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Meeting of the Federal Open Market Committee
December 11, 2001
A meeting of the Federal Open Market Committee was held in the offices of the Board of
Governors of the Federal Reserve System in Washington, D.C., on Tuesday, December 11, 2001,
at 9:00 a.m.
Present:
Mr. Greenspan, Chairman
Mr. McDonough, Vice Chairman
Ms. Bies
Mr. Ferguson
Mr. Gramlich
Mr. Hoenig
Mr. Meyer
Ms. Minehan
Mr. Moskow
Mr. Olson
Mr. Poole
Messrs. Jordan, McTeer, Santomero, and Stern, Alternate Members of the
Federal Open Market Committee
Messrs. Broaddus, Guynn, and Parry, Presidents of the Federal Reserve Banks
of Richmond, Atlanta, and San Francisco respectively
Mr. Kohn, Secretary and Economist
Mr. Bernard, Deputy Secretary
Mr. Gillum, Assistant Secretary
Ms. Smith, Assistant Secretary
Mr. Mattingly, General Counsel
Mr. Baxter, Deputy General Counsel
Ms. Johnson, Economist
Mr. Reinhart, Economist
Mr. Stockton, Economist
Ms. Cumming, Messrs. Fuhrer, Hakkio, Howard, Lindsey, Rasche, Slifman,
and Wilcox, Associate Economists
Mr. Kos, Manager, System Open Market Account
Mr. Winn, Assistant to the Board, Office of Board Members, Board of
Governors

Messrs. Ettin and Madigan, Deputy Directors, Divisions of Research and
Statistics and Monetary Affairs respectively, Board of Governors
Mr. Simpson, Senior Adviser, Division of Research and Statistics, Board of
Governors
Mr. Connors, Associate Director, Division of International Finance, Board of
Governors
Messrs. Oliner and Struckmeyer, Associate Directors, Division of Research
and Statistics, Board of Governors
Mr. Whitesell, Assistant Director, Division of Monetary Affairs, Board of
Governors
Mr. Skidmore, Special Assistant to the Board, Office of Board Members,
Board of Governors
Ms. Low, Open Market Secretariat Assistant, Office of Board Members,
Board of Governors
Mr. Rasdall, First Vice President, Federal Reserve Bank of Kansas City
Messrs. Eisenbeis and Goodfriend, Mses. Krieger and Mester, and Mr.
Rosenblum, Senior Vice Presidents, Federal Reserve Banks of Atlanta,
Richmond, New York, Philadelphia, and Dallas respectively
Messrs. Bryan, Judd, and Krane, Vice Presidents, Federal Reserve Banks of
Cleveland, San Francisco, and Chicago respectively
Mr. Weber, Senior Research Officer, Federal Reserve Bank of Minneapolis

Transcript of Federal Open Market Committee Meeting of
December 11, 2001

CHAIRMAN GREENSPAN. I would first like to welcome our new members—Susan Bies
and Mark Olson.
MS. BIES. Thank you.
MR. OLSON. Thank you.
CHAIRMAN GREENSPAN. Would somebody like to move approval of the minutes of
our November 6th meeting?
VICE CHAIRMAN MCDONOUGH. So move.
CHAIRMAN GREENSPAN. Is there a second?
MS. MINEHAN. Second.
CHAIRMAN GREENSPAN. Without objection, they are approved. Mr. Kos.
MR. KOS. Thank you, Mr. Chairman. I’ll be referring to the charts that
were distributed to you this morning. 1
The top panel on the first page shows U.S. and euro-area cash and forward
rates. The 3-month U.S. dollar deposit rate, the solid red line, is little changed
since your last meeting and as you can see the 3-month forward rate largely
tracked the cash rate. But the 3-month deposit rate 9 months forward, the red
line with narrow dashes, reflects the volatility of expectations in the past month.
First, the 9-month forward rate moved upward after release of the stronger than
expected retail sales report on November 14th. Then it declined about 1/2
percentage point after the November 27th Michigan Confidence report was
weaker than expected and comments by Governor Meyer were perceived as
keeping the door open for a further easing of policy. Subsequently, on
December 5th, that rate rose again after the nonmanufacturing NAPM index--an
indicator that generally receives little notice--rose sharply and heightened
expectations for a near-term recovery. Friday’s weak employment report did
not alter the optimism that is built into forward rates. That leaves the market in
a somewhat unusual position of having priced in a bit more ease in the near
term--indeed 22 out of 24 primary dealers expect an easing at this meeting--but
then an aggressive tightening beginning sometime in the second half of 2002.
1

The charts used by Mr. Kos are appended to this transcript.

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In the euro area the ECB reduced policy rates by 50 basis points on
November 8th, two days after the FOMC action, and cash rates--shown in the
solid green line--have been stable since then. Forward rates fluctuated mostly
in response to U.S. data. On balance, the market expects that short-term rates
probably will decline by another 25 to 50 basis points over the next few months.
As you can see in the bottom panel, interest rates in Japan remain very
low. The discussion in Japanese financial circles is about what further steps the
Bank of Japan (BOJ) can take to make policy even more accommodative. So
one might ask why forward rates are beginning to drift higher. The answer is
not fully clear. Certainly, there is no expectation that the BOJ will abandon its
zero interest rate policy any time soon. One possibility--and I stress it’s only a
possibility--is that forward rate agreements, which are obligations of banks, are
beginning to reflect a credit risk premium that is not showing up, at least not
yet, in other money market instruments.
Turning to page 2, the charts on the top half of the page depict the
volatility of Treasury yields over the past 45 days. The top left panel graphs the
2-year yield along with the target fed funds rate. The top right panel graphs the
10- and 30-year yields. In general, these yields moved in very much the same
pattern as the 9-month forward rate I mentioned earlier. They rose in early
November because of optimism about the economy, retraced that rise as the
optimism cooled, and then spiked higher despite data on some days, such as
Friday’s weak labor market report, that would typically be associated with
lower, not higher, interest rates. On balance, 2-year yields have risen a bit more
than 1/2 percentage point over the intermeeting period and the spread between
the 2-year note and the fed funds rate has risen to 100 basis points, the largest
this year. Yields on 10-year and 30-year Treasuries rose about 75 basis points.
The complaints from market participants about volatility can be supported
by the data in the bottom chart on page 2. The red line is the volatility of daily
yield changes in the 2-year note, measured in basis points on the left scale, since
February 1988. Fluctuations have been smoothed by using a 60-day moving
average. In general, during most of that period this measure of volatility moved
in a range of 3 to 6 basis points and usually between 3 and 5 basis points.
Recently, the volatility of the 2-year note was as high as 7 basis points; that
level had been approached briefly a couple of times in the mid-1990s and was
exceeded only in the late 1980s. The chart also graphs the target fed funds rate
over the same period. The relationship between the two rates is not perfect, but
casual observation suggests that spikes in volatility are frequently associated
with anticipation of the end of a monetary policy cycle or are coincident with
the beginning of a new one. For example, the volatility spike in 1992 occurred
at end of the early 1990s easing cycle and the 1994 spike coincided with the
tightening cycle that began in February of that year. Again, the relationship is
not precise and I don’t want to make too much of it. Nevertheless, it is possible

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that at least some of the volatility in recent weeks reflects indications that the
bond market is beginning to adjust to expectations that the forward markets are
taking more seriously, namely that this cycle is nearing a conclusion.
Another question is why have yields on coupon securities risen so high?
Expectations about economic recovery are certainly part of the story. The rally
in the equity market suggests that this factor is at work there as well. But it is
difficult to explain the scope and speed of the move by that explanation alone.
The second factor at work may have been positioning among dealers,
speculative funds, and other investors. A number of strategies involved going
long in Treasury bonds, especially at the short end of the curve. This worked
fine for most of the year, but the trading attracted many imitators and created
ingredients for a pronounced effect if everyone were to head for the door at the
same time. Third, corporate supply has continued at a rapid pace. And a fourth
factor cited recently is the reputed impact of hedging by large mortgage
investors. With rates rising, mortgage investors tend to sell Treasuries to
maintain their duration targets, a point I’ll talk about a bit more in a minute.
Finally, there may have been a calendar effect. November 30th is the fiscal
year-end for a number of large investment banks and December 31st the yearend for almost everyone else. With dealers scaling back positions and
individual traders protecting their bonuses, it was not an opportune time to have
large demands for liquidity from both investors and hedgers on the same side of
the market. Ultimately, the dealer community absorbed this supply but only
with a large price adjustment. Perhaps any one of these reasons alone would
not explain the fluctuations we’ve observed, but a shift in perceptions, a
position overhang, a price insensitive group of hedgers, and a risk-averse dealer
community came together at a delicate point in time.
The fourth factor I mentioned was the importance of the mortgage market.
That market has grown substantially in recent years, increasingly influencing
the Treasury market. The top panel on page 3 graphs the outstanding supply of
publicly held Treasuries and the outstanding supply of mortgage-backed
securities (MBS). Five years ago the Treasury market was twice the size of the
MBS market. Now the two are converging. And if one takes a broader
definition of the MBS market, its size is bigger still.
The bottom panel graphs the yield on the 10-year Treasury note and the
estimated duration of the aggregate MBS market from September 4th to
December 7th of this year. I should stress that this is an estimate by one
investment bank and differing assumptions regarding prepayment speeds could
change the duration, though the overall pattern should be similar. When yields
fell in September and October the duration of mortgage-backed securities also
fell, as prepayments rose and investors received cash flow sooner than
expected. In that environment, asset managers will buy Treasuries or swaps to
maintain their duration target. Even if the hedging is via swaps, ultimately
swap dealers will hedge themselves with Treasuries and the net result will be

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the same. When Treasury yields rose in November, the duration of mortgagebacked securities, shown in the blue line, rose sharply. Following their models
in such circumstances, large mortgage holders sell Treasuries, which
contributes to rising rates, which in turn extends the duration of mortgage
portfolios and leads to more selling until the process finally dissipates.
Because mortgage portfolios are managed against a duration benchmark
and because hedging behavior is driven by similar models, asset managers will
to some extent be price insensitive. If the volume of those sales or purchases is
large enough, given the set of liquidity conditions, it could influence prices in
ways that are counterintuitive to new pieces of information. That may have
been the case last Friday when the weak labor report was followed by higher,
not lower, yields. Finally, given the swiftness with which American
homeowners refinance mortgages in response to lower yields, mortgage-backed
securities are becoming more concentrated in fewer pools than in the past. And
this implies that as a mortgage pool gets closer to the point where refinancing is
economically advantageous, the impact of related hedging will be larger. As of
November 30th, mortgage-backed securities paying coupons of 6-1/2 to 7
percent represented 60 percent of the entire outstanding MBS market.
Turning to page 4 and the corporate market, the top panel graphs the
spread between A and AAA corporate bonds and also the spread between BBB
and AAA corporate obligations. On balance, spreads were relatively stable
despite the continuing large supply and the Enron bankruptcy; the BBB spread
rose slightly while the A spread narrowed. The spread of high-yield bonds to
Treasuries, not shown here, actually narrowed from 850 basis points to 715
basis points.
The bottom panel depicts changes in commercial paper spreads as the yearend approaches. The red line shows the A2/P2 minus A1/P1 spreads for 19971998. The green line is the spread for 2000-2001 and the blue line is the spread
for the current year to date. On the left side are the 30-day spreads and on the
right side the 90-day spreads. Both the 30- and 90-day spreads widened earlier
this fall after 9/11 but actually have begun to narrow more recently. And both
are narrower than in the comparable period last year. One reason, and perhaps
the main reason, is that the A2/P2 sector has shrunk substantially as many
A2/P2 companies exited their CP programs and instead issued longer-term
obligations, generating breathing room but also increasing their interest cost.
Turning to page 5 and developments in Japan, the top panel graphs the
dollar-yen exchange rate since September 3rd. The dollar has been appreciating
gradually since the BOJ’s late-September intervention and the close of the
Japanese fiscal half-year. In part, the yen’s depreciation may be due to the
performance of the Japanese economy, which has deteriorated, with few
forecasts looking forward to a strong recovery in 2002.

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Recently the dollar-yen exchange rate has also been influenced by a
boisterous, if sometimes confused, debate in Tokyo about the BOJ’s monetary
policy. Within some Japanese policy circles, the BOJ is being urged to buy
foreign bonds as a way of easing its monetary policy still further. Now,
whether the BOJ buys Japanese government bonds (JGBs) or foreign bonds, the
reserve impact in yen is the same. While stepping up purchases of JGBs may
add more liquidity and weaken the yen, buying foreign bonds is viewed as a
more direct way to influence the exchange rate. Hence, the foreign exchange
market is monitoring this very closely for signs as to whether monetary policy
and more traditional foreign exchange intervention will be converging. Adding
confusion to this mix is uncertainty about the U.S. response to the idea.
Newspaper stories have suggested that the Administration favored it, or more
subtly that a weakening yen would be acceptable as part of the broader effort to
counteract deflation in Japan.
The middle panel shows the 10-year JGB yield over that same period.
JGB yields have stayed low despite recent downgrades of Japan’s debt by both
Moody’s and S&P and despite the talk about the Bank of Japan purchasing
foreign bonds. Presumably, such an action by the BOJ would remove or reduce
the activity of a very big buyer of Japanese government debt.
The bottom panel depicts the Topix composite index, which has risen
slightly since its post-9/11 low. But the Japanese stock market has not had as
much of a recovery as those in other countries. Bank shares continue to decline,
as confidence in Japan’s ability to clean up the bad debt problem deteriorates
still more.
Finally, let me say a word on domestic reserves management. Since the
last meeting we have been building up our holdings of long-term RPs to help
meet needs associated with the seasonal growth in currency. We expect that
currency will have increased about $23 billion from its late-October level to its
peak in early January before beginning to unwind. Over this roughly twomonth period, our holdings of 28-day RPs will have risen a net of about $8
billion and are expected to peak at $32 billion or so before reverting to the low
$20 billion range by sometime in February.
Mr. Chairman, there were no foreign operations in this period. I will need
approval of our domestic operations, and I will be happy to take questions.
CHAIRMAN GREENSPAN. I’ve been hearing talk in the last week to ten days or so about
this issue concerning whether or not we, the United States government, approve of this notion that has
surfaced in Tokyo of purchases of long-term U.S. Treasuries by the Bank of Japan. We are the
government. What in fact is our opinion on this issue? I guess we’re not the government! [Laughter]

12/11/01

I know of no official who has made any comments, certainly not publicly. Has anybody spoken to the
Treasury? There are only two possible sources: Larry Lindsey at the White House or John Taylor at
the Treasury. I haven’t spoken to them about this issue. Has anybody?
MR. KOS. I have had conversations with lower level officials of the Treasury. The views
have been somewhat vague in the sense of suggesting that if the yen goes down because of actions
taken to stimulate the economy, that’s one thing. But if there’s a deliberate attempt to weaken the yen,
that would be another.
CHAIRMAN GREENSPAN. Well, how in the world can you distinguish between
purchases for one reason or the other?
MR. KOS. Absolutely, that’s the difficulty.
CHAIRMAN GREENPAN. Maybe I’ll ask somebody the question. I won’t have to ask
you, though I may have gotten a clearer answer out of you than I will from them! [Laughter]
I find this correlation between the 10-year Treasury yield and duration in the mortgagebacked securities market bizarre. It’s not a correlation that one normally sees; it’s one we see only
when one of the variables departs from the other. I look at these weekly jiggles or daily jiggles that
are occurring and I wonder what this correlation would look like if you went back to before September
4--the first observation on your chart.
MR. KOS. I haven’t looked at that. One should look at it over a decade or so and we
haven’t looked at it back that far. But I think--and this is only a hypothesis--this correlation has been
getting tighter over time and the reason relates to the trends depicted in that top chart on page 3. That
is, the mortgage market has been getting bigger and there are more methods for hedging and managing
the mortgage books. As mortgage books first of all become concentrated--and there are some very

12/11/01

large holders of mortgages out there--and as models become similar, the impact is greater both
because of the size and the technique.
CHAIRMAN GREENSPAN. In the study the change has not been that great in the last few
months. What would happen if you went back to the spring? Do you have any idea?
MR. KOS. I don’t, but that is work we will do.
CHAIRMAN GREENSPAN. My problem is that when I see somebody publish a chart like
this I know the earlier data don’t fit because if they did, the producer of the chart would show them.
[Laughter]
MR. KOS. I haven’t looked at that.
MR. REINHART. Mr. Chairman, they are highly correlated because they are functionally
related. The prepayment speed is a function of the level of mortgage yields, and given the close
relationship-CHAIRMAN GREENSPAN. Yes, I know that. Sure.
MR. REINHART. Right. And if you look at a short period where there hasn’t been much
change in the underlying pool of mortgages, that function is going to show up as much closer. If you
stretch this back over time, where there is a bigger diversity in the outstanding pools of mortgages,
then the correlation will be changing. So I think you’re right. If you take a snapshot, a relatively short
window, they are going to be highly correlated because basically you are looking at prepayment speed
for a given set of mortgages that all have similar coupons.
CHAIRMAN GREENSPAN. Clearly, the 10-year Treasury note is a crucial element in the
calculation of the option-adjusted duration.
MR. REINHART. Exactly. It’s a crucial element given the net extent of the distribution of
mortgages. In a relatively short period of time, the distribution of mortgages isn’t changing so you

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really see the function. Over time, as the distribution of mortgages changes--as some age and as
prepayments occur--then you’re going to see a weaker relationship. So when Dino and his colleagues
go back and examine this, they’ll see a shifting relationship. In any short window, though, you’ll see a
relatively close one.
CHAIRMAN GREENSPAN. Further questions for Dino?
VICE CHAIRMAN MCDONOUGH. I move approval of the domestic operations.
CHAIRMAN GREENSPAN. Without objection, they are approved. We’ll now move to
the economic situation. David. Oh, today it’s a “double David.” Karen is back?
MR. HOWARD. Yes.
CHAIRMAN GREENSPAN. Karen, I hope your mother is doing well.
MS. JOHNSON. Yes, she is, thank you.
CHAIRMAN GREENSPAN. Gentlemen.
MR. STOCKTON. Thank you, Mr. Chairman. The data that we have
received over the past month presented the usual ups and downs for us to
contend with. But before I discuss the details of our interpretation of that news,
I thought I would take this rare opportunity to make the case that, at least in
broad terms, events are unfolding just about as we had anticipated. In labor
markets, employment has been falling at a rapid clip in recent months, and the
unemployment rate is on a steep upward trajectory. As we had expected, the
manufacturing sector is bearing the brunt of these cutbacks in jobs, and factory
output has continued to drop. Overall activity appears likely to have contracted
at a moderate pace in the fourth quarter, led once again by a sizable liquidation
of inventories and ongoing declines in capital spending. These were all
important features of our November projection.
In writing down our near-term forecast, we were influenced importantly by
readings on the labor market and by the available production indicators. For the
second consecutive meeting, we received a monthly labor report only two days
after we published the Greenbook. For having devised that meeting schedule,
Mr. Kohn, your good Secretary, will not be receiving a holiday gift from the
Research Division this year! [Laughter] To be sure, Don was, as usual,
attentive to the needs of the Committee by enabling your access to these
important data before the meeting. But the schedule also virtually ensures
maximum embarrassment to those of us on the forecasting staff.

