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APPENDIX Notes for FOMC Meeting August 12, 1980 Scott E. Pardee In the five-week period since the July 9 FOMC meeting, market sentiment toward the dollar has improved--albeit in fits and starts--and exchange rates for the dollar are now generally higher. The dollar is up by some 2-1/2 percent against the German mark and the other EMS currencies, 1/8 percent against sterling, and 2-1/2 percent against the yen. Although we intervened on several occasions when the dollar came under selling pressure, on balance the Desk acquired sizable amounts of marks and some Swiss francs from correspondents and in the market. These operations enabled the System to repay some $460 million equivalent of swap debt to the Bundesbank. This improved atmosphere for the dollar has stemmed from a combination of factors here and abroad. News on the real economy heartened the market. The trade deficit for June, at $2.3 billion, was again much better, confirming expectations that we are in a trend towards surplus in the current account, if not in the second half of 1980 at least by early 1981. Release of the latest leading indicators, showing a rise of 2.5 percent in June, prompted a burst of dollar bidding on the view that the economy may not be contracting as rapidly in the third quarter as it did in the second quarter. Several other straws in the wind have given hope that the recession would not be as deep or prolonged as many had feared. In addition, market participants felt that the less precipitous decline, if not a bottoming out of the domestic economy, would reduce some of the pressure on the authorities to take stimulative action, which would endanger the fight against inflation. In this light, the Administration's efforts to head off an early tax cut were somewhat reassuring. And, Chairman Volcker's July 22 testimony, outlining the System's targets for the rest of this year and views for next year, was well received. The 1981 targets embodied in Chairman Volcker's subsequent letter and the Senate Banking Committee's published report this past weekend, strongly in support of the Federal Reserve's anti-inflation approach, have also generated favorable comment in the market. Indeed, those in the exchange market who had been betting against the dollar on the view that the Federal Reserve would be pressed into easing have had a bad time of it in recent weeks. The shorts have been burned repeatedly as the monetary aggregates have continued to come in fairly strong and as short-term interest rates have firmed. In this context, the market accepted the Federal Reserve's full percentage point cut in the discount rate on July 25 as a technical correction, and cumulative selling pressure on the dollar did not develop. This does not mean that the exchanges are any less sensitive to movements in market interest rates. The dollar still has a tendency to decline each time the federal funds rate eases, even over the course of a given day. Looking abroad, the economies of major countries seem to be cooling rapidly, although only the U.K. and Canada are clearly in recession. Slower growth will help reduce some of the massive current account deficits being racked up by most countries in continental western Europe and Japan, but again the market's immediate focus remains on monetary policy and the outlook for interest rates. During the period, several major central banks moved gingerly away from their restrictive stances of earlier in the year. Early in August the Bundesbank began to inject additional liquidity in the money market, and although the amount of marks created was modest, the action was accompanied by an explanation by President Poehl that this was a slight easing of policy. Short-term interest rates in Germany have in fact declined a little. At about the same time, the Bank of France quietly lowered the interest rate at which it intervenes in the domestic money market. By contrast, the U.K. authorities have not been able to reduce MLR further, mainly because the removal in June of the corset on the growth of banks' liabilities was followed by an unsightly bulge in the growth of sterling M3. It grew 5 percent for the month of July, or 60 percent at an annual rate. The Japanese authorities are still holding firm but the market expects some easing of rates soon. In any event, any easing by foreign central banks is expected to be modest, in view of their concerns about domestic inflation and the need to promote capital inflows to finance current account deficits. For the same reason, foreign central banks will be pretty quick to support their currencies should the dollar strengthen very much in the exchange markets. Early in the period we intervened on several occasions in marks, French francs, and Swiss francs when the dollar came under selling pressure. Since late July the Desk has moved to acquire marks whenever we could, either through transactions with the Bundesbank, as we have in the past, with European central banks including those that have bought marks in EMS operations, or in the market at times when the dollar was buoyant. As indicated at the outset, we repaid a net of $460 million of mark swap debt, leaving the total at $683 million. The Treasury is sharing in most of these acquisitions, and although it added more than $200 million equivalent to balances during the period, it still needs some $3 billion equivalent to fully cover its mark indebtedness under the Carter notes. We also acquired some $197 million of Swiss francs for the System and the Treasury balances. With the French franc remaining strong in the EMS, we have not as yet acquired more than nominal balances against our swap debt with the Bank of France. FOMC MEETING AUGUST 12, 1980 REPORT ON OPEN MARKET OPERATIONS Mr. Sternlight made the following statement: The Desk pursued its of the Committee against a As the Desk met path needs for and sometimes policy stance. imagined it Some early light M1B and, even more, the great was also a modest background extent The further path formulations in in factor M2 . strengthening in a clues of aggregates in accommodation strength in The strength of M 2 to the about