilize growth in nominal GDP. Now suppose we observe a high positive correlation between
money growth and nominal GDP. Given that the Federal Reserve could control money growth if
it wanted to, the high correlation would mean that the Fed is permitting variable money growth to




60

Shadow Open Market Committee

destabilize GDP growth. If; on the other hand, the Fed does the best job possible of controlling
money growth to stabilize GDP growth, then errors in hitting the GDP target are random and
unpredictable—that is, no correlation between money growth and GDP growth remains in the data.
This point seems so counterintuitive, until intuition is altered by studying the matter, that an
analogy may help. Consider the driver of a car who has a target speed of 65 miles per hour on the
interstate. Suppose the driver kept the accelerator in a fixed position. The amount of gas flowing
to the engine would be constant, but the car's speed would fall when going up hill and rise when
going down hill. Now suppose the driver (or the car's cruise control) does a perfect job of keeping
the car at 65 mph. When going up hill, the driver feeds more gas to the engine, and when going
down hill less gas. We observe constant speed and changing amounts of gas flowing to the engine.
In both these cases—fixed gas flow with variable speed and variable gas flow with fixed speed
—the correlation between the flow of gas to the engine and the car's speed is zero.
Now consider an inattentive driver on aflatstretch of interstate. Sometimes the driver feeds
too much gas to the engine and the car's speed rises to 75 mph, and sometimes the driver feeds too
little gas to the engine and the car's speed falls to 55 mph. What we observe in the data is a positive
correlation between the amount of gas fed to the engine and the speed of the car. The positive
correlation reflects the structural relationship between the amount of gas being fed to the engine
and the car's speed, all other things (such as the slope of road) being equal. This relationship appears
in the data when the driver does a poor job of controlling speed. When the driver does a good job,
the correlation disappears.
The interaction of the structure (relationship between gas flow and car speed, other things
being equal) and the controller can even lead to apparently strange results. Suppose the car has a
small engine and is pulling a heavy trailer. In the mountains, the driver puts the accelerator to the
floor when going up hill, but the car falls below 65 mph anyway. Going down hill, the driver lets
the car go about 65 mph in anticipation of slowing down on the next uphill section of road. We
observe higher gas flow to the engine when the car is going below 65 mph (up hill) and lower gas
flow to the engine when the car is going above 65 mph (down hill)—the correlation between gas
flow and speed is negative.
Clearly, an observed simple correlation between gas flow and car speed may tell us nothing
about the structural relationship between gas flow and car speed. To uncover the true relationship,
we need controlled experiments, or inattentive driving. Historically, the procyclical relationship
between money growth and GDP reflected the Federal Reserve's poor policy management After
1982, the Fed did a much better job. The Fed broke the old procyclical pattern of money growth.




61

March 6-7,1994

The extent of the changed cyclical pattern goes well beyond money growth. Fve already
noted that the peak for the T-bill rate was March 1989, which was 16 months before the cycle peak
in July 1990. The yield curve was another apparently reliable indicator in the past; the yield curve
is often inverted (short rates above long rates) at the cycle peak. In July 1990, short rates were
below long rates, which confused many forecasters and created substantial uncertainty in the fall
of 1990 as to whether a contraction was really under way.
The economy today appears to be picking up speed. It is possible that the Fed has been driving
skillfully, and that rising interest rates accompanied by much lower growth in the narrow monetary
aggregates will be sufficient to keep nominal GDP growing at about the target rate. It is also possible
that the Fed has gone over the crest of the hill with too much momentum, which will show up in
rising inflation and rising interest rates. My purpose here has not been to speculate on the future,
but to emphasize that recent money growth is highly relevant to forecasting inflation. The zero
correlation between money growth and nominal GDP after 1982 is not a good reason to ignore
money growth. Understanding why is the beginning of wisdom on this subject.




62

Shadow Open Market Committee

NOTES

*I thank Data Resources, Inc. for providing access to its data bank, from which I drew the
data for the figures.
l

I prepared short pieces on MZM for SOMC meetings in September 1991 and March 1992.