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In the event, the surprises in last Friday’s report were less embarrassing
than those of a month ago. The unemployment rate rose to 5.7 percent last
month, a steeper rise than we had anticipated. And, after declining nearly
490,000 in October, private payrolls tumbled an additional 325,000 in
November. We had been expecting a drop of about 250,000. But the report
presented some positives for us as well. The workweek rose, and total
production worker hours did not drop as much as we had been looking for. All
in all, it was a weak report. But it probably was not as weak as some of the
headline figures would suggest and, on balance, it was not materially different
from our expectations.
The events of September 11 continued to cast a shadow on the labor
market. Job losses were once again sizable in the airline industry, and levels of
employment in areas such as hotels and amusement remained depressed. Not
surprisingly, the hiring of security guards has been brisk, but this provides only
a small counterweight to losses elsewhere. Health care is the only major sector
in which job growth appears to have been unaffected by the economic downturn
this fall.
The most prominent feature of November’s labor market report was the
continued extraordinary weakness in manufacturing and related industries.
Manufacturers shed more than 160,000 workers last month, while help-supply
jobs dropped nearly 90,000 and wholesale trade employment declined 25,000.
Although the falloff in employment and hours might suggest another very large
drop in industrial production in November, we are expecting only a modest
decline--perhaps down about 1/4 percent for the month. The reason is that, in a
number of areas where hours declined significantly, we have more reliable
measures of physical product that show greater strength. Still, assuming
another moderate drop in December, IP will be off at nearly a 9 percent annual
rate in the fourth quarter, very close to the weak performance that we had
anticipated at the time of the last meeting.
This concludes the self-congratulatory portion of my remarks, and I shall
now return to a more familiar motif characterized by a combination of
confessions and excuses. There have been some developments in the incoming
data that have had important implications for our forecast going forward. While
production and labor market indicators have been coming in close to our
expectations over the past month, we have been consistently surprised by the
strength of the readings on final demand. Sales of new motor vehicles remained
much stronger in November than we had anticipated, even making allowance
for the extension of the recent incentive programs. Retail sales outside of autos
bounced back more sharply in October than expected, as did the consumption of
services. New home construction and sales have also exhibited greater
resilience than we had expected. In the business sector, shipments of capital

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goods moved up on balance in October, and the rebound in new orders was
even more pronounced.
These readings have presented us with an especially challenging signal
extraction problem. In almost every case, the rebound in October followed a
sharp drop in the preceding month that was, at least in part, related to the events
of September 11. In most of these areas, we had anticipated some
improvement, but one that was stretched out over a few months. The October
increases might just indicate that we had the timing wrong. Alternatively, the
data could be signaling that underlying final demand is stronger than we had
been thinking. True to form, our econometric and statistical filtering models
suggest that the best interpretation is probably a little of both--a quicker
snapback and stronger underlying demand. And, for the most part, that is how
we have constructed the near-term forecast; we have revised up the growth of
final sales in the current quarter, but not by the full extent of the October
surprise in the spending data.
The incoming data have led us to alter one other important aspect of our
forecast. We no longer expect an appreciable further hit to consumer
confidence stemming from the events of September 11. As I noted last month,
the extraordinary strength in car sales had given us pause about this element of
our projection, and that concern intensified over the past few weeks. Both the
continued firmness of the available measures of consumer confidence and the
actual strength we have observed in household spending led us to remove most
of the restraint we had imposed on our consumption forecast in anticipation of a
serious retrenchment in confidence.
Taken together, these changes have led us to mark up our projection of
final sales to show a 2 percent annual rate of increase in the fourth quarter
rather than the 1-1/2 percent rate of decline that we had projected a month ago.
Because we don’t see corresponding strength in production, we have revised up
our forecast for the growth of real GDP only a bit--from a drop of 2.4 percent in
the last Greenbook to a decline of 2.1 percent in our current forecast.
Obviously, this forecast requires a much sharper liquidation of inventories to
reconcile the disparate revisions we have made to the near-term outlook for
spending and for production. In the case of motor vehicles, we have some hard
evidence suggesting that this is, in fact, occurring. But outside of motor
vehicles, our projection of a $75 billion annual rate runoff of inventories in the
fourth quarter is still largely forecast, not fact.
These revisions also have implications for the dynamics of the economy as
we move into next year. The combination of more upward momentum in final
sales and deeper inventory liquidation suggests the likelihood of greater impetus
to production in the coming months. That added impetus is obscured a bit in
our forecast because we pushed back by a couple of months the second round of
tax rebates assumed in our fiscal package. But we would characterize our

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forecast as one in which the economy will be entering 2002 on a stronger note
than we thought likely a month ago.
In that regard, there are some notable upside risks to this outlook. A
significant further positive surprise to sales could cause firms to revise up their
plans for production both quickly and sharply to meet higher sales and to
rebuild depleted buffer stocks. Signs that materials prices could be firming-such as have been apparent in commodity markets in recent weeks--would
provide further incentive for these actions. With the stance of monetary policy
remaining quite accommodative, faster sales growth might also lead firms to
retrieve capital spending plans that had earlier been shelved. Add in some
knock-on multiplier-accelerator effects, and the economy could pick up a
stronger head of steam next year than we have anticipated.
Clearly, participants in financial markets appear to be expecting a more
ebullient outcome than is incorporated in the staff forecast. The increase in
rates implied by fed funds futures, the declining risk spreads, and the rise in the
stock market over the past few weeks suggest that a considerable shift in
sentiment about the economy has occurred over the past month or so. I’ll admit
that my jaw has dropped on a couple of occasions at the extent to which rates
have moved all along the yield curve in apparent response to data that we do not
see as having especially high information content. The non-manufacturing
Purchasing Managers’ report and the preliminary Michigan survey certainly
come to mind. But, I don’t think the signals from the financial markets should
be ignored entirely either.
We made an attempt in the Greenbook to gauge how large a revision in the
economic outlook would have been required to generate the shift in the path of
the expected funds rate that we have observed between FOMC meetings.
Needless to say, that exercise should be taken with an ample grain of salt. The
results suggest that financial market participants have likely revised up their
outlook significantly, but the size of that revision does not seem implausible.
So why haven’t we shared fully the market’s enthusiasm for incoming
information about the economy? I have already noted that we are a bit leery
about reading too much into what must be considered still very tentative
improvements in the spending data. Moreover, we still see considerable drags
on activity going forward. Even allowing for the recent improvement in the
stock market, the deterioration that has occurred in household net worth over
the past year and a half seems likely to restrain household spending and keep
the saving rate on an uptrend over the next year or so. In addition, our earnings
forecast does not provide much encouragement for further strong gains in the
stock market. And, while we can’t rule out a faster recovery in investment
spending, we are hearing few reports yet of a significant change in business
sentiment regarding capital spending. Finally, we do not expect the rest of the
world to provide much stimulus to activity in the United States.

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Indeed, we see a few conspicuous downside risks to our projection. The
stock market is one. The equity premium implicit in recent stock valuations has
again gotten mighty low. It is not difficult to imagine a disappointment similar
to that which occurred last summer if the recovery is weaker next year and
earnings fail to rebound with the vigor currently anticipated in the markets. We
remain worried about the possible fragility of consumer spending in coming
months. With the labor market continuing to weaken, consumers may at some
point pull in spending plans more sharply than we have now allowed for.
Perhaps we have thrown in the towel too soon on our story of deteriorating
consumer confidence. Moreover, if household spending were to sour
appreciably, it is hard to see how we would get the upturn we are projecting in
capital outlays next year.
A final downside risk to the projection concerns our fiscal policy
assumptions. Aside from the earlier-noted modification to the timing of the tax
rebate, we have not changed our package for this forecast. But it is clear that
the probability of gridlock has risen significantly over the past month.
Moreover, the possibility that a package will be enacted that is larger than the
one we have assumed also appears to have gone down. The risks to this portion
of our forecast would appear to be skewed to the downside.
With respect to our inflation projection, we have made another small
downward adjustment to our forecast for core PCE prices. The indirect effects
of lower projected energy prices, continued favorable news on inflation
expectations, and a small upward revision to structural productivity led us to
mark down our forecast of core PCE inflation by 1/4 percentage point in both
2002 and 2003. We now expect core prices to decelerate from about a 1-1/2
percent pace this year to a bit above 1 percent in 2003.
Dave Howard will now continue our presentation.
MR. HOWARD. Our overall outlook for foreign economic activity is little
changed from the outlook we had at the November FOMC meeting. We see
continued weakness in the near term, with a recovery taking hold during the
course of next year. In 2003, foreign growth is projected at about 3-1/2 percent.
Our forecast reflects importantly the projected U.S. recovery, monetary easing
already put in place by several key foreign central banks, an assumed absence
of significant spillovers from Argentina’s troubles, and stable conditions in the
oil market. The Greenbook forecast was finalized on Wednesday, but economic
developments, of course, have continued to unfold, including in two areas that
are important to our view of the global economy.
On Friday, December 7, the Japanese authorities announced that real GDP
in the third quarter fell 2.2 percent, at an annual rate, about what we had
estimated in the Greenbook. The decline in the third quarter was led by a large

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drop in private consumption expenditures, suggesting that the household sector
is weaker than has been widely believed. Private investment held up
surprisingly well in the third quarter, but recent monthly indicators point to
sharp declines in the next few quarters. The third-quarter report and the
revisions to back data that were released at the same time have not caused us to
alter our forecast of Japanese economic activity. They have, however,
confirmed our pessimism about Japan’s prospects.
Argentina’s long-running economic and financial difficulties continue. On
December 1, the Argentine authorities announced a series of measures intended
to slow the drain of funds from the banking system and from the country’s
foreign exchange reserves while the government conducts a restructuring of its
debts. These measures include limits on cash withdrawals from banks and
controls on transfers of funds abroad. Late last Wednesday, the IMF
determined that Argentina had not made sufficient progress in its adjustment
program to be eligible for the $1-1/4 billion loan tranche that Argentina had
been counting on as a means of funding some upcoming debt payments.
Argentine Economy Minister Domingo Cavallo countered with talk of
suspending payments on debts. Subsequent discussions between Argentine
officials and the IMF reportedly have produced an agreement on an additional
$4 billion in fiscal restraint in 2002. Cavallo, of course, has to deliver, and he is
likely to face considerable political opposition. Details of the new fiscal plans
are expected to be released today or tomorrow.
Financial markets so far have taken these developments more or less in
stride. Argentine spreads rose about 100 basis points between last Wednesday
and this morning. More important, at least from the point of view of the staff’s
forecast, Brazilian and Mexican spreads actually edged down during that same
period. Equity markets in Brazil and Mexico have been firm.
There are many reasons to believe that Argentina’s financial troubles will
be relatively contained. There has been a very long run-up to this crisis, and
indications are that investors have anticipated it, have diversified their risks, and
are now--and have been for a while--differentiating among emerging market
economies. Moreover, most important emerging market economies now have
somewhat flexible exchange rate regimes, which eliminates one area of
vulnerability. There are, of course, many reasons to worry as well: Emerging
market economies have a history of crises; policies in these economies are far
from perfect; and, given the current delicate state of global economic
conditions, emerging market economies at the moment would seem to be
particularly susceptible to adverse shocks to confidence.
CHAIRMAN GREENSPAN. Questions for our colleagues? President Poole?

12/11/01

MR. POOLE. When I look at the details of the forecast, clearly the timing of the consumer
recovery is an important piece of this story. And I think your forecast has a significant increase in the
saving rate in the first quarter of next year and a continuing negative on consumer durables, which I
assume is a good part automobiles. Now, one of the things that struck me is that the nature of labor
contracts in the auto industry essentially has turned a lot of labor costs into fixed costs. I don’t quite
understand the past behavior of the industry, but one of the reasons why I suppose they were so
willing to introduce all these incentives was that they were stuck with those labor costs anyway, so
why not get something rather than nothing. Presumably that motivation would continue in the first
quarter and thereafter, so if the underlying demand is on the soft side we might see another round of
incentives of some sort. Does that argument make sense? And if so, how much weight would you put
on it in terms of the shape of the durables part of the forecast?
MR. STOCKTON. That argument certainly makes sense. It is actually an issue that we
have struggled with and in some sense we revised up our forecast a bit in the face of both the response
to the strength in auto sales and what we can see happening with motor vehicle production going
forward. In our view, however, that would not imply that there won’t be any adjustment on the
production side. We think that may mute the production adjustment, and in our forecast we have
production falling in both the fourth quarter and the first quarter before leveling out in the second
quarter of next year. In part we have followed what we are hearing from the automakers themselves,
which is that they are going to be extending downtime during the Christmas holiday period, and that
some of these production cuts are actually going to occur. But, when push comes to shove early next
year, it’s unclear whether or not they will decide to extend the incentives for an even greater period of
time. I think it is certainly a possibility and it’s an upside risk to the projection both of auto sales and
auto production that we’ve built into this forecast.

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CHAIRMAN GREENSPAN. Vice Chair.
VICE CHAIRMAN MCDONOUGH. At our board meeting last week at the New York Fed
we had a considerable discussion about the possible effect on the economy of additional terrorist
activity. My own view is that the big surprise of 9/11 was that we thought it couldn’t happen here and
that if there is more terrorist activity, the American people will respond quite strongly. Do I gather
correctly that your forecast essentially says either that there will be no terrorist activity or that if there
is it will not have a significant effect on demand?
MR. STOCKTON. I think that is exactly what is implicit in this forecast. As I believe we
noted at the time of the October meeting, we just didn’t know how to cope with such an event in the
forecast other than to make the assumption that it won’t occur or that if it does, it won’t have a big
effect. But that clearly looms out there as an enormous uncertainty. We just didn’t see any way in
which we could sensibly provide any value added by trying to build in such an event into the forecast.
CHAIRMAN GREENSPAN. President Jordan.
MR. JORDAN. Thank you. David, as always, I can’t quarrel with the baseline forecast
because I don’t have an alternative that is more convincing or in which I have more confidence. And I
always find the alternative simulations and assumptions that you provide to be useful. But this time
more than usual I have a problem reconciling the policy assumption in the baseline forecast with the
forecast itself. It’s not that I’m convinced that the forecast is wrong. But if it is correct, I have trouble
understanding the policy assumption. Or if the policy assumption turns out to be correct, I don’t see it
as consistent with this forecast. Maybe you’ve answered my question in your forward-looking
futures-based scenario in the Greenbook. But let me at least try with you a mental exercise that I
would have wanted to run. And that is, imagine that we get to October of next year and that you have
nailed the forecast exactly. Nominal GDP accelerates in the second quarter as you have it; in the third

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quarter it goes to 6 percent and real GDP is up to 4-1/2 percent as you have forecast. And suppose all
of the associated information that would have been released on a weekly and monthly basis goes along
with that kind of forecast. In that environment, I think the 30-year rate and the 10-year rate would
have marched somewhat higher as that scenario unfolded. Certainly the 2-year rate would have
marched higher and I expect that 3-month and 6-month yields would be considerably above where
they are today. Then I try to imagine your producing a forecast that says yes, all that has happened
and the 2 percent fed funds rate is still correct. I can’t get that to square because to me a ceiling on the
funds rate of 2 percent would produce an explosive increase in the monetary base, assuming that all
the rest of the data come out exactly as in the baseline.
MR. STOCKTON. Where I might differ with your presumption of how these developments
could unfold is with respect to long-term interest rates. We think a couple of things are going on
there. One is that we would expect, if the Committee were not raising interest rates as much as the
markets currently expect--or as the markets began to realize that the outcome was not going to be as
strong as they currently anticipate--that there would be some subsidence in long-term interest rates.
The way in which we thought about our policy assumptions was that, through 2003, we saw an
economy that was still running with a considerable degree of slack in resource utilization and one in
which inflation was still headed lower. Therefore, the imperative to raise rates would not be so clear
that we were going to build it into our forecast by the second half of 2002. As you know, we do have
rates on an uptrend in 2003 as the economy gathers even more strength and as the unemployment rate
begins to turn down. Even then, the environment is still one in which we would expect to see some
deceleration in overall measures of inflation.

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MR. JORDAN. But your answer suggests that the consensus private sector forecast is for
even stronger growth than in your baseline forecast of 4-1/2 percent real GDP in the third quarter and
6 percent nominal. That’s not what I saw in the last Blue Chip forecast.
MR. STOCKTON. Yes, indeed. But I don’t think the Blue Chip forecast or our forecast is
consistent with what is currently built into fed funds futures. In some sense the experiment that we
tried to construct in the Greenbook was to ask how much of an upward revision would the markets
have had to make in their outlook. Now, that wasn’t designed to tell you what the markets’ forecast is.
I don’t really know for sure what it is. But my guess is that it would have to be stronger than the one
we’re showing to justify the markets’ expectation of a more aggressive tightening action by the Fed as
early as they see it. So that would say that the consensus private forecast is probably closer to the
Greenbook than what appears to be embedded in financial markets now.
CHAIRMAN GREENSPAN. President Moskow.
MR. MOSKOW. I had a question on the stimulus package. You identified rather clearly
what the short-term benefits are, and you obviously placed a lot of emphasis on that. I was just
wondering if you’ve given any thought to the longer-term impact of this package beyond the forecast
horizon, particularly as it would affect multifactor productivity and capital deepening. Are there any
longer-term costs involved that we should be thinking about?
MR. STOCKTON. I don’t think there are very significant longer-term costs in the package
we have designed. We have designed a package that we thought was sensible--and we still do think
it’s quite sensible from an economic perspective. Whether it makes any sense politically is a different
matter. It was designed to provide stimulus for the economy over the next two years without imposing
long-term budgetary costs. Most of the items that we have built in--the temporary investment
incentive, which has a big effect, and the one-time sets of tax rebates--obviously would go away. So

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we don’t really see those as necessarily having longer-term budgetary consequences. Now, one could
certainly imagine that something might be labeled a short-term stimulus for the economy that really
would impose longer-term budgetary costs. Obviously, any kind of permanent change in either
spending or taxes would feed forward and would produce bigger effects on long-term interest rates,
more crowding out of private investment, and therefore less capital deepening going forward. But
that’s not what’s in our forecast.
CHAIRMAN GREENSPAN. But I think the question was more related to what I assume is
the effect of moving up a tranche of capital investment and getting an earlier technology.
MR. STOCKTON. Yes.
CHAIRMAN GREENPAN. And presumably that’s suboptimal from a market point of
view, but the question basically is whether the effect is big enough to make a difference.
MR. STOCKTON. The suboptimal part I’d say would be of a second order. Certainly in
the longer run, because that package goes away, the cost of capital is not affected. You’d still have the
same capital-output ratio over the longer haul and the same level of productivity at some point.
CHAIRMAN GREENSPAN. The capital-output ratio is the same but the composition of
the capital may not be optimal or as effective as-MR. STOCKTON. Certainly to the extent that temporary tax policy is used to provide the
stimulus, private decisions are distorted in the short run, and we would have a suboptimal capital
stock. But I think that would be a pretty small effect.
MR. MOSKOW. Have you actually done any analysis on this, David? Is there anything
written--any papers or studies--on it?
MR. STOCKTON. Well, since the proposal of some kind of temporary tax incentive was
put forward, we’ve been working hard to develop the analytical apparatus. Obviously we have a

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couple of problems in doing that. One is that there just aren’t enough observations in the data to
justify thinking that we’re going to be able to estimate this very precisely. So what we did was to use
several different analytical models, parameterized to replicate some of the key features of the
economy, and then we tried to examine how sensitive the outcomes that we get are to the assumptions
that we have made. What we put in the forecast I’d say would be consistent basically with both
“putty-putty” types of models of investment and the “putty-clay” models of investment. But there can
be big differences, depending upon the cost of capital adjustment. This relates to some of the issues
that we talked about in the productivity presentation at your meeting last June; some of those
parameters can make an important difference in the size of this effect. We don’t have any research
papers on this currently available but it’s something that we will have to continue to work on.
CHAIRMAN GREENSPAN. President Minehan.
MS. MINEHAN. Let me explore a couple of related issues. Dino talked about the different
explanations various market participants are giving regarding the jump in the yield curves. A couple
of people that I’ve talked to in the Boston area really have been affected, in terms of the way they look
at the market, by the level of volatility. They view the uncertainty quotient relating to some of the
yields as significant, particularly on the bond side where they see a market that is not as deep because
of corporate supply conditions. On the equity side, the question of how to interpret what the equity
markets are saying is a very interesting one, given the drop in inflation expectations and the rise in
equity prices and in yields on the bond side. I’m wondering whether, if instead of extreme optimism,
we’re seeing as well a degree of real uncertainty. There’s perhaps a desire to climb on and not be left
behind but also--if one combines the volatility and the lack of depth of markets--some underlying
uncertainty about where things are going. Those market moves may not be as clear a message of
strength as one might be inclined to interpret them. I wonder how one factors that into one’s thinking.

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A related issue, I think, involves what you said in answer to President Jordan’s question
when you talked about excess capacity and your forecast of the unemployment rate and a declining
rate of inflation even into 2003. The declining rate of inflation is at odds with most of the other major
forecasts and may be at odds with the way the market sees it as well. Could you comment on both of
those points?
MR. STOCKTON. With respect to the financial markets’ assumptions, to the extent that
some of the factors that Dino cited have been at work, one wouldn’t necessarily expect those to persist
over the next two years.
MS. MINEHAN. Right.
MR. STOCKTON. And in some sense we have not level-adjusted our forecast for all of the
recent upward movement in long-term interest rates on the assumption that some of that will fade
away over the course of the first half of the year, as the situation becomes clear. So that volatility goes
down.
On the stock market portion of it, I don’t want to pretend for a moment that our baseline
assumption was any better than the other two that we put into the Greenbook as alternatives. We
certainly have had five years of experience with forecasting either flat or declining stock markets only
to be consistently surprised to the upside. Could that happen again? Could that be the process that
we’re starting to see, or are equity market participants just looking beyond the near term? Maybe they
are just better able to look through this near-term disappointment in profits that we see occurring and
are willing to anticipate a stronger rebound in both activity and earnings down the road. I think that’s
a real possibility. I also think, given how low the equity premiums have gotten, that there is still
downside risk in that portion of our forecast.

