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Notes for FOMC Meeting April 18, 1978 Scott E. Pardee Since the last meeting of the FOMC, the dollar has gained resiliency in the exchange market and has even firmed somewhat over recent days. This better tone has not stemmed from an improvement in fundamentals by any means. The latest U.S. trade figures have not been encouraging. The U.S. is still without an energy bill. Recent figures show that industrial production in Japan and Germany has not been as robust as hoped. Moreover, price comparisons are less favorable than they were, with a quickening in our underlying rate of inflation while many major countries abroad continue to show progress toward greater price stability. The market’s attitude toward the dollar has nevertheless shifted away from the extreme pessimism of recent months. This mainly reflects a change in perception of U.S. policy. The various efforts of the U.S. authorities to reassure the market that they are indeed concerned about the integrity of the dollar and about domestic inflation are now generally taken to be sincere. Many market participants remain skeptical, however, that the authorities will be able to deal effectively with these problems. For the time being, at least, the rush out of dollars seems to have stopped. Even the yen has eased back in recent days, despite news of another record trade surplus for March. In general, against currencies like the yen and the mark, there is little evidence of new short dollar positions being built up, while earlier short positions may have been trimmed somewhat. The build-up in adverse leads and lags also seems to have tapered off, and the dollar’s very resiliency in the face of otherwise bad news suggests that some natural unwinding of earlier leads and lags is taking place. In addition, we have seen and heard of shifts back into dollars by central [unintelligible] other currencies. But such evidence remains scattered. With market psychology still basically negative towards the dollar’s long-term outlook, any number of adverse developments could lead to renewed heavy selling pressure. During the four week period, we intervened on only two occasions for a total amount of $120 million equivalent of German marks. Some $20 million of this was financed out of System balances. The remaining $100 million was financed by equal drawings by the Federal Reserve and the Treasury on their respective swap lines with the Bundesbank. The Treasury has now drawn the full $1 billion available under the January 4 swap facility. Procedures are now in place for the Treasury to use SDRs to acquire additional marks from the Bundesbank to finance further intervention. We have continued to pick up mark balances from correspondents and the Treasury has begun to share in the purchases, providing it with a modest cushion. Federal Reserve indebtedness under the swap line with the Bundesbank now amounts to $1,843 million. Meanwhile, the System has accumulated some $125 million equivalent of mark balances, with the result that we actually reduced our net open position by some $30 million over the last four weeks. To enable us to show some progress in unwinding swap debt in our next published report, which will cover the period February through April, we are considering making a modest swap repayment toward the end of this month. PROPOSALS AND RECOMMENDATIONS FOR FOMC APRIL 18, 1978 During the month of May, the System has nine maturing swap drawings on the Bundesbank totaling $304 million and four on the Swiss National bank totaling $50 million. I recommend that the Committee approve that these swaps be renewed. They are all first renewals. James L. Kichline 4/18/78 Introduction -- FOMC Chart Show In our briefings this morning we will be referring to the package of chart materials distributed to you. The first chart indi- cates the principal assumptions that underlie the staff's forecast of economic and financial developments. For monetary policy, the assumptions are consistent with longer-run Alternative B in the Bluebook, which incorporates a shifting forward of the base level to the