the path. aggregates slightly reserves, revisions making judgments adjustments to produce only further the of the appreciable strength and timing of technical of by small upward but a point was soon reached where was not deemed appropriate--in had found, strengthening and of reserve needs was accommodated the path and uncertainty Initially, it looked as though aggregates were growing about on track. an easier the last meeting drumbeat of restlessness in the financial markets. the market searched, reserve paths since appeared increased in our need for adjust- ment borrowing, but the combination of this slightly increased need along with a large bulge considerable firming in in 8 rate excess reserves up from its 1/2 percent lower bound above briefly, for the money market in This sent the Federal funds mittee's demand to late produced a flirtation around the August. July-early 10 percent with the Comarea or while adjustment borrowing rose from roughly $100 mil- lion area to averages around $400-500 million in the weeks of July 30 and August 6. As a result, some members of the army of Fed watchers quickly swung from near-certainty in mid-July that the System was easing to an equally firm conviction that a tightening was under way--a thesis they sought to support with evidence from weekly money and some business indicators that appeared during the aggregates interval. Other observers were not so quick to draw conclusions but nevertheless they experienced enough uncertainty or confusion to contribute to a series of skittish market reactions and counterreactions. For a series of days, it looked as though the content and timing of every Desk action was instantly analyzed, and typically misinterpreted, and some observers turned with nearly equal fervor to analyzing the absences of Fed action when they expected something to be done. In the last few days the money market has been steadier, with Federal funds hovering around 9 percent and adjustment borrowing back down to the low levels that preceded the late July rise. The very high level of excess reserves in the last two full weeks remains something of a puzzle. Conceivably, since the high excess emerged in the week that the recent large reduction in reserve requirements took effect, the excess may reflect a lag in employing some of those released reserves, but we don't really know. So far this week, it looks like a more normal level is emerging. A constructive result of the recent gyrations in sentiment, as analysts sought to overinterpret System intentions and Desk actions, is that market participants seem to have learned--for a while at least that the Federal Reserve really meant it last October when it was stated that there was less emphasis on the funds rate and that funds could move over a considerable band without it having great policy significance. However, I can think of better times to try to put this lesson across than a quarterly Treasury refunding period-it has given the market, the Treasury, and ourselves some trying moments. As for achieving our paths, it looked as of last Friday as though total reserves might average about $160 million above path for the five-week average, while nonborrowed may come out very close to path. The overrun on total reserves can be related on the one hand to the high average level of excess reserves, and on the other hand to higher average adjustment borrowings than were incorporated into the initial path. Operationally, the main thrust of Desk activity during the period was to drain the reserves released by the roughly $3 1/2 billion reduction in required reserves effective July 24. Some $875 million of bills were sold on the market that day, while on that and other days nearly $1.4 billion of bills were sold to foreign accounts and $950 million were redeemed in auctions. The total decline in outright holdings was thus about $3.2 billion. were no outright purchases during the period. There Short-term injections and withdrawals of reserves were used to cope with temporary swings in reserve availability. Over the next week or two we expect to have a need for outright reserve additions, some of which could probably be met in the coupon area. Before too long, though, we'll be having to look ahead to the large need for reducing the System's holdings again when phase-in of lower reserve requirements begins. Market interest rates backed and filled over the recent period, but ended up higher on balance. Aside from the gyrations 4 in sentiment mentioned earlier, in response to Desk moves and funds rate variations, there was an underlying caution in response to per- ceptions of greater Treasury and private sector demands for funds, reinforced by reports suggesting that the recession could be less deep and shorter-lived than had been anticipated a month or so earlier. Price news remained discouraging. The markets also took note of Chairman Volcker's testimony, which underscored the System's determination to stay the course with an anti-inflation program, and in particular not to press reserve growth aggressively over the rest of this year merely to assure that the narrow aggregates make up for slow growth in the first half. The discount rate reduction announced July 25 was accepted as "purely technical" and elicited virtually no market reaction. Treasury bill rates have risen about 65-100 basis points over the period. Three- and six-month bills were auctioned yesterday at about 8.72 and 8.89 percent,respectively, compared with about 8.21 and 8.11 percent shortly before the last meeting. The Treasury was continuing to add to bill supplies steadily during the period while, as noted, the System cut its bill holdings. In the intermediate term area, Treasury yields rose about 80-125 basis points while rates were up 80-100 basis points at the long end. The Treasury raised over $4 billion in coupon issues during the period, much of it in the quarterly refunding issues sold last week for August 15 settlement. Given the uneasy sentiment in the market during the auction period, investors shied away and dealers were left to take down large shares of the new issues. There has been some distribution since the initial take-downs but dealers 