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With respect to inflation, we see the environment on the pricing side as one in which core
measures are more likely to be going down than up. We’re already seeing what we think is the front
edge of some deceleration in compensation. We think both structural and actual productivity are
likely to improve somewhat over the forecast period. We made a small nod in the direction of some of
the good news that we’ve received on inflation expectations. And the energy markets also suggest that
the indirect cost pressures coming from energy are likely to subside some. So when we put that
together, despite the fact that there is some reacceleration of activity, it looks to us as if there will still
be little upward pressure--and more likely downward pressure--on inflation going forward.
MR. REINHART. Just an observation, President Minehan. It is certainly true that if you
look at implied volatilities on bond contracts, either the 10-year or the long-term Treasury securities,
they are very much elevated. They are in a range we haven’t seen since 1993; in some way it’s similar
to the observed volatility that Dino showed in his presentation. But the implied volatilities have come
off in the stock market, so it isn’t obvious-MS. MINEHAN. Yes, it was the bond market volatility.
MR. REINHART. It isn’t obvious that the equity markets are more uncertain now than they
were for most of this year. And in the Greenbook financial projection David didn’t respond
completely to the run-up in long-term yields over this intermeeting period in the same way he didn’t
respond completely to the remarkable and inexplicable decline in the previous intermeeting period that
was associated with changes in Treasury debt management. So if I were to add to your and Dino’s list
of market-specific events that have affected the amplitude of the swings in yields, I think I would also
have to include the discontinuation of the 30-year bond.
MS. MINEHAN. Yes.

12/11/01

MR. REINHART. So some of the run-up we’ve gotten in this period reflects some rollback
of what we saw last year.
CHAIRMAN GREENSPAN. How far are we from inserting some mortgage-backed
security duration variable in our macro model?
MR. STOCKTON. Far enough that I don’t care to comment! [Laughter] I don’t see any
immediate prospect.
CHAIRMAN GREENSPAN. I’m wondering because this conversation is leading us in a
very peculiar direction. What concerns me about it is that we are seeing this very high sensitivity to
long-term mortgage rates, for example in the extraction of home equity that tends to lead promptly to
consumption expenditures. I wonder whether or not we’re going to find that the convergence of those
two lines on the stock-of-debt chart--Treasury and mortgage-backed securities--may have some
macroeconomic significance. I hate to find us doing macro simulations and then orally commenting
on why it doesn’t work in these terms. At some point you’re going to want to put a variable in there
hopefully to capture this.
MR. REINHART. All the macro simulations you will care about will be at the shortest a
quarterly frequency; and probably you’ll really only want to think about it in terms of year-by-year
effects. A lot of these market mechanisms, including the changes in the duration of mortgage-backed
securities, affect the amplitude of interest rates in a relatively short period. But I’m not willing to say
that the level of the long-end of the yield curve is noticeably higher because of these mechanisms
relative to a year ago-CHAIRMAN GREENSPAN. I know you’re not because it’s not in the forecast! [Laughter]
MR. STOCKTON. Well, we’d still think those longer-term rates would be strongly linked
to saving and investment flows in the economy. That would be important. I will anxiously await

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Dino’s further research on this correlation between the option-adjusted duration and the 10-year
Treasury. I wouldn’t want to ignore an important piece of forecasting information here.
VICE CHAIRMAN MCDONOUGH. That research project got shifted to New York!
[Laughter]
CHAIRMAN GREENSPAN. President Parry.
MR. PARRY. I’d like to ask two short questions. The first one is to Dave Stockton and
perhaps Don Kohn. In the Greenbook and also the Monday morning briefing there was a report about
the Michigan survey of one-year-ahead inflation expectations, indicating that it dropped to 2.8 percent
in September, to 1 percent in October, to 0.4 percent in November, and then bounced back to 1.6
percent in December. It seems to me that there’s some potentially very interesting information there.
After all, we’re very much interested in what is happening to the real federal funds rate. I just
wondered how those data, admittedly volatile but still considerably below what we have been looking
at in the recent past, are influencing your views about the real interest rate as far as the fed funds rate
is concerned?
MR. STOCKTON. Well, certainly, the point we were trying to make in our briefing was
that we also find this very interesting. We pretty much wrote those data off when they dropped those
first two months, thinking that it was completely outside historical experience. We were inclined to
think it was a fluke. The longer the decline persisted the more we felt that we needed to at least
consider the possibility that it was giving us some information about a drop in inflation expectations.
MR. PARRY. So, you don’t think policy is as easy as you previously thought?
MR. STOCKTON. Well, maybe Don will want to comment as well. But I certainly don’t
think that there has been a 2-1/2 percentage point rise in real short-term interest rates as perceived by
anyone involved in spending decisions at this point. However, the survey results might be, on the

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margin, a reading that you would want to take on board in assessing the stance of policy--just a piece
of an inflation forecast that should not be completely ignored from the perspective of the current
setting of policy.
MR. KOHN. I certainly agree with what Dave said. And the fact that long-term inflation
expectations haven’t changed very much would lead one to discount this survey result a bit. The
question would be whether the implied rise in real short-term rates is exerting upward pressure on
intermediate- and long-term rates. But I think we can explain--more or less as President Minehan and
Dino have tried to do--why those long-term rates have risen through just the general optimism plus the
volatility. I don’t think, as yet anyhow, that a rise in real short-term rates is putting upward pressure
on real long-term rates. But if inflation expectations were to continue to edge lower, that would be
something you would need to take account of in assessing the stance of policy.
MR. PARRY. I’d also like to ask Dave Howard a quick question. The revision to the
forecast for Japan is pretty stunning, particularly real growth being revised down 1/2 percent in 2002.
In addition, there’s deflation in every quarter through 2003. One has to begin to wonder about the
impact of this in the financial sector. My question is: What is your current view about the
probabilities of a crisis in the financial sector in Japan in light of this possible forecast outcome for the
next two years?
MR. HOWARD. I think it’s safe to say that it is a major risk. We have the Japanese
economy coming back a bit toward the end of the period, mainly because world economic growth
picks up. The Japanese do not yet appear to be fully ready to take the kinds of measures that need to
be taken to remedy their problems. We see the problems sort of simmering there for the indefinite
future I’m afraid, and certainly through the forecast period.
MR. PARRY. Thank you.

12/11/01

CHAIRMAN GREENSPAN. President Minehan.
MS. MINEHAN. Just one follow-up question. I wasn’t very clear before on the issue of
the drop in inflation expectations. With inflation being a measure of resource capacity use--whether or
not we have excess capacity--is it possible that the declining inflation expectations are telling us
something about people’s expectations about unemployment rates and pressures on capacity in the
future that is significantly different from what the stock market is telling us about the optimism for
real growth?
MR. STOCKTON. It could be, except that in the same survey from which those inflation
expectations are drawn the unemployment expectations haven’t really deteriorated as much.
MS. MINEHAN. They haven’t dropped at all?
MR. STOCKTON. They have deteriorated some but nowhere near as much as one might
have imagined if the outlook for inflation were the primary motivation. It could just be that people are
thinking that 2002 will be an excellent year in terms of low consumer prices. Obviously, people could
be hearing about zero percent financing for autos, great deals on airfares, and lots of discounts in the
stores. I think it’s perhaps more a reflection of that than of some enormous shift in their views about
the economy going forward, which have been relatively firm.
MR. KOHN. The longer-term inflation expectations embedded in the yield curve dipped
right after the September attacks, hit a low point at the end of October, and have come back up again.
But on balance they haven’t changed appreciably since last summer. So they’re not showing the
same-MS. MINEHAN. The same bounce as the shorter-term expectations.
CHAIRMAN GREENSPAN. President Jordan.

12/11/01

MR. JORDAN. On that same point, Dave, in the Michigan survey the 5-to-10-year
inflation outlook didn’t budge. And the survey that our people do together with the folks at Ohio State
University showed the same thing. That survey indicated a very near-term drop in inflation, which
correlates with people’s experiences at the gas pump and with rebates and so forth, and zero change in
the longer-term expectations. Measures of inflation expectations beyond a year or two don’t seem to
have moved at all.
CHAIRMAN GREENSPAN. Further questions for our colleagues? If not, who would like
to start the Committee discussion? President Parry.
MR. PARRY. Thank you, Mr. Chairman. Economic conditions in the Twelfth District
have been weak, but there were a few signs of improvement recently. It’s now clear that the terrorist
attacks severely damaged economic conditions in tourist-dependent areas. In October, travel-related
employment fell about 3 percent in Hawaii and Nevada. Significant losses were evident in most other
states as well and on net the District’s transportation and services sectors contracted substantially. As
a result of the shrinkage in these sectors and others, new claims for unemployment insurance surged
and unemployment rates increased noticeably in most areas. Since mid-October the surge in such
claims has receded somewhat but the levels of claims remain elevated, suggesting that unemployment
rates in these areas probably rose in November as well. The San Francisco Bay area has seen rapid job
destruction all year, especially among high-tech companies. Unemployment there has increased by
around 11,000 people per month since the first of the year and that pace doubled in October.
Accordingly, the share of job losers in California’s unemployment pool has risen. And if
unemployment durations last as long as usual, we’re likely to see additional increases in the
unemployment rate in the future.

12/11/01

On the positive side, housing markets remain healthy. A primary exception is the San
Francisco Bay area where home prices have started to decline a bit. But in most other areas, demand
for new and existing homes has been solid and the pace of residential construction remains high.
Moreover, industry output and sales figures show some indication of a turnaround in hightech manufacturing. At this point, however, a rebound in demand for high-tech equipment that is
strong enough to get the industry back on a solid growth track does not appear imminent. And with
Boeing committed to cutting about 15,000 jobs nationwide between December 14th and January 25th-most of them on the West Coast--the outlook for the District’s manufacturing sector more generally
remains weak in the near term.
Also troubling are the District’s state and local fiscal positions, which have deteriorated
further since we last met. Most states have cut or have proposed cutting agency budgets by up to 15
percent and several have frozen hiring as well. This will put a damper on economic activity,
especially in California, where growth in state and local government jobs has been a key factor
supporting continued expansion in Southern California and the Central Valley this year.
Let me turn to the national picture. The weakness in November employment put a bit of a
damper on the generally more positive tone of recent economic data. Still, there are more positive
signs that I believe are worth noting. Car and truck sales have been outstanding in October and
November. Of course, that reflects a temporary surge in response to zero interest rate financing deals.
Still, I believe it is encouraging from the standpoint of consumers’ confidence in the future that so
many people are willing to undertake such commitments. The recent increase in the admittedly
volatile new orders series also is encouraging, especially since the surge was led by orders for
computers and semiconductors, sectors that had led the recession. And finally, even though thirdquarter productivity growth was revised down recently, I believe the 1-1/2 percent increase is robust

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considering the decline in real output in that quarter. Relatively strong productivity growth over the
past year reinforces the view that the economy is cycling around a trend growth rate that continues to
be significantly higher than the one that prevailed before the mid-1990s.
Overall, recent data seem broadly consistent with our forecast as well as the Greenbook’s
that the recession is likely to be relatively mild. And financial market developments since our
November meeting reflect greater confidence in that view. The steepening trajectory for federal funds
and Eurodollar futures rates is notable in this regard.
Our forecast shows a drop in real GDP of 1-3/4 percent in the current quarter. We’re
assuming another 25 basis point cut in the funds rate at this meeting and we anticipate a rather gradual
pickup in growth in response to monetary and fiscal actions in combination with the end of the
inventory and investment cycles. The recovery in 2002 in our forecast is less pronounced than that in
the Greenbook in part because we are a bit skeptical about how quickly firms would take advantage of
the proposed partial expensing rules for investment. Of course, such legislation has to pass.
Our inflation forecast is little revised, with slack in labor and product markets holding the
increase in the core PCE price index to just over 1-1/4 percent in 2002. While the recession appears
likely to be fairly mild at the present time, that outcome is quite vulnerable to the possibility of
negative shocks. It’s not difficult to come up with a list of candidates. Confidence is fragile and could
be adversely affected by expected increases in unemployment, a negative turn in the war, or more
terrorist activity. A large decline in equity or real estate values could deepen the recession. And given
the deadlock in Congress, it’s not clear how much additional fiscal spending or fiscal stimulus will be
forthcoming. Thus, even though it seems likely that economic growth will rebound next year without
any further policy action, a case could be made for an additional easing of policy as a bit more
insurance. Thank you.

12/11/01

CHAIRMAN GREENSPAN. President Moskow
MR. MOSKOW. Thank you, Mr. Chairman. The Seventh District economy remains weak
and I must admit I’m having difficulty reconciling the numerous press reports of an imminent
recovery with what I’m hearing from my business contacts. So far, most contacts in the Seventh
District are not seeing signs of a bottom, let alone a recovery. As we all know, airline travel has been
significantly below last year’s levels. And according to one major carrier, bookings for the Christmas
holidays show no improvement from Thanksgiving relative to last year. The CEO of Boeing indicated
that they are not expecting air travel to return to pre-9/11 levels for another 28 to 42 months. About
the only positive news I heard from the travel and tourism sector was that people were starting to
respond to price discounts offered on cruises and hotel rooms. But activity in this sector generally
remains very weak.
In the steel industry, about half of the current output of the domestic steel industry is being
produced by firms that are either operating under or have filed for bankruptcy protection. Moreover,
one major steel distributor we talked to is expecting another down year in 2002.
Construction activity in our District definitely has slowed. On the residential side, softening
has been reported around the District. In particular, demand in the Chicago apartment and
condominium market, which has been booming for several years, is down sharply. Vacancy rates are
likely to rise further as many additional units will be coming on the market over the next year from
projects that are already under construction. Despite these negative developments, we have not seen
any adverse spillover to the banking sector, as bankers have limited the excess use of leverage by
developers and have better diversified their loan portfolios relative to previous cycles. Nonresidential
construction activity has slowed in virtually all areas. Office vacancy rates have risen, particularly in
Indianapolis where one-fifth of downtown office space is now empty.

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On the other hand, there were a few positive reports about demand picking up for medical
instruments, defense-related parts and components, and security equipment. And according to one
manufacturer, customer stocks of machine tools have fallen to such a low point that orders for tools
are starting to pick up. Incentive programs continued to boost light vehicle sales more than expected
last month, and October and November are now in the record books as the highest back-to-back
months for such sales ever. A year ago inventories were well above desired levels; now they’re very
lean. Indeed for some models, dealers are lucky to have even one in their showrooms. But dealers are
being cautious about restocking, and automakers have not boosted production significantly because
they know that the recent sales pace cannot be sustained. In fact, one of the Big Three firms indicated
that sales weakened considerably in late November and early December.
The experience in the light vehicle industry clearly illustrates that consumers are very price
conscious, and as a result many retailers are offering sizable price discounts. Sales so far in the
holiday shopping season, however, have been disappointing for most retailers we’ve talked with, and
as I noted last time their sales expectations were fairly low to begin with. But as retailers keep
reminding us, sales are often concentrated toward the end of the holiday shopping season, so we really
won’t know until then how good or how bad sales actually were.
Reports on labor market conditions generally indicate further slackening. Research by our
staff confirms that a pickup in demand for temporary help tends to precede recovery in the labor
market. We have two very large temporary help supply firms headquartered in our District. They
differed on their assessment of whether there was any bottoming in the demand for manufacturing
workers. One thought maybe there was; the other said definitely not.
Turning to the national outlook, the economy is clearly in recession and the November
employment report indicates that activity has not bottomed out yet. The breadth of job loss extends

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beyond manufacturing. The Greenbook forecast has an economic rebound taking hold by the second
quarter of next year. Our analysis and most consensus forecasts point toward a qualitatively similar
rebound. An important feature of the data so far is that the deterioration in labor markets appears not
to have spilled over into an unraveling of consumer sentiment and household spending. Price
discounting, low interest rates, and low energy prices are clearly positive forces offsetting the weak
employment situation.
However, I see three major risks that potentially could weigh on activity for some time.
First, despite the favorable experience to date, I think the uncertainty associated with the 9/11 attacks
and income losses from the weakening labor market could result in a sustained period of hunkering
down by households. This could dampen growth in consumption and residential investment by more
than assumed in the consensus outlook. Second, I think we may have a good deal further to go in
unwinding the capital overhang that became evident following the bursting of the high-tech bubble.
And third, the widespread nature of the slowing in economies throughout the world makes me
concerned that global activity will be weaker than we’re anticipating. So on balance, I see the risk for
growth in the United States as continuing to weigh substantially on the downside.
CHAIRMAN GREENSPAN. President McTeer.
MR. MCTEER. It appears that the economy in the Dallas District has finally joined the
national recession. Growth has been slowing since the fall of 2000, but employment continued to rise
until this past September. The widespread layoffs in the travel and entertainment industry, combined
with reductions in high-tech employment and a slowing in the energy sector recently, have brought
about the first employment declines in the Eleventh District since 1986. Mexico’s recession and the
increased difficulty of crossing the border are making matters worse, as retail spending along the
border has declined significantly from a year ago.

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Two other sources of strength in the Texas economy in recent years have been construction
activity and export demand. Both have turned into sources of weakness recently and are expected to
remain so. Construction activity has been declining since early this year and reports of over-capacity
in some office and expensive home markets suggest that construction investment will continue to
slow. When oil and gas prices are low, as they are now, expansion of petrochemical facilities usually
offsets some of the local slowdown. However, that is not happening this time around because of
extreme over-capacity in the chemicals business.
Exports in a wide range of product categories and to all parts of the world have been
declining for more than a year and our contacts expect little change in these trends. Defense-related
spending seems to be one of the few areas of strength. Semiconductor demand may have reached a
bottom, but our contacts concur with the Greenbook analysis that it will be a long bottom and that the
demand from the telecommunications sector likely will not pick up until the second half of 2002 at the
earliest. This is a significant negative for the telecom corridor just north of Dallas.
I concur with the broad outlines of the Greenbook forecast, though I’m a touch more
optimistic that GDP growth will resume in the first quarter. But I agree that on a fourth-quarter-overfourth-quarter basis growth in 2002 will probably be around 3 percent. I think it’s notable that the
Greenbook suggests that most of the weakness in current-quarter GDP will be accounted for by
inventory reductions and that final sales are holding up surprisingly well.
On the inflation front, I concur with the respondents to the University of Michigan survey
who seem to have bought into our rhetoric a few years ago that we were only one recession away from
price stability. We now seem to be getting the disinflation we wished for, but in my opinion we’re
still a long way from deflation.

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On the policy side, I see the economy stabilizing or at least not getting worse. If economic
conditions do deteriorate, I’m confident that we will get plenty of fiscal stimulus. In fact, it’s possible
that we’ll get plenty of fiscal stimulus whether the economy needs it or not. With about two-thirds of
our monetary policy stimulus still in the pipeline and lower energy prices likely to be with us for
months to come, it would appear that there is no shortage of policy stimulus at this stage of the game.
And with the world economy continuing to show signs of weakness, I’m not particularly concerned
about a potential outbreak of inflation in 2002.
Overall, I see the balance of risks we face as having shifted significantly and to such an
extent that I think we should pause in our policy easing. I believe the balance of risks is still tilted
toward weakness, but not so much that the easing in the pipeline shouldn’t be sufficient to deal with it.
Perhaps the best Christmas present we could give the financial markets at this stage would be a
message in our statement that the Fed sees some signs of stabilization and is taking a wait-and-see
posture before acting again. When I first came into my job and inherited Harvey Rosenblum as the
Bank’s Director of Research I asked him if he had any rules of thumb concerning monetary policy.
He said, “Yes, when in doubt, don’t ease.” And I think that’s about where we are now. In my view,
any additional benefit of further easing now is likely to be more than offset by the disadvantage down
the road of having to reverse that easing earlier than otherwise. Thank you.
CHAIRMAN GREENSPAN. President Hoenig.
MR. HOENIG. Mr. Chairman, economic activity in the Tenth District is likely to be lower
again in this quarter. The manufacturing sector remains in a slump and labor markets are soft.
However, the consumer sector shows signs of having turned a corner. In our opinion, housing,
consumer spending, and auto sales are pointing up. We interpret these data as suggesting that
economic activity in the Tenth District may be at or near its bottom.