^ e correlation between monthly data for the commercial paper rate and the 12-month growth
rate of the Friedman-Schwartz M2 series was slightly negative for the period May 1908 to December
1960. This outcome is dominated by observations during the two world wars, the sharp recession
in 1920-21, and the Great Depression. An examination of a graph of the data suggests that relatively
normal subperiods are characterized by a positive correlation, but it would seem to be cooking the
book to search too hard to find such periods for the purpose of reporting some positive correlations.




63

March 6-7.1994

Figure 1
Monetary Aggregrates, Jan 1989 - Jan 1994
12-Month Growth Rate
15

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10

I

MZM •,

%

I t t i i i t t i n




1989

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1990

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64

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1992

t

i i i i i i i i i i I

1993

Figure 2
12-Month M1 Growth Rate and T-Biil Rate
January 1960 - January 1994

t

i

1960




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< i

1965

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t

1970

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1975

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1980

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1985

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1990

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1994




March 6-7,1994

66

Shadow Open Market Committee

PUBLIC DISCLOSURE AND FOMC DELIBERATIONS
Robert H.RASCHE
Michigan State University

Recently the issue of when and how to disclose the policy deliberations of the FOMC has
attracted some attention, including testimony of all seven members of the Board of Governors and
eleven of the regional Federal Reserve Bank presidents before the Committee on Banking, Finance
and Urban Affairs of the House of Representatives on October 19,1993.1 Attention is focused on
two different questions: 1) should verbatim transcripts or recordings of FOMC meetings be made
public and if so with what period of delay, and 2) should the FOMC directive be released relatively
quickly after each meeting; in particular before the next meeting of the Committee. A third issue,
the public disclosure of a measurable long-run inflation objective has not generated any noticeable
interest The focus of public discussion on the first two issues is unfortunate, since the potential
social value of the information in the third type of disclosure undoubtedly far outweighs any potential
gain from the first two types of disclosure.
There is considerable agreement in the testimony of the incumbent Governors and Presidents
in support of the status quo, namely that a release of the so-called "Minutes of Federal Open Market
Committee Meeting" shortly after the subsequent meeting of the committee is adequate public
disclosure of the committee deliberations.2 The two arguments against more detailed or timely
disclosure of information on the Committee deliberations that appear throughout the testimony are
1) that release of verbatim transcripts or recordings would seriously inhibit discussion at the
meetings or violate the privacy of individuals, corporations or foreign governments, and 2)
immediate disclosure of the directive would significantly increase interest rate volatility without
improving the effectiveness of monetary policy.
The arguments against the release of a verbatim record of the proceedings appear sound. Such
a record cannot be released immediately, since the transcript would have to be edited to insure that
confidentiality of privileged information is respected. The only alternative is to permit the committee
to adjourn to executive session to protect such information, which is likely to prove impractical.
The argument that the release of an edited verbatim transcript, even with a considerable delay,
would inhibit free discussion at the committee meetings also seems sound.




67

March 6-7,1994

The argument against the delayed release of a detailed summary of the proceedings, such as
the "Memorandum of Discussion" that was published with a five year lag before 1976 is problematic.
One Reserve Bank president indicated his personal impression that discussion at Committee
meetings in recent years is much less formal and more free wheeling than when the "Memorandum
of Discussion" was published. The published lists of individuals in attendance at the FOMC
meetings during the past year suggests that there is only a very small number of individuals who
have served under both regimes. Therefore it is almost impossible to test the hypothesis that
publication of detailed summaries inhibits free discussion of policy issues. Changes in the tone
and/or substance of the discussions over the past seventeen years can just as easily be attributed to
the personalities of the changing participants.
Several presidents noted that the delayed release of detailed summaries of the discussion
would be of considerable use to historians and scholars studying the history of monetary policy in
the U.S. and indicated that they, therefore, supported the release of such a document The recommended delays ranged from one to five years. I believe that this position should be strongly
endorsed. The format of the old "Memorandum of Discussion" protected any individual member
of the Committee from personal embarrassment It did not protect the Committee from collective
embarrassment in the event that they agreed to policy actions which subsequently can be shown to
be inappropriate based on the information available at the time of the policy decision. However,
such risk exposure is appropriate for the Committee. Without this risk exposure the Committee is
not accountable for its policy decisions in any meaningful sense.
The present situation where there is no disclosure of the details of the FOMC deliberations
seems analogous to the secrecy that surrounded research into the effects of radiation in the 40s and
50s. In recent weeks we have seen and heard revelations of tragic consequences incurred by
unsuspecting victims of radiation experimentation as a result of badly designed policy experiments
that were conducted in secret and under the presumption they would remain so forever. The only
way to avoid replication of badly designed policy interventions is to permit the public examination
of the historic policy record. Is is equally important to obtain public disclosure of all of the staff
analysis that is prepared for the FOMC deliberations as it is to obtain disclosure of the summary
proceedings. Without the supporting analyses, the information set on which the policy decisions
are based is obscure, and it is impossible to distinguish the quality of the policy decision from the
quality of the input into the decision process.