5 still have very large holdings--a total of $4 billion in over-one-year maturities, meeting. compared with about $1.8 billion at the time of the last Dealers took on their holdings price concessions, only after exacting further in view of present uncertainties, of new issues are all under water now. but their holdings If retail distribution picks up, the dealers may not fare too badly, and indeed some hope to see prices rise as distribution proceeds, but if investors hold back, the overhang of inventories could contribute to a further push up in yields. James L. Kichline August 12, 1980 FOMC information indicates Recent in the economic activity quarter. second BRIEFING is slowing, In that the rate of decline following the huge drop during in consumer expenditures are markets and in housing large measure, developments for responsible the improvement. In housing markets, of mortgage credit ability the increased level of homes increased in June starts and permits indicate July. however, and in part starts, activity the two months was signaficant element Sales of and home sales still that The still depressed rates in the housing market were bolstered by removal of sales cyclical experience, in both June and July in retail upturn in the low but up the in are quite low, sales total retail fairly widespread, but in reports constraints. auto sales during sales were To July. from the unusually some extent July auto incentive programs the credit restraint in reached a 9 million unit considerably spring. following in both turnaround--especially foreign and domestic models annual rate, Housing residential building permits four months of substantial declines terms. Sales of new and early rose vigorously in June owing to financial real influencing after a strong advance in May. Consumer outlays rose the past element will be moderate compared with past nominal and and greater avail- in recent months. forecast suggests our cost has been the key another strong rise in Permits, recovery also the reduced sales and probably by program as well. the The absence of such special forces next couple of ance. terms Even months so, of auto it leveled off it in July later fell by the drop somewhat less there and weakness other of points are months, further jobs were reliable with business information some nondurable two major in availindi- in goods. July dropped 12 percentage in the and is the drop undoubtedly capital in reflects spending. that service that the in million, indicator--remained is as aggregate decline quarter employment month, One trade substantial In part production be declines or roughly clear. Another cut another lead produc- further sizable last demand significantly. a as lumber in June. for manufacturing directions employment recent growing showed in to have The further, points peak. different a number the hous- 2.4 percent in production of rate of industrial the seem to have been In labor markets, the but total than falling below 75 percent 1979 bottoming-out index for July will not probably in seen the worst in These sectors--such in utilization pointed the related areas appears in capacity its in the July perform- this week, although available machinery output below that we've or increased. limit Nonetheless to match with an apparent industrial production able until cates likely it difficult sales and production. steel--helped The make firms auto markets, production ing and tion. for auto appears Consistent and could well extremely manufacturing the happens, there less than was during employment actually industrial sector manufacturing the workweek--a fairly low. employment continued Shipments sometimes employment; and series weakness and in of nondefense capital in goods in nominal a whole were first off collected tinues poor. percent terms in 1968. in real And the in the outlook for capital is expected since these the beginning of business to curb tories in 10 generally have moved industrial production a relatively successful of figures in May effort and by Business stocks. constant dollars were reduced and the off the year. the further backup sharp April rise, goods were in nonresidential contracts The continued contraction of employment also reflects capital outlays con- second quarter, with machinery orders Little growth spending quarter as second sharpest drop since the data were orders for nondefense terms down even more. lower since in June and for the 2.7 percent--the New construction fell inven- following the for June also suggest little accumulation at most. Given the tion than had than-expected likelihood of earlier at an recent data activity for the annual rate. rates employment and decline about 3 third percent, in housing less than last month. in constrained by high interest uncertainty regarding expect a decisive do not from peak to trough is about three staff the capital outlays continuing to activity before year-end. in real GNP the stronger- quarter--about a 4 percent drop income prospects, we upturn in overall as smaller decline than last month spending damped by and consumer stock liquida- on housing and consumption, But with the recovery contract, less appeared necessary as well is now projecting a somewhat economic somewhat quarters of The cumulative now estimated to be a percentage point -4- The in 1981. forecast continues the assumed Even with cretionary fiscal policy. 