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More specifically, the Bank’s November manufacturing survey found that production was
lower than a year ago, capital spending continued to decline, and firms were not yet done paring
inventories. On the positive side, though, the weakness is less than it was last month. The year-overyear decline in production was not quite as great as in October and was significantly less than in July
when the manufacturing slump appeared to be at its steepest. In fact, some of the anecdotal reports
that we’ve received recently from a number of our directors suggest that they are seeing a pickup in
orders and actually are talking about hiring additional workers.
Having said that, the labor markets have eased and are continuing to ease in the District. In
our latest labor market survey, only a quarter of the firms reported any difficulty hiring or retaining
workers, and that’s the lowest percentage in our survey’s history. However, while unemployment rose
in October, initial unemployment claims fell in November and layoff announcements in November
were the lowest we’ve seen this year.
Consumer spending in the region has held up better than many people expected. Mall
traffic was healthy immediately after Thanksgiving, and sales during the first 10 days of the holiday
season were up modestly over a year ago in most places. And the anecdotal data we’ve gotten have
pointed predominantly toward fairly strong consumer sales. Residential construction and home sales
rebounded from the drop-off after the terrorist attacks. As in the case of retail sales, the lower end of
the market is doing noticeably better than the higher end. Home sales in Denver were not as far below
year-ago levels in November as they were in September or October, despite mounting job losses in
that city. On the negative side, however, Realtors throughout the District say sales of high-end homes
remain very soft.
Energy activity has fallen since our last meeting. Conditions in that sector have been a bit
diverse in the District, with Oklahoma showing a fairly noticeable decline in activity because of their

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higher costs of extracting gas from their resources and Wyoming actually seeing a continued high
level of activity because of their lower costs. Price pressures in the District are in fact very minimal as
we see it.
Turning to the national economy, Mr. Chairman, my views have only strengthened since the
last meeting. I still believe it is helpful to split the outlook into two time frames, the very near term
and the intermediate term or second half of next year. Within these two time frames, I think growth
will decline in the current quarter, turn around probably late in the first or in the second quarter of next
year, and be more robust in the second half, which is very similar to the Greenbook outlook. For this
quarter and the first quarter of next year the economy, as I said, will remain weak. But my point is
that there’s not much we can do about that today. As for the intermediate term, growth in the second
half of next year appears likely to be relatively strong without requiring further action on our part.
Like the Greenbook, I expect growth in the second half to be close to 4 percent. The factors
generating this growth have been noted elsewhere and I’ll just highlight them.
Monetary policy, in my view, is accommodative and is contributing to strengthening
demand. Fiscal policy right now is stimulative and could become more so in the future. Energy costs
are declining, and the contribution from the change in inventories should begin to be positive in the
first or second quarter of next year. Certainly, there are risks to consumer and business confidence
that we have to be mindful of, and the weakness in foreign economic growth is also worthy of note.
With our current policy stance, which is accommodative, the consensus forecast--both inside and
outside the Federal Reserve--seems to be for stronger growth in the second half of next year. Finally,
it seems to me that we should not take actions now on the basis of events or shocks that we cannot
anticipate or even assign probabilities to today. Thank you.
CHAIRMAN GREENSPAN. President Guynn.

12/11/01

MR. GUYNN. Thank you, Mr. Chairman. While overall business conditions in the
Southeast remain weak, we’re beginning to get hints of at least some marginal improvement in the
consumer and related sectors. Retailers in our area indicate that Thanksgiving holiday sales met or
exceeded their lowered expectations. This is largely consistent with the most recent data on samestore sales nationally. Merchant inventories are reported to be lean and retailers are guardedly
optimistic about the prospects for the holiday season. Home construction and sales, while off their
peaks, remain at high levels, driven by lower mortgage rates.
In contrast, while record auto sales occurred in October as a result of manufacturers’
incentive programs, one of our directors who owns a diverse set of dealerships in the Atlanta area
reported the worst month ever in November. And our contact at Ford indicated that their sales in the
Southeast were the weakest in the country last month. Additionally, weakness continues in the
commercial real estate sector, with commercial vacancies increasing in every major market. At the
same time, manufacturing has continued its 15-month contraction and tourism shows little sign of
recovery.
Speaking of tourism, while we know that September 11th had significantly adverse effects,
particularly on the desire to travel and stay in hotels, the important question is how persistent will that
shock be. Recent developments shed light on both the persistence issue as well as on how the ripple
effects are playing out. Specifically, they suggest that the shock to business travel has been
significantly shorter-lived than the shock to leisure travel. Our contact at Delta Airlines reports that
overall air traffic has returned even more slowly than the pessimistic outlook the industry gave the
federal government in the first weeks following the disaster. Delta tells us that while traffic slowly
continues to come back, it is currently 20 percent below the pre-attack business plan and revenue is
still 30 percent below that plan. The recovery in business travel is also reflected in major business

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centers like Miami, where CVB hotels have seen a pickup in business traffic. In contrast, occupancy
rates on Miami’s South Beach and other localities frequented mainly by tourists remain desperately
low, as the key European leisure traffic has essentially dried up. As a consequence, Disney has
postponed indefinitely opening the first 3,000 rooms of an almost 6,000 room resort in Orlando. AAA
indicates that requests for theme park tickets in the Southeast are 80 percent of last year’s sales, but
their data indicate that most of the travel to these facilities is by car, not by air. Attempts at price
discounting have not worked to induce leisure travelers to return to the skies. They remain “fear
sensitive.” In contrast, the evidence is that business travel is clearly more fare sensitive; airlines have
recognized this and are discounting business fares in order to sustain momentum in that area.
Reflecting the reduced air traffic, car rentals in Florida for the past week are down some 25 to 30
percent from a year ago. ANC Rental Corp, which owns Alamo and National and relies primarily on
air traffic for patrons, has filed for Chapter 11 protection, and a senior industry contact suggested that
not be far behind. In an effort to cut costs, car rental firms in Florida are reducing their
fleets and have dumped an estimated 50,000 vehicles onto the used car market in the past 90 days.
Interestingly, Hertz is not among these companies. It’s a subsidiary of Ford and has been prevented
from responding to market pressures in the same way as the independent firms. Two Florida cruise
lines have also filed for Chapter 11 protection, and two others have merged.
The fallout from these travel-related developments is also being felt in the services
employment statistics. The Sixth District was home to some of the strongest growth in services
employment in the nation during the 1990s. In particular, almost 40 percent of Florida’s 7 million
plus workforce are employed in the provision of nonfinancial, nonretail services; the state has about 50
percent more people employed in hotels and related activities than the national average. As a result,

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the slowdown in tourism has hit service-related jobs hard and will continue to do so for some time in
the future.
We have continued to press our regional contacts for insights into when we might expect to
see some recovery in investment spending. While excess capacity in most industries certainly will
discourage spending to add capacity, there are now some signs of renewed spending on technology.
Our contact at the corporate headquarters of UPS in Atlanta tells us that while they have cut spending
on trucks and planes, they are planning a 6 to 7 percent increase in technology spending next year
because of its central and growing importance to their business. Likewise, a contact from Cingular
Wireless, a major telecommunications firm serving our region, tells us that they plan to go ahead with
substantial investment in a new generation of technology next year in hopes of getting a jump on the
competition.
On the national front, I believe the extraordinary uncertainty affecting the national outlook,
which concerned us all at the last meeting, may be resolving itself at least somewhat. While I’m not in
any way suggesting that the economy has turned around, it would appear that the run of high
frequency data released in the last week or so has been more positive and could be suggestive of a
response to the stimulus already present in the economy. As noted in the Greenbook, personal
spending is up relative to expectations and the manufacturing sector has begun to show some signs of
life. And several major tech firms, including Intel and AMD, have revised upward their sales
expectations, so perhaps that sector may be on the verge of bottoming out. The new technology
spending plans of a couple of the large regional companies I just cited a minute ago are consistent with
that view.
As Dave Stockton noted, a major difference in the outlook from our last meeting is the
prospect for additional fiscal stimulus, which now looks more problematic than it did a month ago.

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That is reflected in one of the alternative Greenbook simulations. This would cause me more concern
except for the fact that we have a direct stimulus from the significant drop in energy costs, which has
added to income and has lowered costs. We estimate this has added as much as 1-1/4 percent to
disposable personal income in the second half of this year--and our estimates do not take into account
the extra bonus of a warm winter so far.
As we move to our policy discussion, I would join President McTeer in urging patience, in
light of indications of an emerging recovery. The prospect of a recovery is also supported by the
improved situation in equity markets. I am not convinced that a further move at this time will alter the
near-term path of the economy by speeding up the recovery. Finally, I’m not enamored with the
argument that we need to move now as a precaution against further shocks, as yet unrealized.
In short, I don’t think we need to do something just to do something or simply to ratify
market expectations. I think it’s probably time to give greater weight to longer-term considerations.
Thank you, Mr. Chairman.
CHAIRMAN GREENSPAN. President Minehan.
MS. MINEHAN. Thank you, Mr. Chairman. The New England economy slowed further
since our last meeting and remains largely in sync with national trends. That is, the nation is now
officially in a recession and so by extension is New England. Payroll employment for the region
declined in October and job levels in every state are below their earlier highs, though for the region as
a whole employment still remains slightly above its year-ago level. The regional unemployment rate
continues to be below that of the nation but the regional rate has jumped up at a faster pace recently.
Looking forward, a significant increase in initial claims for unemployment insurance suggests that the
unemployment rate will rise even further. In addition, help-wanted advertising deteriorated markedly
in October, with print ads falling about 40 percent on a year-over-year basis. Online job listings have

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not fallen as much and their rate of decline has abated a bit. That may signal some bottoming out in
the market for high-tech workers, but overall prospects for the job situation in New England seem
weak.
Our Beige Book contacts reported in November that the region’s commercial real estate
markets deteriorated in the last few months, with the Boston area affected most significantly. After
almost a decade of markedly below average vacancies as compared with the nation as a whole,
Boston’s rates have converged to national averages over a period of only four quarters and in the
process have tripled. Rental rates, not surprisingly, have come down as well, especially in the
suburban markets. Contacts say that commercial markets outside the Boston area have been less tight
during the previous few years and as a result have felt the slowdown in recent months to a lesser
degree.
Manufacturing continues to be weak, with employment declining by 4 percent in October
on a year-over-year basis. In particular, the value of manufactured exports has fallen significantly and
at a much faster pace than in the nation as a whole. So, the situation in the region is looking much
gloomier than only a few short months ago--in the early to mid-summer.
One striking indication of this is the downturn of Massachusetts State revenues. Through
the end of fiscal 2001 in May, revenues were growing at a pace of 4 percent--below plan but solid.
Beginning in June, revenues stopped growing and in fact dropped by 3 percent; that drop has
continued through today. That is a sharp and sudden swing, which I think reflects the broader
experience in the region--a mild slowdown in the spring and then a sudden negative jolt as the summer
began. Obviously September 11th did not help but it now seems that the slowdown was well at hand
before that tragic day.

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One key question after such a drop in activity is: When will things get better? We held
several meetings in the last few weeks aimed at gauging answers to that question. We met with local
business people to talk about business prospects, particularly with regard to technology spending. In
addition, we reviewed several measures of regional sentiment--consumer, manufacturing, and hightech business confidence--along with a set of economic indicators for Massachusetts alone. Finally,
along with our Beige Book calls we also contacted a series of temporary help agencies in the region.
Taken together, the data and anecdotes suggest that New England consumers,
manufacturers, and high-tech sector executives do not expect an improvement in economic conditions
before the second half of next year, nor do the leading indicators forecast a turnaround. Many contacts
in temporary staffing firms indicate that business may improve late in the second quarter or possibly
early in the third quarter. Manufacturers and retailers see the upturn further out in the second half.
But contacts in software and IT firms are much more uncertain, and the predictions they give when
pushed are generally concentrated in late 2002 or early 2003. Some tech executives say the
technology recession will be longer and deeper than that of the rest of the economy and report that
more shakeout is still to come among technology firms.
Finally, to end the regional discussion on a bit more upbeat note, our New England
Advisory Council met last Friday and that group of small business people clearly sees this period as
not only a time of uncertainty and challenge but also a time of opportunity. Most members of the
group reported that one or more product lines remain strong and commented on this being a period
when attention to customers and/or innovative products or services would pay off in terms of
increased market share. A member of the group from a technology consulting company reported a
very recent major positive change in U.S. bookings. Based on his personal contacts, he believes this
spate of new business was shared by the major consulting firms like McKinsey and Bain as well.

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Business remains poor outside the United States, however. He attributed these increased bookings to
the stock market upturn, which he regards as a leading indicator for the consulting business. Several
members noted an increased ability to hire skilled workers, which had enabled them to be more
innovative and source new products and services in house. The two problems faced by all were the
increasing costs of insurance--not just for health care but for property and unemployment insurance as
well--and a lack of bank financing except on a fully secured basis. In sum, these small businesses in
New England seem at this point to be weathering the recession well and preparing to be stronger
competitors when the economy turns up.
Turning to the national scene, certainly the equity markets seem to think the time is near
when economic activity will turn up. But I wonder whether that seeming confidence is a bit
premature. My reading of the incoming data, particularly as they relate to employment, is that the
upturn may be further out than the market expects. And my confidence in the strength of the upturn in
2002 projected by both the Greenbook and our own staff forecast is less than 100 percent.
After a first-quarter pause in spending, the consumer continues to be the mainstay of the
forecast, with the dramatic surge in motor vehicle sales in October and November evidence of their
resiliency and confidence. Even outside of autos, real durable goods spending rose over 1 percent in
October. However, real income fell sharply and the only recently elevated saving rate collapsed.
Consumer borrowing may not be growing at the same pace as it had been, but debt service as a share
of disposable personal income is rising to levels that are historically quite high, at least relative to the
last 20 years or so. Combine falling income, rising debt burdens, and the potential for rising
unemployment as seen in initial claims data and layoff announcements, and it may be a recipe for the
sharp consumer retrenchment we have yet to see in this recession. In fact, our Bank’s forecast sees

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unemployment rising about 1/2 percentage point higher in 2002 than does the Greenbook, which
combined with falling inflation suggests a potential for considerable excess capacity.
The inventory swing from 2001 Q4 to 2002 embodied in this Greenbook projection really is
quite significant, particularly given how little data we have on inventories as yet. That swing, along
with fiscal stimulus, drives a relatively robust upturn in 2002. We see a similar though smaller version
of this mechanism at work. But there are certainly risks that the inventory depletion and rebound will
be much milder and, as I noted, there are risks with respect to consumer spending. Corporate profits
are dismal and the high P/E ratios in the S&P 500 reflect both rising Ps and rapidly dropping Es. I
think the very euphoria of the stock market right now is a risk in and of itself and not so much an
indicator of optimism. If the market were to adjust to more normal P/E ratios with a drop in price, that
could well feed back to even slower business spending and declines in consumer wealth and
confidence.
Finally, both the Greenbook and our own forecast contain a rather sizable amount of fiscal
stimulus. As each day passes without some consensus in Congress, both the timing and the amount of
such stimulus come into question. The alternative Greenbook scenarios suggest that a lack of fiscal
stimulus could negatively affect 2002 growth and unemployment rates in a significant way.
Moreover, whether or not the federal government acts, state and local government spending likely
would need to be contractionary in early 2002 to bring state budgets into balance.
At our last meeting I argued that while the economic picture was clearly negative and the
risks remained on the downside, I thought the more cautious forward-looking policy would be to move
rates downward in small steps. I recognize the logic in aggressively addressing economic weakness in
the absence of inflation, but I believe we have done that. I continue to believe that the resilience of
our economy and the health of our banking system, just to name two factors, make it less likely that

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we will face a deflationary spiral. I also think it’s generally not wise to move policy in fear of
potential disruptions that have not yet occurred.
In that regard, there are glimmers of light at the end of the tunnel. Durable goods orders
and semiconductor chip sales may be signaling a turnaround in business spending. But I think they’re
only glimmers as yet, no matter how they are received by the equity markets. Risks remain weighted
toward weakness beyond that incorporated in our forecast, and inflation is quiescent if not declining.
Given the uncertainties on the fiscal side, there may well be room for a bit more policy ease, though I
do have some measure of agreement with several of my Reserve Bank President colleagues about how
close a call this is. I still favor the cautious approach, but taking out a bit more insurance right now
against the downside risks strikes me as a reasonable and measured step. Thank you.
CHAIRMAN GREENSPAN. President Broaddus.
MR. BROADDUS. I don’t have a whole lot to say about our District economy that is new.
Overall activity seems to have continued to decline in November. In particular, retail activity in our
region fell sharply in November, based on information we received in the monthly survey we conduct.
Much of the decline seems to be the result of a drop-off in car sales. Moreover, most of the retailers
that we talked to are not optimistic about the holiday season. There’s a lot of discounting going on at
all levels and in all categories of stores. Only the big box discounters like Wal-Mart and Target seem
to be having fairly good results so far.
In the manufacturing sector also the news that we’re receiving is not favorable. Shipments,
new orders, and order backlogs all declined further in November overall. Many manufacturing
companies are either reducing their capital budgets further or freezing them. A few manufacturers
among those we talk with regularly did report some pickup in business and a few indicated that they’re

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reconsidering some of their earlier decisions to cut capital spending. But those firms are definitely in
the minority.
On the national economy, clearly there may be more reason for optimism regarding the
outlook today than there was at our November meeting. Others have made a number of comments
about that already. The stock market is up, Treasury bond rates are up, credit spreads have narrowed,
and the federal funds futures market suggests that market participants expect policy to be tightened
more aggressively next year than was expected earlier. There is some evidence, though I would say it
is limited, in the recent economic reports that the contraction in activity may be moderating. And at
least some indicators--the Michigan survey, for example--suggest that consumer confidence may be
stabilizing. Also, the small increase in nondefense capital goods orders in October could be an
indication that the rate of decline in business spending on equipment may be slowing a bit. But in my
view the downside risks in the outlook are still material. So let me play Scrooge and underline them.
Cathy Minehan and others have already made some of these points.
First, I would suggest that the optimism so evident in financial markets may reflect to some
extent the assumption on the part of a lot of investors and others that this recession is going to end in
the spring because the average postwar recession has lasted about 11 months. But this assumption
may well be unwarranted if this recession is different from the go/stop kinds of cycles we have
experienced in recent decades. The optimism may also reflect confidence that fiscal stimulus will be
forthcoming and that when it comes it will be effective. But in my view--and others have said this
too--it’s not clear that fiscal stimulus will be forthcoming. And even if it is, it’s not clear to me that it
necessarily will be effective.
Beyond that, the latest hard economic data we have are not as a whole rosy in my view.
The Greenbook reports that, despite indications of somewhat more favorable news with respect to

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equipment investment, the staff is now forecasting a very significant further drop in spending on
equipment and software in the current quarter. And while people have recognized the weakness in
labor markets, I wonder whether we may be minimizing just how weak that November job report was.
After all, the level of payroll employment was about 200,000 jobs lower than had been anticipated
before the report was released. And the rise in the unemployment rate over the last three months has
been the fastest increase in a long time--since 1982, I believe. Moreover, the drop in manufacturing
jobs, at 163,000, was the biggest decline so far in this cycle and, of course, that number has been
coming down now for a long time. With weak labor markets, of course, the risk is that the contraction
could be deeper and longer if household confidence is shaken. Confidence may be adversely affected
by job losses that have already been reported, if people are concerned about losing their jobs or about
the prospect for slower growth in wages and income.
One other statistic that I think underlines the downside risk is the sharp deceleration in oneyear-ahead inflation expectations as measured by the median response in the latest Michigan survey.
As Bob Parry mentioned, that number dropped from 2.8 percent in September to 0.4 percent in
November. The December survey showed a rebound, but the level is still much lower than in past
months, looking further back into the past. Some of this decline may be transitory, related to what is
happening to fuel prices and so forth. But I think there are broader reasons to be concerned about
disinflation. The Greenbook estimates that core PCE is currently running at a rate of about 1-1/2
percent and the staff is forecasting that it’s going to come down 1/2 point to 1 percent by 2003.
Moreover, focusing again on labor markets, it seems to me quite plausible that the unemployment rate
could peak at a higher level than is now being projected in the Greenbook. If that happens, I think that
would have an impact on wages and also implications for disinflation going forward. Fortunately, to
this point our reductions in the nominal funds rate have prevented the disinflation that apparently

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already has occurred from pushing up the real funds rate. But I continue to believe, given all the
information we have, that we need to do what we can to keep real short rates from rising in the nearterm future.
CHAIRMAN GREENSPAN. President Stern.
MR. STERN. Thank you, Mr. Chairman. I’m not sure I have a lot to add at this point, so
let me be brief. I’ve reported for a long time now that the District economy has been tracking the
national economy rather closely. As a generalization that still is the case, but let me make a few
comments about things that are a little different or new.
Clearly, labor market conditions in the District have eased--that is not new--but the
unemployment rate has actually risen very little to this point. And I would have to say, as best I can
judge from anecdotal reports, that holiday hiring was better than I had anticipated earlier. The major
retailers I’ve spoken with seem satisfied so far with holiday sales--relative to their subdued
expectations let me add. Nevertheless, they are not complaining inordinately about what they are
seeing. The pattern in sales that has been evident for quite some time--with discounters doing better
than full service department stores and specialty apparel people somewhere in the middle--seems to be
continuing, based on same-store sales data and discussions with these retailers. The large retailers also
indicate that they have made no adjustments to their capital spending plans for the next year or so.
History tells them that if they cut back, they will find that they’ve done it just as the economy starts to
improve and will wish they had proceeded with the additional stores. So, on those grounds, they
haven’t changed their capital spending plans.
In conversations with some people from several large financial services firms, we hear that
their business with consumers remains very active both in terms of demands for credit and sales of
financial instruments, though demands from the business side are slow. And finally, while

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commercial construction activity is slowing in the District, housing activity as measured either by
construction or sales continues to be reasonably robust. It certainly has held up longer and better than
I would have expected by this stage.
As far as the national economy is concerned, I’m more confident than I have been for some
time that something like the Greenbook forecast will materialize. The basic story as I see it is that the
strength in consumer spending is restraining the weakness this quarter. There will be some payback
for that next quarter but then a more sustained improvement will get under way. The latest data
indicate to me that, if nothing else, the economy is clearly in a process of stabilizing. It is not falling
off a cliff. And as I said, I find the Greenbook story reasonably convincing, although I would
certainly not be astonished if it took another quarter or so for the recovery to get under way. I think
timing is always a matter of considerable uncertainty.
As I’ve commented before, housing activity is a measure we might consider in thinking
about the mindset of the consumer. After all, the purchase of a house is a long-term commitment.
When people are willing to buy a new home, that involves a 15- or 30-year commitment, even
allowing for sales and refinancings and so forth. And the housing activity numbers continue to
suggest to me that consumer confidence remains reasonably healthy.
I would also note that whenever economic activity starts to pick up, it’s likely to take us
some time to recognize that upturn unless all series turn positive at once. My experience is that that
rarely, if ever, happens. So even if the economy starts to improve in the second quarter my guess is
we won’t recognize that with much confidence until the third or the fourth quarter. I would think, by
the way, that the unemployment rate is going to continue to go up for some time. That seems to me to
be almost baked in the cake.
Finally, I will restrain myself and not discuss policy preferences at the moment.