68

Shadow Open Market Committee

There appears to be general agreement among the Governors and Presidents that it is
impossible to hide any Open Market Policy Actions (that is changes in the Fed funds rate target).3
Several witnesses in the October hearings indicated that financial markets were well informed about
any decision to change policy at the latest by 11:30 AM of the day the decision is implemented,
and that the information would not be disseminated any more rapidly if the FOMC called a press
conference simultaneous with the policy action.4 The consistent theme throughout the testimony
is that immediate release of the directive precludes the adoption of any contingent policy actions.
Chairman Greenspan states:"... say that the central bank phrased its policies in terms of contingency
plans—that is if certain economic or financial conditions prevailed, a particular action would be
taken. If those decisions were made public, markets would tend to incorporate the changes
immediately, preventing the policies from being effectively carried out as planned. ...immediate
disclosure would tend to produce increased volatility in financial markets, as market participants
reacted not only to actual Federal Reserve actions, but also to possible Federal Reserve actions."5
Similar assertions are contained in the statements of Governors Angell, LaWare, Lindsey and
Presidents Syron, McDonough, Broaddus, Melzer, Stern, Hoenig, and McTeer. In each case the
proposition that immediate release (or release before the next FOMC meeting) of the directive
precludes a contingent instruction to the System Accounts Manager is stated as a fact Yet no
empirical evidence or theoretical analysis is invoked in support of this "fact" My reading is that
considerable skepticism about such a "fact" is warranted, both on the basis of theoretical models
and empirical evidence.
Considerable attention has been focused on the decline in the stock and bond markets coincident with the announced 25 basis point increase in the Funds rate target on Friday, February 4,
1994. The Dow Jones industrial average fell by 96.24 points (2.43 percent) from its close on
Thursday, February 3 to the close on Friday, February 4 and long bond yields rose about eight basis
points over the same period. It should be noted that the market reaction corresponded with the
Fed's announcement that the change in the Funds rate target had occurred. The market did not
decline on the previous Monday when Chairman Greenspan indicated in testimony before Congress
that a future increase in the funds rate was likely.
It is also inappropriate to attribute any significant effect on financial markets to the public
announcement accompanying the change in the funds rate target on February 4. The historical
record suggests that a decline of this magnitude, while large, is n£l highly unusual compared with
the behavior of the market at times of unannounced changes in the funds rate target. In a recently
published study, Thorbecke and Alami examine the behavior of equity markets between the close