2¼ percent over expected to edge percent rate in for And the fourth tance there prices seems this year. sources is not as measured anticipate by continued with the index slowing next year. is food this large increases and energy the 8½ have in food prices. likely to time in unit inflation. labor eased assis- But supplies--and product fixed weight rapidly--at of this year. 1981 in pace by envision much period, labor to continue--especially affecting food percent is slowdown in severe underutilization of an 8 inflation improvement a considerable latter half difficult inflation in continued of It to rate is slowing Price increases increases will ease in environment of force rise by of unused physical and somewhat more rate--in the that price to still be in in progress the gross business expected to rise 9-3/4 percent is projected slight hope for any recent adverse weather index are against little some moderation and from these with the GNP a restraining quarter. largely as a result of prices energy to be billion, dis- the unemployment the high rates the balance of recently, $28 down during the year, but despite capacity. Real 1981, and Unfortunately, expected tax cut of policy is believed along with monetary about to show a sluggish recovery about a We do an resources-- the end of greater progress given the likelihood costs and high rates of August 12, 1980 FOMC BRIEFING - Edward C. Ettin As noted in the Bluebook, the evolving patterns in the monetary aggregates suggest that M-1A growth over the QIV '79 to QIV '80 period is likely to be near the low end, M-1B near the midpoint, and M-2 at--or perhaps even above--the upper bound of their respective long-run ranges. The divergence among these growth patterns raises difficult questions for the Committee's review of its short-run targets. Alternative A retains the Committee's 7 percent minimum M-1A target for June to September, a target which the Bluebook notes would imply growth of M-1B, and especially of M-2, above their 8 percent targets for the third quarter. Alternative B is designed to begin moving M-2 closer to its short-run target in order to increase the probability that this aggregate will finish the year within its longer-run range. The relation- ships are such, however, that the staff believes a sharp increase in interest rates would be required to reduce M-2 growth significantly over the remainder of the year. And such a reduction would cause M-1A growth to slow further, increasing the probability that this aggregate would fall below its longer-run target. In choosing between alternatives A and B--or even evaluating a more restrictive policy designed to lower M-2 growth significantly this quarter--the Committee may be aided by consideration of the major factors that appear to be affecting the growth patterns of each of the aggregates. The recent stronger growth of the narrow money measure appears to reflect the pick-up in rates, in nominal spending, the earlier declines in interest and a firming of the demand for cash balances after unusual weakness the second quarter. Even with the pick-up in yet returned to the lower bound of its its growth, longer-run range. M-1A has not In short, the narrow money measure does not appear to have been expanding recently at a surprising rate, but rather at a pace consistent with the expected and targeted patterns. the GNP projection implies that maintaining However, the present 7 percent or so target for the balance of the year--which would result in 4 percent growth for the QIV '79 to QIV '80 period--would be associated with some further rise of interest rates later this summer and into the fall. The alternative B pattern, which further restrains higher interest rates than assumed for the M-1A growth, would imply still staff GNP forecast. The relatively stronger growth of M-1B had, expected in of course, light of the public's shifts to ATS/NOW accounts, differential in been but the the growth rates between M-1A and M-1B since May has been somewhat larger than previously thought likely. may have been boosted in However, growth in M-1B the last couple of months by the surprisingly sharp expansion of savings deposits. have the same ceiling rate, it is Since both ATS and passbook accounts quite unlikely that bank customers have separate ATS and savings accounts; a more than normal amount of the growth in "pure" savings deposits may consequently have been captured in measure. the ATS Our projection that savings account growth will slow thus implies a narrowing gap between the rates of expansion of M-1A and M-1B in months ahead. the In evaluating the tendency of M-2 to run at or above its longerrun range, it may be of interest to the Committee that M-2 is behaving quite 1975- similarly to previous periods when interest rates declined--such as in 1970-71, 76, and 1967. By contrast, in presenting to the Committee the options for the longer-run ranges early this year, the staff had assumed that the MMC and the MMMF--which either did not exist or were relatively unimportant in previous cycles--would greatly moderate the interest elasticity of M-2. That is to say, we expected that as interest rates changed shifts among assets captured in and non-M-2 assets. M-2 would dominate shifts between M-2 assets Over the interest rate cycle more stable growth in this aggregate relative to income was expected to result. If that expec- tation was shared by the Committee, and was in fact incorrect, the M-2 target has been misspecified and larger M-2 growth would be consistent with the same degree of restraint previously assumed to be associated with a lower pace of expansion of this aggregate. Even if there was no misspecification initially, it is also possible that the behavior of M-2 this year may reflect some unusual shifts in the composition of the public's holdings of financial assets. For example, large denomination MMMF shares have been unusually strong in the last few months, perhaps reflecting substitution out of the declining volume of bank CDs. In addition, although moderating most recently, savings bond attrition has been extraordinarily large this year, and it is reasonable to assume that a significant portion of these funds were re-invested in M-2 type assets. Moreover, the recent adjustment in the ceilings for floating rate deposits has probably made these instruments relatively more attractive. And, finally, the uncertainty about the interest rate outlook may have induced a temporary shift of funds from market securities to such liquid assets as MMMF shares or even savings deposits. Such shifts between assets that are not in M-2 to those that are in M-2 do not, policy, it seems to me, but rather a shift in to events. imply a more expansionary monetary the public's asset preferences in reaction If this view is correct, efforts to slow M-2 growth in order to counter such a change in asset preferences could result in more policy restraint than may be desired by the Committee.
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