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CHAIRMAN GREENSPAN. President Santomero.
MR. SANTOMERO. Thank you, Mr. Chairman. Underlying economic conditions in the
Third District have remained essentially flat since our meeting five weeks ago, suggesting that the
economy has once again stabilized. This is an improvement relative to the conditions I reported here
at the November meeting, when the District’s economic situation was worsening. We know that
consumer spending will be an important impetus to the recovery. Holiday sales in the District have
not been as weak as many had feared, although it’s still too early to make predictions for the season as
a whole. Regional data do not yet show a broad-based pickup in retail sales, and some of our retail
contacts are expressing concern that sales may remain weak into the spring. And consumer
confidence in our region continued to decline through November.
The housing market has not fared as well in the region as it has in the nation. While
housing permits and the value of residential construction contracts were up in the spring and summer,
they’ve remained flat since then. The falloff in residential real estate markets is expected to be a
modest one, however. Business investment is not likely to contribute to growth in our region, at least
until the second quarter of next year. Investment in structures by businesses declined this year and
nonresidential building contracts in our three states dropped dramatically over the last few months.
Vacancy rates in the city of Philadelphia and its suburbs are up about 5 percent since the beginning of
the year. The market is not as overbuilt as it was in the 1980s, so the real estate cycle will not be as
deep as in the previous recession. Of course, this also means that real estate will not be the engine of
growth for the recovery.
Equipment spending by respondents to our South Jersey survey, which includes retailers,
service firms, and manufacturers, was down in the third quarter and is expected to grow only modestly
over the next six months. In November, manufacturers in our business outlook survey reported that

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they expected no rise in capital expenditures, including structures and equipment, over the next six
months. Manufacturing in our District remains quite weak. The indices of general activity, new
orders, shipments, and manufacturing employment in our survey have not recovered from the steep
declines reported right after September 11th. Survey results suggest that there is some inventory
correction still to come in our manufacturing firms, with about 1/3 of the firms reporting in November
that they plan further cuts in inventory. When asked when they thought the recovery would occur,
over 70 percent of the respondents to our surveys, including manufacturers, retailers, and service
firms, expected to see some improvement before or during the second quarter of next year. But the
service firms and retailers were somewhat more optimistic than the manufacturers. This is consistent
with the Philadelphia staff’s forecast, which suggests some modest pickup in employment in all three
of our states by the second quarter of next year accompanied, however, by continued increases in
unemployment rates in our region.
It is also consistent with many forecasts for the nation as a whole. For example, the median
forecast from our fourth-quarter Survey of Professional Forecasters also predicts economic recovery in
the second quarter of next year, as does the Greenbook. My own view for both the region and the
nation is a bit less optimistic. I think it will take some more time before businesses and consumers
feel the recovery is in place--perhaps by midyear or the third quarter--although I must admit that the
error bands around these forecasts make it difficult to distinguish among them.
Consumer spending is the key element in all the forecasts. Obviously the pattern of growth
will be affected by auto sales, which were pulled forward by the zero percent financing deals and,
therefore, will fall back next quarter. Nonetheless, in most forecasts consumption is the engine of
growth next year beyond the first quarter. As growth of consumer spending accelerates, inventory
building resumes, followed by a pickup in investment spending, which helps solidify the recovery.

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Philadelphia staff analysis of the behavior of leading indicators during previous recessions
suggests that we are on path for such a recovery. However, I remain somewhat concerned that the
economic recovery could be delayed, even given the sizable monetary stimulus applied this year,
which no doubt has helped to attenuate the downturn.
In particular, two parts of the recovery scenario appear problematic. First, the strength of
the recovery is dependent on further fiscal stimulus, the details of which remain to be worked out.
Secondly, weak labor market conditions could undermine consumer confidence and spending. Should
this happen, the timing of the recovery would be later and the magnitude smaller. That said, as I
discussed last time, I believe the Committee should begin focusing on the medium- and longer-term,
recognizing that the full effects of its actions--those implemented throughout the year as well as any
action taken today--are felt with a lag. We need to prepare the markets and the public for the time
when further rate cuts are not needed, and I think a more measured approach today to policy is
appropriate. Thank you, Mr. Chairman.
CHAIRMAN GREENSPAN. President Jordan.
MR. JORDAN. Thank you, Mr. Chairman. First, I’m surprised by Al Broaddus’s negative
tone on the labor report because I really expected him to come in here and note that West Virginia,
which is more in his District than in mine, had its lowest unemployment rate in the history of the data
series.
MR. BROADDUS. I started to do that but in light of the reaction to what I said about West
Virginia last night, I thought that might not be wise. [Laughter]
MR. JORDAN. And about nine other states registered drops in their unemployment rates.
Our region enjoyed spring-like weather last week, setting a record high of over 70 degrees on one day.
So even the shutdown of LTV steel production did little to reverse the gradually building optimism.

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The range of opinion of people we talked with ran from those who are expecting noticeable
improvement in their business in the first half to those who merely believe that the economy has
stopped contracting but are not confident that a pickup will occur in the near term. Even the hard-hit
heavy truck manufacturers believe that we are at or have already passed the absolute low, although
most think that it will be late next year at best and more likely in 2003 before there is a noticeable
increase in truck production. My guess is that the strong rebound in auto sales plus the continued
firmness in residential real estate markets in our area have helped restore confidence more than just a
little. An accumulation of small stories--such as a GM stamping plant announcing last week that it
had openings for 200 people and a data services company in Kentucky saying that it plans to hire
several hundred people in the coming year--has mitigated somewhat the long-expected loss of steel
worker jobs in the region. One steel company executive went so far as to say that she hopes the bad
prospects last long enough to get the consolidation that we need in the steel industry. A large regional
bank announced that they are reinstituting hiring bonuses in an effort to fill the continuing large
number of openings that they have. Health-care organizations are now the largest employer in many
of the metropolitan areas in the region and they continue to report hard-to-fill openings and
considerable wage pressure.
Construction spending continues to be strong except for the building of hotels and
restaurants, which has stopped completely. We were told by a union official--this probably reflects
what Jack Guynn was saying about his area, too, though I don’t know what share of hotel/restaurant/
hospitality workers are unionized in his region--that nationally the union expects to lose half its
members. A director in the construction industry reported that since September 11, over $3 billion of
commercial construction has been either cancelled or suspended because the lenders cannot get
insurance or its cost is prohibitive.

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On retailing, as Gary Stern was suggesting, we’re all accustomed to retailers expressing
disappointment with holiday sales. They’ve been doing it for 50 years at least! But now what we’re
actually hearing is that they are pleasantly surprised. In some cases such as Kohl’s--one of our
directors is on their board--they actually have had very strong sales. For other companies like
Federated, sales haven’t fallen as much as their worst fears and, therefore, they express some
satisfaction with how the holiday shopping season has played out so far.
We surveyed all of our current and former Small Business Advisory Council members last
week and the tone of their remarks was similar to what Cathy Minehan said about her group. They are
weathering the downturn better than they had expected, so their reports were not strongly negative in
tone.
On the fiscal picture, I have a little different perspective than what I’ve been hearing so far
this morning. Namely, I think the stalemate between the executive and legislative branches is a very
positive long-term development in that it has gone a long way toward disabusing the public of any
residual notion they had that there was such a thing as a discretionary countercyclical fiscal policy.
[Laughter]
One of the interesting developments in this recession--especially since September 11th--has
been the difference as compared with 1990 in both the behavior and the perspective of households and
businesses. If you recall, at this point in 1990 with Desert Shield leading up to Desert Storm, both
households and businesses seemed to go into a hunkering down, worst case, mini-max mode--an
“avoid the worst outcome” type of approach. Households simply have not done that this time,
whereas businesses seem to be acting very much as they did in 1990. Everybody in business is from
Missouri! They’re not going to believe in anything good until they see it in their order books or sales.
Well, from this starting point one of two things can happen: Either households will belatedly turn

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pessimistic and become more conservative or businesses will finally shake off their pessimism and
conservatism about the outlook. Either scenario has major implications for the set of financial market
conditions that will be associated with whatever economic developments actually occur.
GDP in the current quarter, which only has 20 days to go, will be a negative number, if the
Greenbook is right, and it’s going to be negative because of a very large decline in inventories. That’s
not necessarily a bad thing, either for our own economy or for our trading partners around the world.
So maybe we ought to be hoping for a negative fourth quarter if inventory liquidation is what it is
going to reflect.
I can’t forecast interest rates even as well as most people can, but I’m fairly confident that
we’re going to have a flatter yield curve a year from now. Especially if the Greenbook forecast is
right, I see the yield curve flattening mostly from the short end. It’s a question of how we get from
here to there. I’ve been puzzled about all these reports that we are expected to cut the funds rate at this
meeting by 1/4 or 1/2 point. Most people surveyed--and I don’t who these people are--say we’re
going to cut the funds rate. One of my directors is on a government affairs council for the American
Bankers Association and they had a meeting very recently, I think at the beginning of last week. Over
100 bankers attended and, after listening to an economic briefing, they were asked to indicate whether
they thought the Fed should lower the funds rate at its meeting today. He said no one raised a hand
among the 100 or more people there. And when asked if they thought the Fed had already cut rates
too much, he said almost everyone raised his or her hand. So I asked my Community Bank Advisory
Council that first question last Friday at our regular meeting. One banker did say that she thought we
ought to cut the funds rate by 1/4 point today simply because it was already built into expectations--I
guess she reads the newspaper--and everybody else said no.

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I still think about the level of the fed funds rate differently from the way I think about an
action to cut the federal funds rate. If I look at the level, I don’t see a need for additional insurance. I
believe we are providing an adequate amount of liquidity at the current level of the funds rate. An
action to change the funds rate is news that will be broadcast on CNBC and CNN and it’s going to get
a headline. The issue is: What is the message we’re sending and to whom are we sending it? If we
want to send the message to Main Street, then perhaps we ought to cut the funds rate 1/16 of a
percentage point. It doesn’t matter how much we cut it; we get the headline regardless. But I think
there may be some merit, as a few people have suggested, in disappointing the Wall Street
expectations of a cut. By doing so we may signal a more positive tone, indicating that we are
comfortable that the outlook is improving. Thank you, Mr. Chairman.
CHAIRMAN GREENSPAN. Okay. Let’s break for coffee, which I presume is outside.
[Coffee break]
CHAIRMAN GREENSPAN. President Poole.
MR. POOLE. I will try to fill in a few interstices of the discussion without repeating what
is already before us. My Wal-Mart contact said a couple of things that I thought were very interesting.
He said that when Wal-Mart compares prices of items being sold this holiday season that were also
sold last holiday season, the prices of these identical items are 16 percent lower this year. I think the
retail environment can only be described as brutally competitive. My contact also said that there is a
lot of evidence that consumers are very cautious. It looks as if people may be waiting even more than
usual to purchase items in the holiday shopping period this year. They may be planning to pile up
purchases at the end of the season or may just be waiting for lower prices. There is a higher
percentage of layaway purchases than usual. That’s not a retail strategy that many of us around this
table use but some parts of the population do. There is also a continuing preference shift among

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consumers away from premium products toward so-called value products, the lower priced items in a
line of merchandise. Inventories at Wal-Mart are in very good shape, right on track with where the
company wants them to be. My contact said that for the first time he’s finding that the softening in the
labor market has made it easier for Wal-Mart to hire sales associates. You may remember at earlier
meetings that I said Wal-Mart continued to find a lot of tightness in the labor market for that level of
skill.
My FedEx contact said that absolutely nothing had changed in their situation since we
talked six weeks ago, except perhaps that heads are not hanging anymore. It looks as if things are just
settling down. His firm’s forecast for next year shows a flat first calendar quarter over the first quarter
of this year and they’re anticipating some improvement in the second quarter and beyond.
I note that Jack is trying to horn in on my UPS monopoly here. [Laughter]
MR. GUYNN. I won’t do it again, I promise!
MR. POOLE. That’s okay. I’m from Chicago and I believe in competitive markets,
[laughter] including for information. The overall tone at UPS seemed to be a little more bullish than at
FedEx. My contact said business has been fairly good and UPS is anticipating that volume in the
beginning of next year will be up by 2.2 percent--that is their business plan--compared to the first part
of 2001. This year’s volume is coming in about flat compared with last year.
My contact at J.B. Hunt, a trucking company, says that business is particularly slow. His
firm sees no basis for optimism about the first quarter of next year.
Let me make a couple of comments on the national economy. There has been a lot of
discussion about fiscal policy and I think it’s worth reflecting on the fact that the Greenbook really
can’t make any assumption other than that temporary is temporary and permanent is permanent. But I
think a better way to view fiscal policy right now is that fiscal policy is in play and is likely to be in

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play for some time to come. When we think back to the early 1990s, a stimulus bill--I think it was
called an investment credit at the time--was under consideration at the beginning of the Clinton
Administration but was not enacted. Then there was a tax program that was enacted narrowly. After
that, fiscal policy was settled for quite a long time. It began to be discussed again during the election
campaign last year. Now fiscal policy is in play, and I think we’re going to see continuing discussions
about adjustments. Fiscal policy is not going to be a source of stability in our outlook. We cannot
expect that everything will be resolved, however this stimulus bill comes out. That’s not going to be
the end of it, I think.
It seems to me that we are in the neighborhood of a cycle trough. I don’t know exactly what
that means, but I’d say it means the trough will occur within the next few months. That’s consistent,
of course, with the Greenbook forecast.
One other comment I’d make is that I think it’s clear that household behavior is not
characterized by expectations of ongoing deflation. People are responding to sales incentives as a
reason to buy rather than to project that better deals will be available in the future. Therefore, the sales
incentives are leading to additional sales now rather than the postponement of purchases with the
expectation of getting an even better deal by waiting another few months. So, that’s my take on the
current outlook.
CHAIRMAN GREENSPAN. Governor Gramlich.
MR. GRAMLICH. Thank you, Mr. Chairman. For some months now the economic
statistics have been very negative. All year the Greenbook has been responding to these statistics by
revising down its forecast, as have the Blue Chip and other forecasters. But we now find ourselves in
a more ambiguous situation. Some indicators still look weak but others are turning up. We may be
approaching an important crossroads for monetary policy.

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The list of indicators that are beginning to show signs of strength, or at least stabilization, is
long. In the last month the NAPM durable goods orders, personal spending, and construction
spending have all turned up. Consumption of semiconductors has risen as have computer shipments.
Nonfuel commodity prices have increased lately, perhaps indicating future strength in demand. And
oil prices have dropped, which paradoxically could be an expansionary force. Bond and stock markets
are both indicating that credit markets think better times are ahead. But welcome as these signs are,
one should not get carried away. Fans always feel good when their team’s losing streak has ended but
this does not make their team a strong team. [Laughter] As the recent employment reports indicate,
the economy is still soft and it will take a long run of good news before we can declare the recession
or the soft period over.
Perhaps because of the imminent signs of strength, it now seems less likely that Congress
will pass an economic stimulus package. My own most likely Greenbook forecast has become the one
labeled “no fiscal package.” An important boost in the baseline Greenbook forecast is given by fiscal
policy assumptions, specifically the acceleration of depreciation loss. If I assume that the fiscal
package doesn’t pass, I can sidestep this debate between Jerry Jordan and the Greenbook forecasters
on the exact impact of that package. The forecast in that no fiscal package scenario shows another
year of sub-trend economic growth, with growth not returning to trend until sometime in 2003 and
with the unemployment rate peaking at 6.4 percent, which is a long way from full employment by
anybody’s definition. Moreover, it’s almost too gruesome to mention, but the economy is still
vulnerable to negative shocks, whether from further terrorism or just plain negative economic shocks.
For whatever reason, short-term anticipations of inflation by those responding to the
Michigan survey have taken a sharp drop. When combined with the high unemployment, the low oil
prices, the incipient drops in measured inflation, and the fact that productivity is holding up

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remarkably well for a recession, there are solid grounds for projecting lower inflation as the
Greenbook has done. Indeed, there are solid grounds for projecting lower inflation than the
Greenbook has forecast. Given all this--the still weak economy, the still vulnerable economy, and
possible reductions in inflation--I think one can make a very strong case for a further easing of
monetary policy more or less in line with what the Bluebook has called “a perfect foresight policy.”
That’s a self-congratulatory label, though one that suits my present purposes! [Laughter] But in
contrast to my feeling for most of this year, the case for further ease is not quite as compelling today.
Thank you.
CHAIRMAN GREENSPAN. Vice Chair.
VICE CHAIRMAN MCDONOUGH. Thank you, Mr. Chairman. The Second District’s
economy has shown clear signs of rebounding from the depressed levels noted in my report to you at
the last meeting, and there are further signs of downward price pressure. Consumer spending in the
District seems to have rebounded in November but remains below pre-attack levels. Retailers across
New York State report that sales were up 2 to 3 percent from a year earlier over the Thanksgiving
weekend but were flat in the following week. In both weeks, sales were said to be particularly
sluggish in New York City.
Construction and real estate activity have been mixed. Manhattan’s office market softened
further in October despite the loss of the Trade Center. Manhattan’s apartment sales and rental
markets also have softened since the attack. However, single-family home sales throughout New York
State rebounded in October with prices remaining well ahead of year-earlier levels. Both singlefamily and multifamily housing permits in October were little changed from pre-attack levels.
The story about Manhattan’s commercial real estate market is really quite interesting
because everybody was quite convinced until the 11th of September event that the commercial real