69

March 6-7,1994

of the market immediately before and immediately after changes in the funds rate target during the
period September 1974 through September 1979.6 They found that on average a 25 basis point
increase in the funds rate target is associated with a 0.3 percent decline in the DJIA. However, the
standard error of their regression is quite large.7 The ratio of the residual from their regression on
February 4,1994 to the standard error of forecast for that regression is 1.87. On the basis of the
Thorbecke/Alami regression, a residual this large can be expected to occur slightly more than 6
percent of the occasions when the funds rate is increased by 25 basis points. Whatever the short-run
impact of this change, there is a long-run gain in terms of lower interest rates because of lower
inflation.
Contemporary theocratical models of both macroeconomic behavior and financial market
pricing emphasize that the behavior of private agents is conditioned on their best forecasts of future
contingencies, including contingencies about the time pattern of policy interventions. In these
models, contrary to the view expressed by Vice Chairman Mullins: "It is our actions that affect
interest rates and the economy, and those actions are made public immediately,"8 it is both actions
and expectations of future actions that affect interest rates and the economy. With an immediate
release of the directive, including possible contingent instructions, the information upon which
private agents make their forecasts of future policy interventions is increased beyond that available
under the current disclosure policy. In this type of environment the release of additional information
which clarifies the probability of contingent outcomes generally has social value. This is summarized quite succinctly in a published article by a member of the research staff of the Board of
Governors addressing the question of immediate versus delayed release of the directive:9
Suppose, however, that some one in authority (a nontrader) has information of a special
condition unknown to the traders. Assume further that this condition, when combined
with the traders' own information, implies a set of conditional probabilities which are
different from those determining the traders' expected marginal rates of substitution in
the initial equilibrium. If markets are not complete or if expectations are not homogeneous, the marginal conditions and consequent set of trades which served to maximize
expected utilities in the initial equilibrium will not generally be the same as those
maximizing expected utilities based on conditional probabilities. Consequently, there
exists another set of potential trades which could make everybody better off in terms
of improving their individual conditional expected utilities. Under the appropriate
competitive assumptions, assuming that individuals calculate the conditional probabilities correctly and ignoring wealth distribution effects, disclosure of the information
and the resultant trading will lead to the appropriate marginal conditions for
maximization of the conditional expected utilities. In this sense, we can say that public
disclosure of the information will have social value.




70

Shadow Open Market Committee

In summary, markets can be expected to function better when information about public policy
is disclosed than when it is intentionally withheld. This point about the value of public disclosure
generally seems to be ignored and made the point that markets can operate more efficiently with
more knowledge of FOMC decisions and the rationale behind such decisions.
It should be noted that the established theories of the value of additional information imply
that interest rate behavior will be different in a regime ofimmediate disclosure of the FOMC directive
than the patterns under the present regime. Furthermore, it is not guaranteed that observed interest
rate variance (volatility) will be reduced by disclosure of the directive, even if the information is
of considerable value to market traders. All the theory implies is that the conditional expectation
of interest rate variances is reduced by additional disclosure.10 Therefore, increased interest rate
volatility in a regime of public disclosure of the directive, as hypothesized by many of the Governors
and Presidents, is not evidence against the social value of immediate disclosure. At worst there is
a tradeoff: improved functioning of markets versus higher volatility of market prices.
The hypothesis that public disclosure of the directive precludes the formulation of conditional
directives is contrary to historical observations in other areas of economic and social behavior. It
is common practice for meteorological services to make conditional forecasts of various phenomenon (hurricanes, tornadoes, tidal waves) that endanger the public. No one, to my knowledge,
proposes that the system of "watches" be discontinued because such conditional statements about
future events will engender mass panics. To the contrary, most people seem to adjust their behavior
in an appropriate fashion to protect themselves from possible harm.
This carries over into the realm of economic behavior. The weather service releases long-range
forecasts and short-term warnings about weather conditions and their likely effect on agricultural
production. Such announcements have significant effects on trading on commodity futures
exchanges. The reactions of prices on these exchanges to such conditional projections is generally
regarded as socially valuable.
An additional example, which stands in direct contrast to the delayed release of the FOMC
directive, is the treatment of fiscal policy decisions in the U.S. Under our constitutional system,
the executive branch makes public proposals to the legislature about changes in tax and expenditure
policies. These proposals are then publicly deliberated through the committee process and ultimately
voted up or down by the Congress. A budget message or a tax message from the President to the
Congress is, in effect, an announcement of a conditional fiscal directive. The public announcement
of such fiscal policy directive can and does impact financial markets and other areas of economic
activity. The economic stimulus package submitted by the Clinton administration to Congress in