first quarter of 1978. On the fiscal side, we continue to assume a $25 billion tax cut--mainly effective at the beginning of the next fiscal year--and budget outlays in line with our assumption for the past few months. At present, a great deal of uncertainty attaches to the tax assumption; the Congress may well alter appreciably the size, composition, and perhaps timing of the Administration's proposed tax program. The crude oil tax portion of the energy program also faces an uncertain fate in the Congress. The next chart displays several key indicators of recent economic activity. Retail sales and industrial production increased strongly late in the first quarter, after being depressed earlier by severe winter weather and the lengthy coal strike. Nonfarm employment continued to grow at an exceptional pace throughout the first quarter as businesses apparently have plans to add to production schedules. On the disappointing side, the merchandise trade deficit widened substantially in the first two months of the year. Over-all, real GNP growth was small in the first quarter but current indicators suggest we entered this quarter on a strong upbeat. Mr. Zeisel will continue the presentation with a discussion of domestic economic prospects and likely price developments. CONFIDENTIAL (FR) CLASS II-FOMC Materialfor Staff Presentationto the Federal Open Market Committee April 18, 1978 PRINCIPAL ASSUMPTIONS MONETARY POLICY * Growth of M1 averaging 51/4% annual rate from Ql 1978 base * Growth of M2 averaging 73/4% annual rate from QI 1978 base FISCAL POLICY * Tax cut of $25 billion in FY 1979 * Unified budget expenditures of $455 billion in FY 1978 and $500 billion in FY 1979 ENERGY PROGRAM * Wellhead tax of $3.50 per barrel on domestically produced "old" oil beginning mid-1978 CURRENT ECONOMIC INDICATORS Billions of di 1977 1978 JFM J F M 1977 1978 1978 1977 1977 1978 Change from previous quarter, annual rate, millions NONFARM EMPLOYMENT * Manufacturing -4 12 1976 1977 AUTO SALES 1978 Millions of units -- 10 Domestic Foreign 197 1976 19717 1977 1978 CONSUMER ATTITUDES Index * 100 Conference Board so80 Michigan Survey 40 40 1974 1975 1976 * Michigan Survey Research Center Index of Consumer Sentiment (1966 Consumer Confidence (1969-1970=100) 1977 Q1= 100) and Conference Board 1978 Index of BUSINESS INVENTORIES Billions Moving Average 1976 1977 1978 Ratio Inventories Relative To Sales -1.5 -J 197 1976 19717 1977 1978 I A HOMES SOLD Millions of units New and Existing 1974 1976 1975 1977 1978 OUTSTANDING COMMITMENTS AT SAVINGS AND LOAN ASSOCIATIONS 1979 Billions of dollars -30 --420 I 1974 1975 1976 1977 1978 STARTS 1979 Millions of units S2.0 1974 1975 1976 1977 1978 1979 GOVERNMENT PURCHASES OF GOODS AND SERVICES Change from previous period, annual rate, per cent S10 I ------ s ------ 0 5 1974 1975 1976 1977 1978 GOVERNMENT PURCHASES RELATIVE TO GNP 1974 1975 1979 Per cent 1976 1977 1978 CONSTRUCTION CONTRACTS REAL NEW ORDERS Billionsof 1972 dollars Millions of square feet 12 Nondefense Capital Goods 80 Commercial and Industrial Structures S10 60 S8 1974 1975 1976 1977 1978 40 1974 1975 1977 1976 BUSINESS FIXED INVESTMENT 1978 Billionsof 1 // / ^/ /0e 1974 1975 1976 1977 1978 .0 1979 Change from previous quarter, annual rate, per cent REAL GNP S1972 Dollars 10 5 0 5 10 1974 1975 1976 1977 1979 1 )78 UNEMPLOYMENT RATE Per cent -8 - 197 1974 197 1975 197 1976 19717817 1977 1978 m -6 1979 GNP PRICE INDEXES Change from previous period, annual rate, per cent Total 10 Food I I 10 FBI'I II -----------iiinnimi --------- II I 1 I I I I II -- -- - --- -- -- Total Less Food and Energy 1975 1976 1977 -5 0I r-10 r- 1974 I ' 1978 - 5- 1979 NET EXPORTS Seasonally adjusted, annual rates, billions of dollars - 20 GNP Net Exports of Goods and Services 0 Trade Balance / "' 1975 1976 1977 1978 1979 Seasonally adjusted, 19 Ratio of Foreign Real GNP to U.S. Real GNP 1974 1975 1976 1977 1978 20 - 40 -. / 1974 - 1979 U.S. INTERNATIONAL PRICE COMPETITIVENESS CPI Adjusted Foreign Exchange Value of the Dollar 1975=100 SPrice Adjusted Dollar= 10o Foreign Exchange ValueyRelative Consumer Prices 104 100 96 1973 1974 