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estate market was quite tight. About 7 percent of the office space was wiped out by the attack on the
Twin Towers, but suddenly we don’t have any shortage of available office space. So it became clear
that some of the apparent tightness in commercial space reflected hoarding--a real estate version of the
over-investing that seems to have been taking place, and not just in the tech sector.
There has been good news for the future of lower Manhattan. John Whitehead, who for
four years was Chairman of the Board of Directors of the Federal Reserve Bank of New York, has
been named by the governor to be Chairman of the Lower Manhattan Development Corporation. I
think that will bring some necessary decisiveness to what is going to happen in the City, which is a
very important factor in restoring both consumer and business confidence.
Nationally, based on the assumption that monetary policy will be eased and that the funds
rate then would be held steady through a good portion if not all of next year, we have forecast
economic growth of 3 percent Q4 to Q4 in 2002 and of 3.4 percent in 2003. We see the core PCE
deflator at 1.7 percent next year and 1.6 percent in 2003. The unemployment rate in our projection is
quite benign. It reaches 5.9 percent by about the middle of next year and then gradually comes down
to about 5.7 percent in 2003. We do assume in this forecast that about $100 billion of fiscal stimulus
will be passed by the Congress and that it will be reasonably effective. Should that not happen, our
economic forecast would be somewhat weaker although obviously, depending on the nature of the
fiscal stimulus package, how much effect it will have next year is very questionable.
The mood of business leaders in the District is extraordinarily glum. It’s reaching the point
where it seems to be becoming fashionable in New York business circles to show that one can be at a
greater depth of despair than one’s neighbor. In fact, I’ve given up trying to discuss rational forecasts
with business leaders and now have shifted to asking this question: When you figure out that you’re
wrong, can you revise your business plan and do it quickly? The answer to that is yes, which I think is

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far more pertinent than whether these business leaders have the right forecast. But the degree to which
the spreading of gloom can be self-fulfilling I think is a downside risk to the forecast.
We are assuming that growth abroad will continue to be anemic and that, therefore, the
current account deficit--what I view as the long-run weak point of the American economy--will
continue at about 4-1/2 percent of GDP. We think that can be financed and probably financed with
very little if any weakening of the dollar. But it is something that concerns me greatly over the longer
run as an indication that the world economy simply isn’t balanced well. Thank you.
CHAIRMAN GREENSPAN. Governor Ferguson.
MR. FERGUSON. Thank you, Mr. Chairman. The conversation thus far has indicated that
it is extraordinarily difficult to identify with great certainty turning points in the economic cycle. A
number of people have already pointed to some of the positives that emerged in the intermeeting
period, including retail sales, new orders of durable goods, auto sales, et cetera. I would only add to
that by saying that even our appropriately cautious financial and forecasting gurus here at the Fed have
looked at those data and produced a Greenbook that for the first time in several rounds does not
feature a downward revision to the outlook. However, as others have noted, the fed funds futures
markets and market participants in surveys are nearly uniform in their expectations of another easing
move at this meeting. So why is that? I think the answer is because the turnaround implicit in the
positive data and even in the forecast is still quite tentative. And some of the positives we have seen
may reflect in large part a one-month bounceback from the shock of September 11th and may not
necessarily prove to be a certain precursor to a sustained turnaround. I see the risks in the turnaround
scenario to be quite clear and almost all to the downside.
Labor market conditions are continuing to deteriorate, which might have a negative effect
on consumption by households and delay the expected turnaround. Second, I believe almost all

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forecasts assume some form of fiscal stimulus and, as we’ve already discussed, the state of fiscal
stimulus is very much in play and quite uncertain. Third, there is risk from the international
environment where we have a synchronous global downturn. I think the turnaround internationally
depends much more on whether or not our economy recovers as opposed to our looking to others to be
the engine for recovery. Finally, financial markets could easily deteriorate if the expectations of a
return to growth and profitability are not met. And if such a negative event to financial markets were
to occur, that clearly would be a drag on consumer and business plans, not a support for them.
A number of issues have emerged with respect to policy. I, like President Stern, will
restrain myself on that subject but not as much as he did. [Laughter] First, some people have
suggested that we shouldn’t move in expectation of a terrorist attack and I would think that is certainly
true. We cannot inoculate the U.S. economy from potential or actual political threats. On the other
hand, we can position policy in such a way that we can make the economy as robust as possible, even
in its relatively weakened state. Secondly, I’ve heard at least one or two people refer to the risk that if
we move today and then reverse our stance later, that might be surprising to the markets. I find that a
little hard to understand because the markets have already built in an expectation of a turnaround in
policy. So were we to move today and then turn, we would simply be validating what the markets
expect.
Governor Gramlich stole my thunder with respect to the perfect foresight policy. I know I
don’t have it, but presumably a goal of having a Committee is that we approximate something like
perfect foresight with the consensus-building that goes on here. So I would encourage all of us, before
we get to the policy discussion, to look at pages 11 and 12 of the Bluebook if you haven’t done so.
And finally, Harvey Rosenblum’s name was mentioned as a superb economist. I will not
try to bring the views of another economist to the table, but I would bring Samuel Johnson to the table.

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Samuel Johnson demonstrated his wit on hearing that an acquaintance was planning to remarry by
describing that as a triumph of hope over experience. When we get to our policy discussion, I would
certainly expect that this Committee, with perfect foresight, would not let hope triumph over its
wisdom and experience. [Laughter]
CHAIRMAN GREENSPAN. Governor Meyer.
MR. MEYER. Thank you, Mr. Chairman. Recently at FOMC meetings, one of the key
issues that has weighed on the policy decision is whether or not the forecast is stabilizing. In fact, as
Governor Ferguson just noted, in each of the previous FOMC meetings this year there has been some
meaningful downward revision in the Greenbook forecast. And these revisions have been followed by
further easing. So it seems that a precondition for an end to the cycle of easing is a stabilization in the
Committee’s forecast. This Greenbook delivers such a stabilization. Indeed, it has a small upward
revision in projected growth for next year. My forecast has the same property and a number of you
around the table have reached the same conclusion. This at least puts on the table the possibility of
holding the line on the funds rate, if not today then perhaps after today.
Of course, we face a tension between the forecast and the incoming data on production and
employment. The incoming data reflect the projected decline in output this quarter, and over the next
several months we’re likely to see further increases in the unemployment rate until economic growth
comes back to trend. In my view, prudent monetary policy would call for an end to the policy easing
cycle before an end to the rise in the unemployment rate. Nevertheless, the sharpness of the increase
in the unemployment rate in November and the uncertain effects of that on sentiment and spending at
least put back on the table the possibility of a little further easing at this meeting.
One way of thinking about monetary policy is in terms of the path of the funds rate. A
second way that I sometimes find useful is in terms of the desired path of real GDP growth, as if that

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were the instrument under control. Given the lags in the response of monetary policy and the
preference with regard to moving interest rates, when I play this game I don’t adjust GDP growth for a
couple of quarters. The question I ask as I look at the Greenbook is whether the strength of the
rebound as we get to the middle of next year is about right or, for example, would be better scaled up.
I view that as a way of gauging whether or not there is room for further easing. That room depends on
three considerations: the rate of employment in mid-2002, when growth moves above trend in the
Greenbook forecast; the inflation rate at that time relative to the Committee’s long-run objective; and
how much projected growth is above trend in the following year or two. The Committee does not
have an explicit long-run inflation objective, so I do the exercise in terms of my own long-run
objective for inflation, which is 1-1/2 percent for the PCE core inflation rate.
It seems to me that these considerations reinforce each other and suggest relative to the
Greenbook forecast some room for further easing. The unemployment rate peaks just above 6 percent
and is still 5-3/4 percent at the end of 2003, as compared to my estimate of the NAIRU at that point of
5-1/4 percent. And the inflation rate is almost 1/2 percentage point below my long-run objective at the
end of the period. A number of people, Governor Ferguson and Governor Gramlich both, mentioned
the perfect foresight simulation, and this is the message that comes through in that particular forecast.
On the other hand, just to keep it close, I expect that growth might be stronger by mid-2002
than projected in the Greenbook and I’m slightly more pessimistic than the Greenbook about inflation.
First, I expect a sharper cyclical rebound in equities and therefore I start with the staff’s alternative
simulation with a stronger stock market. The Greenbook equity path is predicated on further earnings
disappointments and a perception that there is some overvaluation today, given the excessively
optimistic earnings expectations. There’s good logic in this assessment, to be sure. But I suspect that
this logic will be overwhelmed by a more normal cyclical rebound if the economy performs as

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projected in the Greenbook. Down the road, we’ll face the implications of any resulting
overvaluation.
Second, I believe we may be at an inflection point. We are shifting from progressive
downward to upward revisions to the forecast. And this reflects a tendency toward a coincidence of
positive errors or smaller negative errors in spending equations during recovery periods.
With respect to inflation, the Greenbook focuses on the effects of declining oil prices and
the emerging slack in labor markets. I would put more weight than the staff does on the implications
of what looks like a significant adverse supply shock. The staff estimate of structural productivity
growth has declined from a bit above 2-1/2 percent in 1998 and 1999 to about 2 percent this year and
about 1-1/2 percent next year. We, or at least I, placed a lot of emphasis on the effect of the
productivity acceleration on both demand and inflation to explain the exceptional performance of the
economy in the second half of the 1990s. Now, the deceleration is different in character from the
acceleration, and perhaps this will matter. It reflects a move from overshooting in 1999 and into 2000,
relative to some longer-run sustainable growth rate for productivity, to undershooting next year. In
addition, it reflects some effect from increased spending on security. But it seems to me that this
swing could damp the projected disinflation. To be sure, the staff has taken this into account in their
forecast but not with the weight I would have given it. As a result, I view the negative supply shock as
at least a risk factor relative to the Greenbook forecast.
The bottom line is that there appears to be a little room for further easing, but we are rapidly
approaching the point where it may be prudent to hold the funds rate stable for a while. Even at this
point, the Committee will still be able to adjust the degree of stimulus going forward by its decision on
how long to remain at the low prevailing funds rate and how gradually to return to neutrality.
CHAIRMAN GREENSPAN. Governor Bies.

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MS. BIES. Well, given my long tenure of a long weekend and a day to look at this
information, I won’t pretend to be as up-to-date on many of the series as the experts around the table.
But I wanted to bring to the table some observations I’ve noted, which are more from an anecdotal
perspective of the business community and the banking community.
First, my main concern regarding where we are in this business cycle is where we are on the
business investment side. The reason is that I believe what got us into the recession was the drastic
drop in investment in certain key technology sectors. I feel optimistic that inventory corrections are
well under way in that sector and that we may actually begin to see some stabilization in sales.
The consumer has really kept the economy going in this cycle. We can see that both in
housing and in auto sales, even though I believe a lot of the recent auto sales represent a timing
difference due to the attractive financing programs. But the consumer has been using the refinancing
of homes as a way to increase disposable income every month, and we know that the pool of
mortgages that can be profitably refinanced by consumers is dwindling. In fact, I would argue that the
recent uptick in refinanced mortgages is what we normally see when long-term mortgage rates begin
to go up, as the astute refinancers jump in and lock in rates that they believe have hit their lows. So, I
don’t believe we’re going to see much more of an increase in spendable income coming from the
consumer. And obviously, as many others have said, the threat of terrorism may put a damper on the
consumer, as will unemployment worries.
The other sector that concerns me--and I say this in light of recent personal experiences--is
state and local governments due to the financial stress currently being placed on them, particularly in
areas that depend a great deal on sales tax revenues and on revenues tied to the employment situation.
Those entities are having to spend substantial sums to support responses to potential terrorism
activities.

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Finally, most corporate executives I talk with feel that they have very little ability to raise
prices at this time. In fact, they’re feeling more pressure to cut prices, as has already been discussed,
to deal with inventory accumulation and excess capacity. So I find very little pressure on inflation at
the moment.
CHAIRMAN GREENSPAN. Governor Olson.
MR. OLSON. First, I’d like to associate myself with Governor Bies’s preamble. I share the
same view. I would like to make one observation on the subject of fiscal policy and the stimulus
package, which has been discussed by a number of people. I do so from the standpoint of having
spent much of the last 30 years being very closely involved in the public policy formation process.
Congress functions best or most rationally in two environments, either a crisis or a
consensus. That's not because members of Congress are necessarily weak people but because the
system was designed that way. We reelect the entire House and a third of the Senate every two years,
and that is not a circumstance that lends itself to creating statesmen or women or to fostering longterm thinking. As we move away from a sense of crisis, we move into an environment where I think
the stimulus package is in some jeopardy. That is not, as President Jordan suggested, because it
involves a conscious rejection of discretionary countercyclical fiscal policy but because we find
members of Congress, particularly in an election year, tugged by their core constituencies. Where that
leaves us now is that to the extent there is a growing sense of confidence in the economy--despite that
confidence being based in part on the assumption of a fiscal stimulus package--it will in fact have
jeopardized the possibility of a stimulus package being passed. It’s a bit of a Catch-22. So in that
very narrow component of the outlook, I think the probability of an economic impetus package is less
than it was 30 days ago. Thank you.
CHAIRMAN GREENSPAN. We move on to Don Kohn.

12/11/01

MR. KOHN. Thank you, Mr. Chairman. As many of you have remarked,
perhaps the most striking--and certainly welcome--aspect of this intermeeting
period has been the mixed character of the incoming economic data. For the first
time in many months, data have not pointed to further downward revisions to
current and prospective economic activity. Importantly, although measures of
aggregate employment and output show the economy overall continuing to
contract appreciably, key elements of private final demand have firmed, and by
somewhat more than expected. This latter development would seem to provide
the first concrete indication that further contraction in the economy could well be
limited, and some tentative support for the projected turnaround beginning early
next year. The key issue for you today would seem to be whether, with the
economic outlook perhaps stabilizing, the monetary stimulus already in place is
sufficient to foster an adequate rebound, thus arguing for keeping policy
unchanged at this meeting, or whether the persisting softness in activity and
prices, along with the possibility that you are seeing a false dawn and the
recovery may be damped, justifies a further slight easing of policy of 25 basis
points.
In practical terms, the differential effects of either standing pat or easing by
1/4 point may not be that great. Because both represent a step-down from the
recent pace of easing, either will reinforce perceptions in the market that the
FOMC believes that the end of the easing cycle is near. With such an
expectation already largely embedded in the term structure of interest rates, longterm interest rates should not change much under either alternative. Still, the
choice will matter to some degree. In addition to its effect on the cost of shortterm finance, it could have some small influence on longer-term rate
expectations, especially if you do not ease as markets anticipate. Perhaps more
importantly, the inferences market participants draw about your own economic
outlook and your weighing of risks and costs in policy decisions will help them
to shape how asset prices respond to new information going forward.
A decision to leave rates unchanged at this meeting would seem to rest
mainly on the combination of a more stable outlook and the extent of previous
policy easing. Policy has eased more rapidly than in most economic downturns,
in part reflecting your efforts to take account of the implications of new
information not only for the current situation but also for the path of the
economy into the future. In this regard, you may see the degree of stimulus in
the stance of policy at the end of your last meeting as already based on
expectations of further weakening in the economy and as sufficient to foster a
satisfactory recovery beginning next year from the lower level of resource
utilization in train. Indeed, to some extent, the aggressiveness of policy easing
may have reflected your attempt to protect against downside risks, as well as to
address the central tendency of the outlook. This seemed especially the case at
your last meeting when several of you remarked that the choice between 25 and
50 basis points was a close call. If you thought you had policy positioned about
right at the end of your previous meeting for the forecast and the balance of risks

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you saw at that time, the information you have received since then--which
suggests smaller downside risks and no more contraction than expected--could
be seen as supporting a decision to keep policy unchanged.
In addition, if you believe that the staff has been relatively conservative in
its interpretation of the recent news in its assessment of final demand, you may
see some greater upside risks to the staff forecast than perceived earlier. Judging
from the rise in bond yields and equity prices, the private sector has become
considerably more optimistic about the prospective pickup in the economy-accentuating the disparity with most economic forecasts that has existed for
some time. The persistence of the steep upward slope of the yield curve for so
long may mean that optimism extends beyond bond traders and financial
intermediaries to savers and spenders. One piece of evidence in support of this
possibility has been the surprising resilience of consumer confidence in the
Michigan survey--notably in expectations about the future. Even if the staff has
the fundamentals right, they could be trumped by animal spirits for some time as
the economy turns around, bolstering equity prices and spending for a while.
Moreover, as a number of you remarked, some of the important downside
risks to the staff forecast may not readily lend themselves to being incorporated
as an influence on the current stance of policy. Stock price misvaluations could
last a long time, and in the interim policy that adjusted out of concern about the
effects of a future sharp drop in prices will have been promoting suboptimal
economic outcomes. And, in the case of equity prices, easing a little now to
protect against a future major decline might only feed the current perceived
disequilibrium. The possible effect of a second major downside risk--another
terrorist attack--would also be equally difficult to build into policy today, given
the wide range of possibilities. Altogether, the Committee may see the practical
policy risks around a central tendency forecast as much more balanced than at
your previous several meetings, supporting the argument to hold rates unchanged
at this meeting.
However, although the outlook seems to have stabilized and the risks around
the forecast seem to have become better balanced, the recent data are preliminary
and tentative. And, as yet, they are inconclusive as to whether a reasonably
strong and prompt rebound is in process or the economy is likely to remain weak
for some time and the recovery delayed and tepid. Economic activity continues
to contract, and, while the current stance of policy means that the Committee will
need to stop easing well before growth picks up substantially, you might want
some greater assurance that a turnaround is in process before pausing. If so, you
should consider easing policy slightly further at this meeting.
Moreover, the Greenbook forecast, itself, may not point to an entirely
satisfactory economic outcome. In that forecast, with the federal funds rate at its
current level through 2002, growth is not strong enough next year or the year
after to cut very substantially into the excess margin of underutilized resources

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that is coming to prevail. Persisting excess production capacity and relatively
modest profit growth hold back the upswing in investment and repress
consumption growth by weighing on equity prices. These forces of restraint
erode only gradually, and to promote recovery they must be countered by
maintaining an accommodative stance of policy for some time. The perfect
foresight simulation in the Bluebook showed that, with inflation already low and
likely to decline further in the staff forecast, policy can be eased even further to
promote a more vigorous recovery, without sacrificing the Committee’s longerrun price stability objective. And, as Dave pointed out, the staff forecast is not
without its major downside risks, in addition to those posed by a sharp correction
in equity markets and another terrorist incident--notably the potential influence
of increases in unemployment on consumer confidence and spending and the
possibility that fiscal stimulus could be considerably smaller than assumed.
Easing policy today by 1/4 point might have little immediate effect on financial
asset prices, as it is fully anticipated by the markets. But it would encourage and
give greater scope for a later downward adjustment of long-term interest rates
and, hence, support for asset prices and spending, as investors confront the
disappointing reality embodied in the staff forecast--or something even weaker.
Even if you suspect that the staff may be unduly pessimistic about demand
and activity next year, you might still favor an easing at this meeting. Such an
action could be seen as providing greater protection against the possibility that
the economy could remain weak for a while or that the upturn could turn out to
be insufficient, without incurring much inflationary risk. To be sure, the more
you ease, the sooner and by more you may have to tighten, and that reversal
could need to begin next year, especially if the economy does turn out to be more
vigorous than in the staff forecast. Such a pattern was another feature of the
“perfect foresight” model, and it is built into market expectations. But, if the
Committee is willing to stop easing when a turnaround is seen as more
definitive, and to tighten preemptively as strength becomes evident, the level of
resource utilization that seems likely to prevail, even under more optimistic
outlooks, should keep downward pressure on inflation for long enough to allow
such a policy reversal to forestall inflation pressures from emerging.
Financial market participants seem confident that you will carry it off,
judging from the combination of low inflation compensation and a sharp
turnaround in expected short-term interest rates after further easing today that is
built into the structure of interest rates. Such market confidence, itself, provides
a safety margin for the Committee, because it keeps inflation expectations
damped and raises real longer-term interest rates promptly in response to
surprisingly strong economic news. In effect, a further easing could be seen as
taking advantage of the credibility growing out of your past actions and good
inflation outcomes to provide a margin of protection against the possibility that,
at the current stance of policy, the economy will turn out to be weaker than is
consistent with fostering the Committee’s objectives of maximum employment
and stable prices.

12/11/01

Whichever policy you chose at this meeting, you might still see the risks to
achieving those long-term goals as tilted toward economic weakness for the
foreseeable future. Even if you thought that the economy might be stronger than
in the staff forecast, output is likely to grow more slowly than the rate of growth
of potential for a while and inflation should be moving lower. At some point, the
prospect of higher output gaps in the short run could be balanced by expectations
that growth will pick up sufficiently over a longer period to raise questions about
inflation pressures at the prevailing policy setting. But given the very tentative
nature of the indications of future economic recovery, that point would not seem
to have been reached yet.