71

March 6-7,1994

early 1993 is an example of a conditional directive that was not implemented. I am unaware of
anyone who seriously proposes that the Constitution be amended to preclude the announcement of
any fiscal or expenditure measures until after the President had signed such measures into law. I
do not belive the Governors and Presidents who vigorously support the delayed release of the FOMC
directive would advocate such a Constitutional amendment to provide fiscal policy deliberations
in the environment presently available to the FOMC.
A final example of conditional directives is the requirement that various regulatory agencies
such as the EPA and OSHA publish proposed regulations and changes in existing regulations in
advance and to solicit public comment on such proposals. In effect this requirement amounts to
the preannouncement of regulatory directives. Regulatory changes can seriously impact certain
sectors on the economy, and indirectly affect relative prices on financial markets. Yet I know of
no serious argument to abolish the public comment requirement on the grounds that the request for
public comment may cause changes in the equity prices of certain firms that are subsequently
reversed when the regulations as implemented differ from the initial announcement
In summary, it appears that the argument for serious consequences of an immediate release
of the FOMC is difficult to support on either theoretical or empirical grounds. An entirely different
question is whether the social benefits that would accrue to immediate release of such information
are very large. In the absence of any historical experience with immediate release of the FOMC
directive, it is extremely difficult to obtain a precise answer to this question. Research into this
question concludes that the benefits are relatively small.11 It is appropriate to interpret these conclusions with caution.
There is, however, a sense in which the social gains to immediate release of the directive are
of secondary importance. Maiket participants probably can forecast the contents of a current
directive with considerable accuracy under the present regime. What is difficult, if not impossible,
is to produce accurate forecasts of inflation over longer periods of time, say five or ten years. Nothing
in the directives or other information that is publicly released by the Federal Reserve facilitates
improvement upon such long-run forecasts. It is not clear that either the Federal Reserve or the
FOMC presently have a well articulated long-run inflation policy. Rather than spending a lot of
resources debating the merits of releasing the directive before the next FOMC meeting, the Governors and Presidents could do much greater public service by debating a well defined long-run
inflation policy and articulating to the public the strategy by which this policy will be realized.




72

Shadow Open Market Committee

NOTES

*See Federal Reserve Bulletin, December 1993, pp. 1107-1127.
2

Since the first FOMC meeting in 1993, the public disclosure documents is titled "Minutes
of the Federal Open Market Committee Meeting." This document continues the directive to the
System Open Market Manager. Prior to this date, the public disclosure document carried the title
"Record of Policy Actions of the Federal Open Market Committee." The major substantive revision
associated with the change in title appears to be the addition of a complete list of individuals in
attendance at the FOMC meeting.
3

In 1967 the FOMC began releasing its "Record of Policy Actions" with a 90 day delay
(Federal Reserve Bulletin, January 1968, p. 72). In early 1975 the delay was reduced to about 45
days and in 1976 the FOMC adopted the current policy of releasing the "Record of Policy Action"
(now "Minutes") shortly after the next regularly scheduled FOMC meeting (Federal Reserve
Bulletin, June 1976, p. 552).
4

For example Vice Chairman Mullins states: "It is our actions that affect interest rates and
the economy, and those actions are made public immediately. Changes in reserve conditions are
transparent to the market by 11:30 AM on the day of the change in the open forum of the financial
market." (Federal Reserve Bulletin, December 1993, p. 1110).
s

Federal Reserve Bulletin, December 1993, pp. 1107-1108.

*Thorbecke, W. and Alami, T. "The Effect of Changes in the Federal Funds Rate Target on
Stock Prices in the 1970s," Journal of Business and Economics, 46, February 1994, pp. 13-20.
7

Thorbecke and Alami do not publish the standard error of the residuals of their regression.
I replicated the regression they report in Table 2 from the data in their Table 1 after obtaining a data
correction from W. Thorbecke.
^Federal Reserve Bulletin, December 1993, p. 1110.
9

0'Brien, James, M., "Estimating the Information Value of Immediate Disclosure of the
FOMC Policy Directive," Journal of Finance, 36, December 1981, pp. 1047-1061.
10

Ibid.. p. 1050.

"ibid, pp. 1054-60 and James M. O'Brien, "The Information Value of the FOMC Policy
Directive under the New Operating Procedures," Journal of Money, Credit and Banking, 16, May
1984, pp. 155-162.




73


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102