1975 1976 1977 1978 1979 1975=100 - Foreign Exchange Value' -of the U.S. Dollar - 10 104 100 Relative Consumer Prices Foreign*/U.S. 96 1973 1974 1975 1976 1977 1978 1979 *Weighted average against G-10 countries plus Switzerland using total 1972 trade of these countries. U.S. MERCHANDISE TRADE Non-Oil Imports Percentage change Oil Imports Percentage change Value Value +25.9 +19.6 -78 Price +1 0.6+11 + -Price 2 1 .6 +9.5 0 QuantityQuantity +24.6 +10.8 +5.3 0 -167 -18 0IM 1975 1976 1977 1978 Non-Agricultural Exports '79H1/781 / 781 Percentage change +25.4 [Walue + 12.2 +5.3 1976 1977 Agricultural Exports 1978 '79H1/78H1 Percentage change I I II r.I. i 1975 Value II +76 IU I +51 ,i +4.2 -0.8 +0.4 +20 -2.1 +03 +2.7 +17 Price Price +62 M +55 F.M. +9 7 - +8.1 +1.8 r! -2.3 Quantity +15.9 Quantity r9 +12.0 II -3.7 -0 3 +2.2 II +18 e Ii 1975 1976 1977 1978 791 1975 1976 1977 1978 '79H -6.1 78H1 m 1975 1976 1976 1975 +2.3 1977 1978 1977 1978 '7 , GROWTH IN GNP AND MONEY Change from previous quarter, annual rate, per cent A -15 S1 - 10 4, 1974 1975 FUNDS RAISED 1976 1977 5 1979 1978 Billions of dollars r-i 300 H S - 200 CORPORATE FINANCE Borrowing Billions of dollars CI4. Long-Term 1974 1975 1976 1977 1978 Balance Sheet Ratios 1979 Per Cent -1I Liquid Assets to Short-Term Liabilities -125 Short-Term Debt to Total Debt 1974 1975 1976 1977 1978 1979 Change from previous period annual rate, per cent - 20 - 10 -0 1974 1975 1976 1977 1978 BANK BALANCE SHEET RATIOS + 19779 Per cent Securities to Earning Assets Managed Liabilities to Earning Assets 1974 1975 1976 1977 1978 1979 - 30 - 25 Change from previous quarter, annual rate, per cent DEPOSIT GROWTH S&L's and MSB's - 15 -- 10 --A 5 1974 1975 1976 1977 1978 HOME MORTGAGE LENDING 1979 Billions K MIB Federal* and Other E ] Depositary Institutions 1974 1975 * Includes FHLBs Lending 1 1977 1978 1979 Joseph S. Zeisel April 18, 1978 FOMC BRIEFING Given the strength of the economic rebound in the past few months, we expect that by mid-year, activity will have recovered most of the first quarter shortfall. Consumer demand, supported by employment and income gains, should play a key role. The top panel of the first chart, beyond the yellow separating sheet, indicates the impressive gains in nonfarm payroll employment in the first quarter, in the face of the unusual winter weather and the coal strike. Moreover, as can be seen in the shaded section of the bars, a significant proportion of that growth has been in manufacturing employment, which had fared rather indifferently for much of last year. With the recovery of the workweek from reduced January-February levels, these employment gains are currently being reflected in stronger take-home pay. Furthermore, there are indications of consumers willingness to spend. As the bottom panel shows, car purchases--a particularly - 2 sensitive component of the consumer market--picked up strongly last month after sliding for almost a year, and the high sales rate continued in early April. The improved car sales may of course be transitory, reflecting better weather and sales-incentive contests, but as the next chart shows--consumer attitudes as measured by both the Conference Board and Michigan surveys have remained at comparatively high levels. Another sector of demand which should be supportive of industrial activity in the short-run is business inventory accumulation-- the next chart. Despite a drawdown of coal stocks, inventory investment picked up strongly in the first quarter, following a sharply reduced rate of growth late last year. Some rebound was expected since, as the bottom panel indicates, the inventory sales ratio had dropped substantially by late '77--to near the lower end of postwar experience. The latest reading for this ratio remains low, suggesting the need for further additions to stocks in coming months, even if only to maintain parity between inventories and recent increases in sales. - 3On the other hand, residential construction--shown in the next chart--appears on the verge of turning down, as we have been expecting. As the top panel shows, total home sales dropped significantly in both