CHAIRMAN GREENSPAN. I have a couple of questions about this “perfect foresight”
model. It’s an ideal way to make monetary policy, if we have a perfect foresight or even some
foresight! [Laughter] I’m just curious about it from a technical standpoint. With reference to the
model, there’s a sentence in the Bluebook that says, “The policymaker is assumed to view both the
output and inflation gaps with equal distaste, and the penalty on interest-rate changes was selected to
deliver policy predictions that make the funds rate about as volatile as it has been over the past ten
years.” I’m a little curious as to why that constraint in the forecast is required if the model fully
determines what the economy is going to do. It’s a fully deterministic model, but there has to be an
optimum path for short-term interest rates that does not require that sort of tradeoff. Why is it there?
MR. KOHN. If you didn’t have it there you would have some much sharper declines in
interest rates. It’s a tradeoff. By putting in that constraint you are deviating from the optimum
possible economic performance.
CHAIRMAN GREENSPAN. I understand that. Why do we want to? If in fact you’re
getting the sort of result that you find distasteful, are you not suggesting that the model may be at
fault, rather than the assumptions?
MR. KOHN. For one thing, if that constraint weren’t there we would be dealing with a zero
bound situation, given the staff forecast. That’s not a reason not to show it.

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CHAIRMAN GREENPAN. I think we all know what’s happening here. Let me see if I can
rephrase my question in defense of my position that the constraint undercuts part of the point of this
exercise. You have a set of fixed coefficients here. In any econometric model there is a rigidity that
probably does not exist in the real world, and there are second-order and third-order coefficients that
tend to stabilize instead of producing distinct, exact effects; they smooth everything out. And that I
presume is what you’re doing.
MR. STOCKTON. This experiment requires in essence the specification of the
policymaker’s preference function. If you’re telling us that you really don’t care about fluctuations in
interest rates, then this isn’t the optimal or perfect foresight policy for you. The reason that in some
sense the constraint is in there for this particular exercise is that one could infer from the data and your
past behavior some preference for limiting movements in interest rates. And this is a policy that is
predicated upon not just a constraint on movements in interest rates but also on some notion of what
your distaste is for output and inflation gaps.
CHAIRMAN GREENPAN. I think the issue is not about our feelings or our tastes; this is a
question of fact. If you have a perfect foresight model that is wholly deterministic, then any action
you take should exactly replicate what is going to happen in the real world. That’s the presumption.
But if you are putting additional constraints into the model, of necessity you must be overriding the
deterministic nature of the model because the model solves in the sense that you have as many
unknowns as you have basic inputs. Consequently, you’re over-determining the model on the basis of
judgments that essentially say that you don’t want an optimum conclusion or, which is more likely and
is obviously a fact of life, that the model itself is not a true replication of reality in all respects.
MR. REINHART. There are two aspects to what you said. The first is, yes, the model
represents an average behavior over the historical period that was estimated. That by itself smoothes

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the reaction of households and businesses to changes in financial market prices. It smoothes the
reaction in financial market prices to changes in behavior. Putting all that smooth behavior into the
model would, as your intuition suggests, allow short-term interest rates to move a lot in order to
stabilize the results. But the second aspect is the word “deterministic.” This really is a perfect
foresight path. It assumes that you know the whole future path of the outlook and you know what the
coefficients are precisely. If you just had uncertainty about the coefficients in the model, and
depending on which coefficients they were, you might attenuate; you might not react as strongly to
that news. So it is possible to construct an optimal path in the presence of uncertainty about both the
model and the shocks that, depending on the objective function, potentially will have the property of
moving the funds rate in the outlook period by less. The shorthand way of capturing that without
working out the very hard problem of specifying the uncertainty about the coefficients and the shocks
in the model is to say, well, find the solution under perfect foresight but put a penalty on movements
in interest rates.
CHAIRMAN GREENSPAN. I don’t want to pursue this at length here, but I do want to
determine precisely what you’re suggesting. It involves a very complex mathematical solution. You
just can’t say that smoothing creates this result and that the constraints that you’re imposing with
respect to the exercise, including equal taste-MS. MINEHAN. Distaste.
MR. REINHART. Equal distaste.
CHAIRMAN GREENSPAN. It’s equal distaste; that is the better term, which is a
mathematical term. The problem is that it’s a very useful concept if only we could apply it! And I’m
just trying to ferret that out, which gets me to the real question I wanted to ask. Granted that the
presumptions with respect to policy are what you stipulate, namely that in effect there’s equal distaste,

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that there’s an objective function endeavoring to limit volatility, and there’s a constraint, which is
really part of the model, that the federal funds rate has to be greater than zero. Assuming all of that,
how significant are the effects of alternate economic assumptions on the path of the federal funds rate?
Is this a model in which the input specifications for the economy, not the policy they are imposing,
create a very sensitive, fluctuating funds rate? Or are the policy restraints such and the nature of the
long-term structural outcome of the economy such that, almost independently of what some of the
input variables are in the economy, the path is essentially robust?
MR. KOHN. The model used for this is the same model used in the alternative simulations
in the Greenbook.
CHAIRMAN GREENSPAN. I assumed that, right.
MR. KOHN. So you do get a sense of how sensitive the economic outcomes are to different
policy assumptions. For example, the fiscal policy assumption that Governor Gramlich mentioned
produces a somewhat different outcome for the economy, and that would feed back through the policy
path. And importantly, because this is a perfect foresight model, even if you anticipate something
happening or not happening, say, out a year or two, that feeds back into your current policy stance.
CHAIRMAN GREENSPAN. That’s the reason why I’m raising it.
MR. KOHN. The Committee is assumed to choose a whole path for the federal funds rate
that minimizes the squared deviations of the output and inflation gaps at every point in time, taking
account of all the information you have way out into the future.
CHAIRMAN GREENSPAN. Yes. The reason I’m raising these issues is that I think this is
a very interesting, original addition to the various vehicles that we’re employing in making monetary
policy. And despite the presumption, which is obviously factually true, that all we ever set is the
funds rate for the next 15 minutes, there is nonetheless a path that we should have in the back of our

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minds. Granting all the weaknesses in this type of approach, it is conceptually the way we really
ought to be going about policy issues. It gets to the kinds of notions President Broaddus was raising in
earlier periods about the optimum inflation rate--where we should be, how we should get there, and
what is the path of the funds rate that stabilizes inflation and therefore presumably long-term real
growth. So I’m merely saying that this is a worthwhile endeavor to pursue. It’s just that I’m trying to
understand it.
MR. REINHART. Just to underscore what Don said in terms of the robustness of
alternatives, it really depends on the duration of the other alternatives. Some of the types of shocks in
the Greenbook alternatives, which are relatively temporary, don’t perturb this path all that much. But
one can imagine other types of shocks, including different assumptions about productivity growth, that
could displace the path by much more because you are choosing an entire path. And here comes our
part of the presumption of putting this in the Bluebook: We had to make an assumption about the
Committee’s long-term inflation goal. These simulations were constructed using the assumption that
it was 1 percent. But if you move that a bit, it will have marked consequences.
CHAIRMAN GREENSPAN. But the optimum long-term inflation goal should be
determined by the model if you believe the model. There is a level of inflation that maximizes longterm economic goals. It shouldn’t be an input to the model. President Poole.
MR. POOLE. I have a different subject to raise.
CHAIRMAN GREENSPAN. Okay, go ahead.
MR. POOLE. A very quick question: On page 8 of the Bluebook there is a statement to the
effect that investors currently believe that our decision at this meeting will include a balance of risks
weighted toward weakness. Is that conclusion from talking with people, from surveys, or is it
extracted from the fed funds futures market, or what?

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MR. KOHN. It’s from several surveys that show a universal expectation among economists
and market observers about the balance of risks. You can’t infer anything about the balance of risks
from financial prices per se. So it is survey based.
MR. REINHART. One, for instance, is the Money Market Services survey. In last Friday’s
survey, twenty out of twenty respondents said the balance of risks would be tilted toward weakness.
For the January meeting it was three out of twenty who thought it would go back to the neutral. By
the time you get to their expectations for the March meeting, it is half toward weakness and half
toward neutral.
MR. HOENIG. Don, let me see if I can ask a question on interest rate volatility. I observed
that after we moved the last time, futures funds rates actually went up.
MR. KOHN. I think the immediate reaction to our move was that the Eurodollar futures
rates went down by 10 to 15 basis points.
MR. HOENIG. Right.
MR. KOHN. And then there was the new information-MR. HOENIG. New information that brought it up, okay. But they are now higher.
Secondly, assuming that we have an easy policy now and also assuming that if we have an easy policy,
it would be better to have less volatility in interest rates than more volatility, are we not risking, by
moving the funds rate down, increasing the volatility of interest rates?
MR. KOHN. I think if you move down and then up, in some definitional sense that
increases the volatility of interest rates over the period of time. But I don’t think it necessarily would
increase the volatility of interest rates in the short run because moving down now is exactly what the
market expects. In some sense not moving would increase the short-run volatility of rates because you
would be doing something unexpected. That’s not necessarily good or bad. You ought to do what you

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think is the right thing to do. But I don’t see that an easing today would have a material effect on the
volatility of interest rates other than in the definitional sense that at some point next year or the year
after you’ll have to raise them again in order to further-MR. HOENIG. Raise them more than you otherwise would.
MR. KOHN. More than you otherwise would.
CHAIRMAN GREENSPAN. Further questions for Don? If not, let me get started.
Prior to September 11, I think there was clear evidence of stabilization in some sectors of
the economy. That pattern was broken decisively on September 11. Not only did the quite intense
forces that were causing deflation in asset prices and economic activity prior to September 11
subsequently gather momentum, but new forces of a similar nature began to press down quite
significantly on the economy. Frankly, that was one of the reasons why I was concerned that the
Greenbook forecast prepared for this meeting would be revised downward. I was delighted to find out
that I was wrong. And I suspect the reason I was wrong is that something is going on in the economy,
even in the world economy, that was not evident earlier, namely that we are seeing a greater
synchronousness of activity within this economy and worldwide. There is far greater synchronization,
for example, among the twelve Districts, among different types of companies and products, and
clearly among the world economies. That has generally been read as an indication that the world is
becoming more vulnerable to cumulative downturns because if every economy is moving in the same
direction, it becomes a self-feeding, self-reinforcing process that can induce volatility in the economic
system.
I suspect that that view has to be tempered at least in part. And I think the evidence we
have seen in the last couple of months, especially since September 11, is that to a large extent the
synchronousness in world economic activity is due to the availability of very substantially improved

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information. Thirty years ago we used to see companies and industries moving in quite different
directions. One of the reasons was that the information available to individual firms was distinctly
different because, unlike the situation today, a real-time data system that permits everyone to look at
the same database did not exist. What that means in today’s environment is that imbalances that
emerge can be more readily resolved, but the resolution can create contraction or expansion in
economic activity. If everyone is looking at the same data and is subject to somewhat the same
imbalances, we get synchronousness, but it is not a synchronousness that is necessarily selfcumulating on the downside.
One can very readily argue that the evidence of the last two months is indeed a fascinating
test of whether the latter is the case. If there ever were a situation in which the fabric of confidence
was going to be breached throughout the business and consumer sectors, September 11 would have
done that. Indeed, for a couple of days the economy came to a very dramatic halt. What we are now
observing, however, is not cumulative weakening but the emergence of mixed signs in the economy.
We’re seeing some evidence of stabilization, and the question is basically whether we are looking at
the emergence of forces that are engendering not only stabilization but an actual recovery from here.
The markets are obviously saying yes. The stock market is difficult to understand, especially in terms
of what we know about earnings, and the bond market is even more difficult to understand. But there
are well-informed people in those markets who are trying to maximize their asset positions. So it’s not
a roulette game out there.
If the very considerable and continuing overhang of deflationary forces, which we discussed
at considerable length at the last meeting, is still there--and all of the evidence suggests to me at least
that it is--then the question is what is going to reverse this contraction in economic activity. Well, one
of the elements that have been discussed around the table is the inventory situation. And indeed the

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inventory numbers are simply awesome. My recollection is that October motor vehicle inventories
went down at an annual rate of $100 billion on a national income and product accounting basis. We’re
seeing very significant liquidations, which essentially means that as soon as final demand stabilizes,
days’ supply in an operational sense will go down very rapidly. When that occurs, business firms will
suddenly start to find themselves short, and orders will turn up. Well, we are not quite there yet, but
we are getting a few very early signals of some firming of demand. They are occurring mainly in the
commodity markets, which tend to be reflective, especially the metals, of the base of the durable
goods economy, the most volatile and inventory-laden part of the economy. Prices are beginning to
move up in commodities markets, suggesting that demand is beginning to pick up there because
inventory liquidation has probably reached a maximum. That means that the rate of production will
start to rise relative to the rate of consumption of materials and products.
That inventories may now be closer to the point where firms will start to taper off the rate of
liquidation is evidenced by the responses to the National Association of Purchasing Managers question
on customer inventory positions. Since by definition all inventories are manufactured goods, the
people who know what’s happening are those who sell such goods. So, the purchasing managers of
manufacturing or industrial concerns are in the best position to get a sense of the current status of
inventories. A full survey of all those who actually hold inventories is a very difficult undertaking, the
data collection process is lengthy, and when such a survey has been tried the results have not been
satisfactory. This survey, which is relatively new, seems to be capturing a goodly part of what is
going on in the marketplace.
Contrary to what outside estimators are suggesting with regard to the industrial production
index for the month of October, we are beginning to see a very dramatic slowing in the rate of decline.
The reason we are seeing a smaller negative than the markets is that there is a lot more current

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productivity growth--or more exactly growth in output per hour--in the manufacturing area than
outside observers are assuming. That slower rate of decline is also reflected in the very rough weekly
series that’s supposed to replicate the industrial production index; it shows that most of the decline in
October occurred in the first two weeks of the month. Production started to come back in the last half
of October, but it couldn’t come back enough to prevent the average for November from being below
the average for October. These figures, if we can believe them, essentially are saying that the level at
the end of November is above the average level for November or at worst about equal to it. That
would suggest that production levels are beginning to support a reduction in inventory liquidation.
If this is indeed happening, then final demand clearly is where the uncertainties are. The
crucial sector is personal consumption expenditures where there are a number of forces at play. One is
motor vehicle sales, which have been startlingly high in October and November and in fact have been
engendering a good part of the liquidation in inventories for that part of the economy. However, as
best we can judge, motor vehicle sales slumped very sharply in the first 10 days of December. They
were really quite weak, and one would assume that they were close to the average level projected in
the Greenbook for the month of December; but they seemingly are on the way down. So motor
vehicles no longer seem to be a positive force.
Another positive force that has been removed stems from the rise in mortgage interest rates.
They obviously are up quite significantly. Indeed, the 10-year Treasury yield, which usually is a good
proxy for mortgage rates, has gone up almost a full percentage point. And as best I can gather, that’s
pretty much what has happened to mortgage rates. Low mortgage rates have been a key factor in the
turnover of existing homes from which realized capital gains are engendered. And since those realized
capital gains are a major part of the extraction of home equity for consumption purposes, one would
assume that higher mortgage rates will foster some weakness in existing home sales and, indirectly,

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some weakness in consumption expenditures. It is certainly the case that the cash-outs in refinancings
mentioned earlier also would be affected, largely because the absolute level of refinancings is already
declining significantly, and there is no evidence that the cash-out proportions have changed enough to
offset that. So we are beginning to see some softening after a prolonged period when the extraction of
funds from home equity has fostered consumption expenditures.
On the positive side, obviously, we’ve seen a significant decline in the prices of fuel oil and
gasoline. The effects can be quite substantial, as a number of you have indicated. But remember that
these are one-shot effects and that in order for those effects to continue we have to get still further
declines in crude oil or natural gas prices. That’s not likely to happen, but it is certainly the case that
we are now getting the full impact of the declines. What we used to call an oil tax cut probably exerts
its effects with very little lag. It has been a major factor in the markets and it may well be a factor
holding up Christmas sales. But we don’t know that quite yet.
The major uncertain negative is the further rise in the unemployment rate. I am not
referring primarily to its eventual level because if the rate went to a higher level and adjusted there, the
markets would also adjust and we would pretty well know what consumption expenditures were
associated with that level of unemployment. But when the rate of change is as great as it has been in
recent months, and when the rate of layoffs is as high as it has been, we are getting a whole new set of
consumers that are shocked by uncertainty. The impact on consumption is indeterminate at this stage.
The sign is pretty clear. It has to be negative but we don’t know how negative. So at this point we’re
not clear as to how to view this weakening employment situation or we shouldn’t be clear because I
don’t think there is any way in which we can know.
Fortunately, homebuilding per se has been holding up, and while the rise in mortgage rates
may trim it some, the weather clearly has been positive in the areas where the major population centers

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are located. As a consequence, weather is likely to give us somewhat better residential construction
activity in the period ahead, and I presume that’s also the case for some areas of nonresidential
construction.
How the combination of final demand balances against the issue of inventory liquidation
probably comes down at the end of the day to capital investment, as a number of you mentioned. And
capital investment gets down to corporate cash flow. Here I think the uncertainty relating to the
ongoing deflationary pressures is still very formidable. While we have had much better output per
hour than we anticipated for this particular period and presumably wage increases and general worker
compensation are decelerating, the ability of firms to pass through increasing costs is virtually
nonexistent. This is another way of measuring the extent of the deflationary forces that are pressing
on the economy. The evidence we have, both anecdotal and otherwise, is that it is very difficult to
pass on cost increases to customers. Profit margins have come down very sharply. Indeed, if we look
strictly at the nonfinancial, nonenergy corporate sector, profits are down to levels that are as low as I
remember them and the inability to raise prices is really crippling cash flows. What that suggests is
that the outlook for profitability is very important to the general outlook and that’s where final demand
is going to be financed.
It’s certainly the case that security analysts, as I have mentioned to you previously, are not
terribly good as forecasters but they are not bad as reporters. And they are reporting that the high-tech
earnings outlook has stabilized in the last three or four weeks. The non-high-tech area, however,
continues to deteriorate though at a lesser pace than it was. This clearly is a pattern of earnings
expectations that is inconsistent with what stock prices are doing if one believes current standard
capital asset valuation models. But as Dave Stockton pointed out, it may very well be that the markets
are displaying increased flexibility and that the ability of this economy to recover will differ from what

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it was in the past. Analysts and stock purchasers may be looking beyond the current squeeze in profit
expectations to a much better longer-term outlook and may perceive that the increased flexibility of
the markets may itself enable lower equity premiums and the obverse higher price/earnings ratios to
persist in the marketplace. But how all that will come out clearly relates to the outlook for capital
investment. At this stage I would say it is just too early to make a judgment.
When we get to policy, it’s pretty evident to me that the case for standing pat at this point
requires that the stock market remain overvalued for a protracted period of time. Now, that’s not an
inconceivable event. It may be, as Dave says, not an overvaluation but possibly a new way of looking
at the market. You didn’t say exactly that, Dave; I’m just interpreting what you said in a somewhat
different manner. Or it may be, as often happens, that the markets stay overvalued or undervalued for
protracted periods of time. If that’s the case, it is conceivable that the earnings outlook could stabilize,
perhaps even improve, in which case capital investment can stabilize and consumption may still do
well on the presumption that long-term mortgage rates do not keep going up and create additional
problems. But it is a credible position.
I would only argue that the risk of doing nothing is too high because I think that the playout of deflationary forces, at least looking at profit expectations, is not anywhere near complete. It
may have an extended period to go; we don’t know that. But so long as that is the case, I think we
would probably be wise to move the funds rate down another 25 basis points, as the market expects,
and retain the statement that suggests that weakness is the most likely risk in the outlook. I don’t deny
that our history--that is, the Federal Reserve’s history--is one in which we’ve typically moved at least
once more often than we probably should have on both ends of the cycle. I’m not sure that’s all bad.
First of all, we’re not absolutely certain that had we not moved we would have gotten the outcome that
we are looking at in retrospect. But we’re always dealing with uncertainties and unknowns and we’re

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always tacking away from one place or the other. If I knew for certain that the economy was going to
be moving up in the second half of 2002 as in the Greenbook, I would say it would be a grave mistake
at this point to move the rate down. I don’t know that and I don’t think anybody can know that. As a
consequence, I think that the least risky action is to reduce the rate because, as I’ve said in the past,
one way of looking at these types of situations is to ask ourselves what are the consequences if we are
wrong. And in this case I would suggest that if we move the rate down 25 basis points and that turns
out to be wrong, I cannot conceive of the deflationary forces moving away sufficiently quickly to
prevent us from moving the rate back up well before inflationary pressures rise. If on the other hand
we stand pat and these deflationary forces are larger than we expect, we’ll look back and find that
standing pat was a mistake. I know it’s a close call and I don’t want to argue that this is a closed issue.
I do think that the weight of the evidence at this stage suggests that the best solution is in fact to move
down 25 basis points and stay asymmetric to the downside. Vice Chair.
VICE CHAIRMAN MCDONOUGH. I concur with your recommendation, Mr. Chairman.
CHAIRMAN GREENSPAN. President Poole.
MR. POOLE. Mr. Chairman, I support your recommendation but I do want to express a
little uneasiness about the balance of risks statement. Let me explain. I ask myself the question:
What difference does that sentence make? It’s clear that the downward move of 25 basis points is
built into the markets. And in my view long-term rates are going to go wherever they go, but this is not
going to affect their direction in coming weeks. I think our task at this point is to start an orderly
process toward a changed policy stance. That is, we seem to be close to a turning point in the
economy. And what we would not want is a situation in which the market believes for some reason
that we are pretty committed to additional cuts in the future even though the data might start to come
in rather convincingly in the other direction. So that’s my concern about the balance of risks. In other