January and February. It is not clear how much of this may have been weather-related, but certainly the downturn in outstanding commitments at S&L's--portrayed in the middle panel--appears to foretell a weakening in starts. Given the less accommodative financial markets that appear in prospect, it looks as if housing starts--the bottom panel--will not reattain late '77 levels this year; we project starts to drop to about a 1.8 million rate by year-end, and then to level off, supported in large part by mortgage funds made available through Federal sources. The next chart illustrates another sector where the contribution to over-all economic activity is expected to be diminishing. As the top panel indicates, the rate of real growth of government purchases--Federal, State and local--is projected to be somewhat more moderate in the next year or so. The sharp drop in the Federal component - 4 -4this quarter represents a fall off in CCC payments, but the moderation in growth of government spending generally--particularly at the State and local level--reflects the smaller contribution of Federal counter- cyclical revenue sharing and public employment programs later this year. As is indicated in the bottom panel, total government purchases as a share of GNP are expected to drift down over the next year. While this would tend to have a salutory effect on the deficit, in the short-run, the result is to damp real GNP growth. With less contribution from housing and government, our outlook thus critically depends on business fixed capital outlays to help sustain the momentum of the economy beyond mid-year. While not showing all the vigor one might desire, real gains in this sector still appear likely to provide continued substantial support. As the top left panel in the next chart shows, real new orders for nondefense capital equipment have continued to trend upward, rising by close to 15 per cent since last year. Moreover, the recovery in building contracts over the past year suggests that we may finally get - 5 some significant increases in plant construction later in '78. As the bottom panel shows, we are forecasting a sustained rate of real increase in business fixed investment averaging 6-1/2 per cent at annual rates through mid '79--considerably more than the rate of GNP growth. On balance, as the next chart shows, following a strong rebound in real GNP growth of about 6-3/4 per cent in the second quarter, we are now projecting the gain in real GNP over the subsequent four quarters to average close to 4-1/2 per cent. This is slightly less than indicated by last month's projection--the result mainly of the damping effects of the greater foreign trade deficit now projected. In addition to the continued rise expected for fixed capital spending, we are projecting a better-than-average increase in personal consumption expenditures, representing in part the effects of the tax cut assumed for late this year. But as is evident in the bottom panel, we expect only a modest further reduction in unemployment--to about a 5-3/4 per cent rate in mid '79 reflecting smaller employment gains. The labor - 6 force is likely to continue up at a fairly rapid pace, since the rise in living costs will continue to influence secondary workers to seek work. As is evident in the next chart, the acceleration in prices recently--to close to a 7-1/2 per cent rate in the first half of 1978--is largely a function of higher food prices, reflecting mainly reduced supplies of meat. This situation is now expected to affect food prices through the year. But our price projections also reflect the recent and anticipated weakening of the dollar, which is expected to put upward pressure on prices of imports and competitive domestic goods. With wage demands likely to respond to increased inflation, and little chance of an offsetting surge in productivity given the moderate pace of over-all growth, there appears no hope for an easing soon of the uptrend in unit labor costs. As a result, we project the rate of inflation to continue in the 7 per cent range over the next year, about half a per cent more than last month's forecast.