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words, the message that I personally would like to send--to put some probabilities on it--is that there
may be a two-thirds chance that we will not change the funds rate at the next meeting and a one-third
chance, if the data continue to come in weak, that we will reduce rates another time. What I would not
like to do is to create an impression that we believe there’s a high probability that we will be cutting
rates again at the next meeting. That’s my concern about the balance of risks statement.
CHAIRMAN GREENSPAN. I agree with that and I think there are two ways to handle that
problem. One is in the balance of risks statement and the other is in the full press statement that we
make. I would much prefer to put something in the full statement itself that recognizes that the
situation has changed from an unmitigated set of negative forces to a more mixed environment now. I
would prefer to do it that way because, as far as I’m concerned, it’s too abrupt an adjustment to change
to a balance of risks statement that says it is just as likely that at the next meeting we will raise rates as
lower them. I just don’t think that’s credible. But it’s certainly credible--in fact I agree with your
probabilities that the chances are probably two to one--that we will not be changing the funds rate at
our next meeting.
VICE CHAIRMAN MCDONOUGH. Mr. Chairman, the reduced size of the rate decrease,
from 50 basis points several times in succession to 25 basis points, will in and of itself send the kind of
signal that I think we’re looking for. That’s part of the message that comes from reducing the size of
the cut.
CHAIRMAN GREENSPAN. President Parry.
MR. PARRY. Mr. Chairman, it seems fairly likely to me that economic recovery would
occur next year without any further easing of monetary policy. However, that outcome is vulnerable
to a number of negative shocks that could hit the economy at any time. With inflation well in hand
and Federal Reserve credibility in good shape, I believe we have the flexibility to respond to these

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risks. Therefore, I strongly support your recommendation of a 25 basis point reduction in the funds
rate as some insurance against downside risks. I also prefer a balance of risk statement that
emphasizes economic weakness.
CHAIRMAN GREENSPAN. Governor Ferguson.
MR. FERGUSON. Thank you, Mr. Chairman. I support your recommendation and would
like to associate myself with President Parry’s view. The reason I support it is in large part because of
the uncertainty about how to interpret the incoming data and the outlook. In those circumstances, as
he suggested, insurance is probably a good thing to have.
CHAIRMAN GREENSPAN. President Broaddus.
MR. BROADDUS. Mr. Chairman, let me make a couple of comments that may make your
recommendation look a little more moderate and restrained. [Laughter] There are certainly some
differences in the situation we face today from the one we were looking at when we met last month.
But I think there are a lot of similarities as well. At the November meeting I favored a 50 basis point
reduction in the funds rate, which we eventually did, and I favored it very strongly and categorically.
There were primarily two factors that conditioned my thinking. First, I didn’t see any evidence of
either inflation or rising inflation expectations anywhere. And second, given our high credibility, I
thought we would have time to reverse course, if we needed to, and move the rate back up. After all,
we did that in 1999, so we have had at least one recent experience when we were able to pull that off.
Given these two preconditions, I thought we ought to use some of our credibility to ease policy
aggressively and to reduce the risk that disinflation might undercut the stimulative impact of the
reductions in the nominal funds rate we had engineered. I think those two preconditions are still in
place and in my view the policy risks today are much the same as those we faced last month.

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What I think we need to do above all is to avoid getting into a situation where inflation
expectations are quite low and we have the nominal funds rate close to zero. That’s the so-called zero
bound problem. It’s very difficult to get out of that, as I think we know. We don’t want to go there.
As we discussed earlier in the meeting, inflation expectations in the Michigan survey have dropped
quite abruptly over the last several months as a whole. So I think that risk of a zero bound problem is
still with us. For that reason I believe a persuasive case can still be made for another 50 basis point
reduction today, using the current core PCE rate, which is about 1-1/2 percent, as our measure of
inflation. That would take the real funds rate down roughly to zero. Now, granted, we’ve gotten into
difficulty in the longer-term past when we have pushed the real rate below zero--and this was
especially evident in the 1970s. We took the real funds rate to zero in 1992--which is where a 50 basis
point reduction today would put it--and we did not get a subsequent increase in inflation. So I still
think the case is persuasive and in my view a 50 basis point cut is the best option. I recognize though
that the tone of the economic data is a bit stronger in some respects and in some places this time.
Therefore the argument for a half point is a little less compelling today than it was last time. But if it
were my choice, I think that is the way I would go.
CHAIRMAN GREENSPAN. President Moskow.
MR. MOSKOW. Mr. Chairman, I agree with the recommendation for a 25 basis point
reduction in the rate. In my view it’s appropriate this time because I think it will help to underpin the
consumer while the inventory cycle completes itself and corporate profits and capital spending slowly
return to more normal levels. I also believe that the balance of risks should be toward weaker
economic growth. And I strongly support the idea of putting a signal in the wording of the press
statement to the effect that the situation is not as bleak as we saw it last time. I don’t want to
encourage people to think that we continue to see only negative news on all fronts.

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CHAIRMAN GREENSPAN. President Stern.
MR. STERN. Thank you, Mr. Chairman. I would prefer to leave policy unchanged today.
Let me quickly sketch out the elements of my reasoning. Part of it I touched on earlier. I do think that
the story in the mainstream Greenbook forecast is a reasonably convincing one and I’m certainly more
confident about the outlook than I have been for the past several meetings. Is it a done deal? Of
course not, but that I think is too high a bar. We’re not going to know that for quite some time. It
does seem to me that the recent spate of data suggests that the economy is stabilizing. Not only do the
data suggest that but a lot of market participants are expecting that, based on the way financial assets
are being priced. And at least in my view our economy has a history of being resilient and largely
self-correcting. Beyond that, I think policy has been very expansionary. I’m not talking just about
aggressive reductions in interest rates, although we have done that. We have also had very rapid
growth in the monetary aggregates and it would be a shock to me if we got deflation, given the kind of
growth we've had in money for some time now. I don’t know how fiscal policy will play out, but I
would guess that we will get some added fiscal stimulus. And while it’s certainly true that if this
further reduction in rates turns out to be a mistake we can reverse direction when needed, it’s possibly
destabilizing--though I don’t want to overstate this--to embark on that kind of policy path. So for that
combination of reasons, recognizing that perhaps no one of them is convincing by itself, I would
prefer to stay where we are.
CHAIRMAN GREENSPAN. Governor Meyer.
MR. MEYER. Thank you, Mr. Chairman. I support your recommendation. While I
support a statement of unbalanced risks toward weakness, I also believe that the Committee should
avoid encouraging an expectation of further easing at the next meeting. Given my recent experience
in communicating with the markets, I’m not giving any advice on how to do so! [Laughter] I will

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view with great interest the statement this time, as it tantalizes us with a possible way of
accomplishing that goal.
I’m very pleased to see that the Committee will continue its practice of using its two-day
meetings as an opportunity to have a wider discussion of key issues related to the strategy of monetary
policy. Because this is my last FOMC meeting I will not have an opportunity to participate in these
discussions or even to make suggestions for the agenda. So I thought I’d take this opportunity to
unveil some recommendations--in this case for improving the transparency of monetary policy--in the
hope that the Committee might find it worthwhile to discuss this topic in the future. Let me also note
the excellent contribution to this topic from the recent conference at the Federal Reserve Bank of
Philadelphia.
Transparency means, in my view, revealing to the public both the objectives that drive the
policy decisions and the rationale for specific policy decisions. I see greater transparency as serving
both to enhance the accountability of the Fed and to increase the effectiveness of monetary policy by
improving the market’s ability to anticipate future policy actions. In terms of transparency about
objectives, I would urge the Committee to discuss again and to consider further setting an explicit
numerical value on its long-run price stability objective. I stated my case on this recommendation in a
paper earlier this year, so I’ll focus today on recommendations related to the minutes and the role that
document plays in conveying the FOMC forecast.
The Committee’s press statements have become briefer and more repetitious this year and in
my view less revealing. Moreover, some Committee members have expressed a preference for
moving further in this direction. To be sure, it is a challenge to have more than a very brief statement
and still represent the consensus of the Committee. In any case, as a consequence the minutes have
become a more important vehicle for revealing the Committee’s views on the outlook and policy

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options. The minutes serve to illuminate the rationale of the recent action and in addition they
recognize the diversity of views on the Committee.
The first change I would recommend is either to eliminate the discussion of recent
indicators at the beginning of the minutes or to move it to an appendix at the end. This discussion is
presented on page one, I presume, to set the context for the meeting, not to describe what we
discussed. As it is today, it is the first substantial section in the minutes. To my mind at least it numbs
the reader [laughter] and may even distract those who continue on and remain for the summary of the
Committee’s discussion that follows.
I had thought about recommending that the next section, which is the paragraph that
summarizes the staff forecast, be expanded maybe to a full page. In the end, after some quite
interesting and constructive discussion with the staff, I decided not to recommend this course of action
out of concern that moving in this direction might interfere with the freedom the staff currently
perceives in putting together its forecast. At the margin though, it still might be useful to expand the
paragraph a little to better tell a coherent story about what underlies the staff forecast. Furthermore,
particularly to the extent that the Committee’s press announcement on the policy decision becomes
less revealing, it would in my judgment be constructive to speed the release of the minutes--perhaps to
the third Thursday following the meeting, or just over two weeks after the meeting.
My next set of recommendations relates to the FOMC members’ own forecasts, now
revealed twice a year in the testimony and report on monetary policy. My first concern is that these
forecasts may not be developed as advertised. That is, the forecast is supposed to reflect appropriate
monetary policy from the perspective of each member. This is a very weighty assignment, especially
if the forecast extends out beyond a year--perhaps similar to the perfect foresight policy in the
Bluebook this time. It might be helpful, therefore, if the Bluebook included such a forecast based on

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perfect foresight in the policy-related material. I think the Committee members might want to discuss
whether they’re preparing the forecast under this type of model and if not, whether and how to do so.
Second, these forecasts in my view should always cover a period of at least one and a half to
two years. In particular, the forecast prepared each January now extends only to the end of that year,
while the forecast prepared in June extends one and a half years. The January forecast in my view
should be extended to the end of the following year, a two-year period. Now, I appreciate that this
recommendation was considered and rejected in 1994. Some members of the Committee were
concerned at that time that such an extension could allow the public to infer the Committee’s
objectives! Should I repeat that? To my mind, this is an advantage. Publishing an extended forecast
might require more discussion by the Chairman at his monetary policy testimonies and perhaps by
other Committee members. That’s what transparency is all about.
Third, the ability of the forecast to serve as a rationale for the Committee’s decisions is
limited today because the Committee does not reveal the assumptions underlying its consensus
forecast and in particular the funds rate path. I understand that this is especially radical, but I would
encourage the Committee to consider revealing the central tendency of the funds rate path that
underlies its consensus forecast. I’d also suggest perhaps looking for other ways to reveal the key
assumptions underlying that forecast.
Finally, I’d encourage the Committee to consider increasing the frequency of such forecasts
from twice a year to four times a year. This forecast provides a rationale for the Committee’s
decision. And it is more important in this respect because of the absence of a full statement that
otherwise provides that rationale. Just as a picture might be worth a thousand words, so might that be
said of a forecast.

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Let me conclude by repeating what I said during my very first meeting in June 1996. This
has been even more fun than I expected it to be! It has been a privilege to serve on this Committee.
I’m certainly fortunate to have served during a time that has been so interesting and challenging. I’m
fortunate to have served on this Committee under the leadership of Alan Greenspan and with all of
you. I’m fortunate also to have had the exceptional support of the staff, as I wrestled with the outlook
and tried to make contributions to the policy discussion.
CHAIRMAN GREENSPAN. We will obviously be considering your notions and I’ll
appoint two or three people to be the proxy for you. It’s going to require two or three people to do
that! [Laughter] In any case, I’m sure that in the weeks ahead there will be a lot of statements about
your contributions to this Committee. But I doubt that any of us has to say very much. I think we’re
all acutely aware of your accomplishments. [Applause] Governor Gramlich.
MR. GRAMLICH. I didn’t necessarily want to follow in this order! Let me first say a
word to my good friend, Larry Meyer. I don’t always agree with him, but he always makes us think.
And I believe he has done that today. I’m frankly a little too tired to think about disclosure and
transparency at this particular moment, but I agree that perhaps we ought to consider that issue again.
However, I would say that lately the Fed seems to me to have been very well understood by markets.
When a data series comes out, everyone says here is what the Fed thinks about that and they’re usually
not far wrong. So I think somehow or other we are communicating fairly well already. That’s not to
say we can’t do more, but I don’t think communication is a huge problem at this point.
Now, back to the Chairman’s recommendation. I agree with going down 1/4 point and with
continuing the bias toward weakness. I think that’s about the right policy in level terms. As I’ve said
many times over the year, I’m not too worried about the reversibility issue. If we have to, we can do
it. We have done it. Also, in line with what Bill Poole said, this small step paves the way for an

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orderly repositioning of policy, which I think all of us want to do. The final thing I would say about
the policy recommendation is that, if I’m not mistaken, going down 1/4 point today would be
following exactly the strategy built into the Bluebook forecast in which the staff imputed the so-called
perfect foresight policy. I think it would be pretty close to the way they’ve got us in their equation.
Thank you.
CHAIRMAN GREENSPAN. President Minehan.
MS. MINEHAN. Thank you, Mr. Chairman. Hopefully we don’t all have to comment on
transparency because I’m not going to! I am in agreement with your recommendation. Given the hard
time I had with the 50 basis point reduction last time, some might ask how I could be and, frankly, on
the case for standing pat I think President Stern has some good arguments. But as I view the data that
have come out since the last meeting, there are not only glimmers of a turnaround but some enhanced
downside risks as well. I thought you covered them well in your statement: the trajectory of the
unemployment rate, the euphoria in the stock market, the potential for no fiscal policy or one that’s not
effective in any way like what is in our forecast, downturns in corporate profits, and so forth. So I see
some new risks here. I agree with the statement that the risks are biased to the downside, certainly
over the near term. So with that logic, I come down on the side of a 25 basis point decline in rates as
you have suggested. In some ways I think it is a measure of insurance and in fact I’m hopeful that it
is. I’m also hopeful that the positives we’re now seeing do turn out to outweigh the potential for
negative developments and that the next time we meet policy will be stable and the risks will be
balanced.
CHAIRMAN GREENSPAN. President Guynn.
MR. GUYNN. Mr. Chairman, I can accept your recommendation, but I have a preference
for no change at today’s meeting. I would like to associate myself with President Stern’s comments.

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It seems to me that after eleven months of very aggressive front-loaded easing and having been in an
accommodative stance for some time now--the degree of which we could argue about--we have the
latitude to pause today. That’s not to say we can declare victory but I think we ought to pause and see
how things play out. People around the table have made the point that we’re very likely to see some
more ugly data over the next couple of months or next couple of quarters. But I would argue that there
is some considerable value in signaling several things. One is that we are seeing some first signs--I
underscore first--of stabilization and that many of the further adjustments that still need to be made are
not particularly interest rate sensitive. And finally, having done what we can to cushion the slowdown
over the cycle, we can send the message that we have gotten back to--in fact have never gotten away
from--a focus on the optimum long-term policy. Perhaps the statement that you have crafted will
achieve much of that, but I think there is some significant value today in making some of those points
to the people who watch what we do. Thank you, Mr. Chairman.
CHAIRMAN GREENSPAN. President Santomero.
MR. SANTOMERO. I support your recommendation, Mr. Chairman. The recovery
appears to be on track or at least visible in the distance. As you point out, the timing and magnitude of
the recovery depend on consumer spending, which is still uncertain. And to counter the risk
associated with that, I support further easing. I also support leaving the risk statement weighted
toward economic weakness at least at this time. But I also feel that the wording of the press
announcement is particularly important this time, so I look forward to seeing the craftsmanship.
CHAIRMAN GREENSPAN. I’m glad it’s short! [Laughter] President Jordan.
MR. JORDAN. I agree with the views stated by Gary Stern.
CHAIRMAN GREENSPAN. President Hoenig.

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MR. HOENIG. Mr. Chairman, I really think we ought to stay where we are. A 2 percent
fed funds rate is stimulative. We’ve cut the rate 450 basis points this year, which is very aggressive
for us, and 150 basis points of that has been done since September 11th. We are seeing some signs of
improvement and not all of the stimulus has come into play yet. While I recognize that inflation is not
an immediate issue, and I appreciate that, I still think we need to take a little longer-run view at this
time. So, I have to say I agree with Gary Stern’s comments.
CHAIRMAN GREENSPAN. President McTeer.
MR. MCTEER. I can support your recommendation, although I’d like to associate myself
with the comments of Gary, Jerry, Jack, and Tom. I think this would have been a good time to pause
and no real harm would have come from it. It seems to me that it would be a good time to signal to
the markets that they can’t get a cut every time they build one into the fed funds futures. On the risk
statement, since we put it out we have to say that the risks are biased toward the downside because
they clearly are. Nevertheless, I continue to feel that having such a risk statement at every meeting is
not serving us all that well because I think it’s almost always interpreted as one more easing move to
go. So, eventually I think we ought to take another look at that practice. One additional way we
might signal that we’re winding down other than the language of the statement and the fact that the cut
is 25 rather than 50 basis points, is to consider not reducing the discount rate.
CHAIRMAN GREENSPAN. I might note that in fact that issue did come up and the
general consensus, at least among the staff, is that it probably would create more uncertainty than
otherwise. But it’s an interesting idea.
MR. MCTEER. Well, I’ve suggested it at the last two meetings as well.
CHAIRMAN GREENSPAN. I’m aware of that.

12/11/01

MR. MCTEER. It seems to me that our long-run plan is to reverse the positioning of those
two rates and that we’re missing a good opportunity to get a head start on doing that.
CHAIRMAN GREENSPAN. Governor Bies.
MS. BIES. I support the recommendation, but I do also support the comments that other
people have made about beginning to signal that this may be one of our last easing actions.
CHAIRMAN GREENSPAN. Governor Olson.
MR. OLSON. I support the recommendation.
CHAIRMAN GREENSPAN. Will you read the directive wording?
MR. BERNARD. The directive wording is on page 14 of the Bluebook: “The Federal
Open Market Committee seeks monetary and financial conditions that will foster price stability and
promote sustainable growth in output. To further its long-run objectives, the Committee in the
immediate future seeks conditions in reserve markets consistent with reducing the federal funds rate to
an average of around 1-3/4 percent.” And the statement for the press release that goes with that reads:
“Against the background of its long-run goals of price stability and sustainable economic growth and
of the information currently available, the Committee believes that the risks continue to be weighted
mainly toward conditions that may generate economic weakness in the foreseeable future.”
CHAIRMAN GREENSPAN. Call the roll.
MR. BERNARD.
Chairman Greenspan
Vice Chairman McDonough
Governor Bies
Governor Ferguson
Governor Gramlich
President Hoenig
Governor Meyer
President Minehan
President Moskow
Governor Olson

Yes
Yes
Yes
Yes
Yes
No
Yes
Yes
Yes
Yes

12/11/01

President Poole

Yes

CHAIRMAN GREENSPAN. I’d like to ask that this Committee go into recess and that the
Board of Governors congregate next door where we will address the issue of discount rate requests by
the Reserve Banks. I hope that while we are doing that, the preliminary statement will be distributed
to everybody.
[Recess]
CHAIRMAN GREENSPAN. The FOMC meeting is now back in session. The Board of
Governors, much to everybody’s surprise, voted as was contemplated in the first paragraph of the draft
press release. Has everyone had a chance to read that statement? Are there comments or suggested
alterations?
VICE CHAIRMAN MCDONOUGH. The statement captures it just fine. It’s good.
CHAIRMAN GREENSPAN. I tried to capture what I thought would be the center of the
Committee’s views. If there are no objections, we will consider this the statement of the Committee.
I’d like to remind you all that our next meeting is a multiple-day meeting, to be held on
Tuesday and Wednesday, January 29th and 30th. We can go to lunch. We have as our guest a
prominent Treasury Department official whose name I won’t mention until he arrives.
END OF MEETING

Full text of Federal Open Market Committee Meeting Minutes, Transcripts, and Other Documents : Meeting, December 11, 2001 : Transcript

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